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Exclusive Q & A With Economist Reuven Brenner of McGill University (Part 1)

By the time he appeared on the cover of Forbes Magazine late last decade, a chorus had already developed within some circles in the United States that the best economist in the world was living north of the border. Reuven Brenner, the Repap Chair Of McGill University's School Of Management in Montreal, by most measures, at least, was the best economist that Canada had produced since Robert Mundell - 1999's Nobel Prize Economist. In fact it was Mr. Mundell, himself, some years ago who outright identified Reuven Brenner as sitting at the top of the profession.

What impresses most people about Reuven Brenner is his ability to make the complex simple and put economics jargon in laymen's terms. The Force Of Finance, Mr. Brenner's latest book, is a case in point. The Canadian economist outright states at the beginning of his book, his preference for being understood by the majority rather than impressing a small minority, and often arrogant elite in his profession, "...I do not use jargon in this book, no matter how technical the subject."

Reuven Brenner successfully applies this principle in his latest book, and through the use of anecdotes and metaphors delivered in oral presenatations or written form, he is able to produce clarity in a profession that seems to increasingly reward its practitioners for excellence in obfuscation, and thus supporting the label that many have given the field of economics - that of "the dismal science." publisher, Cedric Muhammad spent two days in Montreal last month, for a simultaneously intense, jovial, and fascinating dialogue with Reuven Brenner regarding his unique worldview; his new book The Force Of Finance; and how the Canadian professor's ideas are increasingly relevant to the global Black electorate. From the plight of indigenous populations, the recent U.S. accounting and corporate scandals, reparations, and the economics of immigration, the two men exchanged both complimentary opinions and respectful disagreement, in over 6 hours of discussion. A third of what was covered in the wide-ranging dialogue was conducted as an exclusive interview of Reuven Brenner for Today we run Part 1 of the interview that took place on the second day of meetings between the two parties.

Cedric Muhammad: In your opinion, what makes your perspective different from most academic economists?

Reuven Brenner: Because my starting point is completely different. I look at various societies not through any aggregate measures or the usual lens that separates the economic, from the financial and political. I look at them from a very simple viewpoint which consists of the following: If you want a country to prosper then people must have access to capital. No matter what country you look at - today or in the past you have five sources of capital - you can have retained earnings from savings that people have accumulated over time, a country may have natural resources that it may sell, and the most important is access to financial markets to borrow against future income. If you don't have these three for one reason or another, and especially if you don't have access to financial markets then you have only two forms of access to capital - government or crime. And in many countries, those two forms are unfortunately hard to distinguish. This view of the five sources of capital is the departure point of differentiation between myself and academic economists. The second point is that if you look at what makes countries prosper then it is an issue of matching. You have to match the capital with the right people and who you trust to manage that process. There is a big difference when financial markets do that matching and when governments do that matching. The point is not that the private sector does not make mistakes, which the last few years have shown so clearly. The point is that the mistakes are corrected much more quickly than when they are made from within government. Take as an example, as harmful as Enron and Worldcom and other mismatches of capital and people have turned out to be, they have been corrected the moment the information came to the forefront. If you look at how long it takes government to get out of the steel business or electricity business in some countries or other business that they mismanage, well, it can take decades or sometimes a century and then mistakes accumulate at a compounding rate. I would say that these are the two big differences in my approach to economics: 1) I have the five sources of capital and don't look at any other of those macro variables and 2) I look at the matching process and whether in that process both sides are kept accountable. From the beginning I have said you cannot trust these uniformly calculated numbers by statistics bureaus which pay absolutely no attention to the institutions of various countries. So you have GNP calculated in Libya and in Russia and in Mexico and the United States, as if they mean the same thing or that people infer from that these countries have the same type of policies. But as you can see, numbers have no meaning unless you have checks and balances - whether we talk about countries or companies. To illustrate this and how you perceive things differently when you look at it through my approach, I will give you two examples. When Russia collapsed and people were saying, "the solution is free markets, that's all," well, for me it was clear that could not succeed because you needed a source of capital. If the financial sector was not open, then it was clear to me that whatever was promised - "free markets" or "free prices" was more words or slogans because there was nothing happening at the bottom. There was no way that people could go give collateral and borrow money to go and start a business. So it was the source of capital that really wasn't changed in those years that was the problem. The same was true with Mexico when you have a very high inflation rate which wipes out, very completely, people's savings, you don't have open financial markets as a source of capital. So again, you have to look societies through that perspective and what can really happen rather than through simply looking at valuations and aggregate numbers. That is why my predictions were completely different regarding those two countries than the rest of the economic profession.

