The Men behind Contra Our Investment philosophy Our Annual Returns Contra in the Media Contra Tweets Questions Frequently Asked Look Who's Talking Subscribe to Contra Renew Contra Email Service Get in Touch with Contra Hear Benj Speak Questions about Contra? Give Us Feedback Site Support
left navigation image map

Copyright © 2023
Investments Inc.

spacer July 2009

The concept of "economic man," or Homo economicus, has been around since the birth of classical economics. John Stuart Mill's definition is "a being who inevitably does that by which he may obtain the greatest amount of necessaries, conveniences, and luxuries, with the smallest quantity of labour and physical self-denial with which they can be obtained."

Put that way, Mill's protagonist sounds like a bit of an egocentric lout, but Adam Smith came to the conclusion that if this self-interested fellow were more or less left alone to compete and jostle with his brethren, the aggregate prosperity of a nation would be increased.

As the productivity of free markets became more evident, H. econ's reputation amongst theorists grew, and he became endowed with a new attribute, that of "rationality." Apparently, he was quite clever when it came to coolly maximizing his benefits and minimizing his costs, and though he might make poor choices at times, he and his mates collectively did such a good job of wheeling and dealing that the price of potatoes in the marketplace was just what it ought to be.

Eventually, this view became the foundation for the efficient-market hypothesis, whose popularity reached its zenith in the 1970s and 1980s. As many of you know, we reckon this theory is a load of bunk; more to the point, overconfidence in the rationality of unfettered markets has led directly to the global financial crisis that we're still wading through.

After three decades of deregulation, the pendulum is now swinging the other way. Some of the rules that were abolished during the go-go years were originally implemented after the financial system's derailment in 1929. For example, the Glass-Steagall Act of 1933 separated commercial and investment banking, because it had been found that the risks associated with new financial schemes undermined the safety of traditional banking.

Banks lobbied vociferously against the law for years, and were eventually rewarded with its partial repeal in 1999. The passage of the Gramm-Leach-Billey Act that year allowed banks like Citigroup not only to own insurance companies and investment houses, but to create and trade derivatives such as mortgage-backed securities, collateralized debt obligations, structured investment vehicles, etc. And the rest, as they say, is history.

Various ideas for new oversight and regulations have been floated in the aftermath of the recent disaster. Many of them seem very sensible. Higher capital requirements for banks would give them a greater degree of safety during periods of stress. Requiring banks to hang on to a portion of the financial products they sell would encourage them to reduce the toxicity of those offerings.

Reining in mortgage brokers will ultimately benefit both consumers and lenders. But the "elephant in the room" that is still being tiptoed around is this notion that certain institutions are "too big to fail" -- that is, their very size dictates that their survival is necessary to the economic system, so taxpayer subsidies, of virtually any size, are compulsory.

Backing up for a moment, let's take another look at Homo economicus. We're in accordance with the idea that looking out for number one makes the wheels of capitalism go round, albeit with many negative consequences. But unlike the preachers of the efficient-market hypothesis, we don't see a top-notch blackjack player, diligently playing the percentages as he counts the cards, so much as we see his ne'er-do-well relative from television's The Simpsons. Call him Homer economicus.

This guy does indeed want it all, while expending as little effort as possible, but his degree of rationality may be encapsulated in a famous internal monologue from the show: "All right, brain. You don't like me and I don't like you, but let's just do this and I can get back to killing you with beer."

Homer's facile view of the world, knee-jerk reactions, naked greed and disdain for logic are all features that undermine his ability to analyze, say, the optimal reset on his adjustable-rate mortgage. Of course, it's not just consumers who do painfully dumb things: bank presidents, fund managers, investment bankers have all proved themselves to be museum-quality specimens of Homer economicus.

In surveying the damage, even the ultimate champion of free markets, former Fed chairman Alan Greenspan, admitted, "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

Efficient-market proponents can't account for bubbles and busts because, if the market truly is properly valued, they simply shouldn't occur. If we accept that the market is inefficient and at times irrational, such events are not only explainable, but are to be expected in the normal course of events. Even so, the difference between a trough in the business cycle and financial Armageddon is a matter of scale, and gigantic financial institutions magnify the effects of poor decisions.

In Canada, our big banks are weathering the crisis comparatively well. Credit is claimed on behalf of our stronger regulatory framework and more conservative business culture, which eschewed the wildest of the risky business. In fact, there is a mood of casual superiority, as if our bank presidents would never allow the crazy shenanigans that occurred south of the border.

But in our view, a key reason for the resiliency of our banking sector is the decision made in 1998 by Paul Martin and Jean Chrétien not to allow the mergers of Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank.

This is no paean to the adage "small is beautiful." All four banks are plenty big, and they epitomize the benefits of economies of scale and geographic diversity. But they wanted to get bigger -- much bigger. There was no modesty or temperance when these executives argued to Parliament that the proposed mergers were not just desirable and in the public interest, but absolutely essential to the future health of the Canadian financial sector.

BMO chairman Tony Comper pleaded, "If Canadian banks are not able to grow and compete in an international market, they will quickly become unable to serve Canadian corporations in their global transactions and become irrelevant within the next ten years." Fortunately for him, hardly anyone remembers his off-base prediction, so his current missives are perceived as pertinent.

Imagine what would have happened if Comper had his way, and the newly merged banks had been able to follow in the path of then celebrated Royal Bank of Scotland, which metamorphosed from dowdy backwater hick to debutante. What other regulations would have been pared back in the pursuit of becoming a global powerhouse?

One only has to look to the U.S., where the concentration of power in Fannie Mae and Freddie Mac spurred them to spend $200 million to curry favour with politicians on both sides of the aisle.

How big is too big? When an institution is so large that its sudden failure would cause a national catastrophe. Once that point is reached, the prudent approach would be to make it smaller. Not only is a pared-down entity less of a danger to the fabric of the economic system, it is likely to be more nimble, adaptable and better able to manage and understand the risks it takes in its business.

Unfortunately, the trend in the U.S. is still in the wrong direction. Though the big banks have been greatly diminished in terms of market capitalization, the potential scope of their influence over the economy has swollen. In a little over a year, we've seen Wells Fargo take over Wachovia, JPMorgan Chase gobbled up Washington Mutual and Bear Stearns, while Bank of America engulfed Merrill Lynch and Countrywide Financial. This does not bode well for the long-term security of America's banking sector.

As for the failed theory of efficient markets and Homo economicus, we wonder what they will be replaced with. If, as the old analogy goes, alchemy is to chemistry as astrology is to astronomy, what will economics become?

spacer Archives \& Investment Info