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The Private Sector in China 2001

Funded&published by International Securities Consultancy, Hong Kong, 2001
All rights reserved by International Securities Consultancy


  1. Prior to socialism the private sector was the primary economic strength of China. In 1820 it made China the largest economy in the world and by 1860 Shanghai had become the financial and commercial hub of the East. Private enterprise was universal and vigorous and the private sector exercised considerable political power. In fact it was the attempt by Empress Dowager to nationalize the railroads that brought about the fall of the Qing Dynasty and ironically, by way of Sun Yat Sen’s popular revolt, the ascent of the Communist Party of China (CPC) in 1949. At the time there were about half a million private enterprises in China active in a variety of sectors including mining, manufacturing, transportation, finance, and munitions.
  2. The private sector continued to drive the Chinese economy even under socialism. It supplied the People’s Liberation Army during the Korean War. The initial position of the CPC was that private enterprise was complementary to and could co-exist with socialism. But after the Korean War the CPC reversed itself and began to expropriate private sector assets citing ideological reasons. Labor is the primary economic asset in socialism just as capital is the primary economic asset in capitalism. It is therefore unacceptable in socialism for an individual to profit from the labor of another.
  3. During periods of recession and unemployment socialist doctrine was tempered to engage the private sector in job creation; but by 1966 private enterprise had disappeared from China. An industrial structure consisting of state-owned enterprises (SOE) with centrally planned capital allocation, production targets, wages, and prices was installed in its place. The system failed.
  4. The SOEs grew into giant bureaucracies with social service obligations intermingled with production obligations with thin and invisible lines separating SOE business decisions from from government policy decisions. The SOEs were overstaffed and they used outmoded and polluting technology to produce an excess of inferior goods. As a business enterprise they were grossly inefficient and not competitive in a global context.
  5. In 1978 a program of reforms was initiated to overhaul these enterprises. Enterprise reform is the centerpiece of China’s market reform program. Its premise is that the State-owned enterprises will morph into efficient and globally competitive businesses if they are subjected to market forces. Chinese leaders chose to carry out these reforms within the context of State ownership and without a mass privatization plan.
  6. It was acknowledged, however, that privatization issues aside, a private sector would be needed in China if only to absorb the excess workers that will be laid off by enterprise reform. Accordingly, the Party formalized the recognition of private enterprise with constitutional amendments in 1988 and again in 1993 in which the
    private sector is described once again as an acceptable “complement” to socialism.
  7. A third amendment in 1999 elevated the status of the private sector to a “component” of socialism. Although entrepreneurs were still barred from Party membership, it became clear that the CPC (Communist Party of China) wanted to grow a grassroots entrepreneurial sector.
  8. Private enterprise responded enthusiastically and grew rapidly from zero to a significant economic force though mostly as self-employed tradesmen and small family businesses such as restaurants, laundries, repair shops, retail stores, manual trades, transport, and light industry. There are only a handful of private businesses with assets of more than 100 million yuan and these are restricted to specific sectors and they are owned for the most part by insiders (2001). Even so, the private sector soon took over as the primary engine of China’s economic growth disproportionately to its relative size.
  9. Yet, ambiguities remain in regards to the intended role of the private sector (2001) in the reform era. The State’s Constitutional responsibility as an ally of the private sector is compromised not just by ideological conflicts but by its own vested interest in the State sector that includes obligations to workers, retirees, and an entrenched bureaucracy. The private sector finds itself operating in an economy where the necessary industrial and economic infrastructure is captured by an inefficient State sector and where the interests of the State sector are the primary concern of the State’s regulators and economic planners.
  10. Besides, in the absence of the rule of law and without clearly defined property rights, the relatively higher profitability of the private sector provides the incentive and the opportunity for State predation. So the relationship between the private sector and the State is characterized by contradictions. The State simultaneously encourages the private sector and persecutes it.
  11. Discrimination against the private sector is both formal and informal. The tools of formal persecution include entry barriers, excessive fees and permit requirements, sectoral restrictions, and restricted access to capital, raw materials, product markets, and industrial infrastructure. The most severe is the capital constraint. The nation’s banks and securities markets are owned by the State and are reserved for the State itself. At stake is a 7 trillion-yuan household savings pool held hostage by the State’s banking monopoly.
  12. Informal persecution arises because the reform process functions in a legal vacuum with respect to property rights. The institutional mismatch endows bureaucrats with discretionary power that victimizes both the State and the private sector. In dealing with government officials, entrepreneurs must resort to bribery or rely on guanxi, a method of developing a personal relationship with bureaucrats by virtue of mutual friends and relatives.
  13. The capture of the formal capital market by the State squeezes the entrepreneurial sector into niche and informal capital arrangements and a higher cost of capital. Venture capital has flowed into China sourced mostly in Hong Kong, Singapore, and Taiwan but the venture capital market is still relatively small because of limited exit strategy options. Domestic and foreign venture capital could serve a bigger role but venture capitalists need an IPO exit, an option not available to the private sector in China.
  14. The State’s predatory policy towards capital fragments capital markets in China. Asset allocation is distorted, scarce resources are wasted, and the ability of the private sector to generate new wealth and to provide employment is curtailed. Escape from this trap is possible because the savings pool is a zero sum game only in the short term. Given access to capital, the private sector will create new wealth that will increase and not decrease domestic savings in the medium term. There are even benefits in the short term because increased competition for scarce capital will enhance capital allocation efficiency in the State sector too.
