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August 21, 2008

A New Qualitative Capitalism
by Davide Accomazzo

Introduction

A few months ago I penned an article titled: The End of Capitalism as We Know it; as we were witnessing the collapse of many widely held beliefs about our economic system, it seemed appropriate to take a moment and reflect on the underlying dynamics. In all fairness, the philosophical approach to such analysis had been floating in my head for years; since the early part of this last decade, I had uncomfortably witnessed the unstoppable force of economies of scale and economic leverage take over every aspect of our system in complete disregard for any other social aspect. What started to worry me initially was the hijacking and the manipulation of good theories and socio-economic analyses to justify excesses and imbalances that were clearly unsustainable. Milton Friedman's free market theories were never meant to justify cowboy economics especially when picked ad hoc and in a vacuum from his conservative monetarist approach. For that matter, John Maynard Keynes was abducted as well to justify consistent and uncontrolled fiscal and monetary policy manipulation. However, it was not until this "quantity over quality" takeover engulfed the cultural fabric of our society that I started to really question the viability of Mass Capitalism going forward.

Until then only pathetic and factually wrong rehashes of socialistic theories had surfaced to ignite the debate along side discussions simply anchored around the concept of an environmentally sustainable economic process. My previous piece was meant to lay the philosophical foundations for a different approach to economic change: a qualitative economic process; a set of dynamics that would encompass the understanding of capitalism success so far, the understanding of practical human behavior as opposed to ideological and untrue assumptions and the understanding of multi-factor economic sustainability. My starting point was the recognition that every successful economic and social system should retain the personal profit motive and should promote personal freedom and systemic security. Capitalism and freedom, to quote Friedman, are still in my view the two principal characteristics of a successful system; however, it is the unsustainable degree of "quantity and mass production" that can provoke the systemic collapse. We see the takeover of quantity over quality in every aspect of our system: from the credit bubble to the McMansion factor, from the overproduction of generally useless consumable items to the watering down of our educational system, from the energy inefficiency problem to Reality TV shows. Practically every aspect of our social system is now dominated by quantity and suffering potential systemic ruin thanks to such domination.

For the purpose of this new analysis, I intend to explore four concrete areas of intervention that may restructure in the intermediate term the imbalances of today's capitalism and morph it into a more sustainable social system: Qualitative Capitalism. Such four areas I believe are:

1. Monetary policy
2. Education
3. Globalization Management
4. Disclosure and transparency in the regulatory process

Monetary Policy

In a speech delivered in 2004 at the Eastern Economics Association in Washington DC, then Fed Governor Ben Bernanke made the following remarks:

".....The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s." [1]

It seems rather ironic to read these words today, one year after the start of the most disruptive crisis to ever hit modern global financial markets; a crisis certainly induced, among a few other elements, by misguided monetary policy. I have to take issue with this Federal Reserve self-serving statement even beyond the recent parameters. The way measurement of variability in output, inflation and unemployment was significantly changed during the last 20 years makes it difficult to draw solid and scientific conclusions on the effectiveness of modern monetary policy. Furthermore, if we measure policy performance by slightly different metrics such as the variability and frequency of financial and economic crises, the final grade would be rather embarrassing. Certainly the last 10 years have proven devastatingly unstable; the depth and frequency of financial crises has increased dramatically. The 1998 Russian and Asian debacle was quickly followed by the 2000-2002 US equity disaster (with a recession in 2001). This was to be followed again by the mother of all crises: the credit and housing bubbles of 2007 and now the possible de-anchoring of inflation expectations. It is not coincidence, in my view, that increased depth and frequency of recent crises coincided with a significant intensification in activism in monetary policy and a skyrocketing increase in M3.

The key to a successful economic system from a monetary policy perspective is stability; money supply should respond to demand for money (which over the long run grows at a fairly stable pace) and the Federal Reserve should remain vigilant over the stability of the system by overseeing full implementation of rules and regulations and by acting as a lender of last resort during systemic emergencies. I equate this to a choice for quality (less action, more targeted action) over quantity (too much activism, too much money).

