For the sake of efficiency, I am now concentrating on one place as the home for my blogs: Open Forum, at www.openforum.com.au. Have a look at my newest blog here. This is how it starts….

I am writing this as I attend the National Economic Review 2010, at Parliament House in Sydney.

This is a gathering of thinkers from academia, politics, business and the voluntary sector, focused on finding ways to collaborate to create a better future for Australia and Australians. It is about politics, but it is not political and therefore likely to produce concrete initiatives that will produce positive change.

As I sit here, I am pondering the likelihood of a gold bubble.

As people move out of shares and property – and the US dollar – it seems that enormous amounts of money are being turned into gold, in various forms…and the price of gold is soaring to ever higher levels. This is disturbing, for two reasons…….

Last month, the index stood at 122 (2273 items, with 2065 in the previous month and 1939 items originally). This month, perhaps because of Easter or perhaps because the smart money is now moving towards real estate, the index fell back to cover only 908 items, which gives us a value of just under 47. To see if there is anything real going on, I will now also use a broader sample, changing the search to encompass the whole world. This search produces a total of 374,000 hits for the week in question, which now becomes our baseline or 100. Let’s see what happens next month, with both series.

Meanwhile, my new book is out. Here is what Amazon says about Waves of Change: Managing Global Trends in the Financial Services Industry.

“Editorial Reviews Written in the middle of a global economic crisis, this book is about a better future. Patrick Callioni identifies and describes the major waves of change that are coming our way over the next decade or so and then provides practical advice on what to do (or avoid doing) to benefit most or suffer least from what is to come. He describes some of the problems with the present regime of regulation “We are regulating to catch the motes of dust floating in the air, rather than the beams that end up poking out the eyes of our financial markets” and suggests “regulation should focus on rewarding the good, rather than punishing the bad”. He also analyzes some of the behavior that helped to create the ‘Credit Crunch’ – “They took healthy debt – mortgage debt that was likely to be repaid – mixed it up with toxic debt –mortgage debt not likely to be repaid – and then sold the debt on as prime, safe debt, creating untold damage”. Then he presents the waves of change that are coming: the challenges of new technologies; the business opportunities opened by reactions to climate change; and demographic changes as workers and managers are no longer predominantly baby boomers. He also warns of future signs of impending financial setbacks that should be avoided: “A financial crisis will occur only when the fuel is there, in the form of an investment bubble”. In his previous book, Compliance and Regulation in the Financial Services Industry, Patrick Callioni successfully predicted most of the course of the current economic downturn. Over-regulation is as dangerous as under-regulation, so he proposes the creation of a federated network of trust. Throughout this exciting book, he emphasizes the increasing importance of knowledge capital, value that is not captured by existing accounting standards, and in particular soft intangibles (knowledge assets, time assets, motivational assets etc) and he proposes guidance on their measurement and profitable management.”

If you should want to buy it, though, I suggest you get it from the Book Depository in the UK, here. It is slightly cheaper and they do not charge for postage.

Last month I published the first iteration of the Market Fever Index (MFI). In my forthcoming book, Waves of Change: Managing Global Trends in the Financial Services Industry, due out in May 2010, I suggest that it would be useful for investors, especially unsophisticated investors, to have access to a market fever index. My proposal is based on the same logic that underpins bushfire warnings: to let people know that while they are free to invest as they please, they ought to be aware of the risk that is inherent in the environment. It is almost impossible for retail investors to have any such awareness as things stand. I am hypothesising that a useful indicator of risk would be the number of items that appear on the World Wide Web that refer to activity in the global financial markets. The underlying assumptions are that the number of items would be a suitable proxy for the level of activity and that investment bubbles are accompanied by a significant rise in activity.
I have just sampled the news reports on Google and there has been a rise in the number of articles that mention all three search terms: stocks, shares and bonds. The rise is such that the index now stands at 107. I am now wondering whether it would be better to work with a broader sample, which could be generated by searching for news items that include any one of the search terms. What do you think?
Meanwhile, those of you who track the US economy may find this blog interesting: http://tinyurl.com/yl8ltyo. Anyone who is a member of LinkedIn can join the discussion.

