I've been toying with a column that would have the title, "Where's the Leadership?," taking us more or less to task for not exercising what historically has been an impressive and legitimate leadership role in re-shaping the financial regulatory system at a time when no one in their right mind imagines the extant institutions have worked as they should.
That column--which is not this column--would have asked why the leaders of the bar and the leaders of the country's and the world's great law firms have not spoken out, have not written op-ed pieces, convened conferences, assembled wise and diverse people and re-imagined what a 21st-Century financial regulatory system ought to look like. After all, if we don't understand what prudent and what improvident regulation looks like, who does?
But I've decided to back off, primarily on the grounds that it's premature to be questioning our leadership, much less accusatory. Premature why? Because I don't think anyone--ourselves included--really understands yet what precisely went wrong. And Hippocrates himself would surely counsel that if you don't have a diagnosis you would be worse than reckless to suggest a cure.
That column, by the way, has not yet been canceled; it has only, for the moment, been postponed. And it's entirely possible that our actions in future will obviate the need for it. Leadership, in other words, may emerge. But I'll call us all to the carpet if it doesn't.
First, it may help to review what has and what hasn't gone wrong with capitalism. For one thing, there seems to be a widespread lack of understanding in the popular mind, as well as among some participants and some regulators of the capitalist system, of its extraordinary advantages as well as its occasionally powerful systemic mis-steps.
The essence of a capitalist system is not, to my mind, minimal governmental regulation: It's targeted, market-enhancing and not market-suppressing regulation, with disclosure and transparency primary goals, with ample protection against deception and monopolistic tendencies, and with appropriate regulation, taxes, fees, and other charges on "externalities" which markets do not put a price on but which society rightly does (such as, classically, pollution).
Another essential component of capitalism is that it generates growth in knowledge. Not just any knowledge, of course, but knowledge that tends to promote income growth and job satisfaction.
Here's where it gets interesting. Since knowledge is by hypothesis incomplete at any point in time, the very uncertainty about what might be discovered next is capitalism's greatest strength and its greatest source of vulnerability to its critics. When capitalism appears to suffer a systemic breakdown (now, for example), critics will question whether it will ever be able to repair itself. And the only historically, economically, and socioculturally correct answer is, "Of course it will revive itself and come back more powerfully than ever, but it's impossible to predict what industry(ies) will rise from the debris to carry us all to higher heights." This, of course, invites skepticism if not derision.
The actual dynamic of discovering "the new new thing" is far messier. For help in understanding its flow, I turn to Edmund Phelps writing recently in the Financial Times. Phelps is director of the Center on Capitalism and Society, Columbia University, and winner of the 2006 Nobel Prize in Economics.
What he writes about innovation in capitalism is revealing for what it says about its serendipity and the role of people who finance unproven businesses. Emphasis in what follows and bracketed comments mine:
Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists - discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? Joseph Schumpeter's early theory proposed that a capitalist economy is quicker to seize sudden opportunities and thus has higher productivity, thanks to capitalist culture: the zeal of capable entrepreneurs and diligence of expert bankers. But the idea of all-knowing bankers and unerring entrepreneurs is laughable. Scholars now find that most growth in knowledge is not science-driven. Schumpeterian Âeconomics - Adam Smith plus sociology - captures very little.
[This next part describes the "baseline" social, legal, and institutional components requisite to capitalism.]
Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place. The freedoms borne by England's Glorious Revolution of 1688 and the "commercial society" of the Scots were not enough. There had to be financial institutions where there would be disinterested financiers, each trying to make the best investment, and - importantly - a plurality of views among them, so financiers funded a diversity of projects. There also had to be limited liability for companies and a market enabling their takeover. Such institutions had to wait for demand by wide numbers of business people wanting to build a new product or new market or new business model. Rudimentary institutions began to emerge early in the 19th century, from company law and stock exchanges to joint-stock banks and "merchant" banks lending to industry.
Unprecedented rewards soon followed in Europe and America: new cities rising, unbroken productivity growth, steadily climbing wages and generally high employment. Lifetime prospects improved for all or nearly all participants.
[He goes on to describe "Knightian uncertainty."]
From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment. Frank Knight, observing US capitalism in his 1921 book, said that a company, in all of its decisions aside from the handful of routine ones, faces what is now called "Knightian uncertainty". In an innovative economy there are not enough precedents to be able to estimate the probability of this or that outcome. John Maynard Keynes in 1936 insisted on the "precariousness" of much of the "knowledge" used to value an investment - thus the "flimsiness" of investors' beliefs.
Hold that thought.
