The Firestorm is Starting:

Financial Reform, Industry Puschback and Political Sausage-making

By Dave Livingston. Dave is a management consultant with almost 30 years of experience with analyzing
complex business problems and developing solutions and new businesses. He blogs on public affairs at
his blog Parts, Systems, Structures and Outcomes (http://llinlithgow.com/PtW/ ) where he attempts to
apply that toolkit to current affairs and public policy.

Introduction

The problems with the Finance Industry are fairly well known, in some form or another, because we’ve all suffered
the consequences. As a result one of the major issues slowly working itself thru the legislative maze are major re-
formulations of the regulatory framework. The proposed changes, in whatever final form they take, represent as
large a structural change as any we’ve seen since the 1930’s and the reactions to the Great Depression.

Because the Industry is systemically important, touching as it does, the lives and well being of every person,
these reforms are innately, inherently important. One could even say critical. Representing as they do a major
change in the rules by which the game is played it’s no surprise that all the major players are doing their best to
influence the outcome. The question is in whose best interests?

One can’t expect any industry to act purely for the public good but the level and nature of the pushback
represents an attempt to maintain business as usual. And continue the culture that’s brought us three decades of
slow growth, poor job creation, a mountain of debt and stagnant wages and benefit growth. Three decades where
we’ve increasingly seen the results of what economic growth there has been go to those earning the highest
incomes. We’d suggest that the two are not uncorrelated.

The Industry’s pushback is based on the argument that the efficient and effective allocation of capital is essential
for the health of the economy and the prosperity of society. It so happens that, in the long run, that’s true. As Neil
Ferguson discusses and demonstrates in his most recent book, “The Ascent of Money”. But the case against
reform is based on the notion that capital allocation is in fact efficient, effective and, in a word, sound. Ah, there’s
the rub, indeed.

Below we dive deeply into the “business case” for/against reform. We also take a pretty deep look at the political
sausage-making of reform and the current state of play and the outlook Our findings are that the case for deep
and wide-ranging reform are very clear cut. The Industry has pretty well established that self-supervision is not
workable and that adult referees are required to ensure that the game is played well and according to the rules.

There are bigger issues at stake here as well. Not just the most systemically Industry and it’s influence on the
economy and society. Also at stake is the question of how effectively we can reduce the impact of narrow
interests struggling to influence legislation and regulation for their own narrow benefit. In some ways, and not to
be to dramatic, we are in fact debating the nature of Capitalism and what our collective futures will look like.

Can we find, develop and implement an effective governance mechanism that works to everyone’s benefit, or
not? We even argue, and we think demonstrate, that it’s in the interests of the Industry to re-engineer the
regulatory framework. Sadly though they don’t see it that way and want to continue the Bonus Culture, which has
proven dangerous and ineffective.

This is one among many great debates of the time and will tell us a lot about what the future will look like.
 Table of Contents

Essays

The Chinese Goldsmith, Finance and the Next Big Fight 3

Banks Hate Banks, Voters Hate Banks: Hear the People Singing! 6

The Beginnings of a Great Debate: People Singing, Politicians Making Sausage 8

Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin 11

Pictures for a Prosecution: Wall St. Bonuses vs. the Public Good 14

Bonus Fantasies vs Political Realities: the Reform Firestorm This Time 16

Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages 18

Readings

Financial Industry Performance and Reform 22

Background References on Institutions and Economic Development 22

Page 2 of 23
October 22, 2009

The Chinese Goldsmith, Finance and the Next Big Fight

http://llinlithgow.com/PtW/2009/10/the_chinese_goldsmith_finance.html

The last several months have seen partisan fight after

partisan fight in Washington, often leaving us average citizens
as innocent bystanders or even collateral damage, or so it
seems to many people. Now we' ve been focused on the
Healthcare Reform fight and the debate on Afghanistan. On
the first there was some amazingly good news, the last
committee passed a proposal out of the Baucus Committee to
the rest of the Senate, though the day before the Insurance
Industry published a report attacking the proposals that was
so bad even the consultants who wrote it have disavowed it.
On Afghanistan we by stand what we' ve been saying - it'
sa
mess but if we walk away again it' ll be worse.

The big fight you may be missing is the one over Finance
Industry Reform. It was back-burnered because of the
urgency and importance of immediate business, e.g. saving
the country from economic collapse, but is moving center
stage. Like many of the stakeholders in HC Reform those in
Finance have been fighting to water down the bill but in this case with less justification, if possible, more
smoldering anger among the public and, with this week' s announcements. The Industry argues that the last two
quarters of monumental bonuses are right, proper, the way they do business, indicate a return to health and good
for the economy and country. The country' s mood is probably captured by the cartoon collage but just in case
were wondering how angry people are check out this video clip from Dylan Rattigan' s Morning Meeting. The
question is who's right? (http://www.msnbc.msn.com/id/31510813/#33414533 )

Post De-regulation: Finance Industry, Debt and the Economy

There' s no question that a properly functioning Finance Industry is necessary

for a growing economy and contributes to long-run growth and prosperity. Neil
Ferguson covers millenia of history in addressing that in his PBS Special "The
Ascent of Money". We' ll rest the strategic case there and focus instead on the
narrower one of is our finance industry functioning properly? In particular has
it contributed to our wealth and prosperity at an acceptable cost to society,
that is are we getting a return for our money? :)!

The graphic starts to speak directly to that with the top part showing recent
changes in debt among several sectors (NB: all this worry about excess
government borrowing is mis-placed, btw; right now it' s simply absorbing all
the excess sloshing around as everybody else de-leverages and is likely to do
so for years).

The bottom part of the chart is the really interesting part. On the left you can
see ordinary businesses continuing a gradual growth of their borrowing while
the Finance Industry, ex-post mid-80s de-regulation, securitzation and
financial engineering wizardry, shooting for the money...oops, we mean moon.
Similarly consumers got completely carried away as well, again beginning with
the widespread availability of cheap consumer and credit card debt.

Page 3 of 23
Judging from these charts the net impact of the last three decades of de-regulation was to load down everybody
in the economy with loads and loads of debt. Which sustained the explosion in consumer demand that fueled
worldwide economic growth. As the US consumer pulls back, de-leverages and re-builds their balance sheets
we' re facing a fundamental change in the underlying economic structure we' ve been dealing with.

Finance Industry, Debt and Bonuses

So what did the Industry do with all that debt? Well judging by
this chart, again from the WSJ, it looks like what it did was pay
itself bonuses from the profits from loading up the rest of us
with debt.
Just to draw the points home Wall St. compensation before
WW2 was significantly higher than compensation in the rest of
the economy and then went thru a huge equalizing drop. Then,
after de-regulation, it sky-rocketed back to the mooney until it
exceeded the relative levels seen during the 20s and 30s! So
much for the argument that high bonuses are innate in the
Industry or contribute to the overall health and well-being of the
economy.