As I predicted in earlier posts, governments are reacting to the financial crisis by indulging in populist reforms that are intended to punish the culprits – banks and financial institutions – and to stop them from doing again whatever they did that caused the US and global economies to crash in 2008-9. The form and character of what President Obama has said he wants to do – if Congress allows him to do it – is a typical example (this is what the President said, in part):

That’s why we are seeking reforms to protect consumers; we intend to close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight; to identify system-wide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to ensure that the failure of any large firm does not take the entire economy down with it.  Never again will the American taxpayer be held hostage by a bank that is “too big to fail.”

The diagnosis is largely correct, as is the prognosis, but the suggested cure is way off the mark. It seems that the President wants to stop banks becoming too big – on the assumption that having banks that are too big to be allowed to fail creates a risk for the financial system – and he is proposing to strengthen capital and liquidity requirements and to limit the banks capacity to hedge risk. The President and his advisers have obviously missed the point. The point is that the system failed because of the lack of transparency, not because people took unwarranted risk. The latter is not a cause, but a trigger, firing a gun that was already loaded and would have gone off sooner or later, for one reason or another.

As the GLG Group points out – and I have made the same point before this in my blogs and in my 2008 book, which I wrote in 2006-07,

The current crisis was not caused by one or more banks being too big to fail.  Rather it was caused by a collective failure of confidence amongst all credit institutions, such that none were willing to extend credit to any other.

How is making banks smaller and limiting their capacity to hedge risk – as well as taking money out of circulation by keeping more bank funds locked up as “security” – going to prevent this from happening again? The answer is that it won’t, but it will keep the tabloid press happy and it will allow the government to claim that it has done something the public has been asking for: retribution, punishment for the guilty.

While in the recent crisis the proximate cause of the systemic failure of confidence was the securitisation of real estate mortgages, which should be dealt with, as I explain in my new book, the fundamental cause of the crisis was the inadequate state of regulatory frameworks, the inability of the system to manage systemic risk. Restricting what any one player or groups of players can do is not going to remove this fundamental risk. Actually, it may make thing worse. In that new book, by the way, I propose how to fix this fundamental problem once and for all – and the solution is not more regulation.

This is because the likely if unintended consequences of what President Obama wants to do will be these:

• the capacity of the system to manage risk will be diminished if hedge funds cannot play their role, which is to assist in placing risk where it can best be handled and to punish those who take unwarranted risks with other people’s money; and
• the flow of money through the US economy and, consequently, through the global economy, and the speed of that flow will be reduced, perhaps quite substantially.

In turn, these impacts on the US and global financial systems will impair the capacity of the economy to grow at a pace rapid enough to take the US out of recession and to push Europe and Japan towards meaningful growth rates. Furthermore, this chain of events might eventually cause China to re-consider where it parks its billions, most of which are in the USA now, which would contribute to a possibly terminal downward spiral in US economic activity.

What I am saying here is that there is a real probability that what Obama wants to do may give the US the opportunity to experience the Great Depression all over again, having narrowly escaped an opportunity to do so in the last two years, thanks to Bernanke, the Chinese and quite a bit of luck.

Let’s hope I am wrong.

In my forthcoming book, Waves of Change: Managing Global Trends in the Financial Services Industry, due out in May 2010, I suggest that it would be useful for investors, especially unsophisticated investors, to have access to a market fever index. My proposal is based on the same logic that underpins bushfire warnings: to let people know that while they are free to invest as they please, they ought to be aware of the risk that is inherent in the environment.

It is almost impossible for retail investors to have any such awareness as things stand. I am hypothesising that a useful indicator of risk would be the number of items that appear on the World Wide Web that refer to activity in the global financial markets. The underlying assumption are that the number of items would be a good proxy for the level of activity and that investment bubbles are accompanied by a significant rise in activity. To test that hypothesis, on the first Wednesday of each month I am going to publish my market fever index. The index is constructed by reference to a search using Google, as the dominant search engine, for news items on the WWW that mention one of these words: shares, stocks and bonds.

