Two Forms of Cultural Bias:

Asymmetrical Knowledge Cripples the Capacity to Learn

Successful business is learned. Suppliers learn how better to serve customers. Customers learn how better to relate to suppliers so that that they get what they want. Suppliers must act before they are certain they have what a customer needs. If they fail to act or wait on better information, a rival will make the first move with the all attendant advantages. In other words suppliers approximate what they think a customer wants, inevitably committing errors in this process and losing some of their money. But this gives them a chance to improve their offering, correct their errors and gain money as they zero in on what a customer requires. Approximating ---improving, erring ----correcting and losing---gaining are essential to organisational learning. What customers want must be investigated, discovered and delivered.

It is crucial in any wealth generating relationship that each party have the power to reward and to punish the other, to enable the other to lose or to gain depending on the effectiveness of their conduct. It has been well said that we learn from negative feedback that is from something we did not expect. If we are always correct we have no occasion to learn more and will not improve. Our customer or our supplier must be able to change our practices. Note that both customers and suppliers gain from this mutuality of learning. Just as banks punish us for bouncing cheques and for unauthorised overdrafts, so we should have ways of making them more effective, perhaps by taking our business elsewhere.

What might wreck the effectiveness of such a system? One strong candidate is unequal powers to punish and reward or the capacity to evade punishment and loss entirely. At the root of such gross inequality is an asymmetry of knowledge. Banks have a big advantage over us, even over major investors and corporations and they use this to make gains whether they have erred or not and regardless of whether they have satisfied us or not. Seeking profit as all companies must, they contrive to escape any loss whatever might be their error.. This kind of profit maximisation is pathological because learning is crippled.

Banks may even cease helping and sustaining the larger economy and become a burden upon it without realising this!

Finance has always been part-business, part-gambling. In a casino or racecourse the average punter loses and the average layer gains. Bookmakers "balance their books" when they gain whichever dog or horse wins. In a casino the Croupier's Take ensures that 15% or more of the money staked is retained by the house. The more often the wheel spins the more he takes, so increasing the volume of transactions is an important goal. We are not interested in condemning gambling, presumably such persons "buy excitement" and keep coming back for more. We cite this similarity because a bank is not simply a party to a contract but the designer of a system in which customers play and pay, sometimes at a known loss. A system originally designed to join borrowers with savers seems to have come a long way from its original function. The world financial system has an overlay of speculation so massive it dwarfs the initial object of helping businesses to invest and prosper. Money sloshes around the world like an overfilled bath tub.

What we have are financial agents so much more knowledgeable than their clients that when this knowledge is translated into power they cannot personally loose. They write themselves contracts where it is more expensive to dismiss them than retain them, where short-term gains accrue to them regardless of longer term losses. They insulate themselves from the coming crash and leave their foundering companies with personal fortunes. When you crush the feedback loop on your own conduct you become progressively more incompetent and irresponsible ("Power corrupts and absolute power corrupts absolutely"). Consider the likely conduct of someone who "cannot lose". The most likely behaviour to emerge would be an escalation in reckless risk-taking, enjoyed for the sheer thrill of the gamble, a triumph of one's own potency and manliness, a shooting for the moon. Might this not become addictive? Have we just witnessed this and its consequences?

The diagram explains why investors faced with this situation might throw in the towel and withdraw their funds. I am indebted to Jonathan Ford for the argument that follows. He estimates the real long-term returns from stocks as 5-6%. The first "croupiers" to start taking were top corporate executives. By 2002 the share of profits in the form of stock options going to executives reached 20%. And of course their knowledge was far superior. They were "in" the companies and knew their secrets. This knocked a percentage point off the average returns of investors at large. Another half percentage point comes off as a charge for mergers, acquisitions and other services. Then there are the costs of trading, commissions to brokers and the "spread" between bid and offer prices of shares. This accounts for another 1%. A fund manager with an average holding pattern of one year, that is 100% turnover of stocks each year, costs another 1%. All this pushes returns down to 2.5-3.0%. Retail investors fare worse with management and administration fees of 2%, rendering their investment as almost worthless. All this is without the huge increase in secondary trading, derivatives, swaps, options and hedges against volatility.

In the graphic, The Knowledge and Power of Agents has risen relative to the Knowledge and Power of Principals, so much so that the Croupier's Take on the summit of the precipice has swelled. But those funds had to come from somewhere and it is investors themselves who have been getting such scant returns that they have withdrawn their funds en masse with the world-wide collapse of stock markets. There was no check on the conduct of agents. They engineered gains with scant regard for the fate of their clients and appropriated such a large slice of the pie that the banquet ended abruptly.

(please come back tomorrow for Charles' next briefing)