Kay on Kay
When asked what had first attracted him to economics, Kay explains that he started out studying for a maths degree at Edinburgh University. Having worked for a summer in the school holidays at Scottish Widows, calculating surrender values, his assumption was that he would become an actuary.
However, on taking a subsidiary course in economics, he decided he was more interested in practical affairs and ended up studying economics at Oxford. Asked why he had opted for such a varied career, rather than sticking to being an academic economist, his response is simple. “The idea of doing the same thing all of my life was a bit daunting,” he says.
His particular skill, he continues, is “the popular exposition of complicated ideas”. Throughout the conversation, I form the view that is a two-way street – rather than being stuck in a hermetically sealed world of academia, Kay has much practical exposure to the real world. This feeds back into his academic work, potentially changing his views on how the economy works.
Although he professes to not having any other major passions in life “besides my work and walking, where I do my best thinking”, I have the impression that Kay’s work is so wide-ranging that this encompasses multiple interests.
Kay on banking
My opening salvo is to ask him about his most recent FT column, in which he wrote that ‘the reputation of finance has been degraded by the actions of a few. But the few have been running the show, and have imposed inappropriate values on once respected institutions.’
He explains that, during the big bang, retail banks took over firms engaged in wholesale financial activities. “But the retail banks couldn’t control the investment bankers, who were richer and smarter, and so they ended up running the show,” he says. The only way to stop this, he continues, would be to have “a politically driven restructuring of the financial service sector” – a surprising answer, as the Kay Review was pretty limited on government intervention. Instead, we are seeing “the proliferation of a style of regulation that has plainly failed”.
Although he has seen change in the past year – among politicians and with public realisation that what went wrong resulted from the ethos and structure of the industry – he says there is an endemic culture in financial services that makes it incapable of learning from other disciplines.
Sciences that study systems – for example, engineering or biological systems – have developed a sophisticated understanding of how systems actually work. In an ecosystem, monocultures are the most vulnerable and this is exactly what we have in banking, made worse by the current style of regulation, which “freezes the evolution of the system”, preserving the dinosaurs.
It turns out that Kay’s optimism is predicated on the inevitability of another crisis, as the current banking business model is a proven failure, which will basically wipe out the financial system so we can start again.
Kay on economics
I read another column by Kay a while ago in which he wrote that he used to teach modern portfolio theory, but that he no longer believed in it. Asked what changed his mind, he takes us back to the early 1990s, when he was involved with the restructuring of the Lloyds Insurance market, following the London market excess of loss (LMX) spiral. “What had been going on was not the spreading of risk to reduce the cost of risk bearing, but the dumping of risk by people who understood a bit about it on people who understood less,” he says. This typified much of the financial services sector.
So when he observed the credit instruments between 2003 and 2007, “it was with a sense of déjà vu, knowing how this would end”. His conclusion was that most financial market trading was the product of information asymmetry rather than different risk preference and risk attitudes – as assumed by the capital asset pricing model and the efficient market hypothesis. Financial markets are currently explained using models that cannot conceivably account for the volume of trading that takes place in them.
The other experience that led to his change of mind was carrying out some research on London casinos. He found that the typical gambler was a successful, entrepreneurial businessman. Far from being there for the thrill of winning, or losing, money, “these people actually believed that they could win”.
He realised he was observing the upper tail of a distribution of people who were aggressive risk takers, yet naïve about the risks they were taking – the businessmen one sees in the casinos are the ones successful enough to have enough money to lose.
These same people provide the underlying dynamics of capitalism. They are not rational, they do not understand risk and are therefore prepared to take risks that a rational agent would not take. And it is these people who drive the growth of the economy. Again, this entirely contradicts economic theory in which agents are assumed to be rational; it is the irrational agents that drive the markets.
Kay is not the only critic of mainstream economists, and it would seem patently obvious that economics has failed as a predictive and explanatory tool. Was the profession changing? Could there be an Einstein moment approaching, where the mainstream realises that the cranks were right? No, says Kay. Unlike subjects such as physics, you cannot definitively prove economics wrong. “The rewards structure of the economics profession is basically a common value system,” he says. Small marginal improvements are rewarded, critics are considered cranks and ignored.
But surely economists would become increasingly irrelevant as there would be decreasing demand for models that just do not work? Once again, Kay thinks not.
“People are continuing the use of value at risk models,” he says, “although these plainly failed, because extreme observations come from off-model events, not from improbable events within models.”
He cites the Goldman Sachs executive who said they were “seeing things that were 25-deviation events, several days in a row”. This was obviously not the case, says Kay. They were seeing events that were not in Goldman Sachs’ model. What interests Kay as a result is “exploring the limits of probabilistic reasoning” – something that has been discussed since the 1920s but has still not been taken on board.
Kay on equity markets
The subject of the Kay Review was how equity markets affected the economy as a whole. One of the findings was that companies rarely raise money in the stock market. But part of the purpose of savings, according to economic theory, is also to provide investment capital, which allows the economy to grow. Kay thought that this was no longer the case, as companies no longer needed to raise large amounts of capital.
