The post 2008 crises ridden economic landscape of the world can be described by the following features:
Abundance of capital in the 21st century
After the globalization driven industrialization that took place at massive levels in developing countries the global economy has reached a stage where it has abundant production capabilities. Additionally, increasing automation in workplaces continues to further add productivity and capacity. The global economy has far more production capabilities than it can find demand for. It needs a tremendous amount of additional opportunities for labor and capital employment but the current 21st century economy is not only not offering enough new opportunities, it is in fact limiting opportunities that used to exist in fossil fuel based development and industrialization.
There is a great and ever increasing demand-supply mismatch occurring around the world. Relative demand is weak whereas potential supply is abundant and increasing.
A comparison with the Great Depression of 1929
The main culprit behind the 1929 great depression was the same abundance of production capabilities relative to demand, as it is now. The solution then was World War II which created demand for capital goods (tanks, ships, airplanes etc.). War suited the psyche of people then. The destruction of the war kept high level of demand alive and well for decades.
Now we face the same abundance of capital problem and we wish the solution to be investments that enhance possibilities for human wellbeing now and in the future. Investments in space exploration and exploitation; environment friendly energy, infra structure and living spaces; ocean water based living and numerous similar endeavors are among the many obvious choices. These investments suit our desires and survival needs and we need to make them happen but they are not being made at the scale necessary to keep the economy working smoothly. If we don’t find a way to convert those desirable investments into actual demand, World War III may present itself as a solution for demand shortfalls.
An economic theory view of the problem with demand in this century
Demand has two components: consumption and investments. Since consumption is proportionally healthy we would leave it aside for now. The weakness in demand is mostly in investments. This is so because marginal return prospects are low or limited in most industries.
Though there are many ways to explain this phenomenon of low marginal returns on investments but the “law of diminishing marginal returns” gives a satisfactory answer. The amount of capital we have to employ to keep the world economy and labor employed will drive down the marginal return on capital to zero and even below.
But interest, the mechanism used to price and allocate capital, cannot go below zero. Interest rate has been around zero for decades, therefore it cannot drive any further increase in demand for capital.
The capital allocation system, interest, starts to fail as returns approach zero (i.e. go below 2%) because of interest’s zero bound and also because of the expectations created by the history of interest rates over centuries.
Interest’s zero bound and the expectations created by the history of interest rates
Interest rates have hovered around 5% for centuries. Investors generally expect interest rates to rebound once it goes significantly below 5%. So, long before interest rates get to zero, at around 2%, the expectation of its upward rise nullifies the potential benefits of low interest rates on long term investments.
Interest rates have been close to zero for a long time but businesses still need further stimulation. The world economy either needs interest rates to go further down (maybe even negative) or needs the expectation of its upward rise completely eliminated. Because of interest’s zero bound it cannot go below zero. And because of the asymmetric movement possibilities of interest rates at zero coupled with the history of interest rates the expectation of its upward rise cannot be eliminated. Consequently major economies will remain stuck in crises for the foreseeable future.
An appropriate capital allocation tool without a zero bound would have solved the problem much earlier. The world economy immediately needs a capital allocation system that can allocate capital under conditions of abundance i.e. a tool that can also push capital towards business and industry. Sinless capitalism has such a tool.
Interest therefore fails under conditions of abundance of capital
Interest was very effective as a capital allocation tool during the times when capital was very scarce relative to its demand e.g. during the early centuries of industrial revolution. Its hurdle mechanism, in which only those projects that earn above the interest rate get capital, worked well. Hurdle or rationing mechanisms works well in times of scarcity, but in times of abundance the hurdle (interest rate) is counter-productive. In times of abundance of capital we don’t need to restrict its flow but need to cause it to flow. Interest is not really a tool for allocation of capital, it is a tool for rationing capital; it works well only under conditions of scarcity. Now that there is widespread abundance of capital interest is unable to cause it to flow thus failing to allocate all the capital that is potentially available. This failure slows down production of goods and consequently constrains income and employment. Interest needs to be replaced with a system of allocation of capital that works well under conditions of both scarcity and abundance. Sinless Capitalism has such a system.
Interest is a hurdle against investment in environment and space related industries
Sustainable energy industries, like wind and solar power, have relatively low financial returns because their capital requirement is many times of the capital investment required in fossil fuel power-plants. A one-gigawatt wind facility costs more than $2.5 billion to build, whereas a gas facility of the same capacity costs $600 million (Learning curve declines in prices of wind facilities will not materially change this capital intensity ratio). Harvesting wind or sunshine takes far more capital than harvesting fossil fuels which are concentrated packages of energy. Most sustainable energy or resource adding industries are very capital intensive; their profit rates are not high enough to be able to pay interest consistently. Interest is the biggest impediment to mainstreaming renewable sources of energy. No practical amount of subsidy can fully counter that impediment.
Interest is even more detrimental to space endeavors and industries. Space industries and businesses will never go mainstream till interest is part of the economic system. Interest is the reason that there has been little or no self-sustaining business activity in space even though humans have been there for 60 years. If it was not for interest humans would probably be ready by now to build colonies on moon or mars.
Even though interest rates have been low and extremely low for all of this century but still investments in these industries have not picked up sufficiently. Temporary low interest rates do not much help industries with inherently low returns because of the fear of interest rates going up. The lower the interest rate the higher the chances of its going up and the larger the potential magnitude of its upward rise. The mere existence of interest discourages long-term investments in low return industries such as renewable energy and space exploration.