  15. It is extremely difficult for private enterprise to operate in the same product market as State enterprises. For example, a private sector domestic airline would need an operating license, approval of its pricing structure, and airport access from the CAAC, a government agency and regulator of the airline industry that also owns ten airlines. It would purchase jet fuel from a State-owned monopoly that also supplies the State’s airlines. Its business travelers would be largely State personnel. It would also face capital market constraints. To raise equity capital in the stock market it would
    retain a state-owned investment banker and a state owned accounting firm to submit a request to the CSRC, a state agency; and a listing application to a state-run stock exchange. To obtain bank credit it would approach one of the four state bank monopolies1. These banks give preference to State firms and lend to achieve certain policy targets. The loan officer that reviews the application is held personally liable if a private sector debtor defaults although she will face no such liability in loans to state owned enterprises.
  16. More than ¾ of the banking industry is controlled directly by the Big-Four State-owned banks in a country with the world’s highest propensity to save. The balance of deposits and loans are accounted for mostly by thousands of small locally run urban credit cooperatives and rural credit collectives and by the so-called Trust and Investment Companies or TICs. The TICs are allowed to enter speculative markets where banks may not go but as an apparent contradiction, are able to pass their bad loans to the banks. All of these financial institutions are public sector enterprises and controlled by the Party-State.
  17. All of the State’s financial entities are charged with providing a steady flow of capital for enterprise reform and for a bank rescue program. In China separation of the State sector from the private sector is complicated by institutional weaknesses and by the terminology itself. The “State” refers to the central government in Beijing. Yet the government hierarchy includes three levels of local government in addition to the State that are both geographically dispersed and functionally distributed with devolution of administrative and fiscal powers. Provincial, township, and village governments, in addition to discharging their administrative functions, also own and operate factories, railways, fishing fleets, mines, and other productive assets. These so-called “township and village enterprises” or TVEs, are normally smaller than SOEs in scale. In some cases, Beijing has turned over small and medium sized SOEs to the province in which they are located and their status has been changed to that of township enterprises.
  18. TVEs are not included in the statistics for “state owned enterprises” and are not the concern of the State’s enterprise reform project. Their functional category as private or public is often uncertain because of poorly defined property rights. Not all local government enterprises are clearly in the public sector. Some enterprises are leased to private sector operators for fixed rents and they function more like private than public enterprise. Others are actually sold outright to a shareholding corporation that normally consists of managers and workers and these firms would appear to have been “privatized”. However, the lessees and new owners in both cases may choose to pay a fee to local officials and register their business as a TVE to gain favorable access to government controlled markets and infrastructure. Of the local government assets that are still theoretically in government hands, many are actually operated as if they were private sector enterprises. An informal “privatization” takes place and local officials act more like owners than government agents. Legal institutions have not evolved sufficiently in China to distinguish between ownership structures of these various enterprise forms.
  19. It is for this reason that analysts often lump the entire TVE sector with the private sector as simply “non-state. Significant questions remain, however. Thousands of State-owned SMEs whose control is ceded to provincial governments, but whose exact number is not reported, appear in the data as “growth” of the private sector and an apparent decline in the State sector. There are also complications in the data for large SOEs. Some of these firms have undergone an equity carveout procedure in which a share-holding corporation is formed that takes over the productive assets of an SOE in exchange for shares issued to the SOE. State statistics treat these corporations as SOE if the government owns more than a given portion of the shares but as “nonstate” if government ownership is less. The discriminate level of ownership is set at an apparently arbitrary value between 26% and 51% and revised from year to year. These revisions confound trends in the data.
  20. The SOEs are organized in a complex network of pyramidal and cross-holding patterns in which the State and State-owned firms may own 100% of the shares even when “State ownership” per se is minor. In cases where the corporation is listed and 30% or so of the shares have been issued to the public, the State uses pyramiding, cross holdings, and an autocratic corporate governance system to shut out minority shareholders. These complexities render the statistics on state ownership impossible to interpret with a reasonable degree of accuracy.
  21. It might appear that we could estimate the real size of the private sector by adjusting the State’s numbers downwards to account for these effects; but it’s not that simple. First, the incomplete corporate governance system not only victimizes minority shareholders but the State itself. Managers take advantage of institutional weaknesses to seize de facto control of State assets. The methods employed normally involve a shell game with equity in a complex cross-ownership network of assets. In some instances funds are removed by managers in hard currency to a shell company in Hong Kong; and these funds often re-appear in the mainland as joint venture foreign direct investment.
  22. In all of these cases except for those involving pure capital flight, State sector assets do in fact become transformed into private sector assets. In other words, State assets are privatized. No estimate for the size of this transformation is available or even possible. Chaos underlies the superficial Confucian orderliness in Chinese corporate governance and presents daunting measurement problems for researchers. Finally, the reported GDP of China refers only to the formal economy and does not account for the production of the informal sector. The informal sector lies entirely in private hands. Analysts and senior executives of international investment banks who have observed private sector business activity first hand in China feel certain that the informal sector in China is at least as large as the formal sector. They cite the extraordinary official savings rate more than 40% of GDP as evidence that China’s actual GDP is much larger.
