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In 2018, John Coates wrote a paper that argued that “in the near future roughly twelve individuals will have practical power over the majority of US public companies.” That article has now become a book in which he has expanded his analysis. FT Alphaville reports…

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The 2018 paper was focused on index funds, and that is the bit most people have freaked out about. After all, even Vanguard’s founder Jack Bogle raised the dangers of a narrow clutch of rapidly growing passive investment giants controlling more and more of the corporate world.

However, the book finally comes good on a promise made in the original paper to also explore the implications of the rise of private equity. It is the missing piece of the puzzle. As Coates puts it in the intro:

A “problem of twelve” arises when a small number of actors acquires the means to exert outsized influence over the politics and economy of a nation. In US history, problems of twelve have recurred, as the result of a clash of two fundamental forces: economies of scale in finance on the one hand, and constitutional commitments to fragmented and limited political power on the other. Each time, the “problem” has been two-sided. The concentration of wealth and power in a small number of hands threatens the political system and the people generally, and the political response can threaten the financial institutions in which wealth and power are accumulating, even when those institutions create economic benefits.

Today, two late-twentieth century institutions — index funds and private equity funds — are creating a new problem of twelve. As financial organizations, they amass and invest capital, and have been primarily scrutinized through a financial lens. As with other financial institutions, they pool savings from dispersed individuals and channel it to fund major projects. They facilitate capitalism, which has created huge benefits for humanity — wealth, health, and much longer life spans — along with inequality, misery, and the existential threat of climate change. Finance creates value by facilitating change, but distributes the gains unequally, and magnifies the gales of “creative destruction.”

But both kinds of funds are now so large, and have influence over so much of the economy, that they have economic and political power, whether they want it or not. Their power makes them targets of political threats. Both institutions exhibit “economies of scale.” Both are active politically — directly, and indirectly — through their control of businesses.

Their growing and concentrated wealth and power threatens the foundations of a democratic republic built on Montesquieu’s separation of powers as well as federalism — the “checks and balances” taught to every civics student. In a predictable response, the republic is increasingly threatening each type of institution with new restrictions, burdens, and limits. Because index funds certainly, and private equity funds possibly, create value within the US economy, the threats to them are as important as their potential threats to American democracy…

In a thoughtful analysis, FT Alphaville asks, is this a problem to be solved or a dilemma to be managed? “The ‘Problem of Twelve’ — redux” (gift article) from @FTAlphaville.

* Lord Acton (perhaps better known for his remark in an 1887 letter to an Anglican bishop, “power tends to corrupt, and absolute power corrupts absolutely.”)

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As we contemplate consolidation, we might spare a thought for Fischer Black; he died on this date in 1995. An economist, he is best remembered as the co-creator of the Black-Scholes model, a technique for valuing financial options. The model established that an option could be priced from a set-in-stone mathematical equation, which allowed the Chicago Board Options Exchange (C.B.O.E.), a new organization, to expand their business to a new universe of financial derivatives. Within a year, more than twenty thousand option contracts were changing hands each day. Four years after that, the C.B.O.E. introduced the “put” option—thus institutionalizing the bet that the thing you were betting on would lose. “Profit at all prices” had joined the mainstream of both economic theory and practice, and by 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year.

The Nobel Prize is not given posthumously, so it was not awarded to Black in 1997 when his co-author Myron Scholes received the economics honor for their landmark work on option pricing along with Robert C. Merton, another pioneer in the development of valuation of stock options. However, when announcing the award that year, the Nobel committee did prominently mention Black’s key role.

As Warren Buffett (whose birthday is today) observed: “The Black–Scholes formula has approached the status of holy writ in finance … If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.” Indeed, the “ruthless” application of the model has led to a number of disasters for investors (c.f. Long-Term Capital Management).

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