Cedric Muhammad: What do you define as capital?

Reuven Brenner: Excellent question. There is financial capital. There is social capital. And there is human capital, when we refer to the particular individual. When I am using that word capital, I am using it probably in the narrowest financial sense. Obviously you have the family who is a source of capital. I don't discuss it in this book, The Force Of Finance, but I did discuss it elsewhere. I will give you a simple example on how to understand this and how if a country is to prosper, it is the financial market and financial capital that you have to properly focus on. Here is an example. Take China today. As you know, there have been for the last 30 years, the government's very restrictive policy that families that have more than one child would lose their apartment etc... they were penalized. Today, most of the families today have one child. Now if you look back in history at how countries prosper when there are no open capital markets, the money really comes from the family. Now what does family mean? You have brothers, sister, and cousins who all put their resources together and start a family business. When you have one child, no brothers, no sisters, no cousins, then family businesses are just not possible. What will happen? What people don't pay attention to is that OK, you can have a sort of small entrepreneurial business in this very little family but if you want to grow, how can you grow? There is no family capital because you don't have a big family, so unless China goes very quickly to develop contract laws and legal institutions it will be stuck. I am not saying that family capital is not very important but that can bring a country only to a very limited level of development. If you don't get the courts and the financial sector together it will be stuck, very soon.

Cedric Muhammad: In light of you saying that I want to take you to the other extreme - the United States, which seems to have financial capital developed much more than any other country but my take has been that there is a crisis in accounting for human capital - the financial statement analysis world. If you look at a balance sheet or any of the financial statements, anything as far as training and development of employees is an expense or overhead. Anything that develops people is overhead but if you buy a machine it is called a "capital investment." So that lends itself to the accounting paradigm saying nothing about people other than their activities to a degree, but anything else that is physical is able to be viewed as an investment. Having said all of that, you wrote something about the stock options issue, where, instead of saying that options should be expensed on the income statement, as people like Warren Buffet are encouraging, that they should be on the balance sheet as financial liability and the human aspect to the option recorded as an asset. You would like to see the extension and acceptance of stock options properly recorded on the balance sheet as an economic activity that matches human capital and financial capital. Do you see this problem of accounting for capital as a major one?

Reuven Brenner: Well, you see, there are two things at work here. First, accounting was not developed to give valuations for companies. That was not the purpose of that big invention called accounting which happened in Italy...

Cedric Muhammad: double-entry ledger...

Reuven Brenner: Yes, it was a big innovation but that was done for the purpose that the name suggests - accountability, not to give a valuation for a company. The problem starts when you want to use income statements and balance sheets and cash flows to try to value a company. Well, the value of a company really comes from what I stated earlier in terms of the matching process. You are trying to match management with a capital structure. Yet, except in professional sports in the U.S. you don't have people on the balance sheet. Professional sports is the only place where the actual contracts of the players are on the balance sheet. For some reason in spite of the fact that Disney declares that their assets go down the elevator at 5 o'clock, they are not on the balance sheet. But when you look at stock price movements, you can see that this is the place where the market sees whether there is a match or a mismatch. I'll give you a very simple example. Cedric, I don't know if you remember a couple of years ago when Deborah Hopkins was the CFO of Boeing. She left Boeing and she became the CFO of Lucent. The moment, the split-second that this announcement was made the Boeing stock dropped by two dollars and also the Lucent stock dropped by two dollars, so the question is: what does that mean? After all that is a huge change in the market valuations of the two companies. Well, in my view it meant that she might have been a very good CFO for a manufacturing firm, knowing how to control and understand that business but she might not have been a good match for a Research and Development (R&D) company and investors probably knew that. That's why she was a good CFO for Boeing, so the moment she quit, the market valuation of Boeing went way down. But she wasn't expected to be a good match for Lucent so the Lucent stock dropped by $2. And she was fired in about a year, so she really didn't succeed there. The market knew that this match was not made in heaven. And what this shows is that on the balance sheet you did not show these people and personnel changes. The stock market gives you the true assets of the companies and some indicator of whether or not these people are able to solve the problems of the company. And if you think of what wealth creation really is, it is finding solutions to problems, through trial and error and to put those internal checks and balances within a company in place so that if you make a mistake you have a mechanism to stop it.