The search will cover a period of seven days, concluding on the day preceding the day when the index is published. The use of the terms shares and stocks is to accommodate diverse varieties of English. I shall make today (6 January 2010) the baseline, noting that at the moment we are still in the relatively quiet waters that follow a flood due to a bubble burst – in this case, the global financial crisis of 2008-09. The baseline will be expressed as 100 points. Shifts in numbers of items will be tracked and the index will be adjusted up or down accordingly.

I know that there is an underlying trend that will inherently push up the number of items reported – this is the reality of the internet world. However, for this purpose I will assume that the underlying trend is smooth and that the rising tide of information will lift all boats equally. Relying on this assumption, the trend patterns should still be reliable as an indicator of change, although the underpinning numbers might not be. I am also aware that there are confounding factors likely to be associated with the choice of a particular day. I am assuming that since mine is a global search, local or regional factors will, over time, have relatively little impact – the bumps will smooth themselves out over time.

The first search – which covered the period from 30 December 2009 to 6 January 2010) produced 1,939 items, which now becomes the marker for our baseline of 100 points. Let us see what happens on the first Wednesday of February.

This is why China may be the next locus of a crisis that will then affects us all. There are strong wealth imbalances developing in China; the economy, after a relatively brief slowdown, is likely to soon resume its feverish pace; the country’s political and regulatory structures are immature and highly prone to cronyism on a large scale, as evidenced by the melamine in milk scandal and its aftermath; the media in China are not independent; and civil society is very weak. Using fire risk terminology, if China’s economy were a forest, we would say that it is ready to burn and catastrophically so.

Given the amount of capital now vested in Chinese hands and especially given the dependence of the USA on Chinese investors, any bubble bursting in Beijing would have disastrous consequences for the world’s economy. More disturbingly still, it is quite likely that an economic crisis in China would usher in political trouble, because of the gap between rich and poor, between country and city and between the east and the west of that vast nation. Nations in economic and political trouble tend to become warlike or, at best, highly unpredictable.

We should start building our new global risk management engine right now, I suggest, so that we are ready for the next wildfire and, preferably, so that we can start to reduce the risk of fire, right now. Of course, even without a global approach, it is possible for countries or businesses to reduce the impact of a bubble burst. For example, Australia has been left relatively unaffected by the subprime crisis, because its internal regulation of the financial system has made it impossible for any Australian financial institution to become too enmeshed in the business practices that trapped other companies, in other jurisdictions–notably, the USA. However, in the long run financial or economic crises in significant economies cannot be contained by national borders. Even a relatively minor crisis in one continent can, given the right circumstances, quickly become a global crisis, spreading as if by contagion, as if it were influenza or AIDS (Paul Krugman, in The Return of Depression Economics and the Crisis of 2008, provides some good examples of this).

In my last post, I indicated that we need a new approach, if we are to sort out the present mess in the financial services sector. Let’s be honest: the business of regulation is intrinsically difficult, but it is devilishly difficult when money, power and reputations are at stake and all those ingredients are present in the financial sector. John Kenneth Galbraith, one of the great economic historians of the 20th century, observed that “The regulation of economic activity is without doubt the most inelegant and unrewarding of public endeavors. Almost everyone is opposed to it in principle; its justification always relies on the unprepossessing case for the lesser evil.“

I agree with the first part of this proposition, but not the second–I think we can do better than arguing for a lesser evil. Research, experience and judgment combine to tell me that regulation is unavoidable and that an increasingly globalized web of regulation is desirable, to accompany our increasingly globalised way of living and ways of doing business. Also, because the responsibility to regulate rests with nation states, the success or failure of global regulation is dependent on the success or failure of its weakest link, its weakest component and that, in a globalised economy, no country or business can make itself invulnerable to shocks to the system that are big enough to affect a significant element or component of that system. As recent events illustrate, the weakest element can be the largest economy in the world, the lone superpower. This should not surprise us. It is more likely to be the largest economy in the world that puts us all in a perilous situation than a lesser power, such as Mexico, Argentina or even the United kingdom, because our dependence on the former is likely to be much greater than on the latter. Also, the track record of regulation in the USA is not great. Americans have a strong belief in the power of the market, tend to resent government interference and worship entrepreneurs and risk-takers. This is not a good set of indicators when assessing the capacity of a nation to get the balance right between freedom and restriction, which is what is needed to have effective regulation.