  23. Many researchers have found a middle ground by accepting the State’s estimate of the SOE sector and by defining the private sector as the non-state sector. Defined in this way, the private sector appears to have made a remarkable resurgence. In a single decade, from 1989 to 1999, the State and private sector shares of industrial production have flip-flopped. The SOE share is down from ¾ to ¼ with a corresponding rise of the private sector from ¼ to ¾. The pure entrepreneurial sector is smaller but still shows dramatic growth. Its share of industrial production
    went from 2% to 16% of GDP in the same period.
  24. The pattern of private sector development in China flows mostly from the State’s policy decisions. The leaders and bureaucrats of China in charge of its transition are its former central planners; and so it is not surprising that the target economic structure and the transition process itself would contain elements of central planning. A system of geographical preferences is used to set aside “special economic zones” where private and foreign joint venture projects would be allowed. Special consideration is given to coastal regions for private ventures that are most likely to result in exports. There is also a hierarchy of sector designations for private enterprise that run the spectrum from those most encouraged to those that are forbidden. Geographical and sectoral considerations are sometimes
    combined to encourage private sector development in certain geographical regions only in a predetermined sector. For example, Hainan Province and Shenzhen in Guandong Province are expected to develop a private sector in the information technology industry.
  25. Finally, a timetable is used to set up target production rates by the private enterprise in each sector. It may turn out that the important characteristic of state owned enterprises that distinguishes them from privatized firms is not the extent of state ownership per se but the extent to which the state is willing and able to exercise control. It is widely recognized that decentralization and devolution of
    powers in the reform era in China have fostered regional autonomy for local governments and TVEs and has created a “weak center”. The same process has devolved power from the State to SOE managers, particularly in the “unprotected” sectors where the productive assets of SOEs have been carved out into corporations and some have even issued shares to the general public and engaged in joint ventures with foreign firms. These managers enjoy expanded authority to make both cost center and investment center decisions and a system of incentives and profit sharing within the experimental, innovative, and evolving “responsibility system”. The system was initiated at the outset of reforms to overcome limitations imposed by Confucianism. The Confucian ideal is a sense of order even at the expense of truth. For example convicting a suitable scapegoat to regain order after a high profile crime, something that is often observed in China, is a perfectly legitimate course of action for Confucians because social harmony can be achieved without a downside if the scapegoat is either dead or known to be a criminal who deserves punishment anyway.
  26. The State no longer dictates production levels and prices to these firms. Instead, it subjects them to market forces. In other words, State control is yielding to market control. The SOEs compete in the commodity and capital markets. It is expected that market forces will determine prices, production, and cost of capital. Therefore, management expertise and worker productivity will determine efficiency and survival. The role of the State in SOE management is greatly diminished consistent with the “weak center” model of regional decentralization. Whether these efficiency increases have been achieved is a topic of debate among scholars. Initial empirical data do not seem to contain any evidence of increases in SOE efficiency attributable to these organizational enhancements. However, conventional wisdom and anecdotal evidence indicate otherwise. It may be that sufficient time has not elapsed for these efficiency increases to show up in cross sectional statistics.
  27. An efficiency time lag of this nature has been observed by Villalonga in Eastern Europe. In China, the mechanism is one of attrition and consolidation. Inefficient firms will not survive and their assets will either be mothballed or acquired by efficient managers. Until this process advances sufficiently the efficiency losses of he losers will match the efficiency gains of the winners and the cross sectional average efficiency will still be “average. We ought to see an increase in the variability of efficiency across the sample and not necessarily an increase in the mean. A statistically detectable efficiency improvement may occur after enough of the bad firms have dropped out of the population.
  28. The dynamics of the household electrical appliance industry is illustrative. The pre-reform emphasis on regional self-sufficiency in conjunction with the government’s barriers to inter-regional trade bred a large multiplicity of inefficient producers of household appliances. The reform program removed these barriers, discontinued production quotas and centrally planned pricing policies, and set off an intense competition among these producers in the nationwide market for household electrical appliances. Many firms sought to leverage their competitive position with joint venture agreements with established international firms such as Maytag, Siemens, Electrolux, and Sanyo and by raising new capital in the IPO market. The industry went through a period of rapid growth to one of overproduction. Price wars broke out and profit margins stabilized. Winners and losers became apparent. Regional specializations took root.
  29. Washing machine maker Rongshida Group of Heifi in Anhui Province partnered with Maytag and became an industry leader. Among its acquisitions was Chongqing Washing Machine, a money losing SOE that was returned to profitability by Rongshida’s management. The Heifi region emerged organically as a national center for the industry. The city is home to several other industry winners including Meiling Group and Philco. Meiling raised capital by issuing shares in the Shenzhen Stock Exchange and became an industry leader in refrigerators while Philco, like Rongshida, chose the foreign joint venture route to capture market share in air conditioners. Over this period economic growth in Heifei outpaced the national average. Within a decade average household income in Heifei grew from from 500 RMB/month by an order of magnitude in nominal terms.
  30. With thanks to Richard Margolis, Bill Overholt, Steven Xu, Xiaonian Xu, Yan Wang, Christopher Lingle, and that very beautiful banker from England (I have forgotten her name) who shared the depth of her knowledge about Chinese banking in the reform era. These individuals gave me many hours of their time in conversations from which much of the insights presented above are derived. Other sources listed below.
  31.  Hongbin Li and Scott Rozelle, “Saving or Stripping Rural Industry: An Analysis of Privatization and Efficiency in China”, Agricultural Economics, Vol 23, No 3, September 2000
  32. Belen Villalonga, “Privatization and Efficiency: Differentiating Ownership Effects from Political, Organizational, and Dynamic Effects”, Journal of Economic Behavior and Organization, Vol 42, No 1, May 2000











