Steve Hemingway

I have read Brearley and Myers. I have read a lot of books on enterprise and busines. I have read quite a bit of economics. In none of those places have I previously come across an analysis of what makes an optimal size of a firm.

I remember years ago reading something about the ease of communication and enforcing laws being a determinant of the size of countries or empires. Obviously there are problems with this when we look back on the Roman and British Empires, and think about the internet and modern communications.

On the face of it, with the market and prices being such perfect instruments for organising economic activity, it is not clear that firms are needed at all. Scott Adams of Dilbert fame has a large brand that has no employees, and I am fairly sure that Scott works at his PC in his dressing gown. How come the bosses of IBM and and Exxon do not do this?

The answer is to do with transaction costs: the price of using the price mechanism. It may be perfect, but it is not free! The argument is that the explicit arms-length contract that would have to be entered into to make someone a reasonable substitute for an employee is so complicated and costly that you really wouldn't want to bother unless the job was very simple (like operating the works canteen, or doing the cleaning).

I buy the general argument, but I'd like some numbers. I was reading a book, 'The Origin and Evolution of New Businesses' by Amar Bhidé. It simply observed that Oscar Mayer, the leading restaurant vendor of hot dogs in the US was a tiny fraction of the size of MacDonalds (and had a much smaller proportion of the market for hot dog vending market). This it put down to the influence of the founder, Ray Croc, suggesting at the very least, very slow convergence to equilibrium in these kind of markets.

This is one of those questions that business-school types seem to be uncurious about. Maybe it genuinely is a question that is not worth asking, but it would be nice for someone clearly to articulate why.

References

Wikipedia article on this topic, references Coase, who had the seminal insight.

Econtalk discussion of this with Mike Munger - highly recommended.

I don't think Economists think enough about software. I have never seen a professional economist discuss microeconomics of software production. Many businessmen fail to understand the nature of software, assuming that it can be produced in the same way that production line workers produce refrigerators, or building contractors produce tower blocks, or, possibly film producers produce films.

Two blog entries discuss the marginal cost of production of software (an new line of code?) here, and here, the second by the excellent geek Ben Laurie, the first reached through reading the comments on Ben's post.

I am not 100% sure I agree with each (which particularly look at the Open Source movement, rather than software development in general), but they are certainly not far from the correct analysis. As Baudel states, rather eloquently: "Software distinguishes itself from other works of the mind, such as music, in that its originality is by no means a part of its value or utility.".

What is certain is that to create software is to respond to a noble calling.

This letter by Tim Congdon is worth reading.

The key para is:

The second mistake is to assume that, whenever a sum of money is mentioned, an identical flow of resources is implied. In due course the allocation of money to a task does indeed often result in a flow of resources, but not always. Loans can be extended to acquire existing capital assets and repaid from the sale of those assets, and the only resources involved are the time and energies of a handful of bankers, lawyers, surveyors and so on.

Basically he's saying that replacing commercial loans with ones from the BoE and treasury is not a transfer of resources, and may not cost anything. This is clearly right as long as the assets are not that bad quality, as NR insists. I guess it is that any buyer like Olivant or VM are likely to make an offer based on a fairly pessimistic valuation of these assets. It stands to reason then, at least in my mind that the BoE might as well continue to provide capital to NR for at least a couple of years at which point the real quality of the assets should be much more apparent. To sell the bank in a panic now will surely get the wrong price. As long as the existing shares are trading the owners have the option of hanging on or selling out now and at least getting a little for their holding.

It is far from obvious to me why the 'do nothing more' option is not acceptable. There are mumblings about state aid, but a loan at a commercial rate, or a guarantee of of a loan from someone else, is not a subsidy, surely? Congdon says that the BoE loans are at a penal rate. I guess that the governments unseemly hurry to get shot of NR might mean that they know something that we don't - that the credit crunch is going to get much worse, and that we are still heading for that Minsky Moment that George Magnus keeps writing in the FT about.