Interest is the major impediment against progress in the industries of the 21st century. Humans can no longer ignore climate change and other degradations of the planet not only because of its effects on lives of future generations but most importantly because of their effects on the economies of today. Unsustainable economies will be constrained by environmental and planetary limits and remain stagnant whereas sustainable economies will not face such constraints and will grow freely. Most drivers of human progress are driving us towards sustainable and environment friendly living and greater space explorations and exploitation but interest is driving us away from such progress.
21st century economic opportunities
The 21st century economy has huge capacities to produce capital and it also needs huge amounts of capital. The need for capital in this century are so immense that they can be easily compared to that present at the advent of the industrial revolution. The amount of work involved in making all of the global economy shift to sustainable and environment friendly ways of living and working is so huge that it will take a 100 years. Space exploration and exploitation is another area where huge opportunities await mankind; its promise is unmatched by any earthly endeavor.
A new global economic growth trajectory is waiting to be started by any country that sees the opportunities of this century; that country will be the true leader of the world in this century and beyond. It will start a new way of living for mankind. It is obvious that the resource intensive way of living currently practiced in Europe and America cannot be adopted by the seven billion people of the planet. We need a new model of living that is friendlier to the planet and the environment and is perpetually sustainable.
Sinless Capitalism – feature details and explanations
Interest is an impediment against environment friendly and space friendly industries; and interest also fails to allocate capital under conditions of abundance. Both these failures are causing economic distress and taking humans towards a catastrophe that could endanger their survival. Presence of interest endangers both the present and future of mankind. Therefore it is extremely important that interest is eliminated from the economic system. Sinless Capitalism does that in an economically sound and practical way through the following changes in the present form of capitalism:
The three proposed changes are very well thought and all three are required to give Sinless Capitalism a sound economic and social foundation so that the system could last forever. Replacing interest is an extremely challenging task both in theory and in practice and Sinless Capitalism’s design is up to it.
Eliminating interest will keep the world employed; build a sustainable and secure future for mankind and make commercial exploitation of space an everyday reality.
The elimination of interest would also greatly enhance social justice in the society. Interest is unfairly exploitative; it is socially unjust; it is the mother of most other social injustices. Interest and the environment are incompatible; interest and humanity have been incompatible for a very long time. Aristotle and almost every luminary after him was against interest.
There is really no justification for interest any more. Interest was necessary in the gold system because hoarding of gold could bring the economy to a halt. However, that is not the case in a fiat money system because money can be produced at will. 4000 years of tyranny of interest is about to end.
Lord Keynes would be very happy at elimination of interest. In chapters 23 and 24 of his mighty work, “The General Theory of Employment, Interest, and Money” he devoted a significant amount of space on the issues addressed by Sinless Capitalism. In Chapter 23 of the book, Keynes discusses and agrees to a great extent with the economist Silvio Gesell, who, in the earlier part of the twentieth century, tried to trim the powers of money. Sinless Capitalism shares the basic objective of Silvio Gesell’s effort. The main thrust of Silvio Gesell’s work was adding a carrying cost to money so that it could not be hoarded; thus stripping money of the power to demand interest.
Asset tax besides performing the economic functions of interest and income tax will also ensure economic prosperity in a socially just and planet friendly way. Lending will continue in the absence of interest because of asset tax; lenders will lend to transfer their asset tax on cash to borrowers.
Income tax has been eliminated because it is not needed in the presence of asset tax; taxing wealth is much fairer than taxing income particularly if we wish to reduce economic inequality. Sinless Capitalism is big on reducing economic inequality: Interest perpetuates wealth inequality, eliminating it reduces inequality; asset tax reduces inequality by taxing wealth; and elimination of income tax lets the poor accumulate wealth fast.
Sinless Capitalism does not favor the rich nor does it favor the poor; it is a just economic system, more just than any in human history. Sinless Capitalism has all the good points of capitalism because all the fundamentals of capitalism are left intact e.g. free markets, free trade, private property, etc.
The government through the asset tax structure has the role to choose assets and industries that it wants to favor through low or no taxes (e.g. renewable energy and space industries) and those it wants to discourage through high taxes (e.g. polluting assets and industries). Asset tax on cash is like a penalty for leaving cash idle (similar to negative interest rate); governments will be able to force capital to be employed by increasing that penalty thus increasing economic activity, employment and income. Japan, Germany, China and many other countries have effectively and beneficially used government intervention to favor or disfavor industries and business.
Employment is created when capital is produced and again when capital is employed. Sinless Capitalism is inherently friendlier to investment, employment and other economic wellbeing needs of individuals and societies.
Sinless Capitalism protects future generations. Capitalism not only utterly fails to take care of the future generations it in fact creates incentives to rob future generations. Therefore for the sake of future generations capitalism has to be replaced by Sinless Capitalism.
For details of the new system and for answers to FAQs please visit my website: www.SinlessCapitalism.com . Seven chapters of my book on the subject are there; some of those chapters need revision.
Sinless Capitalism – summary of benefits
The economic challenges presented by this century are in fact a great opportunity for formulating a fresh economic leadership agenda that is exciting, popular and can last for generations. The following economic and political benefits of Sinless Capitalism clearly show its immense potentials:
10. Enhanced protection of the rights of the future generations. This is a concept that urgently needs to be defined and practiced, the sooner the better. This ought to be the defining moral agenda of the current generation.