  1. THE UN FORMED A COMMITTEE CALLED the Bureau of the Conference of the Parties to the UNFCCC with 11 members nominated by each of the five United Nations regional groups and six Small Island Developing States.
  2. A VIRTUAL ONLINE MEETING OF THIS COMMITTEE WAS HELD AND A MOTION WAS TABLED AS FOLLOWS: “Committed to take forward crucial work to tackle climate change” 






    Governments Commit to Take Forward Vital Work to Tackle Climate Change in 2020
  2. Bonn, 28 May 2020 – At a virtual meeting today, the Bureau of the Conference of the Parties to the UNFCCC committed to take forward crucial work to tackle climate change under the umbrella of the UN Framework Convention on Climate Change (UNFCCC), despite the COVID-19 crisis. (the Bureau of the Conference of the Parties is an internal committee of the UN)
  3. The 11 members of the Bureau are nominated by each of the five United Nations regional groups and Small Island Developing States, and provide advice and guidance regarding the ongoing work under the Convention, the Kyoto Protocol, and the Paris Agreement, the organization of their sessions and the relevant support by the UN Climate Change secretariat.
  4. Since the last meeting of the Bureau in April, the work of the UNFCCC secretariat has not slowed, with several initiatives launched in order to drive Momentum, showcase continuing climate action and urging greater climate Ambition from all segments of society.
  5. UN Climate Change Executive Secretary Patricia Espinosa, said: “Our efforts to address climate change and COVID-19 are not mutually exclusive. If done right, the recovery from the COVID-19 crisis can steer us to a more inclusive and sustainable climate path. We honor those whom we have lost to COVID-19 by working with renewed commitment and continuing to demonstrate leadership and determination in addressing climate change, and building a safe, clean, just and resilient world.”(translation: we use pandemic deaths to sell climate change)
  6. In addition to several technical meetings organized by the UN Climate Change secretariat, key political events have taken place this year, for example the Petersberg Climate Dialogue and the Placencia Ambition Forum. (
  7. From 1 to 10 June 2020, a series of online events will be conducted under the guidance of the Chairs of the UNFCCC’s Subsidiary Body for Scientific and Technological Advice and the Subsidiary Body for Implementation and with the support of the UNFCCC secretariat, the June Momentum for Climate Change.
  8. The June Momentum events offer an opportunity for Parties and other stakeholders to meet virtually and continue exchanging views and sharing information in order to maintain Momentum in the UNFCCC process and to showcase how climate action is progressing under the special circumstances the world is currently facing.
  9. This will include advancing technical work under the constituted bodies, as well as providing a platform for information exchange and engagement on other work being done under the UNFCCC, including on adaptation, mitigation, science, finance, technology, capacity-building, transparency, gender, Action for Climate Empowerment, and the preparation and submission of nationally determined contributions.
  10. Formal negotiations and decision-making are not envisaged for these events and will take place at the UNFCCC Subsidiary Body sessions which are scheduled for October of this year.
  11. The Bureau of the Conference of the Parties, with the UK and its Italian partners today also agreed new dates for the COP26 UN Climate Change Conference, which will now take place between 1 and 12 November 2021, in Glasgow.
  12. With 197 Parties, the United Nations Framework Convention on Climate Change (UNFCCC) has near universal membership and is the parent treaty of the 2015 Paris Climate Change Agreement.
  13. The main aim of the Paris Agreement is to keep a global average temperature rise this century well below 2 degrees Celsius and to drive efforts to limit the temperature increase even further to 1.5 degrees Celsius above pre-industrial levels.
  14. The UNFCCC is also the parent treaty of the 1997 Kyoto Protocol. The ultimate objective of all agreements under the UNFCCC is to stabilize greenhouse gas concentrations in the atmosphere at a level that will prevent dangerous human interference with the climate system, in a time frame which allows ecosystems to adapt naturally and enables sustainable developmentTHIS ENTIRE SENTENCE IS COMPLETE AND MEANINGLESS BUREAUCRATIC NONSENSE. THEIR ONLY TASK IN THE CLIMATE GAME IS TO REPEAT THEIR MONTREAL PROTOCOL SUCCESS IN ELIMINATING CFC EMISSIONS BY ELIMINATING FOSSIL FUEL EMISSIONS. THEY HAVE NOT DONE THAT. ALL ATTEMPTS TO RECREATE A “MONTREAL PROTCOL” CLONE FOR FOSSIL FUEL EMISSIONS HAVE FAILED. 



International Office Scholarships at University of Bristol in UK, 2017

Polar Warning: Even Antarctica's Coldest Region Is Starting to ...