Looking forward a decade or two, any global accord on how to manage the financial system must take into account the share of risk presented to the system by larger economies, especially those that have a poor track record or inadequate regulatory infrastructure. We do this in our businesses, when we consider with whom to partner and whom to avoid, or when we make decisions about how much insurance to take out, and how much should be set aside to deal with unforeseen contingencies. But we don’t do it in international relations, where nation-states indulge each other with the fiction that each state is independent and sovereign. While the concept of sovereignty makes sense in a legal setting, allowing us to keep our own laws and customs, it makes no sense when we turn to the movement of money across borders. Here each state depends on all others–much as consumers of water depend on the good behavior of all others who are upstream from the point at which they tap the river. Big land users upstream present a much greater risk than individual users, because of their intrinsically greater capacity to pollute. This reality is recognized in law, by placing a burden of responsibility on land users upstream to protect the supply of water of those downstream, whoever they may be. We need a similar approach in the financial services industry. We need to acknowledge explicitly the collective responsibility of nation-states and of large corporations to keep the flow of money clean and unadulterated, within and across borders.

We also need to apportion the responsibility for mitigating risk to the global financial system to those that have the greatest capacity to do harm to that system. Capacity to do harm should be determined by assessing the significance of an economy within the system (scale); the level of competence of that economy in managing its affairs, its creatures (corporations) and its impact on others, through action or omission; and its political and social stability. By my rough calculations, this means that our focus should be primarily on the USA, China, India, Russia, and Brazil, with secondary attention paid to the European Union (EU) and Japan. In the case of the last two, we should actually watch that their natural tendency to over-regulate does not win out, remembering that death from either fever or sclerosis is an equally final and equally unpleasant event. Using this model, the straws blowing in the wind suggest that the next bubble with global impact is most likely to arise in China. I will explain why in the next post.

I wrote about the challenge of regulating financial services in a book that came out in October 2008, Compliance and Regulation in the International Financial Services Industry. In that book I argued, among other things, that the subprime crisis in the USA, in tandem with the regulatory approach taken in the USA and given the size and importance of the US economy in the global financial system, presented an imminent and significant threat to the global economy. It is with little pleasure that I can say now that my diagnosis and prognosis were correct. I was also correct in forecasting that the economy of my home country, Australia, would be less affected by any global crisis, at least in part because of its approach to the regulation of the domestic financial services sector. I am writing about the subject of regulation again, in a new book, likely to be published in mid-2009.

The gist of the argument I am framing in that book is that dying from a runaway investment fever or from sclerosis of the economic arteries has the same effect–we do not want either of the unpleasantly terminal outcomes that result from these conditions. What I mean is that the problem we are dealing with is not too little or too much regulation; rather, it is poor regulation, poorly implemented.

Don’t get me wrong, I am not taking a potshot at regulators–I have been one and I know that it is a tough and unrewarding role. Why is this so? When a public servant has to tell someone or some corporation, “no–you can’t do that”, that public servant is going to win very few friends in the world of business and that public servant will not always be supported by the politicians who made the rules in the first place. Politicians like to play the good cop role, leaving the public servant to be the bad cop. Public servants know this and, fore-armed with this knowledge, they adjust their behavior. So, in the beginning, when fresh in the job and backed by an enthusiastic patron or sponsor, they apply the rules, firmly, but fairly. This goes on for a while, but eventually the road of regulation, paved as it is with good intentions, will develop a few bumps; someone important will complain or tough times may suddenly mean that tough regulation gets in the way of business and profits and jobs are at risk–meaning that votes are at risk also. That is when the speed and the keenness to apply the rules will start to wane.

Sooner or later, regulators tend to take on the expectations and values of those whom they regulate. No one, not even a saint, always acts entirely in the public interest. That is what it means to be human, our institutions, just like the individuals who create them, run them and staff them, are fallible – and the degree of fallibility will rise steeply after each re-structure, legislative refresh or new management appointments. Note that I am not saying that all or most public servants feather their own nests, to profit themselves or to profit their cronies. This is why, as we will see later in the book, regulators need to be truly independent, their activities need to be transparent and accountable, and the politicians who supervise them must be watched closely. Regulators must work to strict, externally imposed standards, with compliance tested by independent and very detached parties, and they must be turned over regularly. By the way, I think this should be done with corporation boards and CEOs also.

