Pancake Economics

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pancakes

Each time I visit a yearly financial asset management gathering (no press allowed) with some of the largest financiers in the country (and the world) interspersed with ambassadors, congressmen and White House representatives (thanks for the tour Meg), I am reminded how fundamentally different finance behaves from production.

Ethereal finance

The people at the top in finance are kind, well groomed, approachable and appear willing to help each other in any way they can. They are out to build lasting relationships with their peers in the industry, to share investment strategies, foster deal flow and secure new career opportunities.

At first glance no one appears to be selling anything to anyone. Instead the esteemed financiers mingle, meet, and greet to prepare to talk shop at some other time or location, hidden from view. No one really shakes the (money) tree with tough questions for the star-studded panel, afraid of becoming collegially disbarred.

Everyone seems to share, and float comfortably in midair, unfazed by the economic threats that keep knocking on our door. Undeterred these financiers proceed to feed their respective firms with investment returns wherever they emerge globally and deploy escapism with cunning precision when the easy ones dissipate.

Void of a clear recognition of their fiduciary role and responsibility in our nation’s health and prosperity, even when tickled by a probing ambassador.

Danger looms

Yet despite finance’s ethereal behavior it has a lot to lose.

The United States (and many other countries that copied our financial model) is in trouble because over many decennia – so do not get partisan on me now – it has amassed a financial system eleven times the size of production.

Think about that stunning fact reported by our government for a while. Let it sink in for a minute. Then continue…

We gained self-induced economic instability as a result of valuing the ballooning gamble on production (with its many derivatives) higher than the creation of production that produces socioeconomic value. A giant financial bubble, bigger than we have ever seen before, is starting to deflate. And no new air blown into it by the sub-optimizations from the Fed or other government institutions will prevent it from deflating further.

Fundamental financial reform is the cure needed to resurrect our economy.

Mark my words; nothing will improve in the economic outlook of our country until we improve the economic imbalance between finance and production.

Production in the more modern definition that is, the intellectual capacity to produce innovation that may yield physical manufacturing, wherever that is best produced (think iPhone: designed in California, assembled in China).

Rebalance

Our economic instability is caused by the extreme imbalance between production and finance, and thus any new legislation that does not deploy an appropriate rebalance will be futile. Regulations that deploy more restrictions on structural in-market deficiencies will have minimal impact on the health of our economy, as they are sure to be circumvented by deeper and even less transparent financial constructs.

Simply put, we need to reduce the size and dependency on finance and improve the size and role of production to ensure economic prosperity and stability. Finance needs to be redirected to trace the opportunity for production more accurately by removing the ability to make perpetual investments in itself.

We need to remove pancake economics.

Pancakes

At the heart of our economic engine are financiers, the aforementioned asset managers, who supported by the free-for-all of an aging laissez-faire economic model – that we have allowed them to deploy – have a convoluted, uninformed and thus unrealistic assessment of risk associated with the underlying assets (production). Yes, I just said that.

Our financial systems are wide in circumference and shallow in-depth, and stacked ten levels deep. Just like a pile of pancakes, filling but with limited nutritional value.

To put it more entrepreneurial:

No company in my portfolio or that I would start would be allowed to deploy the endless diversification of risk and responsibility as it exists in the asset management playbook today.

My point is that financiers are supposed to be the ultimate experts in assessing risk, and yet by my discovery of how moneys are deployed and following the trail, few have a clue. I support that assessment by asking some of the top financiers in the country the following simple question:

Why do you expect to generate sustainable outlier returns from the deployment of no less than ten levels of bottom-heavy diversification (in each asset class) ?

A question these top financiers all – without exception – fail to answer decisively, instead stumbling and stuttering with a sometimes “what do you mean?”, or “that can’t be true” or “I’ll ask my managers” deferred answer. It is a question that does not require knowledge of the workings of finance nor deep domain expertise in a certain asset class. But a question that challenges their understanding of the full value-chain of risk that determines the support of the underlying production.

Elementary logic

Elementary school taught us early on in life that the current deployment of risk in asset management is fundamentally flawed.

By playing the telephone-game (or chinese whispers) in class, a story you tell to the first person that they then need to tell forward to the next, will yield a completely different story (and facts) after it has traversed ten people. And thus an asset management strategy that is supposed to empower production, that is predicated on the deployment of ten levels of (bottom-heavy) diversification will be invalidated by people as smart as elementary scholars.

Eureka

The fantastic discovery my entrepreneurial analysis presents is that a more complete and systemic fix of our economy is steeped in fundamentals, and does not require the fuzzy logic deployed by hindsight laden economists endlessly tweaking the economic dials and feverishly applying a plethora of stimuli that cost us even more money.

My discovery means that the performance of our economy can be made highly predictable again and can be deployed by change everyone can understand and believe in.

The starting point to rebalancing production with finance starts with a very simple entrepreneurial exercise I have deployed so many times in my life; if we were to invent a financial system from scratch today would we invent it the way it works today? The answer to that question based on my findings is: absolutely not.

And thus my new startup, a disruptive fix to our economy has begun.

 

We encourage comments that are relevant to our observations, conclusions and the specific topics discussed in this blog, either in agreement or disagreement. Leaving your insightful comments here will ensure others can learn from them too.  Keep in mind however this is not a place to spew your own theories (go write your own blog), but the best place to question or approve our observations.