  1. What’s happening to ice and why? The way in which ice acts on the global climate and what’s happening to ice and why it’s happening and the ways in which changes to the ice in the Arctic are having global impacts on our climate system and therefore causing effects which we need to really be worried about. It’s not just the ice disappearing by itself. There are two effects. One is the albedo feedback. When sea ice melts and retreats, a big area of white which was the ice is replaced by a big area of dark which is the ocean water.
  2. The ice surface reflects. Fresh snow on the ice reflects 80% of the radiation. It’s called albedo, so it has an albedo of 80%. As the ice gets dirtier as summer approaches and it starts to melt, the albedo goes down but it still has some albedo left. It goes down to 50% or 60% but as soon as the ice goes completely, the albedo of open water is less than 10%. That means that a huge amount of energy is now being absorbed by the surface that wasn’t being absorbed before because it was being reflected, and that speeds up global warming because it increases the temperature of the planet.
  3. So we have our first positive feedback – positive meaning nasty, which is that the retreat of sea ice directly impacts the rate of warming of the atmosphere. As more of the ice melts the faster the ice can melt. This feedback is what we need to worry about in terms of polar ice melt.
  4. So Professor Jonathan Bamber asked 22 researchers how the West Antarctic Ice Sheet (WAIS) would respond to a 5C warming scenario. Aggregating their responses he found a 1 in 20 or a 5% probability of global mean eustatic sea level rise as high as 2 meters. This is something we really really need to worry about.
  5. Bloggers comments: So that’s the science of it anyway, and the physics too. Of course the climate deniers will deny these things because that is their way. They don’t believe in science, so they deny climate science in defense of the fossil fuel industry and they surely profit from their denial in various ways. Believe it or not this kind of nasty climate denial is actually found in polite society as shown in the images below.



















  1. The film “Planet of The Humans” is a critical evaluation by environmentalists of the environmentalism claims of the climate change movement. In the evaluation, environmentalists find that the renewable energy options proposed by climate science to replace fossil fuels are not as reliable nor as environmentally friendly as climate science says they are.
  2. The evaluation finds that solar arrays, solar towers, windfarms, and biofuel, and biomass energy options proposed by climate science as reliable and environmentally friendly energy alternatives to fossil fuels are neither reliable nor environmentally friendly.
  3. In the case of biofuel and biomass, the destruction of trees and forests, either for harvesting trees (as in biomass projects) or for clearing land (as in biofuel projects) is cited from an environmentalism point of view as an unacceptable level of the destruction of nature just to keep humans supplied with an unreasonable amount of energy in view of what nature can withstand.
  4. For wind and solar, their downsides are found not only in terms of their environmental impact but also in terms of significant technical limitations that make them an impractical and unreliable energy source. It is argued that wind and solar energy require a very large expanse of land that often needs to be cleared of trees and wildlife. The other serious concern with respect to wind and solar is that their power generation is intermittent and the amount of power they generate is variable. For these reasons these power generation devices are not reliable and must be backed up by fossil fueled power plants anyway. Therefore it is not logical to claim that wind and solar can replace fossil fuels.
  5. Other considerations include useful life, regular maintenance, and fossil fuel consumption of wind and solar. Solar panels and wind turbines have a useful life of 10 to 20 years. They must therefore be regularly disposed of and replaced. Their disposal has environmental impact implications because of the enormous amount of environmentally damaging material involved. Also, the environmental impact of their replacement has cost and environmental considerations because of the very large quantities rare earths and metals needed from mines in Africa in an activity with serious health and environmental issues.
  6. It is also mentioned that thermal concentrated solar power plants consume natural gas and therefore not really an “alternative to fossil fuels”. Also, it is claimed that they are often abandoned after a few years and that such abandonment involves an unacceptable level of environmental harm . In all cases, renewable energy production must be backed up by coal or natural gas plants. It is therefore a falsehood and an underhanded strategy to claim that they are replacements for fossil fuels.
  7. The film also points out that the the involvement of capitalists in the renewable sector raises serious questions about their environmental credentials.  The move to renewables is making rich capitalists richer and that provides an alternative capitalism interpretation of the move to renewables that has nothing to do with their claimed environmental credentials.
  8. An important contribution of the video is that it finds widespread cheating and lying in the renewable business that exposes an ugly side of the climate movement. This finding implies that climate science claims about their proposed climate action plans are not credible.
  9. The study also finds an inadequacy of battery capacity in the extreme such that the only real solution to intermittency is full scale fossil fuel backup power and thereby rejects the claims to battery storage as an option to overcome intermittency. In summary, the Moore/Gibbs film finds that from a perspective of environmentalism and practicability, the environmentalism claims of the renewable option by climate science must be rejected.




  1. A possible rational response by climate science could have been that yes, there are some unresolved issues in the renewable option being offered to replace fossil fuels. We are well aware of these issues and we are working on their resolution and would be pleased to work with the Moore/Gibbs team in that project. This option would have retained the kind of planet saving environmentalism claimed by climate science. But this is not what happened.
  2. Instead what we find is climate scientists crying foul in a strangely angry and hostile response rejecting the Moore/Gibbs presentation wholesale as rubbish, and calling for the immediate removal of the film to prevent further public viewing. This kind of hostility towards environmentalism by individuals claiming to be environmentally concerned scientists who have set out to replace environmentally unacceptable fossil fuels with an environmentally correct energy infrastructure leads to a very different image of climate science than the image climate science has presented to governments and consumers.
  3. The essence of the climate science response appears to be that the Moore/Gibbs assessment is an unjustified attack on their renewable energy climate action plans because it is made from a purely environmentalism perspective. These objections raise even more serious issues about climate science than prior claims of skeptics.
  4. Climate scientists had voluntarily appealed to environmentalists for support claiming to be environmental agents that will save the planet from the industrial economy of humans. What we see in the Moore/Gibbs video is that this claim is not accurate. This collision between climate science environmentalism and what appears to be real environmentalism reveals that climate scientists lied about their science in both directions by telling climate deniers that their science is bathed in the holy waters of environmentalism and now, blaming real environmentalists for holding them to that claim. These contradictions and conflicts further weaken the reliability and legitimacy of the climate movement.
  5. A more rational response might have been that “yes, we are of course aware of these issues in the renewable option and we are working on it and have made substantial advancements that are not included in the video”. BUT NO SUCH SCIENTIFIC AND HONEST RESPONSE FROM CLIMATE SCIENCE IS FOUND. What we find instead is a childish name calling shouting match with climate scientists calling for the film to be taken down immediately.
  6. Whatever harm the movie may have done to the climate movement now appears to be insignificant in comparison to the harm that climate scientists have done to the legitimacy and credibility of the anti fossil fuel movement of climate science [LINK] and of the claimed environmentalism credentials of climate science such that they are the environmental agents that will save the planet from destruction by fossil fuels [LINK] .