“Companies such as Facebook or Google are capital-light and generate their own cash, which they can invest themselves,” he says. The main capital allocation decision in the economy is therefore taken within companies by company management, not by the capital markets. Most of the large-scale investment of the modern economy is required by government, for areas such as health, education and infrastructure.
The main economic function of the equity markets is not, therefore, to allocate capital efficiently, but to ensure that company management makes the correct capital allocation decisions.
Kay champions the concept of ‘stewardship’ asset owners that have a close relationship with the management of companies they own, overseeing the allocation of capital in a manner that will result in the long-term growth of the company. This is the only way in which the investment management industry can add value.
“Competing with each other on relative short-term performance is a zero-sum game,” says Kay, which is of no social value or value to their clients as a whole. At present, asset managers either do not focus on long-term growth or, worse, they actively encourage companies to behave in a more short-term fashion, undermining long-term value. By and large, therefore, the asset management industry has not been doing its job.
Doesn’t that make the Kay Review an indictment of modern capitalism, I ask? After all, economics teaches us that people’s earnings are based on how much they are ‘worth’ to society, yet the head teacher of my daughter’s school earns a small fraction of what most people working in the equity markets earn, despite her obviously socially important job. The Kay Review argues that what people working in the equity markets do is mostly useless, sometimes positively harmful, with most workers either not doing their jobs properly or not doing them at all.
Kay’s answer is that capitalism is working, but not necessarily perfectly; the most successful economies are obviously based, to a large extent, on free markets. But the UK’s financial services system is currently not serving the rest of the UK economy very well. As a result, the UK has become a global centre that is “quite good at manufacturing a particular set of products, which are of doubtful value, but which are mostly bought by foreigners”. This is the modern moral dilemma of our society.
Kay on actuaries
Before this interview, I searched the Kay Review and found no mention of the word ‘actuary’ and only one of ‘actuarial’. From our subsequent discussion, I can conclude that he lets us off lightly.
When Kay had his first interaction with the profession over 20 years ago, he felt that actuaries were “blissfully unaware” of financial economics. But, since then, he says, we have adopted them wholesale in a particularly naive and uncritical way.
He believes that people best deal with uncertainty, as opposed to risk, through narratives rather than probability distributions. For instance, the legal profession uses terms such as ‘balance of probability’ and ‘beyond reasonable doubt’.
“We might surmise,” says Kay, “that these could be translated into probabilities – the former greater than 50%, the latter greater than, say, 99%.” But this is not the case at all, he continues. Legal reasoning places the onus on ‘the ability to tell a consistent and convincing story’, and the judgment is based on what degree of confidence the judge or jury has in the story. ‘On balance of probability’ means which story is the most convincing. ‘Beyond reasonable doubt’ means the story is a clear and convincing narrative of events.
What Kay would like to see from actuaries is for them to exercise judgment and frame these in convincing narratives.
Another example he uses is taken from Malcolm Gladwell’s book Blink: The Power Of Thinking Without Thinking. A Greek statue in California’s J. Paul Getty Museum was easily recognised by experts as a fake, but it was very difficult for them to explain why they thought this – they just knew. Because of uncertainty, there cannot be an objective truth; expertise is exercising a subjective judgment based on experience, not the ability to run a model.
Kay on the way forward
For investment consultants and asset managers, the Kay Review is little short of devastating. So what does he suggest?
To start with, he says, the methods for picking asset managers and the mandates that they are set are a long way from perfect. First, the theoretical underpinning of current practice – for example, investing against a benchmark and defining ‘risk’ as deviation from that benchmark – follows the efficient market hypothesis and the capital asset pricing model, both of which Kay thinks are nonsense. Second, mandates should be based on “styles and strategies that look compelling”.
In Kay’s view, pension funds should invest in a smaller selection of companies, with whom they should be in close contact, either directly or indirectly via the asset managers, the key concept being ‘stewardship’.
He believes that asset managers should be selected for their convincing ‘narrative’. “They should not be reporting or judged upon quarterly returns against other managers, as this is not in beneficiaries’ interests,” Kay says. Instead, he continues, they should be judged over, say, three years – on whether they are investing in line with their stated narrative and how this is evolving through time.
The investment consultant should exercise professional judgment on which narrative is the most convincing.
Asked whether this was something actuaries could do, Kay suggests we do not, at present, have the right skills set. Instead, the work should be undertaken by asset managers who understand the “competitive advantages and evolution of companies”.
Kay’s message for actuaries is that we should distrust our models – what is not in our models is often more important than what is. And we should develop narratives of what might happen rather than relying on spuriously accurate mathematical projections based on past experience. Equally, we should not blindly follow methodologies implied by financial economics.
In conclusion, the Kay Review has been described as good on diagnosing problems but not on solutions. This impression is strengthened by our conversation, as Kay’s ultimate solution seems to be based on little more than the inevitability of another crisis, after which everything will be fine. Not a very comforting message, perhaps, but I think we should listen carefully to the diagnosis of this most mild-mannered of Cassandras.
Nick Silver 