11. Global leadership in economic thought and practice which is likely to translate into political, cultural, and technological leadership as well.
12. Economic and social harmony in the country.
13. The economy would operate much like the way classical economics said it should. The major flaws that caused it to behave otherwise will be removed.
The long list of almost miraculous benefits mentioned above should persuade people and leaders to adopt this most innovative economic system. It is a silver bullet for climate change and current global economic illnesses, to say the least. For the first time in human history there will be an economic system that will deliver both economic efficiency and social justice, in spades.
Interest as a threat to humanity
Interest is also the major villain in the tragedy of the planet. The planet, including its environment, used to be limitless for human economic activity but now it is showing exhaustion from polluting and depleting effects of a range of human activities; the planet is demanding protection from these activities. Protecting the planet is a public good of the global kind. Capitalism, in its present form, has no means of incorporating public good in its basic structure; it can only achieve that through appendages e.g. subsidies, taxes, regulations etc. In addressing climate change appendages may at best work at the national level but at the global level it has no chance of working.
Interest by hindering investments in environmentally friendly industries is the major hurdle against addressing climate change. It is consequently a threat to the future of humanity.
Measures currently suggested for addressing climate change are economically costly and globally impractical. These include government subsidies and business killing regulations which have huge economic costs; and then there are globally impractical suggestions like carbon tax or cap and trade. These ill-conceived measures offer only partial remedies at very heavy and globally asymmetric costs.
In many economic and political circles it is correctly thought that addressing climate change will bring about or worsen economic slump; climate change denial is probably driven by this belief. Climate change deniers include people who think that there is no workable solution to climate change; so instead of uselessly trying e.g. putting business killing regulations in place, they deny the problem. Climate change solutions as currently formulated are economically costly and effectually ambiguous. No wonder that environmental movements and environmentalists have had little or no success on climate change; they are not likely to have any with the current package of solutions. On climate change environmentalists are not part of the solution they are part of the problem because they promote non-solutions as solutions.
The range of solutions being proposed in bestseller books, in political platforms, and by international and multilateral organization and accords strongly suggest a socialistic approach to addressing climate change. If climate change was a national problem socialism would probably have a shot at addressing it at an extremely high economic cost but since it is global problem socialism is no better at solving this problem than plain old capitalism.
Interest makes technological progress a curse
Generally speaking, as technology advances more can be done by less labor, so technological progress contributes to unemployment and consequently loss of income and bargaining power for workers. Technological progress also contributes to income inequality through concentration of power in the hands of technocrats and capitalists.
Technological advancement will provide prosperity if the society is able to find better things to do with the labor freed; if not it will immiserate labor and society. The solution should therefore include creation of more work for workers, i.e. increased investments in employment generating enterprises, so that employment could increase again. Persistently higher rates of employment tends to minimize income inequality. In my view the pyramids were built to employ the labor freed due to continued technological advancements; the genius of the investment was that it provided better income to the workers and society and lifted the society to a higher level of skills, possibilities, power, wealth and prestige; it is still providing income to the society; it was an extremely good investment. If the Pharos had not built the pyramids in the years that they did their society would have descended into chaos. Modern economies also have to keep finding better and better investments to keep their pool of labor employed and to lift their societies to higher levels of current and future wellbeing. The fundamental essence of statesmanship is to find and develop investment avenues for the society, either in war or in peace. The current European and US economic situation is primarily due to failures in this kind of statesmanship, the effects of which have been highly magnified by the competitive pressures of globalization.
Sinless Capitalism will make it easy for leaders to provide ample means and avenues for new investments in industries that will not only address the employment problem but will also address major national and global problems including climate change. Technological progress gives the leaders an opportunity to determine a course for the nation and mankind that will ensure its survival and improve the chances of having a better future. Interest by limiting investment options does not allow leaders and societies to avail the benefits of technological progress; it in fact makes technological progress a curse.
Urgent necessity of Sinless Capitalism
The global economy has been in turmoil for a decade and it continues to go into deeper trouble even if there are some temporary signs of recovery. The International Monetary Fund (IMF) in May 2018 warned that worldwide debt has now reached a new record high of $164 trillion, equal to 225pc of global GDP. The world economy is more indebted now than before the global financial crisis (GFC) more than a decade ago. The most widely tried solution to the ongoing crisis has been creation of debt, both public and private, a lot of which has been going in consumption and in speculation. These debts have been subsequently supported by printing of money. Since 2007 the central banks of US, Europe and Japan have together pumped $10 trillion of extra cash into the global economy just to keep their economies functioning; in the process they have created a series of disastrous asset bubbles. China is worse. These asset bubbles have spread far and wide; real estate prices even in poor countries are piercing the sky.
These debts and recurring bubbles over decades are evidences that known economic stimulation tools have not only failed but have become counterproductive. If this indebtedness keeps rising the way it is, unmanageable financial crises are inevitable. The IMF thinks that the current economic boom will not last long; I agree.
Sinless Capitalism is the only solution that will eliminate the root cause of current global economic problems and start a new economic growth trajectory that will last for generations. As long as the cause of the ongoing economic problems are not removed from the current economic system wars including World War III will keep coming closer to reality. Wars have economic logic e.g. when demand is low preparations for war is a good way to create demand. Japanese Prime Minister Shinzō Abe’s economic recovery strategy included spending on defense. Sinless Capitalism will create demand in building a sustainable, prosperous and space friendly future; we will not need to stimulate our economies through war and related spending.