Cedric Muhammad: Short of a newsmaking event where human capital is obviously at the center of attention where do you see the valuation of human capital within the scheme of a corporation or company? And to what degree do you think it is possible that financial statement analysis is disproportionate or excessive in terms of...

Reuven Brenner: I think you go back to the subject of how the MBAs and economists have been mistrained. Maybe you should call it professional deformation because the excessive attention to these almost arbitrary numbers shows you what went wrong in the analysis, what was misunderstood about the analysis. These people were always declaring that we had to go behind those numerical values but they didn't do it. And I would say that they didn't do it because the last 18 years were a kind continuous prosperity where you tend to not ask tough questions. So it did not matter what type of analysis you did, people made money. And this is what led to mistaken analysis of companies where attention was not properly paid to the fundamentals. And so this is where I might differ with you, it is not just human capital but it is that human capital must be properly matched. You can be a brilliant CEO of one company and an utter disaster for another. It is the matching that is important and what are the institutions that control that matching? The title of my book, is The Force Of Finance and I know that the financial market is viewed, now, as not having functioned very well but what I am saying is not that the financial market is perfect. It evolves just like others. Unfortunately, I would say that what happened recently is the consequence of bad regulations and bad interpretations of laws done in the U.S. about 12 years ago. When a management is not performing very well, who controls them? Who has the power to fire them? Well, the board in principle has the power but you can fill up the boards very easily with your friends as many, many have done. The good mechanism for handling this can be found in what was practiced in the decade of the 1980s - hostile takeovers. If a CEO votes for himself outrageous compensation and meanwhile gives to his board an outrageous compensation, the board will not vote him out of power. So who can then throw out both the board and management? This can only happen if you can carry out a hostile takeover. Unfortunately, regulations were passed in the early 90s and courts gave interpretations that you cannot pursue a hostile takeover unless you meet so many conditions. As a result, hostile takeovers disappeared completely from the horizon. These abuses that happened over the last 10 years are in my view, an unintended consequence of these badly-sought or badly-conceived regulations. People are talking about greed and so forth, incorrectly. The metaphor that I have in mind is that you have a house well there are say, 3 cats and 10 mice. Well, take away 1 cat and the mice have more leverage to dance. It is not that the mice became greedier or anything. You now have two cats instead of three to keep an eye on the mice. It is not that the nature of the mice changed. Unfortunately the government, inadvertently threw out one of the cats from the house.

Cedric Muhammad: In The Force OF Finance you wrote:

"Occasionally, even in the U.S., the establishment succeeds in imposing constraints on entrepreneurs, often disguising its blatant self-interest as an effort to protect the poor from the greedy. Most recently, we saw in the 1980s a concerted effort in the U.S. to crush the junk-bond market and put Michael Milken, the financial entrepreneur who turned this market into a liquid one, in jail. But what were junk bonds? In truth, they were little more than a financial instrument that would allow relative newcomers to raise money for the non-traditional ventures of the times, ventures that banks were unwilling to support."

Many people have expressed the view that one of the reasons that financier Michael Milken was opposed by the U.S. government and imprisoned is because the financial techniques he developed and/or utilized helped those economic enterprises among groups that operate on the bottom of the socioeconomic ladder, including many Black businesses. Do you subscribe to such a view?

Reuven Brenner: No. The opposition really came from both many threatened competitors in the financial sector (who, once putting Milken out of the game, happily expanded into the high-yield market), and many industries, whose management was threatened to be taken over. I doubt if many saw the more far-reaching implications of moving toward more open, democratized financial markets. The reaction was to the more immediate threat.

Cedric Muhammad: Interesting. Reuven, as you know, my focus and the focus of of course, in many cases is the indigenous populations throughout the world and the Black electorate in the Western hemisphere and in Africa so when I see your book and model, as I have always told you, its greatest application, for good, could be in the innercities of America and these parts of the world.

Reuven Brenner. I think so.

Cedric Muhammad: Now you and I had a conversation yesterday about the native and indigenous populations in Canada and how this model applies to them and even how, the government in its effort to provide reparations, of some type, actually...

Reuven Brenner: backfired...

Cedric Muhammad: actually exasperated the problem. Could you please go over that again?

