Professor Amar Bhide has just written an outstanding examination of the interplay between centralization and decentralization in a free economy, published in the Harvard Business Review and entitled "The Judgment Deficit."
In it, he articulates the insights of economist Friedrich Hayek from the latter's 1945 essay "The Use of Knowledge in Society." Professor Bhide examines the interplay between the decentralization that Hayek demonstrates is ideal for innovation and increasing prosperity, and the need for legitimate constraints on individual choice required to enable that innovation and advancement to take place. He also gives examples which demonstrate that those who have fallen into the temptation to take this necessity for some control and argue that "if a little is good, more must be better" have always ended up impairing or destroying the very prosperity they hoped to enhance.
Professor Bhide then makes a startling and brilliant observation: the financial apparatus of the free world, so important to entrepreneurial activity and continuing innovation, has fallen into exactly that trap of centralization!
Over the past several decades, decentralized knowledge and "boots-on-the-ground" examination has been increasingly replaced by theoretical models and computer algorithms. "In the financial sector," he argues, "funding mechanisms have become increasingly centralized and mechanistic. They no longer reflect the decentralized real economy they were meant to serve."
Professor Bhide illustrates this argument using the example of home loans and securitized lending -- an area that clearly became more and more divorced from reality over the past thrity to forty years and eventually resulted in a worldwide financial meltdown.
We believe he is right on target with those examples, and would argue that his arguments apply just as powerfully to the funding mechanisms for allocation of equity capital (and we know he is aware of this aspect of the problem that he identifies, based on statements he made back in February of 2009 which we quoted in a blog post here).
In fact, we believe that Professor Bhide's criticism of what he calls "robotic finance" is the perfect counterargument to those who have used modern portfolio theory as an excuse for rejecting the old-fashioned examination of individual companies that we believe must form the foundation of any successful investment process. Amazing as it seems, there are huge constituencies who advocate just such robotic finance, including many proponents of "black-box" or "quant" strategies, as well as many proponents of indexing (who argue that examination of individual business corporations is a waste of time).
Even further, we believe that Professor Bhide's application of the insights of Friedrich Hayek to this subject is the perfect counter to those who continue to invoke Hayek in support of such robotic approaches. We ourselves have argued against those who misuse Hayek's theories to repudiate what they call "active management" and what we insist is the kind of "boots-on-the ground" examination of the recipients of investment capital to which Professor Bhide believes we need to return.
There are many other important aspects of Professor Bhide's latest essay, and we commend it to all investors -- and in fact, to all who must wrestle with the fundamental issues of decentralization, innovation and human prosperity (which is to say, everyone). Please pass it on to your friends.
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For later posts dealing with this same subject, see also:
In it, he articulates the insights of economist Friedrich Hayek from the latter's 1945 essay "The Use of Knowledge in Society." Professor Bhide examines the interplay between the decentralization that Hayek demonstrates is ideal for innovation and increasing prosperity, and the need for legitimate constraints on individual choice required to enable that innovation and advancement to take place. He also gives examples which demonstrate that those who have fallen into the temptation to take this necessity for some control and argue that "if a little is good, more must be better" have always ended up impairing or destroying the very prosperity they hoped to enhance.
Professor Bhide then makes a startling and brilliant observation: the financial apparatus of the free world, so important to entrepreneurial activity and continuing innovation, has fallen into exactly that trap of centralization!
Over the past several decades, decentralized knowledge and "boots-on-the-ground" examination has been increasingly replaced by theoretical models and computer algorithms. "In the financial sector," he argues, "funding mechanisms have become increasingly centralized and mechanistic. They no longer reflect the decentralized real economy they were meant to serve."
Professor Bhide illustrates this argument using the example of home loans and securitized lending -- an area that clearly became more and more divorced from reality over the past thrity to forty years and eventually resulted in a worldwide financial meltdown.
We believe he is right on target with those examples, and would argue that his arguments apply just as powerfully to the funding mechanisms for allocation of equity capital (and we know he is aware of this aspect of the problem that he identifies, based on statements he made back in February of 2009 which we quoted in a blog post here).
In fact, we believe that Professor Bhide's criticism of what he calls "robotic finance" is the perfect counterargument to those who have used modern portfolio theory as an excuse for rejecting the old-fashioned examination of individual companies that we believe must form the foundation of any successful investment process. Amazing as it seems, there are huge constituencies who advocate just such robotic finance, including many proponents of "black-box" or "quant" strategies, as well as many proponents of indexing (who argue that examination of individual business corporations is a waste of time).
Even further, we believe that Professor Bhide's application of the insights of Friedrich Hayek to this subject is the perfect counter to those who continue to invoke Hayek in support of such robotic approaches. We ourselves have argued against those who misuse Hayek's theories to repudiate what they call "active management" and what we insist is the kind of "boots-on-the ground" examination of the recipients of investment capital to which Professor Bhide believes we need to return.
There are many other important aspects of Professor Bhide's latest essay, and we commend it to all investors -- and in fact, to all who must wrestle with the fundamental issues of decentralization, innovation and human prosperity (which is to say, everyone). Please pass it on to your friends.
Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.
For later posts dealing with this same subject, see also:
- "The ideology of modern finance" 01/12/2011.