Education

I believe that improvements in this area are at the absolute center of positive social change and if implemented properly and forcefully will be the driving force to redirect the disruptive course our socio-economic system has undertaken. While no one (of any party, color or social class) will ever question openly the importance of globally improved education, the reality is that this major element of social stability, personal improvement and economic growth is perennially understated and often suppressed. Politics, religious manipulations and often just unfortunate market forces dictate watering down of knowledge everywhere around the globe. The United States, once proud global leader of knowledge, are facing the first generation that is about to loose such leadership. Thirty years ago 30% of world's college graduates were produced here, now it is only 14%; while other measures of cultivation of technological talent like the number of new patents awarded or the number of people employed in idea-generating occupations show a less successful generation than past ones [2]. The Middle East thanks to its widespread religious rule and infighting politics has not yet been able to significantly improve widespread literacy or spark substantial original scientific research. But no region is immune; Europe is dedicating only 1.3% of its domestic product to higher education, continuing a trend of underperformance versus the US lasting now almost 30 years [3]. And the much proclaimed Russian "dream to build a knowledge-based economy based on an army of trained scientists remains a dream." [4] Even Italy, cradle of the Renaissance, is now sadly slipping toward the bottom of international education rankings. Quality in education is seriously in danger. This is an issue that must be tackled globally, locally and at different levels of the educational chain.

I strongly support US involvement at the international level in efforts to raise global educational standards. Ideas such as the one put forward by the previous British Ambassador to the US, David Manning, to establish a World Education Bank might have good merits. At the domestic level, it is imperative that standards be raised dramatically, that more and more children be brought into the educational circle, that the unjustified sense of entitlement so rooted nowadays in many of our young students be eradicated in favor of a true appreciation for the discovery of knowledge. Naturally, more money should be spent on these resources via public channels, private funds and a reformation of the present system (a few of Milton Friedman's ideas on this subject are still incredibly valid today); generally speaking the return on investment for a society on every dollar (or other currency) spent on education is one of the highest returns any investment can yield. A recent US study indicates that every dollar spent in early quality care and children education saves about $13 in the future to the taxpayers [5] and I believe this is a large underestimation.

In essence, we need higher quality of widespread education and more understanding of the positive ramifications of globally improved education.

On a different level, a strong focus on research and innovation (as a byproduct of more emphasis on education) could be the spark that will push the United States back into a global leadership position. The opportunities are endless; for example, as a nation we are now facing an energy shock of unsettling proportions. The dire economic and environmental consequences of our (and the world's) dependence on fossil fuels are now rather unquestionable. The US must take the lead in the development of alternative energies at this strategic juncture. Such an act will eventually provide a solution to a problem that is not going to disappear, it will put us in a position of global leadership and economic advantage and it will most likely help restore a lot of that global political influence and prestige which was unfortunately tarnished in the last few years.

I believe it's the time for quality of education and research over quantity of available and superficial information.

Globalization Management

Proper management of the globalization process is most likely the most difficult and most dangerously ideological area of intervention yet it is an essential piece of the puzzle. As this process becomes more and more difficult to manage due to the increased number of involved players and the increased crosscurrents and potential systemic instabilities, it may be instinctive for some of the agents involved to shy away from a beneficially pragmatic approach and move toward more ideological and possibly narrowly focused agendas. The winds of protectionism, for example, have begun to blow again after years of increased trade and capital openness. It would be disingenuous to back away from one of the few economic certainties (open trade and open markets end up raising the general level of standards of living more significantly than closed or closer systems) just because a crisis has occurred. It is not by raising barriers of entry to products and capitals or by targeting global speculators that instabilities are solved; it is not by implementing protectionist laws that trade advantages are maintained; the United States is not losing precious jobs to China or India because it is not protecting itself. The US is giving jobs away that it has no special interest in retaining; our role should be to innovate in products, services and processes (a development obviously linked to the education dynamic). By doing so even manufacturing jobs would be eventually preserved; the ones that really matter, the ones with higher value added. On the other hand, places like China and other developing economies should let the market forces operate more freely as systemic interferences have high long-term costs (see energy subsidies). Developing economies should focus on stimulating internal demand to break free of the unsustainable dependence on the Western consumer and in doing so they would raise the quality of their citizens' lives. Quality of production and quality of life over quantity of production, what a novel concept!

Disclosure and Transparency in the Regulatory Process

As capitalism has grown over the decades to be a powerful and encompassing international force, the need for a global regulatory process and more transparent disclosure of many of it dynamics seems a reasonable expectation.