We won' t go thru the charts or arguments but will mention that

prior to de-regulation and bonuses excesses the US enjoyed
both its highest rates of saving and its highest rates of economic growth. We'
ll also add that the last couple of
years have seen an enormous destruction of wealth for the average citizen. In the readings you' ll find very
extensive links and excerpts to a huge inventory of readings that examine the business performance of the
Industry, economic policy and the state of the economy.

Let'
s summarize the findings so far, inclusive of those readings:

1. The Industry argues that bonuses are a natural part of the way it does business but not only is that not true but
ALL the profits in the last two quarters were the result of proprietary trading, i.e. speculating on their own account.
That'd be o.k. if it were their own money at risk but actually, between bailouts, Fed guarantees and bond
purchrases, etc. it' s our money and our risk but their profits and bonuses.
2. While efficient and effective finance is important we think we' ve also shown that an industry built on leverage,
securitization and financial engineering has created a situation that has over-loaded the economy with debt and
hampered growth. So much for the "social value" argument.

3. The "encumberances" on the rest of us are part of the problem but then again the Industry almost destoyed
itself; in other words by blindly and apparantly mindlessly pursuing excess risks they didn' t understand they
destroyed the last decade' s worth of what turned out to be paper profits inside the industry. In other words as
businesses they performed abysmally.

4. Finally, and obviously of course, they almost brought down the entire economy and destroyed Western
Civilization. Just in case you hadn'
t noticed! :).

Page 4 of 23
Helmet Laws, Adult Supervision and Re-regulation

Peter Drucker tells us a business has three main purposes - it should:

1) create value for society,

2) create an effective work environment that makes people effective and
3) it should contribute to the health of society.

He further breaks down the last point into three major points about organizational social responsibility by arguing
that any organization should also
a) do no harm,
b) act to correct harms innate in its activities and
c) support the correction of society's problems because no organization can be successful in an un-
healthy society.

How would you judge the Finance Industry on those criteria? Based on the points we'
ve summarized above and
document extensively in the readings?

People argued that seat belt or helmet laws are an

unwarranted interference in private decision-making. We
confess to having similar notions ourselves but then we
thought about it. When some idiot goes ripping down the
road without a helmet and crashes society is put to the
problem of cleaning up the mess, treating the idiot and
taking care of the innocent victims. This kind of external
damage is why we end up with helmet laws.

The President and his administration have been inviting the

Industry since taking office to act responsibly and this last
weekend many senior members of the Administration made
appearances on the Sunday news shows to repeat and re-
iterate the appeal. Not to mention the President' s speech to
Wall St. several weeks ago. We' d suggest that when you' ve
got the President and many senior members of Congress
mad at you you' re making a major mistake. When it turns out
your case for arguing with them is beyond wrong you' re in a
world of hurt. Yet the Industry continues to appear tone-deaf
where these issue are concerned. If you don' t think he's serious we suggest you listen to the CSpan vidclip
(http://www.c-
span.org/Watch/Media/2009/10/09/Economy/R/24155/Pres+Obama+Pushes+Regulatory+Reform.aspx )....not
just the words but the tone and body language. For Mr. Cool we' d suggest he'
s more than a little irate.

The Chinese Goldsmith vs the Special Interests

Mancur Olson in his book The Rise and Decline of Nations:

Economic Growth, Stagflation, and Social Rigidities about how
special interest groups eventually seize control of the levers of
power and begin acting in their own narrow interest and sacrificing
the good of society tells an interesting story from the end of the
last Chinese Imperial Dynasty. In seems an innovative goldsmith
tried to introduce modern wire-drawing equipment from the West
that would have enormously improved the productivity of his
apprentices, let him make a lot more jewelry and sell it at much

Page 5 of 23
cheaper prices. The end result? His fellow goldsmiths found this change all together too threatening to their iron
ricebowls and put him to death using the "Death of a Thousand Cuts"!

Now in this case who'

s the innovator and who'
s protecting their iron rice bowls? An exercise for the reader with,
we hope, an obvious answer.

We' ll leave you with a final hint...again channeling Herr Drucker. When an Industry refuses to correct a major
problem it leaves society no choice but to step in and fix it, even when the fix is not ideal. He further adds that its
a fundamental management responsibility to anticipate these problems and fix them before society is forced to.
To otherwise is deeply irresponsible.

And your judgment?

October 28, 2009

Banks Hate Banks, Voters Hate Banks: Hear the People Singing!

http://llinlithgow.com/PtW/2009/10/banks_hate_banks_voters_hate_b.html

We' re going to stick with Financial Reform for a while because

so much has happened in the last week, and even more
importantly, because it' s such an important, even critical, issue.
In some ways, though not all, Financial Reform is the single
most important domestic policy challenge after stimulating the
economy. Healthcare Reform as well as Education, Energy and
Innovation are probably more important in the long-run but to get
there we need to have a healthy, reliable and effective Finance
Industry. Setting aside the natural anger that almost all of us feel
about the last two years, which should be counter-balanced by
the fact that we all rode the gravy train for the last three
decades, we' ve concluded that the policy and business cases for
not reforming Finance do NOT hold up, and in fact are
completely contradicted by the facts and the economic history.
But, like almost every other major policy initiative, we' re now having to pay the Piper for that three decades party,
before he comes to collect with claymore in hand.

Take a few minutes to listen to this BNN clip (http://watch.bnn.ca/market-morning/october-2009/market-morning-

october-27-2009/#clip228128%20 )from the founder of a Canadian securities firm who sounds about like the rest
of us on the banks, but starts with discussing his recent trip to Afghanistan and the level of public dedication
displayed as well as the level of progress. Then close the loop....what a compare and contrast between the
Financiers and those troops. You might also want to check out Andrew Sorkin on Charlie Rose (go to the site, go
to the archives and scroll down) and this recent PBS Special on Brooksley Born and futures regulation. Among
other things Sorkin uses a key phrase - "tone deaf". What' s happening to the Industry is something that they
refused to see coming because they figured it was business as usual. On that topic Ms. Born' s history should give
you a bit of the history involved.

Page 6 of 23
The Vicious Cycle of Malfeasant Financial Engineering

The last post went into some length on

why the business models are broken and
why the case(s) for leaving the Industry un-
regulated don' t hold up as well as pointing
to support from an interesting range of
commentators, from Greenspan to Volcker
to Mervyn King of the Bank of England. In
the accompany graphic we' ve tried to
summarize those arguments and put them
into the context of the bigger economic
picture.

The top box summarizes the key economic

policy goals that we must succeed at, no
ifs, ands or buts, if we' re going to stabilized
the economy, get it growing again and re-
create a healthy long-term outlook for us
all. A healthy and product Financial sector
is vital to all of them, but is key to #6 and
IS #7!