This ongoing perilous economic conditions will not heal on its own. If the current system is left to continue either a new economic order on the failed socialistic model will emerge or the world will go towards major wars; or both. Sinless Capitalism is an effort to “save the world.” Sinless Capitalism is probably the most important idea of the current times.
THE GLOBAL EMPLOYMENT CHALLENGE
Capitalism has been a very successful economic system for centuries. The current series of economic crises that had its first major appearance in early 2008 and that continues to persist in the developed world has caused many to seriously question the future of Capitalism.
Even though each country in these crises has its own set of problems the problem common to all is anemic economic growth. Insufficiency of economic activities in developed countries is causing these economic crises to continue; it seems that developed countries are running out of economically viable businesses or investments to undertake.
The inability on the part of developed countries to make adequate investments is translating into lackluster economic performances and higher unemployment rates. High unemployment and economic distress are the major forces driving the overall economic and social malaise in the developed world.
Temporary monetary and fiscal solutions are just pushing the problems down the line or buying time for development of a permanent fix. The fixes that are being currently debated e.g. infrastructure spending, tax cuts, fiscal austerity, reducing wealth/income inequality, income redistribution, erecting trade barriers etc. are all trying to address a symptom rather than the problem. This paper proposes a fix that will address the root cause of the problem and will be a permanent solution.
Inability to make adequate investments
Generally higher levels of development leave increasingly smaller room for further development and growth given a particular trajectory of growth. Those inherent challenges to growth in developed countries are, however, being further compounded by the tightening planetary constraints on resources and the environment.
Even though oil and other fossil fuel prices have recently been low it does not alter the fact that further growth on the fossil fuel trajectory is difficult for most developed countries; it does not alter the fact that use of these fuels cause environmental degradation; it does not alter the fact that oil and other fossil fuels are a dwindling resource and its end should be counted in decades and not in centuries. Long term trend in oil prices has been that of rising and it is likely to continue and accelerate. These facts factor into major (long term) investment decisions and produce adverse investment decisions and economic consequences; they will continue to do so in the foreseeable future.
The economic effects of planetary constraints are high in developed countries because of their high dependence on fossil fuels (energy). Because of the presence of fossil fuels in the foundations of most business activities further growth on the fossil fuel trajectory is becoming increasingly difficult for developed countries.
Developed economies, therefore, have to rapidly move away from their dependence on fossil fuel. Lasting economic recovery in the largest economy of the world will only come about if the foundations of its economy is shifted from fossil fuels to sustainable sources of energy and other raw materials.
Even if the US and the world in general is not interested in addressing the need for resource sustainability it has to nonetheless address the problem of unemployment and inadequate economic growth. The proposals in this paper squarely addresses the problem of unemployment and economic growth because they are directed at eliminating the root cause of these problems: unsustainable economic structure.
Developing countries are not immune to the pressures being felt by developed countries on the fossil fuel trajectory; they will also face the same pressures in times to come. In the 21st century fossil fuel based development is an illusory dream which will never lead to long lasting prosperity. Developing countries such as Pakistan should stop chasing such dreams.
Low rates of return in sustainable energy industries
Since it seems that all countries need to gradually move away from fossil fuel, let us look at the general feasibility of sustainable and other sources of energy. Sustainable energy industries, like wind and solar power, have inherently low returns because they require many times the capital investment required in fossil fuel power-plants. For example: A one-gigawatt wind facility costs more than $2.5 billion to build, whereas a gas facility of the same capacity costs $600 million.
Interest on capital is no longer sustainable
The current financial system only allows allocation of capital to businesses that can pay interest. Most sustainable, resource adding or other futuristic industries don’t make profits high enough to be able to pay interest consistently. Temporary low interest rates don’t make these industries viable. As interest rates fall their probability of rising tends to increase; fear of higher interest rates in future makes investments in low return industries financially unviable. Government subsidies cannot support such a huge and exponentially growing part of an economy forever.
Sustainable energy industries have inherently low returns; many other industries in developed countries promise low returns for new ventures because of little room for growth on the fossil fuel trajectory, global competition and other global challenges. The overall financial return structure for new businesses in developed countries has shifted down significantly over the years of this century; this fact is reflected in near zero interest rates there for most of this century. The new normal for interest rates seems to have become zero in developed countries.
It seems reasonable to suggest at this point that developed countries may need to make zero interest rate a permanent feature of their economy; or in other words get rid of interest.
Interest is a relic of the gold system, which required payment of interest to keep the limited amount of gold (money) in circulation. Under fiat money interest is not necessary in that sense because money can be created.
NEW CAPITALISM – THE SOLUTION
The book titled “New Capitalism – Capitalism Re-engineered for 21st Century” presents a new model of a market driven economic system that will eliminate interest and thereby make most sustainable industries viable. By changing the foundation of the economy from fossil fuel to sustainable energy it will improve the business potentials of most other industries. It will start a new trajectory of sustainable economic growth lasting for generations.
The most pressing problem of this century is subpar economic performance in most of the world; the other side of which is high unemployment. New Capitalism will open up a huge range of investment opportunities that are required to build a new and sustainable global economic structure. New Capitalism will keep most of the global population employed for generations irrespective of the fact that human jobs will continue to be lost to machines and robots.
