George Soros first mentioned this, as part of his study of the “historical process” in “The Alchemy of Finance”. All human behavior (and stock prices are just one small application of human behavior in evolution) evolves through a “historical process”, which is subject to the phenomenon called Reflexivity. This is, of course, too deep a subject to be recounted in a column. I will only refer to the part that applies to us “cycles of regulation” just now.
Declaimer: This article was originally in February 2009, and some data points may be outdated
The Cycles of Regulation
Among the many applications of Reflexivity he studies, he mentions “cycles of regulation”. In this, he refers to how people in power react to the Historical Process, in the context of markets. As the downturn begins, bad news flows in, and the excesses of the Boom period get cleaned out. This discredits many market players, who are seen, directly or indirectly, to have participated in the excesses or been responsible for it. The credibility of the market and its players is destroyed.
People in power, a.k.a. PIP (Regulators, Government, Legislators, Media, even the general public) now tend to believe that ‘they could have done a better job’. The excessive innovation of the market during the Boom period is now replaced by over-regulation, and past innovations are throttled to death. Whatever merit there was in the earlier set of (human) behaviors, the baby is thrown out with the bathwater.
The Government moves in with an “I can do better” attitude, and sets people out to breathe down the neck of the earlier discredited market players. This sets the bottom of the market. Only those who were COMPLETELY separated from the last Boom will survive.
As in all basic emotions, our relationship with power is rooted in instinct. We react to an exercise of power in just two ways: fight or flight. So either we will seek to win a power battle, or we will genuflect before power. PIP (i.e. people in power) almost always come from a grandparent ego state, which entails talking down to their subjects, an attitude that is known to be the antithesis of a learning ego state. Au contraire, the learning ego state is the child, who is open-minded and accepting.
The Regulators of Markets
The Peak of Regulation is a period when accepting, and exploring people, who NEED to innovate to survive, have been discredited. They are now replaced by a non-learning, “I-know-better” attitude that permeates the regulators of markets. This makes things worse and reinforces the feedback loop, which is the point behind the Theory of Reflexivity, i.e. that the chain of human behavior is so structured as to make things worse, not better. ONLY those who seek to keep out of the trend can survive; those who seek to manage or reverse a reflexive trend will be (most likely) destroyed. Soros used this insight to destroy the Bank of England during the LERMS crisis in 1992 when he made his famous “trade of the century” that netted him a billion dollars in a day. The arrogance of the regulator (in this case, the Bank of England) came from the feeling that they know better than markets, and can defend the Pound simply because they have the monopoly on the power to print (or buy) it. What they forgot was that with a range-bound link to the currencies of Europe, they were now part of the wider currency market, with a limit on their monopoly.
What SHOULD happen during a downturn?
What SHOULD happen during a downturn, is that the now-chastened market players, who are very much the wiser for the mistakes they have made, are actually ‘educated’ enough to take corrective action to ensure that their mistakes are not repeated. However, what happens is that you now have new people, mostly the Govt, take charge to make new mistakes, which only prolongs the pain. In Satyam, what do you think is the probability that a new (internally appointed) CFO will participate in the kind of accounting shenanigans that caused its problems in the first place? Or what is the probability that JP Morgan/ Bank of America, the survivors of the recent banking carnage in the US, will return to their days of over-leveraged bets on exotic derivatives?
The wisdom garnered from this set of events is lost, as discredited players are unseated by whoever is in power: Govt, shareholders, Boards, and Investment Committees of dominant shareholders. All of these are PIP, King Apes who think they know better, but their arrogance will ensure that they aren’t ready to learn anything from the past, except that “something must change”.
Take a look at the prevailing wisdom in Indian banking, which says that the PSU model, of bureaucratic, mindless lending against assets and Balance Sheets rather than business models and cashflow, is better than the aggressive, risk-taking business model of the private banks. Earlier, the PSU model was discredited because it gave money where it was not needed: i.e. if you have assets, I will lend to you. But if I have assets, likely, I don’t have (earnings) potential. They want returns without risk, which is not banking, but capital rationing. This attitude is probably the reason why India has lagged in economic growth because the PSU banks have appropriated national savings and are allocating such savings not where the money is needed, but to where the money is safe.
It is a strange thing to say, but I will still say it. A year back, I was carrying on a relentless diatribe against the aggressive lending policies of the big housing finance lenders. That was vindicated, and those banks stand discredited now. But today, the opposite is not necessarily virtuous either, i.e. the ‘do-nothing’ lending of the stodgy PSU banks is hardly the right way to run a dynamic, capital-starved economy.
Everywhere, whether in markets or the real economy, you have this phenomenon. Rare is the country, company, or market that invests in the wisdom that comes after making a mistake. When I used to be a lender, I would often be struck by how a company that had done a business-related debt restructuring would be shunned by other lenders. Yet, I did notice that such a company now had a soft asset, i.e. an aversion to taking on too much debt, which would make any incoming lender much more secure than the previous ones had been. ‘Abstinence is better than any condom’, the AIDS campaign would tell you; so also with borrowing. Hence, for the same quality of financials, I would always choose a co with a history of debt delays/ default, provided they were business-related. The probability that a company with a history of good times would over-borrow, is far higher than the probability of similar behavior by a company with a history of bad times.
Notice that one thread runs through all these examples. Power leads to arrogance, which in turn leads to ignorance. Turning points in markets or the real economy always demand a sensitive understanding of soft issues, hardly the forte of people in power. This ensures that the problem-solvers only make things worse, never better. This extends downturns or market bottoms. “Off with his head” is never a good strategy.