The righthand box summarizes several of the critical arguments we concluded the last post with on what a
contributory organization has to do to be a constructive member of society. We are after all a large and complex
society that would be unable to function without our large organizations. In other words effective organizations
that make a positive contribution, are well-run and, at minimum, do no harm to society, are inescapable to our
meeting those goals. How would you grade the Finance Industry on those topics (please feel free to review the
last post again)? We' d offer up our grades but there'
s nothing below an F and somehow that seems inadequate
for an Industry that almost collapsed Western Civilization.

It also seems in adequate for an Industry that's taking advantage of public funds and support programs to create
giant trading profits to pay bonuses when there' s no demonstrable positive contribution. In fact we could even
argue that paying those bonuses when, at minimum, they should be used to shore up the capital of the banks is
essential. The lefthand box summarizes our findings from the last post, and all the readings excerpted there, on
where the Industry has failed us. The bottomline is that an argument for bonuses because it' s essential to an
efficient and effective industry doesn'
t hold up very well.

The Economic Outlook

Martin Feldstein was recently interviewed on BNN, the

Canadian Financial News network, about his take on the
industry and regulation in two parts. Wrapped around his
comments in part two are his comments on the state of the
economy and the outlook, and he' s not very sanguine. In
fact he sees a weak recovery with serious downside risks for
another downturn without government support. Now as it
happens he' s NOT as strong on controlling bonuses and
risk-taking as we are but we' d argue that he hasn' t looked at
those issues as carefully as we have, or in much depth. In
fact it'
d be interesting to have him or his team at the NBER
take a look at the issues. You can see Part 1 of his interview
by clicking on the highlights. (http://watch.bnn.ca/headline/october-2009/headline-october-28-2009/#clip228671 )

Page 7 of 23
In fact while you'
re at it here are some other BNN interviews that are directly and specifically relevant on the state
of the economy, the challenges we' ve still got ahead of us and the Industry reaction to regulatory reform. Rather
than leave you entirely in suspense it struck as fascinating and encouraging that the industry business experts
also supported reform. The sooner the better, too!

Dallas Fed President Richard Fisher

The president of the U.S. Federal Reserve Bank of Dallas says he sees the beginnings of an
"inventory correction" in the U.S. economy. But, Richard Fisher also says a recovery is going to
be "tough slog". He spoke with BNN' s Howard Green in this exclusive interview. Part 1 and Part 2

Reaction to Fed Statement on Compensation

The Obama administration' s pay czar released a report calling for big cuts in executive pay at
companies that have yet to repay TARP loans. Paul Bagnell reports and BNN speaks to Scott
Talbot, senior VP, government relations, The Financial Services Roundtable.

The Optics of Executive Pay

BNN investigates executive pay with Christopher Chen, regulatory lead, executive compensation,
Hay Group.

We trust from the opening clip to the Rose and PBS programs to our own arguments plus the BNN interviews and
reporting we've made a sufficiently strong case for why this is critically important? Feel free to write your
Congressman. In fact, please do!

Just in case we haven' t you'll find a rather extensive reading except collection after the jump that is at least worth
skimming IOHO, starting with an excellent Jim Jubak column on how badly broken the banks are in their
traditional lines of business and where they' re making their profits. Plus some stories that back up the
"Malfeasant" part of the title, readings on compensation and some more on the need for structural reform. The
final section on the readings is on Capitalism and its future - we particularly recommend them here. It turns out
we' re fighting another Cold War here.

Several years ago a Marine Archeology team explored Kublai Khan' s "Divine Wind" fleet that invaded Japan in
the 13thC. What they found is that many, if not most, of the ships were built to hugely sub-par standards. Partly
because they were rushed but mostly because the Mandarins in charge grafted off the public funds for their own
purses. Who says History doesn' t repeat itself!

November 19, 2009

The Beginnings of a Great Debate: People

Singing, Politicians Making Sausage

http://llinlithgow.com/PtW/2009/11/the_beginnings_of_a
_great_deba.html

Let's go back and pick our theme of Financial re-

regulation. On the surface that may appear to be a real
swerve from our discussions of, stress and self-
management. Or even the first bookend on "change is
hard". It's actually not. Now this is critically important in
and of and for its own sake. But it' s also a case in point.
It actually points to the problems when self-delusions

Page 8 of 23
and hubris create gigantic problems. It also a perfect example of the problems with sausage-making in the policy
and political factories. It should be fairly clear at this point that reform is necessary and justified. But as reform has
wound its twisty path thru the factory the Industry has been fighting it tooth and nail. Normally all that, like all the
other momentous changes we' re collectively tackling has been more visible than usual so we get an inside view of
the slaughtering and processing that would normally be well hidden. The question, tying both threads together, is
what kind of sausage do you want? In other words this about change on the personal and social level.

The Warning: How We Got In This Mess

An interesting question is it not? Overall it turns out

we all drank the koolaid, some much more than
others and therefore more directly responsible. But a
central cause was a widely shared belief that markets
would govern themselves. An argument that ignores
the vital role of law, a court system and police to
enforce it. As well as rules and regulations that make
markets possible. There is no market that has ever
existed that didn' t have some mechanism for defining
the nature and quality of goods, how they can be
exchanged or what the price-setting mechniams are.
And ways of adjudicating and resolving disputes.
Whether it' s buying groceries, getting a new car or
house, something arcane like a wheat (or pig) futures contract. Or punishing the guilty and malfeasant - just ask
Bernie Madoff or think back to Enron and Ken Lay or Worldcom and Bernie Ebbers. Not only did we all drink the
koolaid and surf a wave of funny money to buy all those things we believed.

Nonetheless when there are rules there are those who will focus on manipulating them to their own advantage
rather than playing the game. And from time-to-time there are key players who try and make sure the game stays
honest, fair and just. When the players spend more time on manipulation than trying to win economists call that a
rent-seeking society - in other words rule manipulations trying to create rents just like the old German River
Barons put up their castles at bends in the river to force merchants and bargemen to pay tolls, or rent. In the late
'90s when the players were really starting to play rules one person, Brooksley Born, took a shot at reforming the
game and was shut down by the koolaid drinkers. With the widespread applause of the Industry and society
ringing in their ears. PBS did a marvelous special on her and The Warning which you click on the picture to
watch. The web page is here.

No More Koolaid? Industry Reactions

Now everybody' s sworn off Koolaid - well almost everybody. A

few weeks back there was an Industry conference in NYC
(SIFMA) where Charlie Rose interviewed Jaime Dimon. Mr.
Dimon is one of the good guys inside the Industry in all this
and he has a lot of wise and insightful things to say. BtW -
Rose has changed the structure of his web site so the clicking
on the clip takes you to it rather than the specific interview.
You have to scroll the archives - in this case the online only
specials. But it'
s really well worth your trouble, at least IOHO.
(www.charlierose.com )

Perhaps the most interesting thing is Dimon acknowledges

the problems and failures, recognizes the need for a massive
regulatory overhaul, has some well thought out suggestions and comments and so forth. But at the end of the day
there are some things he still finds too hard to swallow about some of the proposals on the table. And this is the
best of the best - literally. If he'
s pushing back how' re the lobbyists in the backroom doing? Especially now that
they are really doing God' s Work, at least according to Lloyd Blankfein of Goldman Sachs. You know them - the

Page 9 of 23
secret government who' s profited the most from public money and support and is in the process of paying the
biggest bonuses in a decade? A decade of widespread over-consumption of the Koolaid where bonuses were
outrageous? And now they' re paying bigger ones?