Transparency, disclosure and global regulatory co-operation however, do not mean government take-over. The role of government should be to referee rather than to heavily participate. In other words, governments around the world should provide leveled playing fields for the global economic agents to act. Let's analyze a few specific areas of quality intervention in the realm of global regulations and transparency:

1. Central Banks role. I do believe that a complex economic system such as ours is better off with a central bank type of institution to ensure stability. However, I also believe that their role should be redefined. As already discussed in the Monetary Policy segment, I think central bankers should act mostly as independent financial referees and in emergency cases as lenders of last resorts. I see their value more as "financial cops" rather than as obscure money magicians. For instance, in the latest mortgage mess, it seems to me that an early and prompt readdressing of the breakdown in the relationship between the mortgage origination and the eventual risk bearers would have confined the crisis to a much smaller scale. Along the same lines, a more transparent interpretation and enforcement of the off-balance sheet regulations would also have probably contained the crisis to a more manageable degree. These issues should have been the focus of the Fed and not an obsession with the erasure of the business cycle. As it stands right now, central banks and governments in general are the biggest manipulators of market prices and economic activity and I believe the long term cost of such heavy influence is a very high one to bear.
2. Global tax arbitrage. As part of a welcome harmonization of the global fiscal process and open trade, more fiscal transparency should be the result. In this area of intervention there are two elements: income/capital gains taxes and corporate taxes. The first element needs global co-operation and convergence in exchange for elimination of potential double taxation and for the elimination (or more realistically a reduction) of all inefficiencies and irrationalities of local tax codes. Corporate taxation on the other hand should continue to be subject to global arbitrage; it is this global tax arbitrage that will create efficiencies and will push local governments to rationalize their political will and choices.
3. Centralized and transparent clearing for derivatives. Derivatives are now the largest component of the world's capital structure and they cannot be overlooked. Such a measure would improve in the future the transparency of the price mechanism process with minimal interference from governments. Transparency of positions and prices would have gone a long way toward making this latest crisis a much smaller systemic issue.

In this segment I see a need for quality of regulation, quality of targeted influences rather than quantity of intervention.

Conclusions

Capitalism works. Capitalism may not be perfect but it does respond more efficiently than any other socio-economic systems to the main characteristics of mankind. However, we seem to have hit an important juncture where we may have outgrown its first phase: Mass Capitalism. A new variation centered on a qualitative process rather than a quantitative focus would seem to be the solution to the present economic, environmental and social impasse.

A better tomorrow will come from the global realization that a superior life will blossom out of a need for better things and better thoughts not from more things and more TV shows.

[1] Remarks by Governor Ben S. Bernanke At the meetings of the Eastern Economic Association, Washington, DC, February 20, 2004

[2] Jennifer Wheary, U.S. is loosing education race with China, Newsday.com, August 5 2008

[3] Tony Barber, Europe fails to make the grade, Brussels Blog, Financial Times on line, July 29 2008

[4] Stefan Wagstyl, Weakness in the midst of Russia's strength, Financial Times, August 3 2008

[5] Early Childhood Education for All, Conference sponsored by Legal Momentum's Family Initiative and the MIT Workplace Center

Davide Accomazzo
Cervino Capital Management LLC

DAVIDE ACCOMAZZO has been trading professionally since 1996. From 1996 through 1997 he was employed as a Euro-convertible bond/international equities sales trader for Jefferies Group, Inc.. In 1998 he left to trade his own capital and in 1999 started Kensington Offshore Ltd. In 2001 he launched Kensington Capital Management LLC, a CTA that focused on trading options on futures and currency futures. Mr. Accomazzo was recruited by UBS Wealth Management USA in 2004 to manage the portfolios of high net worth investors. In 2005, Mr. Accomazzo co-founded Cervino Capital Management LLC, www.cervinocapital.com, as Managing Director, Head of Trading.

The analysis and opinions expressed in this commentary are those of Davide Accomazzo as of the date of this issue, and are subject to change. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program of Cervino Capital Management LLC. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

Please mail questions and comments to info@cervinocapital.com. Your email address will be kept strictly confidential and will not be used for any other purposes.

Copyright © 2006-2008 Cervino Capital Management LLC. All rights reserved.

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