Sustainable energy and other futuristic industries are extremely capital intensive; therefore low capital cost is the key to environmental and resource sustainability which in turn are the keys to future economic and employment growth in developed countries. New Capitalism by eliminating interest and income tax will bring down capital costs to the level where environmental and resource sustainability becomes practical and profitable. The salient features of “New Capitalism,” include:
The proposed system basically replaces Interest and Income tax with Asset tax, an annual tax on all assets including cash. Asset tax will perform the functions of interest and income tax and much more. New Capitalism will bring in prosperity and economic growth by increasing investments in sustainable and other industries. Eliminating a major economic cost (interest) will significantly bring down costs and therefore tremendously increase the range of feasible economic activities.
Eliminating Interest
Interest has to be eliminated, because it is the major reason for most unsustainable choices being made in capitalistic economies. Interest currently only permits existence of resource intensive industries which translates into higher consumptionof mineral and other resources. On the other hand, interest does not allow investments to pick up in sustainable energy and other similar industries because they cannot always pay interest. Interest also incentivizes rapid extraction and consumption of mineral resources because minerals in the ground don’t earn interest.
If interest is not eliminated most investments would continue to be made in unsustainable industries till the world manifestly starts running out of resources. In the meantime developed economies will suffocate from increasing resource constraints and lack of business opportunities; developing countries will be chasing an elusive dream. If interest is eliminated economies will have a chance to grow by investing in sustainable industries and simultaneously changing the mix of products in their economies to a sustainable one.
The threat of a devastating global war, potentially humanity erasing, will become real when the planet manifestly starts running out of resources including that of the environment. Interest has to be eliminated for a safe and prosperous future for humanity.
Discontinuing Income Tax
Income Tax has to be discontinued because it is not needed in the proposed system – New Capitalism. Currently, income tax performs the function of generating revenue for the government. Asset tax would do that with higher efficiency and fairness. Wealth is a far better measure of an entity’s ability and fair share of tax than its income in a particular year.
Instituting Asset Tax
Asset tax will perform the function of both interest and income tax.
Once interest is replaced by asset tax, economic growth driven by future potentials of sustainable and other futuristic industries and by low cost of capital will translate into attractive financial returns for investors in these and other industries. Financial return will again become a measure worthy of driving the capitalistic system.
Asset tax will replace income tax as a source of revenue for the government. Asset tax will be easier to assess and administer than income tax. As in any tax system, there will be exemptions, thresholds, moratoriums etc. to keep the system fair and productive.
Economic growth is generally driven either by consumption or by investments. So far in this century, developed countries have tried to achieve growth through increasing consumption; in doing so they have hit many financial and economic constraints, including that of the planet. The world currently needs economic growth through investments in sustainable, resource enhancing, and future building industries.
The crises ridden economic landscape of the world can be described by the following features:
The interest based system is not very effective in allocating capital during times of abundant capital because of the zero bound in lowering rates. Interest is ineffective in dealing with overabundance of capital; it can only handle scarcity of capital well.
The ineffectiveness of interest during abundance of capital results in huge sums of unallocated capital which in turn increases speculative activities. Speculative activities increase asset prices and cause asset bubbles. In the presence of interest, money is far more likely to be invested in bubble forming assets than in low return industries. Asset bubbles can promise to pay interest, sustainable industries cannot. Currently the major reason for capital being wasted in asset bubbles is: interest.
New Capitalism will start a new trajectory of demand for capital for futuristic industries. Consequently it will also increase employment and economic growth. Employment is created when capital is produced and again when capital is employed. New Capitalism is inherently friendlier to investment, employment and other economic well being needs of individuals and societies. In short
The current economicsystem was developed during the time when the environment and other planetary resource constraints were not real issues. Now they are; therefore, the current economic system needs to be reformed to enable it to handle scarcities and constraints of planetary dimensions.
The proposed New Capitalism economic system will adapt capitalism to modern times.
New Capitalism will bring about a capitalistic revolution. It will create a global economy that will produce and use capital with abundance. The economic impact of the capitalistic revolution will be comparable to that of the industrial revolution.
New Capitalism is “Super Capitalism.”
For further details about New Capitalism please visit my website: www.newcapitalism.org
VARIANCE
Variance of returns is widely used as a measure of a financial asset’s risk. Practitioners and academicians have been using variance or standard deviation of returns as a measure of a stock’s risk for the last 60 years or more. However it has long been known that variance is not the best measure of risk.
Semi-variance, which measures the dispersion of losses, is a better measure of risk. Even Harry Markowitz who pioneered modern portfolio management and the use of variance considered semi-variance to be a better measure of risk; he said so in his book “Portfolio Selection – Efficient Diversification of Investments.” But he decided to use variance because of computational difficulties in using semivariance in portfolio management.
Variance is a measure of the volatility of returns. However, when we think of risk we are mostly concerned about losses and not about the general volatility of returns. Volatility on the loss side is undesirable while volatility on the profit side is desirable i.e. only part of volatility is risk. Investors are not volatility averse; in particular they are not averse to volatility caused by higher returns.
Investors in stocks seek maximum profits; not uniform profits. Higher profits are highly desirable therefore they, or any of their consequences, should never form part of risk. But in the variance based system the risk of an asset increases when it earns high returns.