Inside the Factory: Reform Requirements and Outlook

At the same conference Rose also interviewed Tim Geithner

who talked about all the things that need to be done as we
re-think what' s a safe industry and how we get there. There' s
probably no better sketch of what needs to be done and,
from a strictly policy perspective, how we might get there.
Larry Summers and the President have made similar
speeches. We even commented before on the President' s.
The question of how the sausage is going to get made is a,
shall we say, tad problematic. In the readings you' ll find a
collection of excerpts and links to some key readings that
survey the situation, review the history and talk about the
politics involved. Worth skimming at least.

Now at the heart of the Industry' s pushback is the argument

that what they do is essential to the efficient and effective
functioning of our economy, and therefore the health, well-being and prosperity of our society. In the longrun
they're right - throughout history sound capital markets are essential (cf. Ferguson'
s "Ascent of Money" on PBS).
The glitch is in that word sound.

Beginning the Great Debate

In previous posts plus some other investigations the

business case, as it were, practices as usual and limited
reform fail on five counts:

1) Financial Industry malfeasance almost destroyed the

economy, brought on Great Depression 2.0 and might have
collapsed Western Civilization.

2) The collective and cumulatively losses of the last couple

of years wiped out most of the last decade’s profits, even
though they were all funny money in the first place. In other
words the Industry almost destroyed itself. It'
s in their own
best interests since obviously they can'
t be allowed to play
without adult referees.

• NB: the bonuses that the Industry started paying itself grew exponentially starting in the ' 80s, accelerated in the '
90s
and turned into a bubble in the '
00s. And put compensation completely out of line. There is no evidence that those
bonuses contributed positively to the health of society. In fact all the evidence is the other way.

3) Post de-regulation in the '

80s we began almost three decades of wild indulgence in debt and over-consumption
that loaded up the Industry, the consumer and business with leverage that we couldn't sustain.

4) That debt caused savings to drop to nothing and severely retarded investment and economic growth.

5) The lack of economic growth led to a relatively stagnant economy with poor job creation and flat to declining
wages and benefits. And that, in turn, has led to an increasingly stratified society where the top 1% of earners,
strangely enough somewhat concentrated in the Finance Industry, to garner all of the gains of the last three
decades.

Page 10 of 23
When a society, historically, spends more effort on rent-seeking and power elites focus their careers on rule
manipulation then it eventually succumbs to sclerosis and dies. Just ask the farmers and peasants who harvested
all the wood on Easter Island and destroyed the ecology just to keep making giant statues for the Chiefs.
We are not just debating Financial Reform but the kind of society we want, whether we can find it within ourselves
to change and, indeed and not to get too dramatic, the future of Capitalism. Can we find the governance
mechanisms that make it work and renew the most productive system mankind has ever come up with? Or we will
choose to continue the descent into Collapse (cf. Jared Diamond)? A great debate indeed.

September 19, 2009

Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin

http://llinlithgow.com/bizzX/2009/09/ask_not_for_whom_the_siren_shr.html

The title is a play on words of course, taken from

John Donne' s Meditation VII, which starts, "No
man is an island entire of itself; every man is a
piece of the continent, a part of the main" and end
with "And therefore never send to know for whom
the bell tolls; it tolls for thee.". The message being
in a society we are all mutually interdependent.
Sadly, this is a message which not only seems to
have been lost on the Finance Industry but they
would appear, judging from last quarter' s
earnings and their source in proprietary trading
profits, to turned on its head. Ask not for whom
the bell rings for it rings for me, but never thee.

Having been monitoring and analyzing the

business performance of the Industry for two
years now we were, and are, nonetheless very
surprised. Because the other side of that coin is that society requires that it' s major organizations and institutions
provide a service that creates value. And, especially, does no harm to society. When the opposite is true, and
when it looks likely that the behaviors will continue, society has no choice but to act. Well this week is the
anniversary of Lehman' s fall and it behooves us to ask what lessons have we learned, what have we done to fix
the systemic and systematic problems and what will we do. Washington has been focused on saving us from our
own and the industry' s follies but the President marked the occasion with a speech to Wall St. putting them on
notice that the reckless behaviors of the past will no longer be tolerated; and inviting them to constructively
contribute to creating new regulatory regimes. An invitation they' ve had for months and been fighting in every
possible way. The week ended with the Fed' s announcement that they will start setting compensation policy.
Meanwhile Barney Frank on MSNBC provided pretty clear indications of where he sees things going and Pecora
II is about to kick off. Now it' s a siren rushing to the crime scene and the results could be very ugly.

Page 11 of 23
Perverse Incentives, Bad Consequences

Let's review some stuff we' ve gone over before

separately and put a new picture together, plus
add in some stuff, from this week. Here we
look at the overall performance of the
Economy vs sector Profits, the Economy vs
Markets and Wall St. vs Society. The UL chart
we've talked about a lot so moving on the UR
chart is updated and shows real SP500 vs real
GDP cumulative growth from 1950 to now. The
bottom triptych puts charts showing the growth
of Debt with Wall St. relative compensation
and Bonuses. Taken all together it almost
seems to us that a complete story is being told,
eh what?

But what we have is de-regulation that led to a

wave of financial engineering innovation that
started by creating value but soon focused
almost entirely on internal products, e.g.
proprietary trading, that created a tsunami of
debt leading to completely out-of-balance
compensation for the Industry. Not least
amusing is that this didn' t metastasize until this decade. In other words despite all the tooth-gnashing about
systemic problems and accumulated history it wasn' t really until the last five years that we all got ebolasized!
Anyway that' s how we read.

Give 'em More Rope

One of the interesting things, whatever else you

might think, the political sausage-making the
Administration went thru on Healthcare was carefully
managed and got buyin from all the major
stakeholders. The Administration took the same
careful steps, signaling its intent in advance,
contacting the players. trial-ballooning multiple
aspects of its agendii and so forth. Unlike the
Healthcare stakeholders the Finance Industry has
been fighting tooth and toenail. Now that the rest of
the agenda, like saving the economy, has made
some progress they apparantly feel it' s time to dig
into finance. We dissected the major lines of
business, which made money and which didn' t and
how, in a prior post (BaU vs. NN I: Finance Fumes,
Realities and Pecora II).