The Agency Theory of Securities Regulation


  1. In presenting the history of securities regulation we examine the rise of credit and equity financing in pre-industrial Europe and trace the evolution of regulation from the Bubble Act of 1720 through the market break of 1929 and the formation of the SEC, to the present day issues with regard to financial innovations, computerization of trading, globalization of capital markets and operational risks in emerging markets.
  2. Modern finance theory is wanting a coherent theory of regulation. Scholarly work on the theory of regulation forwarded by Bennett, Bentson, Friend, Kripke, Loss, Mann, Merton Miller, Rosen, Seligman, Stigler, and others during a 30-year period (1964 to 1994) address different aspects of regulation and their theories are in conflict.
  3. Much of the theoretical debate has been in the form of for and against regulation. For example, Stigler and his supporters are against regulation because, they argue, disclosure requirements impose unnecessary costs on corporations. According to this view, “disclosure increases share prices” and since managers pay is tied to firm performance it is in the self interest of managers to disclose anyway without the need for externally imposed regulation.
  4. Friend and others dispute this view and argue for regulation. They contend that “it is precisely because” of the managers self-interest in high share prices that he is likely to withhold adverse information or exaggerate positive information. Similar debates (for or against) exist for other forms of regulation such as anti-trust laws, the control of insider trades and SEC rules concerning the behavior of brokers, the operation of exchanges and new issue offerings by corporations.
  5. The purpose of regulation itself is embroiled in controversy. Why does securities regulation exist? Is it to protect the individual investor? from whom? Or is it to preserve capital markets? Or to assist corporations in raising capital? In our analysis we consider all forms of regulation including uniform accounting methods, NASD and exchange internal regulations, and externally imposed regulation by legislation and we argue that regulation exists for all of these reasons.
  6. We support the argument by building a coherent model of regulation using the cost of capital to corporations in the aggregate economy as the operational variable. We then define a term called the `agency cost of capital formation and show that regulation influences the cost of capital (and therefore the wealth of the economy) by acting through this variable.
  7. Rather than argue for or against regulation our theoretical model sets the framework for an optimal level of regulation. We contend that the agency cost of capital formation is a significant portion of the cost of capital to corporations. A well designed regulatory structure is necessary to reach an optimal balance between monitoring costs imposed by regulation and the reduction in agency costs achieved by regulation.
  8. In the absence of regulation, wealth transfers between shareholder, debtholders, and management may occur that drive investors from the market; and prices that are not optimal and do not allocate capital efficiently. Because of the added risk investors demand additional returns. The result is an increased cost of capital to corporations, and less overall investment in productive assets.
  9. Excessive and inappropriate regulation are associated with high monitoring costs to corporations because they limit the ability of the market to attract new capital, to provide liquidity to investors, or to allow corporations to utilize the market to finance new projects.
  10. CONCLUSION: Regulation is optimized when the agency cost of capital is minimized.



Tobin’s Liquidity Preference

Tobin, James: Liquidity Preference As Behavior Toward Risk, Review of Economic Studies, Vol. 25 1958 , pp. 65-86.