About half of the data points included in variance are not elements of risk. Variance is therefore not really a measure of risk. But it is used because it is mathematically elegant and easy to use. The following folktale helps make the point.
Mulla Nasruddin was searching for something under a lamp-post in his garden. When his neighbor asked him what he was searching, he replied that he was looking for his house key.
Wanting to help him, his neighbor joined him asking: ”Do you remember where you dropped it?”
Mulla Nasrudin answered: ‘Of course I do, in my house.’
‘Why are you looking here?’ asked his neighbor confused.
Mulla replied: ‘Because there is much more light here than in my house.’
Variance is counter intuitive and an unreliable measure of risk
Some changes in risk as measured by variance are strikingly counter intuitive e.g. risk measure increasing with increasing positive returns, or risk measure decreasing or remaining unchanged with increasing frequency of negative returns. Investors therefore tend to ignore risk valuation when their intuition does not agree with it. Dependability, a major strength of a numerical measure, is lacking in variance.
The unreliability of the variance based risk measure has led to the development of a business in implied volatility e.g. VIX. Implied volatility is the valuation of risk that buyers and sellers implicitly agree on when they trade options; it is generally a subjective valuation of risk. VIX is the implied volatility in prices of options on S&P500.
The flawed nature and counter intuitiveness of variance is further illustrated by comparing VIX with S&P500. As the following chart shows S&P and VIX move in opposite directions i.e. when S&P is rising VIX is falling and vice versa. This behavior of VIX is intuitively appealing because we expect risk to go down when the asset is performing well. In contrast, variance tends to rise when S&P rises.
VIX shows how an asset’s risk really behaves with respect to its performance and that markets actually lower their assessment of risk in response to higher returns. Currently that assessment process is mostly subjective because of the shortcomings of variance.
Variance is a false measure of risk. No wonder professional quantitative portfolio managers have such a difficult time beating dart throwing monkeys.
SEMI-VARIANCE
In finance the possibility along with the severity of loss is called risk. Risk is a concern about losses; therefore a measure of risk should quantify losses. Semivariance quantifies losses; it measures the dispersion of losses; it is a true measure of risk.
A good measure of risk, if assessed from historical data, should go up for bad results and go down for good results. Risk as measured by semi-variance increases with higher losses and decreases with lower or no losses.
Losses are of many types. Some investors may see profits that are below the risk free rate as loss, they can use risk free rate as the dividing line or the cutoff point for calculating semi-variance; any return below the cutoff point will be considered negative return or loss. Similarly, investors may also use zero return, current return, mean return, expected return or any other measure of return as their cutoff point.
Old (Markowitz) Semi-variance method
Variance of a portfolio is formulaically computed by using variance of individual assets and their co-variances with other assets. As assets or their weights change in a portfolio, the variance of the portfolio is easily recalculated by using the same asset variance – covariance formula. The case with portfolio semivariance (old) is very different.
Portfolio semivariance is based on portfolio returns of those years the portfolio made a loss. Asset semivariances and semi-covariances, specific to the portfolio, are also calculated from the asset return data of the years the portfolio made a loss. In other words, all asset and portfolio semivariances have to be computed using only the return data for the years that the portfolio made a loss.
Since asset semivariance and semi-covariance are not constants but a variable dependent on the portfolio, there is no point in going through the additional step of computing them for use in portfolio semivariance calculations. It is much efficient to compute portfolio semivariance (old) directly from the portfolio loss years’ return data. Portfolio optimization is also done using portfolio loss data.
Failings of the old Semi-variance method
The major failing of the old semivariance method is in portfolio optimization. Since portfolios are optimized using only portfolio loss data the optimization process becomes detached from the assets and doesn’t benefit from reading all of the asset loss data and the trends hidden in them. Some asset loss years are not in portfolio loss years.
The quality of the data on which optimization is based is further compromised by the mixing of positive returns with negative returns; some asset profit years are in portfolio loss years.
Portfolio optimization done with old semivariance is based on a set of data that does not have all the asset loss data and is also a mixture of loss and profits at the asset level. Assets are the fundamental or basic units of risk. A system that does not read assets correctly cannot create an efficient portfolio. Therefore old semivariance optimum portfolios don’t perform well as investments.
THE PULSE METHOD
In old semivariance, asset semivariances and semi-covariances are portfolio specific and cannot be used to compute semivariance of other portfolios.
Pulse method overcomes the problem of portfolio specific asset semivariances and semi-covariances by computing a closely tracking proxy of portfolio semivariance (old).
Pulse asset semivariances and semi-covariances are computed only from asset return data i.e. independently of portfolio data. Pulse asset semivariances and semi-covariances are not portfolio specific; they are independent of the portfolio; they can be used to compute semivariance of any portfolio.
Pulse measures risk by reading asset data completely and correctly. Assets are the fundamental units of risk. Pulse portfolios perform better because Pulse constructs an optimum portfolio by measuring assets’ risks and then combining them in a manner that minimizes overall portfolio risk.
The Pulse method is also superior to many other portfolio optimization models that were proposed to replace variance e.g. those using Lower partial moments (LPM) and/or ARCH/GARCH analysis. The Pulse method is simple, parsimonious and effective.
Pulse method has a clear mathematical formula which can be used, like variance, in computing portfolio semivariance and in portfolio management. Making asset semivariances and semi-covariances constants (independent) is one of the main achievements of the Pulse method.