In future posts I will explain how this can be and should be done.

I have been in New Zealand for a couple of weeks on holidays (vacation for any US reader) – great place to visit, by the way – and I have been following the local debate on the global economic crisis (financial crisis is no longer an accurate term for what is going on), which has already pushed New Zealand into recession. New Zealand is a small economy, highly dependent on agricultural exports, with a very small local employment base and with very little room for government to do anything, because the money is not there for them to use. A bit like Australia or Canada in the 1930s, actually – and that is not a good omen, because those countries suffered more than most from the impact of the Great Depression.

People here are stunned by the huge amount of money the Australian Government is pouring into the economy to keep things moving, just as we Australians were stunned by the sums the Chinese Government committed to their economy and by the size of the budget President Obama has just released in the USA. But then, just like Australia’s population is matched by any one Chinese city, such as Beijing or Shanghai, NZ’s population is about the same as the state of Queensland and the national GDP (US$135.7 billion (2008 est.)  is less than a fifth of Australia’s – and the gap is growing. As a result, the government in NZ is struggling to fund a scheme to subsdise a nine day working fortnight, which would cost about NZ$60 million (about US$25 million) for a year.

This glimpse into another world, with a different perspective, has given me two insights. First, Australia continues to be a lucky country, with sufficient wealth to buffer us (with a bit of luck) against the worst economic crisis since the 1930s. Second, countries like New Zealand and Australia must collaborate to stop the elephants (the USA, China, the EU, and India) carelessly demolishing the delicate edifices of global governance that are the only protection we have against generalised chaos. As useless as the United Nations, the World Bank and other institutions might seem at times, they still remain our best hope of constructing a global civil society.

For every human problem, there is a neat, simple solution; and it is always wrong.

H. L. Mencken

It looks like we are about to face again the challenge of large-scale unemployment and, probably, long-term unemployment for many. While we have a little time to consider how to face this renewed challenge, let us consider an alternative paradigm to deal with the latter, which has proven to be intractable in similar circumstances in past decades. It is generally assumed that the role of the state is to deal with the problem of unemployment by addressing its causes and by managing its nefarious effects. Let us instead posit that the role of the state is to create jobs for people who have been unemployed for longer than twelve months.

Of course, there is more than one way to do this. The US system does it by lowering the price of labour to levels that most Australians would consider unfair, if not iniquitous. The US system is also poor in targeting the long-term unemployed. Because I believe in learning from history, the model proposed here also creates jobs for the long-term unemployed, but the means are different, with fairer and more targeted results. Since we are dealing with a wicked problem, where subjectivity is an acknowledged variable, let me make my assumptions and my objectives explicit. Also, let me make it clear that there is nothing new here, except for the perspective I offer.

The model is based on the positive features of the group training model, common throughout Australia in the vocational education and training sector, and on elements of programs such as the Community Employment Development Program and the Community Jobs Program. There are also echoes of both Working Nation and Work for the Dole resonating throughout, proving how ecumenical public policy can be, if it is abstracted from the political arena.

ASSUMPTIONS AND OBJECTIVES

It is assumed that there are insufficient jobs for everyone who wants one, which means we have a buyer’s market. Given the paradigm within which the model operates, it is not necessary to know why this is so. It is assumed that the main reasons why long-term unemployed people are hard to place in employment are:

• lack of appropriate skills,

• lack of recognised qualifications,

• lack of motivation,

• the attitudes of prospective employers,

• lack of congruence – geographic, demographic, attitudinal.

It is proposed that the following characteristics (“policy objectives”) should apply to any program addressing the problem of managing the long term unemployed into sustainable employment:

• minimum government investment (capital and recurrent) and intervention,

• adequate level of contestability,

• appropriate, meaningful metrics, to test value for money and program success,

• accessibility for users,

• acceptance by the community,

• continuous improvement.