I wonder if it would be better banks were required to buy deposit protection insurance commercially. I just feel that it would have been much less likely for NR to implode as it did if a commercial insurer was looking at the risks that it was running. Obviously insuring credit is a dangerous business as MBIA and Ambac have proved, but the political fallout would have been much less severe if it hadn't been the BoE / FSA / Treasury which had screwed up.

"Does Education Matter?" is the title of a book by Prof. Alison Wolf of Kings College, London. It is a wonderful book.

Oddly enough I just read this profile of Marcus Ospel, chairman and previously CEO of UBS. He left school at 17 and this didn't prevent him from rising to the top and hanging on there for a very long time.

A lot of the book is concerned with the business of vocational training in the UK and the baleful influence of the CBI on government policy. The internal contradictions in the system that lead to uncountable NVQs ('No Value Qualifications') the training courses of many of which were developed at large cost never to be gained by a single employer.

Alison Wolf what seems to be a unique combination of an economist's outlook and an education professional's deep understanding of how the education industry is structured. She points out the existence of tradeoffs that politicians seem compelled to turn a blind eye to, such as the impossibility of having a nationalised higher education industry with soviet tractor factory style targets which is nevertheless expected to deliver excellence.

Her survey of the international scene is very good, and even better is her analysis of why aspects of an education policy that is successful in one country cannot be easily imported into the UK. Not least is her explanation of why the German system of apprenticeships, which has been so successful, cannot be transferred successfully to the UK. As usual the point is that there is competition to get an apprenticeship in Germany, and therefore employers accept apprentices, not because of the skills they have acquired (e.g. BMW employs a lot of qualified bakers) but because the qualification has value as a positional good.

Unfortunately the book is not recent enough to talk about the Swedish system, the great white hope for UK primary and secondary schools. The book is eloquent in explaining why bureaucrats react to personal incentives, just like the rest of us, and not purely to achieve the goals of their organisations. I learned that there is a whole discipline dedicated to understanding this divergence (between public and private incentives) called public choice theory.

I have failed to do justice to this book. It is full of insights. You should read it, and not partial and distorted summaries, such as this.

I saw a quote recently about liquidity. An old hand was saying that it was a slippery (!) concept that even smart new traders didn't readily grasp until they didn't have any and then it became frighteningly clear.

I think the same realisation is dawning on me and a lot of other 'sophisticated' investors concerning equities. There is a widely held view that equities are solid, 'real' assets. I even heard a guy who worked for the equities division at UBS once make the comment that he worked for the bit that traded solid shares in blue-chip companies, not flakey bonds and risky fixed-interest products. The essence of equities is that they are a residual claim on the cash flows of a company after all the other claims have been met in full. They are, thus, more junior than the most junior subordinated deferrable preference shares, and certainly more junior than the most unsecured debt.

I think that part of the problem of understanding the nature of equity comes from the idea that the shareholders 'own' the company, as evidenced by the fact that they alone have a say in who the directors are, whether a takeover offer should be accepted, and whether they wish to be first in the queue to provide more capital through a rights issue. The success of the company is evidenced principally by the share price going up, without much attention being paid to the other creditors.

The alternative view, as discussed in books like Brearley and Myers, is that, in fact, the equity holders have a call option on the assets of the company, and that the strike price of this option is the value of all the other more senior obligations of the enterprise. This is clearly the case: if bonds issued by a company cannot be redeemed, then the bondholders are given all the assets of the company instead. Of course creditors form a queue and it may be that other creditor rank ahead of the bond holders, but clearly the people at the very backmost position in the queue are the shareholders.

This explains why shares are not always a good investment in times of high inflation. The idea that shares represent 'real assets' suggests that a good purging dose of inflation, as we are probably facing right now, should be good for shares. For a company with real assets - say a large manufacturer with extensive factories it owns itself - this is probably true. The problem is that other forms of credit tend to get expensive and risky in times of high inflation, so that the head of the queue are taking more of the gross cashflow. Certainly once inflation gets a hold, creditors need to be protected against the macroeconomic uncertainty of real returns and will, overall, make their credit more expensive.