Pulse method’s advantages over old semivariance
In old semivariance, portfolios are optimized by reading only portfolio loss data; the optimization process does not read all of the asset loss data to be able to read their underlying trends. The quality of the data on which optimization is based is further compromised at the asset level by the mixing of positive returns with negative returns which happens because some assets have profits in portfolio loss years. Portfolios that are optimized using old semivariance are not based on a correct measurement of asset risk.
Furthermore, in the old semivariance method the data keeps changing in response to changes in the variable being optimized i.e. the weights of assets. The optimization process is thus compromised because it is dealing with a different set of data every time it tries a new iteration; a new iteration in portfolio optimization is a new set of asset weights. Portfolios created by old semivariance based optimization can have an optimal risk-return tradeoff only by chance.
In contrast, the Pulse method by using the entire asset loss data benefits from reading the underlying trends in asset risk. Additionally, by using the same set of data and the same asset semivariances and semi-covariances, irrespective of the weights of assets, the Pulse portfolio optimization process has the data continuity necessary to work out an optimal risk return tradeoff; it therefore produces best performing portfolios.
The main achievement of the invention – the Pulse method – is not only that it makes it easier to use semivariance in portfolio optimization but also that the optimal portfolios created by this method are resilient over time and therefore are good investments. Evidence of their resilience for a year is provided in the section on backtest results and in the attached spreadsheet.
Pulse method’s advantages over variance
A major adverse consequence of the use of variance is that investors’ risk averseness gets translated into their being volatility averse. A volatility-averse investment program or portfolio has diminished chances of achieving high return. In the words of Harry Markowitz “Analyses based on semivariance tend to produce better portfolios than those based on variance. Variance considers extremely high and extremely low returns equally undesirable. An analysis based on variance seeks to eliminate both extremes. An analysis based on semivariance, on the other hand, concentrates on reducing losses.”
In other words, variance based (volatility-averse) optimization will reduce potential returns. Harry Markowitz confirms this in the following statement about variance optimized portfolios “The only complaint one can raise about such a portfolio is that it sacrifices too much expected return in eliminating both extremes.”
On the other hand, a semivariance based (volatility-of-loss-averse) investment program or portfolio will only avoid the extremes on the loss side; it will not diminish chances of achieving high return.
Semivariance diversifies away risks. Variance diversifies away both risks and opportunities.
Backtests for the Pulse method – Results and methodology
Performance of the Pulse method has been assessed by running hundreds of back-tests. In each backtest optimum portfolios are constructed using the Pulse method, the variance method and the Markowitz method; a random portfolio is also created.
Optimum portfolios are constructed by maximizing Risk adjusted return or Sharpe ratio. Risk adjusted return = (Expected Return – Risk free rate)/ risk. Expected Return is simply the average return over the period. Risk free rate is assumed to be zero. Risk is semi-deviation (square root of semivariance) or standard deviation of returns. Returns below the mean are considered losses for semivariance calculation purposes i.e. mean is the cutoff point.
Stock returns (total returns including dividends) data of 30 stocks for 38 years (1975 to 2012) is used for the series of backtest discussed here. Each backtest is for a portfolio of 8 stocks; there are millions of 8-stock combinations in a population of 30 stocks.
Each optimization run uses 20 year data. The first 20 year history is used for the first loop of the test run i.e. data from 1975 – 1994 is used to construct the first of a series of optimum portfolios. The second run is for 1976-1995 period. This process is repeated 18 times to reach 2011 returns i.e. every backtest has 18 optimal portfolios for each method.
An investment in each of the portfolios thus created is supposedly made for one year and performance evaluated. For instance, the performance of the portfolio constructed using 1975-1994 data are evaluated using 1995 returns of the stocks; similarly for the loop ending in 2011 performances are evaluated using 2012 returns.
The performances of the Pulse portfolio, the variance based portfolio, the Markowitz portfolio, and the random portfolio are compared. Pulse portfolios outperform all other portfolios in almost all the tests. This result is consistent over the range of assets and times tested. Pulse portfolios outperformed Variance portfolios by margins that were generally higher than 25%.
Pulse optimized portfolios outperformed variance optimized portfolios 14 times out of 18 in the results attached. Over an 18 year period Pulse portfolios earned a return of 258% whereas variance optimized portfolios earned a return of 186% (no compounding assumed). Pulse portfolios outperformed random portfolios and portfolios optimized using old (Harry Markowitz’s) semivariance method by even greater margins.
Matlab’s fmincon is the application used for optimization. A spreadsheet summarizing the results of a simple backtest is attached.
INVESTMENT ACTIVITIES THAT WILL BENEFIT FROM THE INVENTION
Achieving the potentials of quantitative portfolio management
Since variance does not measure risk correctly its use has kept quantitative portfolio management from achieving its potentials.
Risks and returns are the two main variables in asset selection. Since semivariance is a better measure of risk than variance, its use should therefore result in better portfolio optimization. A change in the risk measure from variance to semi-variance will enable quantitative portfolio management to achieve its potentials.
Asset Pricing
Asset pricing models such as the Capital Asset Pricing Model (CAPM) and the Black-Scholes Option pricing model use risk in pricing assets. Use of semivariance instead of variance will significantly improve their performance as asset pricing models. For example, the volatility measure used in options prices will start to have an objective basis; implied volatility and measured volatility will converge.