A corollary to these assumptions is that the proposal should assume a flexibly managed market, not an open, competitive market. This is so as to ensure viability of the market, avoidance of monopoly and monopsony (if possible), and achievement of the policy objective(s). Lastly, it is proposed that the program would be national and would be the responsibility of the Commonwealth.

THE PROPOSED MODEL

The model would function like this. A person identified as an appropriate candidate would be placed with a Group Employment Company (or “GEC”, see below for details of proposed company arrangements). The GEC would assess the person to determine peculiar reasons for inability to secure or retain employment. A personal development and placement plan would be developed (“PDPP”).

Subject to exceptional circumstances (defined by agreed protocol with the government contract manager), on arrival at the GEC the person would cease to receive welfare payments. That is because s/he would be employed by the GEC, and paid a standard salary (funding arrangements for GECs are discussed below). The person would not have the option to refuse employment by the GEC. The GEC and the person would have shared responsibility for the design and implementation of the PDPP.

The PDPP would be peculiar to each person, but would fit within overall parameters agreed with the contract manager. The ultimate objective of the PDPP would be to secure sustainable employment for the person with an employer other than a GEC. Interim stages could include training, processes to secure qualifications or recognition of competencies, personal development, employment for fixed periods (as in “work for the dole”), placements with host or potential employers and so on – as appropriate to the person’s circumstances.

MANAGING AND FUNDING GECS

Business models for GECs would include for profit and not-for-profit organisations, as well as state or local government instrumentalities. The GECs would be regulated by existing arrangements covering employers and incorporated entities. Obligations to the Commonwealth under the program would arise from contractual arrangements, with no specific additional regulation. The GEC would be paid (“funded”) by redirecting welfare payments to which the long term unemployed person would be entitled, supplemented by funds from the Commonwealth (drawn from existing appropriations). There would be supplementation from funds to which the GEC or the person would otherwise be entitled from Commonwealth or state sources (e.g. vocational education and training subsidies, state subsidies to employers and so on). Those funds would be used to pay the person’s salary and for necessary ancillary costs and overheads.

Until the person is placed with another employer, s/he will be employed by the GEC. A bonus would be paid to the GEC on placement with another employer and when the person has remained in employment (other than with a GEC) for an agreed period. A bonus could also be paid if the employment makes a contribution to other policy objectives, such as environmental sustainability, for example. Eventually, operation of the model would produce data that would be used to review and to improve its effectiveness and efficiency.

WHY THIS MODEL IS DESIRABLE

There are several reasons why this model is desirable, of which the first is that it creates a significant number of new jobs. It does so in two ways, first by offering jobs to people who have been unemployed for the long-term, and secondly by creating a new market, with new business opportunities. Another positive, as mentioned earlier, is that the program is designed to hit the target specifically. The Commonwealth’s responsibility is to provide an overall framework within which a person is managed into sustainable, appropriate employment. The GECs are responsible for the person’s employment. This is not a RED scheme redux. The jobs created by this proposal would be supported by a business model that has long-term viability.

The person becomes an employee on arrival at the GEC, which is a positive influence on his/her attitude and on the attitude of potential employers and of the community. It is easier to get a job if one is already employed. Also, the person is no longer included in unemployment statistics. If the GEC can’t place the person with another employer, the person remains in employment, with the GEC, and spends his/her time on meaningful tasks – work, training, community work – arranged by the GEC. The principle of mutual responsibility is satisfied. The Commonwealth has the opportunity to manage its costs more effectively, by integrating funds from diverse programs to an overall purpose and can leverage funds from state sources.

CAVEATS AND POSSIBILITIES

Going back to the characteristics of a wicked problem, it may be that the only way to test this model may be to implement it and HL Mencken many turn out to be right, again. I do not have the data needed to carry out a cost-benefit analysis, but a rough assessment indicates that existing funding from the various “buckets” should suffice – and the model presents the opportunity to achieve greater effectiveness. If the assumptions hold true when they are operationalised, the model should generate a virtuous cycle. I mentioned monopsony and the desirability of avoiding same. The model proposed here would be compatible with an arrangement whereby purchasing and/or contract management by the Commonwealth is made contestable. The contract management could be done by third parties (an elaboration of the brokerage model), while the purchasing could be made contestable also, by contracting out that function.