The bottom line is that the Industry think that not that
they'
ve been saved it' s time to return to business as
usual. In point of fact all the bad capital is still on the
books, it could take a decade to repair, the business
models in each line of business are broke, it' s been

Page 12 of 23
government support and guarantees for Housing loans (80% of mortgages are FHA), "bank" funds and various
Fed instruments (TALF, etc.) that have let things return to a semblance of reality, when we were all trembling on
the edge of the cliff. Yet the Industry and investors are treating things as if it never happened. We use the Finance
ETFs to gauge that where IYG is the Industry, IAI is Broker-Dealers, IAK is Insurance, and IAT is Regional Banks.
Now either we' re completely nuts, the euphorialistic relief rally that the world didn't end is generating enormous
momentum or we' re right and none of this is grounded in any of the realities we' ve just listed out. We know where
we vote...how about you? We think the Industry is going to go thru a decade of poor performance that reverses at
least the last decade of perversities, or more, and returns it to its roots and that' s irrespective of what regulatory
changes occur.

Get Ready for Adult Supervision

Any organization must provide, as we' ve said, a

value to society. It doesn'
t exist for it'
s own sake
but on sufferance. When you take that down
organizations must:

1) create value-add (a profit for businesses),

2) creative a productive workplace environment
and
3) contribute to the existence of a healty society.

The grades for the Industry are so bad here,

unparalleled since the last time they screwed up
this bad, that we won't bother to give them. That'
ll
be your pleasure.

Over and above those when you talk specifically about not creating social damages there are three further goals:
1) do no harm, 2) act proactively to develop solutions to external problems created by the industry that no one
firm can handle alone and 3) contribute materially to addressing broader social problems where feasible; after all
no enterprise can be healthy in an unhealthy society. It is a preeminent leadership responsibility for management
to deal with these rather than ignore them; or worse try and actively oppose them while continuing to create
problems.

In the early part of the 20thC Theodore Vail, the first CEO of ATT, acted to create a productive and constructive
relationship with Federal and State regulatory authorities that kept ATT a profitable private company. The only
such company in the developed or developing world. The rest of the world' s telecom is run by their PTT Ministries.
It should be done, it can done and it certainly shouldn' t be done in reverse. Vail proved himself and ATT capable
of adult self-supervision. Not only did the Finance Industry do just the opposite but it literally thumbed its nose at
society in the last two quarters. The Piper is beginning to ask for his pay.

NO Plan? Don't Worry One Will Be

Provided!

We' d ask, "where' s the plan Wall St." but it'

s
becoming clearer that one will have to be provided for
them. Or so says much of the public, Washington and
the rest of the Industry who was badly damaged by
the malfeasant behavior of a too well rewarded few.

And in the meantime here' s some background

reading that collects the last two years of our
aggregate analysis plus our set on governance and
social responsibility. We suggest you might want to

Page 13 of 23
peruse it to review and refresh yourselves on some of these points.

October 13, 2009

Pictures for a Prosecution: Wall St. Bonuses vs. the Public Good

http://llinlithgow.com/bizzX/2009/10/picures_for_a_prosecution_wall.html

If you' ve been here before you may have noticed we like

to tell our story with pictures and so shall it be this time
as well, with the slight difference that they' ll be more
stories and less the complex graphics we' re prone to. By
this time you' ve no doubt heard that Wall St. is fixing to
pay another set of stunning multi-$B bonuses while the
rest of us are still crawling across the floor of the chasm,
broken and bleeding on the rocks. How does that make
you feel?

It'
s likely our point of view is implicitly clear and if it'
s not
then several of the last posts will make it clearer. One of
the bloggers we both admire and have learned a lot
from, Barry Ritholz of BigPicture, has defended the
bonuses as the way the Street works and if we want it to
recover and do its job that' s the price. Aside from the moral reactions or the questions of good public relations we
thought we' d speak directly to the implied assessment of the contributions of the Street and whether or not they
are justified and earned. We have three major problems leading to a major challenge.
(http://www.msnbc.msn.com/id/3036789/vp/33307524#33307524 )

And We Paid Bonuses Because???

1) Currently the Street' s profits are entirely dependent on public policy ranging from reduction in competition to
implicit guarantees of the TBTF banks to low interest rates to various quantitative easing programs, e.g. the Fed' s
purchase of mortgage-backed securities and the FHA' s being the source of 80% of the mortgage market flow. The
point being their profits are being made off our capital, not their own.

2) There is no evidence that the perverse incentives where all the gains went to the high-earners thru trading
gains (read speculation) while all the losses went to us are being corrected. Add to which the perverse structure
led to the failure or near-failure (including GS which had a near-death experience and was only saved by
government action) of the firms themselves as well as almost collapsing Western Civilization.

3) The really deep argument is that banks and financial institutions are the intermediaries that efficiently and
effectively allocate capital to their highest and best use. Well the prior two points tend all on their own to destroy
that argument entirely but, since we' ve been reviewing the record, let'
s review it. We won' t repeat ourselves but
will simply cite several graphics we' ve previously put up and let you pop them yourselves because, taken all
together they reach a clear conclusion.

• Wall Street profits and compensation

• Historical Growth of Debt
o WSJ Debt Growth
• Savings, Investment and Growth
• Finance Industry Case Theory
• Finance Industry Drucker Criteria Performance

Page 14 of 23
What those charts tell you is a sequential story - a logical syllogism if you will - that makes perfect sense to us
and, IOHO, completely destroys the argument that paying bonuses is innate in the industry, necessary for
performance, part of the culture and ensures that the Industry contributes to the greater good. What they tell us is
that, beginning with de-regulation in the mid-80s, that Wall St. compensation completely pulled away from the rest
of the economy because the industry made exorbitant profits, that we "indulged" in astounding growth in
indebtedness beginning then, which created the profits that paid the bonuses while destroying savings and
investment, that the periods of highest savings were also the periods of highest economic growth (this one is
particularly important), and that the Industry has failed in its duties to itself to perform as businesses and failed to
deliver value to society. We really do urge you to review the charts and see if you agree with the syllogism. And if
not then why not and what alternative data do you have to propose.

The opening vidclip is Sully Sullenberger appearing on

Morning Joe and we put it up as an example of what good
leadership is all about, in the small. We were particularly
taken with and moved by Sully' s comment that one should
"take responsibility for the people". The next vidclip is also
from MJ and is ofered as a compare and contrast for where
we' re at with regard to the Industry. We' ll just list out some
other MJ/MSNBC vidclips that add fuel to the fire. We' ll
particularly point you to the interview with Michael Moore,
not because we don' t think he'
s over the top, but because
he's representative of the firestorm that's smoldering away
waiting to be fanned into flame by more irresponsible
behavior.
(http://www.msnbc.msn.com/id/3036789/vp/33325187#333
25187 )

• Is a second Great Depression possible? : Financial Times'Chrystia Freeland and Donny Deutsch join Morning Joe to
consider whether the U.S. economy is really recovering.
• Rep. Waters ' glad'Obama going to New Orleans: Rep. Maxine Waters, D-Calif., joins the Morning Joe gang to
discuss the state of the U.S. economy and the president's quick trip to the Gulf Coast.
• The end of easy money: New York Times'Peter Goodman discusses his new book, "Past Due," a look at how Wall
St. made reckless bets and how average taxpayers took the hit
• Michael Moore talks ' Capitalism': Filmmaker Michael Moore joins Morning Meeting' s Dylan Ratigan to shed some light
on his new film, "Capitalism: A Love Story."

