Edward Hadas

Is it possible to construct portfolios which perform better than the overall stock market? Two of the three recipients of the latest Nobel prize in economics have tried to answer that question. Roughly speaking, Eugene Fama said that all efforts are in vain, while Robert Shiller said that they are not.

These nearly contradictory views are typical of an intense but inconclusive argument stretching back four decades. Market researchers have produced a mountain of studies, but they rarely consider the macroeconomic, ethical and social meaning of equity investing. That’s a shame. If more attention were paid to these issues, everyone could calm down.

Start with the economics. For the economy as a whole, changes in individual stock prices are basically irrelevant. The companies receive no cash when existing shares trade hands, whatever the price. The trading shareholders may have gains and losses, but they cancel each other out. The net economic effect of frenetic stock markets is zero.

The share price does matter when new shares are issued, but that happens rarely. While promising young companies can use cash to expand, and troubled older ones need cash to survive, in normal times companies generate all the cash they can invest profitably from operations, so they don’t need or want to raise new capital. It’s perfectly reasonable that over the last seven years, the value of newly issued shares was only about 10 percent higher for listed U.S. companies than the value of repurchased old shares, according to data from Thomson Reuters Datastream and Factset.

The main economic influence of share price moves is indirect, and basically negative. Top managers spend too much time watching the stock market. They hope for bonuses which are often based on share prices and they fret about being taken over. Both concerns lead them to follow the advice of stock market investors, outsiders who rarely have much insight into long-term strategic issues. Although activist investors can occasionally clarify their thinking, managers would usually be well advised to ignore the market price and rely instead on their superior knowledge as insiders.

The governments of developed countries have the power to rescue economies from defective finance. There is a radical solution. It would be relatively easy and at least as fair as the current slow generation-long recovery from the 2008 financial collapse.

I have been suggesting massive “start from scratch” financial reform for several years. The response is usually a mix of incredulity (it’s too hard to do) and indignation (it would be unjust). A thought experiment might help deal with those objections. Pretend that the current situation – excessive debts and deficits, unprecedented and risky monetary policy, overly powerful banks, slow GDP growth and unacceptably high levels of unemployment – was the result of a recent war.

Under those tragic circumstances, it would not be strange to say that the prevailing financial order was a relic from a lost period. Perhaps the arrangements were effective and fair back then, leaders would say, but the old promises, practices and privileges are now helping the few, hurting the many and holding the economy back. So finance needs to be reconstructed.

I have nothing against Stephen Elop. The former and future Microsoft executive seems to have done a pretty good job running Nokia. It’s a little awkward that he was offered $7.3 million to move from Microsoft to the Finnish phone-maker and stands to receive $25.4 million to rejoin the his former employer. But the tech industry often has a slightly incestuous feeling, and there were plausible strategic arguments for both moves. Elop did what almost any senior American executive would have done – negotiated and renegotiated favourable contracts.

However, Elop’s packages are part of an outrageous system of executive remuneration. It features pointlessly complex arrangements – base salary, cash bonus, a small collection of share plans plus substantial payments for coming and going. The deals are rigged in the executive’s favour; Elop obtained highly attractive last minute alterations just before the sale of the phone business. And the numbers are all unjustly large, by any relevant standard.

The announcement of Elop’s terms was understandably met with widespread disgust. The same response is typical whenever executive pay comes up.

The U.S. Census Bureau says the median American household’s income was 1.3 percent lower in 2012 than in 1989 after adjusting for inflation. That suggests stagnant American consumption for the last 24 years. That assertion is not as ridiculous as North Korean propaganda about the United States – “their houses blow down very easily and they have to live in tents” – but it’s still misleading.

To start, the country is currently enjoying the fruits of major technological advances in electronics. In 1989, there were almost no mobile phones. Today, more than 90 percent of American adults have one, according to the Pew Internet and American Life Project – and more than half of those phones count as “smart”. The same project estimates that about 70 percent of U.S. adults are daily internet users, compared to zero in 1989.

Considering the increased consumption of electronic goods, a typical American household could only be poorer now than then if there were matching declines in the consumption of other goods and services. But none of the statistics I could find shows this. On the contrary.

It is nearly five years since the U.S. Federal Reserve slid into quantitative easing, the deployment of artificially created money into the bond market. QE and a prolonged period of near-zero interest rates have been the highlights of post-crisis monetary policy. That era is far from over, but it has lasted long enough for a preliminary judgment of monetary policy – especially as the Fed says it is now preparing to “taper” its bond purchases. My verdict: QE could have been worse, and it should have been better.

We know that policymakers might have done a worse job, because that is what they did in 1929, the last time a cross-border credit boom ended in a cross-border credit bust. Today’s central bankers have done better than their professional ancestors. In the 1930s, central bankers in many countries presided over debilitating deflation, and failed to prevent banking crises. This time, prices have neither collapsed nor exploded, and Lehman Brothers was the only big financial institution to topple.