  1. The Tobin 1958 paper is a landmark in the annals of Finance. A truly great paper does not only provide new evidence and interpretation but also gives new insight. Economist James Tobin brings together two great works – the liquidity preference theory of John Maynard Keynes and the portfolio theory of Harry Markowitz and shows that they are complementary and can be considered to be two manifestations of the same underlying principle of economics.
  2. Keynes had postulated that in addition to cash needed to carry out transactions, EUs (Economic Units) also hold cash because of a speculative motive, that is, in case interest rates rise next year. He therefore concluded that the demand for money by the aggregate economy will rise and fall with the prevailing interest rate. When interest rates are high, EUs would be less inclined to think that they will rise any higher and will therefore invest in bonds and give up money. Conversely, when interest rates are low, the EUs would hold more cash and wait for higher rates on bonds.
  3. So, if one plotted the demand for money against interest rate one would get the now well known textbook curve that slopes gently downward from all the money held at zero interest on bonds and asymptotically approaches zero money held at infinite interest. This description of liquidity preference has been severely criticized by Leontief and Miller.
  4. Tobin, inspired by Markowitz, saw Keynes liquidity preference curve in terms of portfolio theory, i.e., the maximization of utility in mean-variance space. Tobin’s theory satisfied Leontiefs critique and brought liquidity preference into harmony with the mainstream of economic thought of his time. He proposes the following lucid and enlightening explanation of the downward sloping money curve.
  5. Each EU holds a portfolio of two assets, $(1-B) in money and $B in bonds (note 2). B is less than unity and represents the value weighted percentage of the portfolio held in bonds. Money pays no interest and holds its value with certainty (note 3). Bonds sell today for $1 and will pay a perpetuity of $Ro. (i.e., Ro% interest rate).
  6. However, next year, the prevailing interest rate may change to R1. At that time, a bond which pays $Ro will sell for $(Ro/R1) and the capital gain will be G=1-Ro/R1 since the EU paid $1 for it. Thus the EUs net gain from holding a bond is interest + capital gain = Ro + G = Ro + 1 – Ro/R1. The assumption that g is normally distributed about an expected value of zero with a standard deviation of Sg leads to the following equations.
  7. (a) Dollar value of net gains from holding the portfolio for 1 year: R = B*(Ro + G). (b) The expected value of R is: E(R) = E(B*Ro) + E(G) but E(G) = 0 therefore E(R) = B*Ro. The variance of R can be computed as var(R) = E{[R – E(R)]2} = E{[B*Ro + B*G – B*Ro]2} = E{B2G2}. Since G is normally distributed about zero (i.e., E(G) = 0), G2 = Sg2 and the standard deviation of R is given by: Sigma = sqrt(var(R)) = B*Sg. Rearranging B = Sr/Sg.
  8. Now we can substitute for B in the equation for expected value. E(R) = B*Ro = Sr * (Ro/Sg) or E(R)/Sr = Ro/Sg = the market price of risk. This ratio which establishes the market price of risk in the aggregate economy is analogous to the security market line and is called the opportunity locus (OL) by Tobin.
  9. Each EU in the economy is identified in the same mean-variance space by his own set of indifference curves (whose shape is defined by his peculiar attitude toward risk) and maximizes his mean-variance utility by holding a portfolio of money and bonds at a point in this space where his indifference curve is tangential to the OL. The point determines the fraction of his liquid wealth he holds in money and that which he holds in bonds.
  10. With returns on the y-axis and risk on the x-axis, the OL gets steeper as interest rate rises. It is easy to see graphically, (and possible to show analytically as Tobin has done for all brave souls that have waded through section 3.3) that for riskophobes a steeper OL means that a larger fraction of the portfolio will be held in bonds easing the demand for cash. This is consistent with Keynes liquidity preference theory (increased interest rate leads to lower demand for money). QED.
  11. Tobin wrestles with the fact that the relationship is reversed for riskophiles but offers no answers. One interpretation I can offer is that since empirical data show that the demand for money is indeed downward sloping, it must mean one of two things; either Tobins simple model of risk free money and perpetual bonds is too simplistic to yield results that can be compared directly with empirical data, or the implicit assumption of invariant prices (i.e. risk free cash) is not justified by the data. Of course, it could also mean that the empirical data suggests that the population at large is risk averse.




Methodological flaws have become commonplace in financial research to the point that familiarity has bred de facto acceptance. Some of these only require refinements in the findings but in most cases the methods used bring to question the findings themselves. In this paper we survey these flaws and investigate their potential impact on conclusions normally drawn from the research. We use simulation to demonstrate how an incorrect conclusion about a known population may be drawn using these methods. We then offer alternate methods that may be used to avoid the pitfalls described. Finally, we examine the validity of the “large sample” statistical model in understanding phenomena and developing theory in financial economics.


Finance, like the other social sciences, inherited a version of the scientific method from the natural sciences and to this day classical Neyman-Pearson large sample hypothesis testing is generally accepted as the only credible research tool in finance. In this research model, we think we live in the world of Ho the null hypothesis, where entropy is maximized and no patterns and therefore no information exists. To find information we seek patterns. We do this by randomly selecting a finite sample from an infinity of possibilities. This is our observation; and given the distributional properties of Ho we may compute the odds that we would observe such a sample by chance. If this probability turns out to be lower than a threshold value of unlikelyhood we proclaim that it is unlikely that we would make such an observation in Ho; therefore we must not be in Ho. The distributional properties of Ho are usually assumed to be described by the Gaussian function.

In practice, financial researchers often stray from this pattern seeking model partly because of convenience and and partly because of unfamiliarity with the actual statistical underpinnings of the research methods; but more importantly, I believe, because the methodology, though a stunning success in the natural sciences, is not a good fit in finance. The Krueger and Kennedy (1990) finding that stock market performance is highly correlated with football games is a harsh reminder that spurious statistics do exist but such a faux pas is harder to identify when the relationships found are the ones we are looking for; or one that is easily rationalized in terms of a dominant theoretical framework.


A commonly found departure from the pattern seeking model is to look for a number of different patterns. The more patterns you look for the greater the odds that a chance pattern will be observed in a sample taken from the Ho distribution. The procedure compromises the statistical method because even in the world of Ho, if you look long enough you will find the pattern you are looking for. In Finance papers mutiple comparisons are frequently used in conjunction with mutiple values of the alpha probability and ex-poste selection of the direction of the effect. Table 1 shows a typical result (Aggarwal 1990). A common practice is to set up a table of many t-tests and then to identify the ‘improbable’ ones with asterisks. The usual code is * = ‘significant at alpha=10%, ** = ‘significant at alpha=5%, and *** = ‘significant at alpha=1%.