This is, in a way, another exercise in syllogism. Only this time it'
s sort of emotional syllogism but it also tells you
how many people are thinking the same things. After all, when a still avowedly conservative talk show host is
repeatedly castigating the Street and getting people like Dylan Rattigan or Maria Bartiromo agreeing with him we
think the case for smoldering embers just waiting to bust into conflagration is pretty well made. But just in case it' s
not, and while it'
s still up, we'
ll point you to the most recent episode of NUMB3RS, which explores the
consequences of the catastrophe and the loss of faith: Playing Russian Roulette - Seven Men Out.

Page 15 of 23
Real Leadership: Her Majesty as Exemplar

At the heart of this whole discussion is the central question, or questions: what does a business owe society and
what does a truly responsible leader owe his firm and society as a whole? Not surprisingly Peter Drucker
considered those questions years ago and came up with some deep and profound answers, which we' ve
discussed multiple times. With regard to society he saw it as the deepest management obligation to do three
things: do no harm, act to reduce negative external impacts and contribute to the overall health of society. We
converted his writings into several simplifying charts over time and we' d point you at two, for the same sort of pop-
up treatment: a Manager' s Responsiblities and Drucker' s Fundamental Principles of Executive Leadership.
We think the case has been made pretty strongly that the Finance Industry has failed to satisfy either it' s private
managerial responsibilities or the fundamental principles, and in fact, by being narrowly self-interested and short-
sighted, has actually failed itself. It would be in each firm's own enlightened self-interest to adopt and implement
those Principles if for no other reason than that society can no longer afford to tolerate their continued violation.

So what does publicly responsible leadership look like? We

think Her Majesty, Queen Elizabeth II, is as much an
exemplar of the discharge of duty with the highest standards
of personal integrity and honor as any public leader around.
We' ll also suggest that the movie "The Queen" captures those
perfectly. If you haven't seen it we highly recommend it. But
why? (http://www.youtube.com/watch?v=P8nD2KB0a_E )

The movie traces out a week that began with the death of
Princess Diana and goes inside the palaces and the Queen' s
behavior to watch her change 50 years of behavior in
response to her subjects need for public grief. All in response
to the irresponsible behavior of a spoiled girl who charmed the
public but in fact failed miserably to live up to her own
voluntarily assumed responsibilities and duties. West Point' s motto is "Duty, Honor, Country". It' s what the Queen
displays, ultimately it's what's asked of public leaders responsible for large institutions and it'
s what their own self-
worth requires. Now that trailer only gives you a small flavor, you really ought to watch and study the movie, but
these other clips will also help: Queen Reflecting on Her Life, Queen' s Christmas Message and the Queen & the
Prime Minister. I don' t know about you but she sets a standard that' s hard for me to live up to!

Now, are we going to get it or not?

In the meantime there are a few brief readings excerpts after the break, some immediate prior posts and the
pointers to our major collections of previous discussions on the Finance Industry and on Social Responsibility
going back almost three years now. We' ll trust you'
ll believe that our brief discussion here is grounded in some
careful thought and some background digging.

October 16, 2009

Bonus Fantasies vs Political Realities: the Reform Firestorm This Time

http://llinlithgow.com/bizzX/2009/10/bonus_fantasies_vs_political_r.html

If you'
re a fan of political theatre this is the season for you. After the stimulus and budget battles we'
ve had a long-
running, multi-scene Healthcare Reform debate that' s almost Shakespearean! But the other one heating up in the
wings is Financial Reform, which is going to be as much a sturm und drang drama as any other, and is moving
rapidly from the cloakrooms on Capitol Hill to the front pages of the MSM and the talk shows.

Page 16 of 23
This post should really be an addendum to the immediately prior post (Pictures for a Prosecution: Wall St.
Bonuses vs the Public Good (Add)) but there was so much that bubbled up that came to our attention today that
we decided to make it a seperate post. In particular we lost weigh too much time watching Dylan Rattigan' s show
this morning and then collecting various URL addresses so you could to. Now Dylan' s always been a little loud
and he' s gotten more so with his new show. So one could take these various clips with a grain of salt or more. If
we were the Finance Industry we wouldn' t however. For technical reasons we aren't able to create a placeholder
of a recent Bloomberg interview with Niall Ferguson on the state of the Industry but will try and create a little
attention space. It doesn't take too long so we recommend you watch it for the level set...on the whole he gets it
mostly right (our basic prejudice for selecting recommendations though Niall has a track record of not having as
deep a knowledge of finance and economics as one would hope).

Ferguson Says Bank of America Shows Crisis Not Over

http://www.bloomberg.com/avp/avp.asxx?clip=mms://media2.bloomberg.com/cache/vn2QTiRB6gaU.asf&vCat=/av&RND=552723310
&A=

Industry Pushback and Administration Counter-attack

We' ve been on this topic for some time (years in fact) but
particularly emphasizing it for the last several months and our
take is that the Industry by pursuing business as usual and self-
interested, narrow and short-sighted lobbying as traditional is
building up a backlash that could swamp them. And under-
estimating the commitment of the Administration, the magnitude
of committed opponents on the Hill and the deep-anger of the
American people. Now the Administration held out a hand to the
interest groups in Healthcare literally days after taking office, and
has slowly been pursuing its goals while continuing to offer them
the opportunity to be constructive in helping shape the new
legislation. Most of them were smart enough to take it and the
Administration is in the process of winning this fight and getting a
pretty good bill to boot (A Taught/Taut/Taunt Moment:
Healthcare Speech, Policy, Politics & Realities, aths Toward
Healthcare: Compromise, Consensus or Conflicts?).
Continued ....

The Finance Industry was offered the same opportunity but has deliberately chosen to bite the hand that fed it.
Much more so than any of the HC interest groups. The President' s speech in early September was a declaration
of war but recent administration speeches are a clear outline of intentions (Saddam Hussein are you listening?).
The video clip above is a recent short speech by the President on a Consumer Protection Agency and financial
reform in general. We urge you, again, to listen to it but not just for the content per se but for the tone and attitude.
The President sounded as angry as we' ve ever heard him, and while much less strident than the folks on
Rattigan's show, the language and tone were pretty similar. When you get the President that disturbed with you
you are NOT in a good place.

After the break you'

ll find some news story excerpts on the state of things, the Administration'
s intentions, some
industry news which illustrate how badly they are handling things and the whole slew of URL' s for the video clips
we mentioned. You don' t need to listen to them all but we suggest at least a couple.