Now let's move on to Robert Shiller's recent interview with The McKinsey Quarterly, in which he talks about "regulating for financial innovation." We know Shiller as co-author of the just-released Animal Spirits, but McKinsey gives him a fuller Shiller introduction:
Professor of economics at Yale University and cocreator of the Case-Shiller House Price Index, which is now one of the most widely used methods of measuring performance in that industry. He also introduced into intellectual circulation the phrase "irrational exuberance," which was picked up famously by Alan Greenspan in 1996. Shiller's body of work on financial markets and economics includes the books Irrational Exuberance and, most recently, Animal Spirits.
Shiller talks about what may come next in financial regulation, and starts on an optimistic note: "I think the US government is actually a world leader in financial regulation, even though people say this financial crisis started in the United States. I think good financial regulation also started in the United States."
You may not be surprised to learn that I agree. Indeed, the single most important consideration that led me to become a securities lawyer was my conviction that the securities laws of the United States gave us a global comparative advantage in capital formation. (OK, OK, this was pre-Sarbanes Oxley.) The philosophy of the securities laws (again, pre-Sarbox) was essentially: "You can do anything, if you disclose it." A deeply attractive philosophy to yours truly, and the key reason I was delighted to become a participant in that area of expertise.
But back to Shiller. He then gets into the heart of the matter, and this is where leaders of the bar and of great firms should have a voice. (Note that the following excerpts are quotes from the transcript of an oral interview with Shiller and not a written article, so if precision of expression suffers we hope that spontaneity of thought gains. Emphasis supplied.)
The business has to be that we have a sort of creative destruction. We have people trying things. And what does an entrepreneur do? You go to a number of different investment banks or venture capital firms, present your idea. And most people can't recognize an important, new idea, but some can. And that process, which is a free-market process, is really an important source of economic growth, and it can't be taken over by the government.
Shiller offers one of the single most powerful and concise critiques of the efficient markets hypothesis I've ever seen, first characterizing it simply and accurately as "that markets fully incorporate all publicly available information, and they do it optimally.":
I think the problem with it is that the very volatility of the market can't be explained in those terms. It moves too much. Often a price move for an individual company represents some news about that company. But there is rarely such news about the aggregate stock market. It's much more ambiguous about how to forecast the market. So, I think it's really psychology that drives the stock market.
Balancing this combination of "psychology and reality" is the manager's challenge. Reality, of course, can scarcely be denied ("You can't get a loan. Now, that's reality"). But there's more to it than that, and it helps to have some historical perspective.
I think it's very important for managers to think about really what's driving this. And it helps them to understand how to do a somewhat contrarian policy and investment policy. And that means you have to understand that not only is there this reality that's crimping your effort to do business, but there's also a component of your own feelings that are being brought along by our natural herd instincts and our natural tendency to pay attention to what everyone else is paying attention to now.
I just have the general feeling that managers have to be Renaissance people in some sense. They have to read widely and try to put events into the context of history.
Putting together what Phelps and Shiller have to say, doesn't it suggest the right direction for a manager at this juncture is to be somewhat contrarian? To pay, as I've said, more attention to history and less attention to the newspapers?
Predictions of the death of BigLaw as we know it, depending on the source and the hysteria quotient involved, strike me as somewhere between preposterous and way way too premature to take action on if one has the most elemental concept of present discounted value analysis. (Note that I specify the "death" of BigLaw, not changes in the model. I have and will continue to advocate strenuously for changes where I see dysfunction.) But consider:
- Globalization is not going away.
- Regulation is not getting simpler.
- Cross-industry, cross-financial institution, and cross-border flows of capital will not cease.
- And the market-driven and historical forces promoting "the rule of law" where it is currently weak or feckless are inexorable.
Finally, I suggest this all contains two implicit counsels to action for you.
The first is simply in managing your own firm and your own practice: Be a "Renaissance" person. Read, converse, and look widely. Think about what's next. Position yourself to be on the right side of the markets and the right side of history.
The second has to do with leadership. Not to hide our light under a bushel, but I firmly believe lawyers who experience the effects of regulation on their clients and the industries they serve are in the most enlightened and the most dispassionate positions to advise on what works and what has poisonous unintended consequences.
Take up that challenge.
And take it up strongly mindful of what both Phelps and Shiller (two Nobel Prize winners, I predict: Shiller deserves his some day) have to say about entrepreneurship and encouraging what's uncertain and what's unknown. Regulation that is so protective of existing institutions that it doesn't permit them to fail when they should--or to fail as quickly and brutally as they should--displays profound ignorance of the true genius of capitalism.
April 20, 2009 8:12 AM
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