About Georges van Hoegaerden

Georges is a serial entrepreneur, venture catalyst, 4x CEO, board director turned innovation economist (by fate). His ideas have raised $14M in venture capital and produced over $100M in returns. More.

  • Joel Weingarten

    Occupy Pancakes.

    • http://venturecompany.com/ Georges van Hoegaerden

      Exactly!

  • konstantyn

    Georges,

    interesting. Can you comment on following arguments? Thanks.

    1. The production to financial services ratio does not necessarily have to be sane. In global economy countries can specialize. Portugal would produce 300% of its domestic demand for wines. England would produce 500% of its domestic demand for wheat. Both would deploy the majority of work force in respective industries as well as the U.S. does in financial sector. Simply put could the U.S. serve the entire word? Can we calculate the ratio’s sanity assuming boundaries for global free trade?

    2. Your analogy with pancakes is correct. Romans had the entire empire grown on wheat – a lot of energy, bad nutritional balance. The lack of balance was compensated by a burn rate that is typical for active army and primitive agriculture. There was no need in sophisticated nutrition science. Such science would be marginally ineffective.

    The history of financial services has deep roots in hedging. Particularly hedging of agricultural and industrial volatility. The industries are known for high burn rates. The higher burn rate, the higher gains from hedging. Hence there was no need in subject matter sophistication in the financial service community. Pancaking was the cure.

    Now, mechanization, satellites, fertilizers, etc. have significantly reduced volatility. Manufacturing industry faces overproduction evenly across the spectrum. The focus shifts from hedging lows to stimulating pikes, i.e. opportunities. Actual structures are not capable to do that. The legacy and school of thought isn’t there. We need an entirely new approach. Why should we blame runners for running if we need to train jumpers for jumping?

    • http://venturecompany.com/ Georges van Hoegaerden

      Konstantyn,

      Fair questions:

      1/ Well, the insanity in finance we have today comes from an endless string of bets on itself, chockfull of bottom-heavy risk diversification that turns any asset into a subprime asset by economic principle. Finance is not an industry in and of itself, yet it can be an catalyst to innovation (and therefor economic progress) when the merit by which it is deployed is held to the same standards as production. Its actual ratio to production is hard to predict, and will be subject to the workings of a free-market in finance we do not have today.

      2/ I would assert no asset manager today actually can calculate risk correctly, simply because the risk calculations so common today merely consists of a shallow definition of pancake asset management, something I call the musical chairs of asset management. Hedging based on that principle is simply opportunistic escapism, and deflates the detection and opportunity for groundbreaking innovation that keeps our world afresh and full of renewable opportunities.

      Our financial systems are structurally broken, but the good news is they can be fixed relatively easily, because its malfunction is completely self-induced.

      Best,

      Georges

      • konstantyn

        George,

        I suspect we just scratch the surface. I’ll intensify expressions to provide contrast. Please give me a real thought.

        Firstly, in your reply the denial to grant financial sector an industrial status is sentimental. Could you please elucidate the parameters failing financial services to qualify as industry?

        Secondly, paraphrasing my question #2, why would you need to fix a car so it can fly? History shows that the financial institutions that you address are designed as cars. In this example I might agree with you that cars are inadequate to transport goods (financing opportunity) in some cases. But cars remain valid as transport in other cases (hedging risks). It would be easier to build a new industrial arm – aerospace – that will manufacture airplanes. If an airplane can’t be build without destroying the car, it is a signal that the airplane has no intrinsic value. That being said, there is a difference between structural deficiency (lack of airplanes when they are needed) and a structural break (complete and utter inadequacy of cars). The difference is significant. The thesis of broken system has to be backed up by the contemplations why the system prohibits building airplanes. Otherwise the discussion turns into a non-scientific, i.e. opinionated and futile rant.

        • http://venturecompany.com/ Georges van Hoegaerden

          Konstantyn,

          Be happy to. 

          1/ The financial sector is non-perpetual, meaning it can only function when it is applied to production (intellectual or industrial). When finance starts to bet on itself (as it has) it loses steam and power quickly. 

          2/ First off science itself is highly speculative, as its foundational theories often are (Einstein theory?). So, to model anything in life only after science is just as inaccurate as speculation itself. Both science and pattern recognition play a role in life, with one winning merit over the other at times. 

          The real question in the assessment of risk in asset management is what would be the best model. 

          My article asserts that marketplace models that are in violation of free-market principles and steeped in 10-levels of bottom heavy diversification is the smoke that indicates, even to a second grader playing the asset management telephone game, the fire that money-in will with high probability not lead to money-out. No need to be a scientific genius for that one.

          So, the way to optimize finance is to assign it the stringent establishment of merit we assign to science (for example) before we allow it to play such an important role in arbitraging production.

          Because if we don’t, production will become a poor derivative of the cumulative mediocrity of financial collusion. A path we certainly have descended down in Venture. 

          Happy new year!

  • Macdougall Bruce

    Your article certainly makes sense , put another way capital has gone through a long term of being overvalued. We are now merely seeing the results of supply and demand, too much capital chasing not enough “value”.

    • http://venturecompany.com/ Georges van Hoegaerden

      Yes, but once you change innovation arbitrage from subprime to prime you may attract the real innovative capacity that currently lies dormant and unwilling to submit to subprime.

      So, one should not simply conclude there is too much capital, it is the quality of capital, i.e. prime arbitrage that matters.

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