In a rising market in an environment of rapid economic growth, gearing, both financial and operational, have been sought after. The amplification of profits 'attributable to shareholders' have been welcomed by boards and investors. The fact that the variance of returns, i.e. the risk of the investment, has been amplified too has been brushed aside as an of purely academic interest. The fact that Modigliani and Miller pointed out that risk-adjusted returns to equity holders were not enhanced by gearing is never mentioned by corporate financiers or boards of directors. This is no trivial observation - the pair were given a Nobel Prize in Economics in 1985 for discovering it.

Now of course we all see how clear sighted these gentlemen were. We understand that capital adequacy ratios for banks are not there just to give structured finance experts an incentive for devising more and more Byzantine off-balance-sheet ways of holding assets. We are beginning to understand why Mssrs Glass and Steagall were not simply spoilsports. We understand that it is not an unalloyed Good Thing for companies to use all of their net cashflow in buying back shares rather than paying dividends no matter how tax-efficient and EPS flattering it might be.

We have enjoyed the party while it lasted. The hangover is going to be a severe one.

At about the time I was born, two US professors looked at how gearing affects the value of a firm. They discovered that like a lot of "businessman's economics" the idea that shareholder value could be improved by the firm taking on any particular amount of debt was flawed. This is a blindingly simple insight as the discussion in Wikipedia makes clear. The two professors' names were Miller and Modigliani. Imagine two firms, identical except in respect of their capital structure. One geared, the other one not. The returns to an investor will be the same given that an investor can choose to gear his own investment in the ungeared firm by forming a portfolio composed of the equity combined with the appropriate number of bonds.

Of course governments continue to incentivise firms to gear by giving special tax advantages to debt finance relative to equity finance for reasons which are quite incomprehensible to me and clearly didn't help in creating the current fine mess we've gotten ourselves into. In principle an investing company (e.g. an investment trust) could itself benefit from the interest payments it makes on debt finance so presumably the theory actually may be valid in the presence of taxes.

The idea that risk is a knob that can be twiddled by the investor is one of the key insights which go into Modern Portfolio Theory which concludes that the market portfolio gives the best tradeoff of risk and return, and that any desired level of risk can be obtained by simply gearing it up.

The funny thing is that both these theorems, which seem pretty watertight to me, are dismissed by most real world practitioners of investment, because if market professionals behaved as if both of them were true there would be a lot less in the way of fees paid to the financial sector, both for those who arrange debt finance for companies and those who manage investments for clients.

To my mind this shows that the insights of Public Choice Theory are applicable to the financial sector. The sector behaves the way it does because of the strong incentives felt by the relatively small number of practitioners in it, even those incentives result in a net cost to the large number of savers and borrowers that the financial sector intermediates between. It seems clear that these perverse incentives have resulted in major misallocations of capital in the economy, e.g. from savers to unbankable US and UK housebuyers.

Politicians talk about new regulations so that this crisis will never happen again. I think it is pretty clear that they will miss the true cause of the crisis, because the lobbying group that benefits from the current structure of the industry is much better financed and organised than any group that ordinary providers and consumers of capital could possibly be. Committees will be set up which employ the very professionals who caused this crisis, do not understand why it arose, and who will propose the kind of detailed procedural regulation that creates large barriers to entry (and therefore ensures large economic rents to the financial sector) just like the mass or financial sector regulation that has been enacted in the past.

John Kay understands all these things and has recently written about Miller and Modigliani in the FT: Surplus Capital Not for Wimps After All. So does his former co-author Mervyn King, I'm sure. Kay also understands that regulation will simply not work, so he's definitely not going to get a call from Alistair Darling.

The Wikipedia article on the crisis grows by the day. The FT is constantly filled with news about the latest manifestation of the collapse in demand.

What worries me is that at times of crisis we look to strong men to lead us out of the mess. Arnold Kling in his recent podcast on Econtalk made the point that actually there is no economic theory to guide the likes of Hank Paulson, Ben Bernanke, Mervyn King, Gordon Brown et al. and that they really are making it up as they go along. Although it seems reasonable to preserve the financial system to allow the essential function of allocating capital and facilitating funds transfer and avoid the heavy costs of unwinding complex derivatives contracts entered into by failed investment banks, it is not clear that a transfer of huge sums from future taxpayers to the owners (and increasingly) to the managers of the banks is such a smart move in the long run.