CAPM will be better able to explain most capital asset prices. Prices suggested by the model would become relatively dependable. Beta will be clearly observable in capital asset price behaviors and consequently will be commonly used and have better intuitive appeal.
Author: Syed GhulamQadir Rye
December 2013.
The following is an example of the results achieved in hundreds of back-tests conducted to test the performance of the Pulse method. The results are annual returns in decimal fractions.
| ACTUAL RESULTS ACHIEVED | PULSE PORTFOLIO COMPARED | VARIANCE COMPARED | MARKO COMPARED | ||||||||||||
| Pulse | Variance | Markowitz | Random | P-Variance | P-Marko | P-Random | V-Marko | V-Random | M-Random | ||||||
| 1995 | 0.372882 | 0.480832 | 0.383018 | 0.362219 | -0.10795 | -0.01014 | 0.010663 | 0.097814 | 0.118613 | 0.0208 | |||||
| 1996 | 0.295784 | 0.151266 | 0.204305 | 0.306529 | 0.144518 | 0.09148 | -0.01074 | -0.05304 | -0.15526 | -0.10222 | |||||
| 1997 | 0.44404 | 0.375196 | 0.402743 | 0.282087 | 0.068845 | 0.041297 | 0.161954 | -0.02755 | 0.093109 | 0.120656 | |||||
| 1998 | 0.225891 | 0.179326 | 0.305187 | 0.235252 | 0.046565 | -0.0793 | -0.00936 | -0.12586 | -0.05593 | 0.069935 | |||||
| 1999 | 0.105359 | 0.067985 | 0.090916 | 0.140664 | 0.037374 | 0.014443 | -0.0353 | -0.02293 | -0.07268 | -0.04975 | |||||
| 2000 | 0.081749 | 0.043593 | 0.095569 | 0.053444 | 0.038156 | -0.01382 | 0.028305 | -0.05198 | -0.00985 | 0.042125 | |||||
| 2001 | 0.085178 | -0.02788 | -0.04144 | -0.04363 | 0.113054 | 0.126617 | 0.128807 | 0.013563 | 0.015753 | 0.00219 | |||||
| 2002 | -0.10859 | -0.16371 | -0.19447 | -0.17732 | 0.055124 | 0.085887 | 0.068733 | 0.030763 | 0.013609 | -0.01715 | |||||
| 2003 | 0.184338 | 0.097884 | 0.051541 | 0.134755 | 0.086454 | 0.132797 | 0.049583 | 0.046344 | -0.03687 | -0.08321 | |||||
| 2004 | 0.122731 | 0.128872 | 0.139538 | 0.098169 | -0.00614 | -0.01681 | 0.024562 | -0.01067 | 0.030703 | 0.04137 | |||||
| 2005 | -0.00014 | 0.021447 | 0.019657 | 0.000887 | -0.02159 | -0.0198 | -0.00103 | 0.00179 | 0.02056 | 0.01877 | |||||
| 2006 | 0.168449 | 0.148543 | 0.134018 | 0.1443 | 0.019906 | 0.034431 | 0.024149 | 0.014525 | 0.004243 | -0.01028 | |||||
| 2007 | 0.060706 | 0.02044 | 0.007741 | 0.058655 | 0.040266 | 0.052965 | 0.002051 | 0.012699 | -0.03822 | -0.05091 | |||||
| 2008 | -0.22238 | -0.24694 | -0.24394 | -0.33023 | 0.024555 | 0.02156 | 0.107849 | -0.003 | 0.083294 | 0.08629 | |||||
| 2009 | 0.345143 | 0.236229 | 0.155131 | 0.249399 | 0.108914 | 0.190011 | 0.095744 | 0.081097 | -0.01317 | -0.09427 | |||||
| 2010 | 0.165765 | 0.104459 | 0.066437 | 0.172264 | 0.061306 | 0.099328 | -0.0065 | 0.038022 | -0.0678 | -0.10583 | |||||
| 2011 | 0.254306 | 0.221153 | 0.189013 | 0.106301 | 0.033153 | 0.065292 | 0.148005 | 0.03214 | 0.114852 | 0.082713 | |||||
| 2012 | -0.00228 | 0.018344 | 0.034765 | 0.059769 | -0.02062 | -0.03704 | -0.06205 | -0.01642 | -0.04143 | -0.025 | |||||
| 14 | 15 | 15 | 15 | 14 | 12 | 12 | 10 | 9 | 9 | ||||||
| -0.33339 | -0.43852 | -0.47985 | -0.55118 | -0.1563 | -0.1769 | -0.12499 | -0.31144 | -0.4912 | -0.53864 | ||||||
| 2.912321 | 2.295569 | 2.279579 | 2.404693 | 0.878189 | 0.956109 | 0.850405 | 0.368756 | 0.494737 | 0.484848 | ||||||
| 2.578935 | 1.857047 | 1.799727 | 1.853515 | 0.7219 | 0.7792 | 0.7254 | 0.05732 | 0.003532 | -0.05379 | ||||||
| Highlighted numbers show the superior performance of the Pulse portfolio | |||||||||||||||
| R22 shows that the Pulse portfolio beats varaince portfolio 14 times out of 18. | |||||||||||||||
| R29 shows that the Pulse portfolio outperfoms variance portfolio by 72% over 18 years. | |||||||||||||||
| The total return of the variance portfolio is 186% (N29) and that of the Pulse is 258%(M29) | |||||||||||||||