Peter Drucker in his magnum opus "Management: Tasks, Responsibilities and Practices" has a whole section
devoted to social responsibility that is the most insightful and brilliant thing we've ever read on the subject. He
points out that no business can be healthy when society is hurting. But he makes a fundamental point that
business executives have a primary responsibility to fix problems they create before society is forced to fix them
for itself. Let'
s turn that around - it is a primary executive responsibility to constructively engage with society and

Page 17 of 23
help shape fixes to problems. To act otherwise is profoundly irresponsible. It is also counter-productive because,
sooner or later, those problems will be addressed and the results will not be to industry's liking.
If we were considering investing in Finance we'd have three major problems:

1) there are lots of problems still exponentiating (bad loans, CRE losses, terrible balance
sheets, toxic assets, the need to raise capital and the lurking problem of mortgage
writedowns. Taken all together they mean the industry is facing years of operational
challenges that make them poor candidates. But,

2) the business models of all the major lines of business are broken which makes them
even worse. Finally,

3) the industry's obtuseness and bad tactics are going to create a major strategic problem
for them on current course and speed!

We suggest you evaluate them with these factors in mind.

November 19, 2009

Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages

http://llinlithgow.com/bizzX/2009/11/firestorm_flaring_up_finance_r.html

Not to rush you along too fast but we thought we' d re-visit our previous posts
on regulatory reform of the Finance Industry. Understanding the state of play
AND the business performance of the Industry per se are important for their
own sake. In fact this post should be considered as another deep dive into
the state of the industry and as a case study. It'
s also important for several
other reasons. One of course is the question of how viable investing in the
Financials is. But because the industry is the ecology of the Markets it is
systemically important and influences how the entire economy does. It also
controls how well you own investment does.

This is particularly important, as we'

ve been covering in multiple posts,
because the old ideologies of Efficient Markets and Asset Allocation are
being fundamentally re-visited. The long and short of it is that discussing
reform touches Business Performance, Markets and Investments and the
Economy! We will observe however that this famous painting, "The Scream",
originally done to express the anxieties of the early 20thC, pretty well
captures most folks feelings about the Industry. Which means, of course,
that the pressures for reform are mounting. Which we' ll discuss but pay
attention!

Page 18 of 23
Market Performance as Indicator

Let's start with a benchmark by looking at the stock

performance of the Industry and its sectors YTD. We use
the XLF ETF as a proxy for the industry as a whole while
SPDR ETF' s for various sectors including Banks,
Regional Banks, Capital Markets, Insurance and
Mortgage Finance are also shown.

As you can they all moved pretty much together into,

through and after the March Madness when everybody
thought the world was collapsing and the Financial Sector
was going to end. Thank goodness for the Stress Test -
it'
s called Animal Spirits, as in the world'
s not ending. The
recovery continued for everybody thru mid-May on the
back of earnings surprises (told you we' d close the loops)
that turned out on examination to be a lot poorer quality
than you' d hope.

Then things changed. The Regionals and Mortgage guys

took some big hits as the size and scope of the CRE
problems became more apparent. And as the up and
downs of Housing optimism waxed and waned as well,
though they both climbed back in the ballpark to keep
playing with tre other teams. Since then the Regionals
have re-deteriorated a bit as reality starts to set in.
The other important differentials ae with the Big Banks,
the Investment Houses and Insurers. Strangely enough
the Banks did relatively well but the real differential performer has been the Insurance Sector. Oddly enough the
Investment folks haves slightly under-performed - it looks like performance actually matters a bit and some horses
run faster than others. Of course which ones are important questions.

Financial Reform and Reactions

For a while there with the news that bonuses were going to be
paid but would be extremely large there were multiple stories
per day in the business press. Given that some of those
bonuses were as large or larger than those paid during the
decade of the leveraged financial boom that's pretty
surprising. One might even use the word outrageous - lots of
folks have.

Now we' ve covered the elements of reform several times in

multiple posts as taking repeated deep dives on the financial
business as a business over the last couple of years. So
many times that we' ve collected all the prior posts into essay
collections which, taken as a whole, are a pretty complete
portrait, assessment and diagnosis of the industry. Pointers to
the URL addresses for those collections are in the readings. If
you' re in the Industry, an investor or just concerned as we all
should be we strong suggest getting them and reading them.

Page 19 of 23
The net net is that the old business models are broke and not coming back. But the business doesn' t believe that,
thinks business as usual is coming back and is pushing as hard as possible against reform. AND the culture is still
locked into the last three decades view of bonuses and excess compensation. It'll be interesting to see what
happens.
As it happens both the House and Senate, with strong support and encouragement from the Administration, are
moving huge bills forward as we speak. One of the best surveys of the consensus views of what needs to be
done is one Geithner gave at a recent SIFM conference, during an interview by Charlie Rose. Rose also
interviewed Dimon who was, overall, very supportive of those arguments but pushed back where his ox was being
gored. Rose has changed his web site so you just go to www.charlierose.com and scroll the exclusive archives to
find them.

The Case For Reform

We think the case for reform is overwhelming on several

counts. But if you cast your minds back to the late '90s
there was an interesting situation where Brooksley Born,
of the CFTC, tried to change te rules of the game to
level the playing field. She was squashed by some major
players, including folks who are again in the arena,
because they were all drinking they Koolaid.
URL: http://video.pbs.org/video/1302794657/

They have since recanted, as has almost everybody.

Except Lloyd Blankfein who thinks they are still doing
"God's Work" of course. We' ll see how this ends up but
we're going to get something, it's going to be big and a bigger change, comprehensively, than anything we'
ve
seen since the 1930' s. And let's not forget the Pecora II commission that'
s busy beavering away in some back
rooms.

It'
s well worth listening to the entire PBS Special on The Warning, or so we think. You can find the web page for
the whole effort
(http://www.pbs.org/wgbh/pages/frontline/warning/?utm_campaign=homepage&utm_medium=proglist&utm_sourc
e=proglist ). If you want to take a deeper dive on the political sausage-making and the state of play, as well as the
big picture implications and debates may we point you to: The Beginnings of a Great Debate: People Singing,
Politicians Making Sausage.

Here the People Singing

In the essay collections plus previous posts digging into

the Industry, its performance as a business and its
influence and impact on the overall health of the
economy we go into some detail about the business
case for business as usual. So let's just summarize our
findings:

1) Financial Industry malfeasance almost destroyed the

economy, brought on Great Depression 2.0 and might
have collapsed Western Civilization.

2) The collective and cumulatively losses of the last

couple of years wiped out most of the last decades' s
profits, even though they were all funny money in the first place. In other words the Industry almost destroyed
itself. It'
s in their own best interests since obviously they can'
t be allowed to play without adult referees.

Page 20 of 23
 • NB: the bonuses that the Industry started paying itself grew exponentially starting in the ' 80s, accelerated in the '
90s
and turned into a bubble in the '
00s. And put compensation completely out of line. There is no evidence that those
bonuses contributed positively to the health of society. In fact all the evidence is the other way.