While monetary policy helped stabilise economic and financial conditions, government bank rescues, large fiscal deficits and the automatic benefits of welfare states all played more important roles. The central banks’ support of weak institutions, and, in the euro zone, of weak governments was more important than their monetary policy.

Moritz Erhardt has become a tragic symbol. The 21-year-old summer intern at Bank of America Merrill Lynch was found dead on Aug. 15 at his rented London apartment. There is no official report of what happened, but coworkers blogged that Erhardt died after working three consecutive 20-hour days. Whether or not that is true, the tragedy has prompted a worthwhile debate about the work culture in banking and other high-pressure professions.

Erhardt’s schedule was not extraordinary for the ambitious young people who are trying to advance on the fast track at investment banks, law firms, consultancies and other practitioners of long working hours. The normal career starts with a period of white-collar slavery: 80 or more hours a week of drudgery in air-conditioned offices, with occasional breaks for take-away meals. The tasks eventually become more interesting, but the years of mega-hours drag on. Later, workers often have lives of privileged desperation: lots of money, luxuriant houses and holidays, and a trail of damage.

Deaths from overwork are rare. But exhaustion, family breakdowns and substance abuse are common in high-stress jobs with ultra-long days. The extent of the gradual degradation of character – intelligent and interesting people reduced to narrow-minded careerists – is a matter of ongoing debate.

I have spent much of the last five years searching for financial villains. The 2008 crisis and the extremely slow subsequent economic recovery have exposed a deeply flawed system, and some people, groups or ideas must be responsible.

There are many obvious culprits: greedy bankers, undercapitalised banks, lax monetary policymakers, reckless governments, weak international institutions and imprudent lenders and borrowers. They’re all guilty, but some of the worst offenders are intellectual – the dangerous ideas that encouraged overconfidence during the credit bubble and ineffective policy in the aftermath. Financial theory is a big problem. In particular, I accuse the risk-free rate of return of being the devil’s work.

Some aspects of the theory have already received a great deal of criticism, but the complaints are mostly quite technical. Beta, or market return, is too often dressed up as alpha, the extra return attributed to an investor’s skill (or luck) picking particular investments. And the distribution of daily returns is actually not mathematically normal, as much of the theory assumes. But I think the problem starts right at the beginning, with the assumption that there is a readily available, perfectly safe investment. The theory basically compares the range of likely returns on every other investment to the certain gain from the risk-free alternative. Additional returns are expected to compensate for additional risk.

Four decades ago, everyone knew that the UK had a social problem. Class divisions stunted the development of a substantial, well-educated middle class, leaving the economy in a strangely Victorian state – divided between a gruff working class, which was prone to strikes and obstruction; and the incompetent elite, which seemed unable to adjust to the end of Empire.

Times have certainly changed. Britain is now prosperous and predominantly middle class. Union strangleholds have given way to flexible labour markets. The country is a magnet for global talent, drawn by a cosmopolitan culture, not to mention the use of the leading global language. High value-added international services are its speciality.

But something is still wrong. A country with so many advantages should be doing better. Think Switzerland – another country of social peace, high skills and a post-industrial economy. The Swiss run a hefty trade surplus. The country has a very low unemployment rate, low inflation and a fiscal surplus. The nation’s biggest monetary challenge is to keep the currency from rising.

I have a dream: a world without debt, and with much more equity. It’s not just that summer holidays are a good time for fantasising. The fifth anniversary of Lehman Brothers’ bankruptcy is a month away, and regulators have recently forced both Deutsche Bank and Barclays to issue more shares.

Some regulators’ beach thoughts may drift to the magic numbers of bank capital ratios. My approach is less technical and more philosophical. I wonder why the financial system relies so much on debt. Loans and bonds are poorly designed for their primary economic purpose – investment.

This observation may sound shocking. Interest-bearing debt is considered totally normal. Financial theory unquestioningly treats risk-free debt as the standard instrument. Savers usually compare all investments to a similar standard: safe bank accounts which pay a steady interest rate.

The bankruptcy of the city of Detroit has many causes, including poor management, industrial history and dysfunctional American sociology. I think there is also an ethical problem: too little cross-border solidarity.

I don’t want to downplay the other failures. A more competent city government would have addressed, rather than added to, the problems. The U.S. car industry proved a disastrously weak economic anchor. And without widespread racism, there would have been fewer ghettoised African-Americans.

Still, the economic and sociological poison has not been spread equally. On the contrary, it is concentrated inside the legal borders of the city of Detroit. The Detroit of common speech and common sense – the big blob on a national map, the urban area served by a single international airport – has suffered much less.