Reuven Brenner: Yeah. What happened for example here in Canada, you look at the aboriginal people who live on reservations. The way the Canadian government compensates them is by transferring to them huge amounts, sums and land and so forth. But, it is given through the old tribal structure so it goes to the chiefs and it is dependent upon them to distribute that money. So you keep in power a kind of institution whose time has come a while ago. But you are officially maintaining that rigid structure in place. So if you have young people who would like to leave the reservation and have a life somewhere else, then they leave without anything. So that keeps them on the reservation. Secondly, because the money comes from the government like "manna from heaven" so to speak, you have the same symptoms and problems among the aboriginal groups not improving, or getting worse - the highest unemployment rate, the highest suicidal rate, alcoholism, obesity and so in that sense the incentive structure of the way the compensation was given with the best of intentions, they were ill-sought and conceived. On a related point, I know this is a big subject in the U.S. - obesity. I remember when I was, for the first time, in Hawaii, and I noticed, among the locals that they were obese. There was an article that I read that indicated that everything had been tried on them in order to reduce the problem. The only thing that worked was when the natives were restored to a diet of food that was indigenous to those islands. Now what I inferred from that is that our bodies have been accustomed for hundreds of thousands of years to some type of food. Most of the people can probably receive a new type of food and it not be perceived as an error-type by the body. But for some people the body does not know how to interpret the new food and it reacts in all directions. Unfortunately this is what happens when a society that is disconnected is suddenly connected with another in addition to giving them resources where they can import all of the food that they were previously exposed to...

Cedric Muhammad: unalike attracts...

Reuven Brenner: and you have these unexpected consequences.

Cedric Muhammad: So a form of development internally, within a society ceases.

Reuven Brenner: absolutely.

Cedric Muhammad: Yesterday, you mentioned the idea of a fund. How could it work where the government of Canada gave compensation? What would be the structure among the natives that would allow them to follow your model?

Reuven Brenner: I think if they gave individual compensation it would have worked much better. I'll give you another example where the same mistake was made. Take Newfoundland which was the last province that joined Canada about 50 years ago. You know there were the great fishermen there. The government transferred a huge amount of money to the fishermen. But before the government put the program in place, the fishermen were fishing for 6 months of the year, and the other time they were traveling and farming and involved in other businesses. Then the government decided that these people were first and foremost fishermen so they could fish for 6 months and they could collect unemployment benefits for the other 6 months. So you know if you offer such generous terms to poor people, they don't necessarily see the long-term consequences. So they accepted the unemployment benefits. They were only fisherman and they completely lost the network and skill that they had before and then the fish eventually disappeared from Newfoundland and you had more fishermen then fish, and a big problem, because they no longer had the other skills. So the essential question is how do you give incentives, not just to maintain previous skills but to have the initiative and incentive to upgrade their skills and to move on and not be stuck on reservations and in ancient occupations? And this is essentially what this type of collective compensation did. It made the social structure rigid as well as the occupations. In addition, you cannot then say, "oh well we will send them to school." If people don't see the application of what they are learning then they are bored silly. That is why among the very young you see such a high rate of suicide on the reservation. You are teaching them mathematics and physics but they don't see anyway that they can use those skills so it is not a surprise that the process does not succeed. I remember a study and documentation I saw, I think it was in New York City. An entrepreneur came into an innercity school in which the students were failing and misbehaving and he decided that he would teach mathematics and statistics by showing how you use it in business and that group was extremely successful within a very short period of time. These poor kids who were misbehaving became big successes. They became entrepreneurs and they all say that they owe it to this teacher who opened their eyes to the application. In that case the application of their learning was obviously in their sight, which is not the case here in Canada with the aboriginals. I see quite often in many countries where they are speaking of investing a lot in education and to me, that doesn't work unless you show them (the students) that you can succeed with what you are learning. Success is not just making money but also creating or doing something. The result of the learning has to be applicable otherwise it is just an abstraction. And as you and I have discussed, this is the same thing when people say "we must write constitutions and the rule of law" for these countries. Unless you see that applied it is an abstraction, it is a piece of paper, it doesn't mean anything. Constitutions are very easy to write. You just take one that has worked, and what, type it up? And an Asian or African nation, because of that piece of paper, suddenly the people and country will prosper? This is silly!

End Of Part 1

Wednesday, September 25, 2002

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