3) Post de-regulation in the '

80s we began almost three decades of wild indulgence in debt and over-consumption
that loaded up the Industry, the consumer and business with leverage that we couldn't sustain.

4) That debt caused savings to drop to nothing and severely retarded investment and economic growth.

5) The lack of economic growth led to a relatively stagnant economy with poor job creation and flat to declining
wages and benefits. And that, in turn, has led to an increasingly stratified society where the top 1% of earners,
strangely enough somewhat concentrated in the Finance Industry, to garner all of the gains of the last three
decades.

When a society, historically, spends more effort on rent-seeking and power elites focus their careers on rule
manipulation then it eventually succumbs to sclerosis and dies. Just ask the farmers and peasants who harvested
all the wood on Easter Island and destroyed the ecology just to keep making giant statues for the Chiefs.Sadly
though the mood of things is pretty well captured by the song "Hear the People Singing" from Les Miserables.(
http://www.youtube.com/watch?v=x6-5g78Nr6Q )

The real problem is that the Industry had an opportunity to both fix itself AND to collaborate on re-shaping the
regulatory framework in a constructive fashion. But has refused to do so. The evidence for helmet laws and adult
referees to make sure the game is played according to the rules seems to be overwhelming.

Page 21 of 23
READINGS

Readings and References

The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models The credit crisis of
2007-2008 that metastasized into a collapse and nearly caused Great Depression 2.0 was largely created by
broken business models based on bad practices, malfeasance, excess leverage and synthetic, structured
investment products. We' ve all learned the hard way that the Finance Industry is more than just another industry
but impacts us all. By looking back, perhaps in anger and certainly in dismay and puzzlement, we can understand
more about how this all came to pass. And, as a result, more about what to expect because all of these problems
remain with us. If you' d like to get a better understanding of how broke the Industry is and what the consequences
are this is a place to start.

The Broken Finance Industry II: Crisis, Adaptation, Innovation and Value? The Finance Industry brought
itself and us to the brink of disaster thru bad practices and poor management. But effective capital markets are
vital to the health of the economy. Now we need to consider what' s broke, how to fix and how govern the Industry
for its own benefit and the health of society.

Facing the Firestorm: Finance Industry, Popular Anger and Re-regulation The Finance Industry appears to
have returned to profitability on the back of public funds and government support programs. Its refusal to
acknowledge that debt is leading to a tidal wave of initiatives for regulatory and legislative reform which will be
made worse by a refusal to constructively cooperate. Society needs a productive Finance Industry and will get it
either voluntarily or otherwise. The Industry's refusal to see these pressures will make things more difficult than
necessary, but are unavoidable without leadership and a sense of social responsibility.

The Corporation vs Society: Performance, Social Responsibility and the Win-Win The unfettered free
market was supposed to bring enduring prosperity but recent history shows that markets and participants are not
self-regulating. In fact markets require an institutional framework to work, publicly responsible behavior by
participants and appropriate regulatory frameworks to balance private gain with public welfare. The results are
better performing markets that are sustainable.

Background Readings

Wealth of Man by Peter Jay. Quixotic it may appear to proffer a one-volume history of the world economy that
holds interest, but Jay succeeds. Exhibiting the flair of a journalist and the worldly wisdom of a finance official,
both of which professions occupied him in Britain, Jay jaunts from the dawn of agriculture to the globalized
present. His story adheres to a highly serviceable metaphor for humanity' s work for wealth: the waltz. First, an
advance increases wealth; the increase attracts political attention; and the threat to wealth from politics
eventuates in rules to regulate or protect wealth from capricious avarice. Commanding a capacious fund of
information, Jay advances illustrations of his waltz motif from the first recorded wars in the Fertile Crescent to
wealth's modern three-step in China. Yet Jay' s erudition is not designed for impressing readers, but for informing
them about the buildup of the material platform of contemporary civilization--about which most are unreflecting.
Far from an apology for laissez-faire, Jay's accessible, non-technical history outlines wealth' s accumulations and
dissipations as a way of cautioning against sanguine expectations of unending prosperity.

• A Concise Economic History of the World: From Paleolithic Times to the Present by Rondo Cameron and Larry Neal

Structure and Change in Economic History by Douglass C. North. This book aims to explain the structure and
evolution of institutions. The author, Nobel laureate Douglass North, concludes that the tension between gains
from specialization and attendant costs is "the basic source of structure and change in economic history."
Institutions arise to exploit the gains from division of labor or to reduce transaction costs. This theory appears to
offer considerable economy and power of explanation. North asserts that, in the prehistoric era, human population
increase would lead to declining labor productivity as resources were exhausted. New technologies could

Page 22 of 23
increase productivity but, if property rights were nonexclusive, as they must have been in a nomadic hunter-
gatherer society, new technologies would simply accelerate resource depletion. Only if a tribe or band could
exclude rivals from exploiting the resource, as they could in a settled agricultural society, would the productivity
gains from new technology be sustained. The advantage that agriculture offered, then, was the opportunity to
establish exclusive communal property rights. This produced what North calls the first economic revolution. The
first economic revolution, occasioned by the rise of agriculture, produced the state, "the most fundamental
achievement of the ancient world." The state specialized in providing security, keeping order within societies and
protecting them from outside threats, while the complex demands of an agricultural economy (compared to those
of a hunter-gatherer economy) required increased specialization throughout the rest of society as well. Over time,
new military technologies led to larger states and more representative forms of government as rulers were forced
to make concessions to their constituents to compete militarily with other rulers.

• The Rise of the Western World: A New Economic History by Douglass C. North and Robert Paul Thomas
• The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes
• One Economics, Many Recipes: Globalization, Institutions, and Economic Growth by Dani Rodrik

The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities by Mancur Olson. Olson
does a stellar job "proving" his theory using accepted scientific standards. His main thesis is that stable societies,
over time, will be stifled by a steady growth of groups each committed to obtaining a disproportionate amount of
society's goods. This theory, composed of only nine implications, is parsimonious with wide explanatory power. It
helps to explain the post-war growth of countries such as Japan and Germany, while providing a reason why the
growth rates of the United States, and especially Great Britain, have been stagnated. I was amazed at how many
phenomena, such as slavery and the Indian caste system, can be at least partially explained by Olson' s theory.
Anyone seriously interested in knowing the way the world works will want to give this theory substantial
consideration. ....Most people recognize that there is something wrong about special interest groups. While most
people think of special interest groups in terms of fairness, Olson examines efficiency issues. Special interest
groups, or distributional coalitions, hinder economic growth in industrialized nations. Special interest groups slow
the pace of change in industry. We will reorganize production and adopt new technologies more slowly as more
coalitions form for the purpose of transferring wealth.

• Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships by Mancur Olson
• Economic Origins of Dictatorship and Democracy by Daron Acemoglu and James A. Robinson

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