The accepted wisdom in the 60's when we were faced with inflation was strong action. Similarly the problems of de-industrialisation in the UK at least, in the 70's, were addressed by industrial policy. The Great Depression lead to the setting up of a lot of institutions, including agricultural subsidies, Fannie Mae and Fanny Mac, and a mass of government intervention into private and public life that has never been reversed.

Looking at the home front, I am incandescent with rage that the utterly useless UK banks, which have treated their customers with undisguised contempt, and pursued a policy of ruthlessly reducing the pay (and therefore the quality) of their staff for years. I am indebted to Prof Robert Shaw for explaining how this works in his letter to the FT today.

It seems to me that what we need is not more regulation of banks, or indeed more subsidies, but more competition. The key to that is reducing the huge barriers to entry that still exist in running a bank in the UK.

This blog gives an update to the e-gold saga.

I have been a member of e-gold for a long time, but I haven't used it for anything serious, mainly because of a lack of counterparties. I was reminded of it when I listened to Russ Roberts latest podcast. It seems very odd to me that national central banks remain a nationalised monopoly provider of money. It seems obvious that there are plenty of candidates for money, and that the 'modern' reserve banking, with arcane rules for money creation all centrally controlled by a central banker, or cartel of them, can't be the right way to ensure good banking. The latest crisis certainly strengthens this conviction.

Anyway, I would recommend listening to Russell interviewing George Selgin about free banking (i.e. unregulated banking, not the absence of explicit charges for running current accounts). It's fairly clear that Russ doesn't 100% understand what George is talking about, which is what I think makes the Econtalk podcast so good. I should probably listen a second time, because I certainly got lost at various points. My previous experience of doing this, with other podcasts, though is that I am bored for most of the time and fail to understand exactly those points I mis-understood the first time through. Maybe I should get the book.

Traditional banking is occupying my hours a lot a the moment, certainly too many for me to spend long writing this. So I'll have to stop.

As I understand it, Schumpeter coined the term 'Creative Destruction' in relation to the need for new players to provided new products and services and thereby raise the productivity of the economy. The idea was that it was necessary for pioneers like Henry Ford to see the potential of the motor car, and to create firms that provided it, because firms that made horse-drawn buggies would just never adapt to the new technology, no matter how clearly individual managers saw the advantages of the new technology.

I checked on Wikipedia and discovered that Amazon, still by a large measure the largest of the online retailers, started selling books online in 1995. Clearly there were a lot of websites running before this, but Amazon had to solve problems of authentication, secure payments, identification of customers etc. which were not needed by the likes of Yahoo!. Twelve years on, banks, whether in the UK or Hong Kong, behave as if the revolution presaged by Amazon never happened. I find that to do some simple transactions from my Hang Seng account in HK I have to send pages of paperwork. Admittedly the forms may be downloaded and printed by me, but I still have to sign them with a pen, provide a copy of my ID and post them to a branch.

This clinging on to old ways of doing business would doom banks like Hang Seng (a wholly-owned subsidiary of HSBC, not exactly a minnow), if Amazon ever entered the banking area. However the heavy regulation of banks ensures that the barriers to entry are just too high. So customers are stuck with a 70's banking environment in the 21st century. Call centre operatives the world over seem to be programmed to explain that these outdated ways of operated are for the customers benefit ('for your security') although clearly they are no such thing.

It seems to me that the time is over-ripe for a proper, free, narrow, commercial, global, internet bank to emerge. The current situation is akin the the Mediaeval guild system where the incumbents reap large economic rents from their state-awarded oligopoly position. The amazing thing is that we just don't seem to care.

Downing Street are taking the unusually brave step of actually engaging with the public, albeit only through YouTube. The idea of "Ask The PM" is this: think of a question you would like Gordon Brown to answer, then post it on YouTube and the most popular entries will be answered by the Prime Minister himself. The above short clip is designed to force GB to justify his policy.

Note that I am not necessarily opposed to a wealth transfer from my generation to later ones.