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A non-essential read for those interested in the lessons from history on the importance of incentives and the implications for investments.
The 1987 film Wall Street included a famous speech made by Gordon Gekko, a corporate raider played by Michael Douglas, in which he stated that “greed, for lack of a better word is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit.”
This is a big statement with strong implications for investments, including the appropriate ownership structures of fund management firms, the appropriate remuneration structures for their employees and the effectiveness of performance based fees, but is it true? The issue was examined in the 18th century by the Scottish economist Adam Smith who wrote: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self interest.” His metaphor of the “invisible hand” is key to our understanding of capitalism today:
But in the 19th century, Smith’s view particularly in relation to the role of Government was challenged by the German philosopher and economist Karl Marx who wrote that “the history of all … existing society is the history of class struggles”, that “the oppressed are allowed once every few years to decide which particular representatives of the oppressing class are to represent and repress them” and “the first step in the revolution of the working class is to … win the battle for democracy”. While the communism that Marx envisioned did not come about through democracy (as the Russian tsar and his family found out) it did become the economic and political system of the East, led by the USSR and China, in the 20th century:
So why did communism fail in the USSR? One explanation can be found in the role of incentives. In this communist system, there was arguably no incentive for workers to be efficient nor ethical. A study in the USSR found that over 50% of the workforce admitted to drinking alcohol on the job and nearly 40% to working a second job without informing their main employer (often the Government). There was little incentive for companies to innovate as there was not the incentive of strong wealth creation nor the threat of wealth destruction that is faced by companies in capitalist systems that fail to adapt. The Austrian economist Joseph Schumpeter referred to this as the creative destruction cycle:
The failure of the creative destruction cycle to operate in the USSR contributed to the collapse of its communist system. But why hasn’t communism in China faced a similar fate? It didn’t have a particularly good start as the “Great Leap Forward” of Chairman Mao in the late 1950s, which attempted to shift China from an agrarian to an industrial economy, failed. Communal farm output figures were artificially boosted due to the perverse incentive to increase food quotas but the false figures led to grain being exported which resulted in widespread famine. This led to the Cultural Revolution as Chairman Mao attempted to purge the remnants of capitalism, driven by his incentive to preserve his position:
So how did China go from such a disastrous position at the time of Chairman Mao’s passing in 1976 to the vibrant economy that we see today? The answer lies in a trip by Chairman Mao’s successor, Deng Xiaoping, to Singapore in 1978. Singapore’s Prime Minister Lee Kuan Yew showed Deng Xiaoping what he had achieved in the very short period since Singapore was founded in 1965 through providing incentives to attract foreign investment and by rapidly transforming Singapore into an export led economy with high education standards, strong social cohesion and a clean environment.
Deng Xiaoping followed the example of Singapore and went about a process of adopting elements of market economics while maintaining the power of the Communist Party of China, which was referred to as “socialism with Chinese characteristics”. By 1980, China had set up a number special economic zones that emulated Singapore, including Shenzhen, and its success has to be seen to be believed:
So what does all this mean for investments? It means that in considering a potential investment, historical evidence shows that strong consideration should be given to the incentives of every participant that will make that investment successful or not. This includes incentives for fund managers, managers (of companies or assets) and employees and also system wide incentives including taxes, Government policies and regulation. While there is seldom a single best answer, these are issues that JANA thinks about deeply in evaluating the ownership structures of fund management firms, their remuneration structures and the potential to utilise performance based fees to improve alignment of interests with our clients.
Rather than Wall Street, history has shown that it is Incentives that we should be watching:
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