Tuesday, January 10, 2012

John Bogle: America's Financial System - Powerful but Flawed

From this lecture by John Bogle late last year:

America's Financial System - Powerful but Flawed

Classical economics has tended to make a distinction between the real economy—the production and consumption of goods and services—and the paper economy—the vast network of financial assets and liabilities that is, finally, supported by the productive economy. The fact is that our productive economy and our financial economy are closely, indeed inextricably, interlinked.

The principal role of our nation's financial institutions is to allocate scarce investment capital among our corporations and economic sectors in a way that maximizes the growth potential of our economy. But changes in our financial sector have undermined this goal. Most notable among those changes are: first, the growing dominance of agents (giant banks and investment banks, and institutional money managers) as stock owners over principals (individual investors); and second, the ascendance of short-term speculation over long-term investment, focused on the illusion represented by the momentary precision of stock prices rather than the reality represented by intrinsic value—simply put, the discounted value of future cash flows. Both of these major changes in how we invest have played a critical role in creating a dysfunctional and expensive financial system, and in turn have ill-served our real economy.

The downside of a dominance of agents over principals? Some excerpts from this interview last year with John Bogle:

...agency dominance is never going away. The problem is if you're an agent and you're not investing your own money, you've got a lot of other things to keep you going. Adam Smith has a saying "Managers of other people's money [rarely] watch over it with the same anxious vigilance with which… they watch over their own."

The focus in the mutual fund business and in the pension business is on short-term performance. It's absolutely idiotic but it is not going to change.

In Bogle's view, we've traded an ownership society for a failed agency society. Later in the interview, Bogle added...

I'm afraid we've got to be satisfied with incremental changes that come down to investors and pension fund managers acting more intelligently. If we did have a fiduciary duty for institutional money managers, it would force the corporations that they control in today's agency system to honor the fiduciary duty to their clients.

Bogle thinks that out of this failed agency society needs to emerge a robust fiduciary society.

So, out of the ashes of our old ownership society and our failed agency society we must develop a new fiduciary society... - From "Building a Fiduciary Society" on Page 11 of America's Financial System - Powerful but Flawed

Now, what about the downside of what Bogle, in the lecture, calls "the ascendance of short-term speculation over long-term investment"?

Wall Street is raising capital for industry, as it always has, in reasonable amounts considering the needs of the corporations. The problem is that primary capital formation or capital allocation — call it whatever you want — it has been totally overshadowed by all this speculation in the secondary markets.

So, in Bogle's view, what's the result?

...speculators don't give a damn about corporate governance. They don't give a damn about executive compensation. They don't give a damn about anything except the price of the company's stock, which is basically a momentary illusion.

In the interview, Bogle refers to the "Wall Street Rule" which essentially is if you don’t like the management, sell the stock. Sounds like a perfectly reasonable practice until you realize how that view of the world might contribute to the so-called agency problem*.

Who has a better likelihood of influencing important changes at the board level to improve corporate performance?

A system where institutional money managers are held accountable to a strong fiduciary duty requirement (the duty to make sure management and the board of companies they own shares in are putting shareholders' interests first) or those that operate under something akin to the "Wall Street Rule"?

Long-term investors or speculators?

A system dominated by relatively short-term oriented agents that live by things like the "Wall Street Rule" and speculators with very short time horizons isn't likely to expend much energy influencing and trying to fix what might be broken with a company's board and management.

In the same interview, Bogle suggests a different rule:

So if you don't like the management, improve the management! It's not complicated.

Even if slowly considering the forces involved, some of the more expensive and economically useless activities in the current system could be replaced by playing a key role in forcing useful change and improvement where crucial resource utilization and investment decisions are made every day. More from Bogle:

I think each of us have a responsibility to leave everything we touch in our lifetime a little bit better. Whether it's a family. Whether it's a community. Whether it's a corporation.

It's unlikely that the current system dominated by 1) short-term oriented agents and weak fiduciary standards along with 2) speculators will play the vital role of improving corporate governance.

America has some fine companies despite the weaknesses in the system. That doesn't mean the status quo is acceptable.

Change is needed and the impact on the real world is far from academic. There's very real economic and social benefits at stake in all this.

Adam

* What's the agency problem in this context? Agents (banks and institutional money managers like mutual funds, pensions etc.) often have enough scale to influence accountability at the board level of a company they own shares in (and ultimately the management) but do not feel, too often in the current system, obligated to fulfill that responsibility. It contributes to an all too frequent outcome. Inadvertently or not, agent and/or management interests end up favored over shareholders' and beneficiaries' interests (even if cleverly cloaked otherwise). The lack of long-term investing by many institutional money managers certainly also contributes. In other words, if you aren't going to own something long-term why bother with fixing an inept board and/or management team. This has a direct and cumulative effect on corporate misbehavior and resource misallocation. The fiduciary duty of institutional money managers in representing shareholders and pension beneficiaries is overwhelmed by their financial interest in gathering and managing the assets.
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