In Table 2 we perform a similar test on 10 samples of n=100 drawn from the Ho population and find three spurious ‘rejections’ which might have been reported as findings in financial research. The example underlines the need for careful analysis of multiple comparison cases.

At an alpha level of 5%, the probability that all 10 samples would fail to reject Ho is 0.95^10 or about 60%. This means that there is a 40% probability that at least one chance rejection will occur. In other words, the experimentwide error rate is 40% instead of 5%. To hold the experimentwide error rate at 5% each comparison must be made at alpha = 0.005. In general, when making m comparisons, the single comparison alpha level (ac) and the eperimentwide alpha level (ae) are related by the equation

(1-ac)^m =( 1-ae)


In simple linear regression models with many explanatory x-variables the beta coefficient of each x-variable may be interpreted only if the x-variables act independently on y, the response variable. When the x-variables are correlated or even when some linear combination of the x-variables are correlated, the regression coefficients become unstable so that neither the direction nor the magnitude of the observed ‘effect’ may have a valid interpretation.

Most papers in Finance that use linear regression do not check for this condition and the few that do refer only to a correlation matrix of the x-variables. A correlation matrix is unable to detect correlations between linear combinations.

Some Examples of Multi Co-linearity in Financial Research

(i) The Intervention dummy variable in time

An example model is presented in Table 3 (Blennerhassett and Bowman 1994). The authors wish to measure the impact of the screen trading intervention in the time series of off-market trading. But here they are analyzing the data in real time and not in event time and the authors suspect that the model is subject to historical effects. An intervention dummy variable identifies the implementation of screen trading. The addition of the time variable to the model is an attempt to remove historical effects. But the dummy variable is also a time indicator. Therefore the two variables are highly correlated. Simulated data in Table 3 show a time variable with two different intervention dummy variables. Note that both dummys are highly correlated with time and, unless one dummy is symmetrical around the other, the dummy variables are also likely to be correlated with each other. Models such as these are common in financial research that attempts to model the impact of a historical event such as a change in regulation, market structure, interest rates, trade agreements, and so on.

(ii) Explanatory variables that are algebraically related

Capital structure, that is, the amount of debt a firm carries relative to equity, is a contentious and unresolved topic in Finance. (DeAngelo and Masulis 1980, Bowen, Daley, and Huber 1982, Bradley, Jarrell, and Kim 1984, Kane, Marcus, and McDonald 1984, Kim and Sorensen 1986). A popular model of capital structure maintained that the value of debt is that it is a tax shield and therefore, that firms that enjoy other forms of tax shields such as depreciation would use less debt. The empirical results are conflicting and inconclusive. The regression coefficients of the models differ in sign from one study to another. Some found the non debt tax shield (ndts) coefficient to be negative and argued that the ndts model is correct since it showed that firms with non debt tax shields used less debt. Others found the coefficient to be positive and argued that firms with more tax shields enjoyed higher cash flows and therefore had larger debt capacities. Still others found no relationship between ndts and capital structure.

A possible explanation for the failure of these empirical studies is the natural algebraic relationship that exists between total assets and depreciation. Since both of these variables were used in the model the regression coefficients were unstable and their spurious sign and maginitude became interpreted into financial theory. The empirical results summarized in Table 4 reveal their random and contradictory nature.

(iii) Linear combinations of explanatory variables are correlated

Frequently the starting point of empirical investigations in finance is not theory but an available database such as COMPUSTAT or CRSP. All the variables in the database become candidates for the model and models built in this manner are frequently unstable even when a correlation matrix of the explanatory variables does not reveal the extent of the dependencies between them.

One of the many models proposed for measuring the determinants of capital structure includes D=total debt, E= book value of equity, and A=total assets as explanatory variables (Kim and Sorensen 1986). The three variables have an exact accounting relationship. A = D+E.

(iv) The small firm effect

Banz (1981) first reported that stocks of small firms tend to have higher returns and this relationship was quickly confirmed by studies that followed. Investigators of asset pricing and market efficiency saw Banz’s size effect as an anomaly that must be removed from the data before other effects can be detected. Fama and French (1992) first removed the size effect from the data before they tested the relationship between beta and returns. If the Sharpe (1964) model is correct, they reasoned, then there ought to be a significant and positive relationship between beta risk and returns. They found that the relationship if any between these variables was negative.

But small firms not only have higher returns; they also higher betas. Chan and Chen (1988) report a very strong correlation between beta and size. This relationship implies that tests of asset pricing such as those of Fama and French (1992) and Fama and MacBeth (1973) are likely to produce spurious values of the coefficients for beta risk; and this is indeed the case. Some studies have found a strong positive effect of beta risk that is consistent with the CAPM (capital asset pricing model) while others have found no significant relationship and still others report a relationship in the opposite direction. These empirical results have caused a great deal of controversy and have forced financial economists to re-evaluate some fundamental assumptions of asset pricing. Yet, these findings may turn out to be a fluke of multi-collinearity.

For example, when Fama and French (1992) removed the size effect from the data they may have also removed that which they intended to measure – the beta effect. A failure to find a beta effect in the residuals of the size effect does not imply an absence of a beta effect. There are better ways to find the unique contributions of the two correlated variables. For example, one might first regress beta against size and use these residuals as the unique contribution of beta and then regress size against beta and use those residuals as the unique contribution of size. Alternately, one might look for orthogonal principal components of size and beta.

An added complication in asset pricing research is that some of the empirical models include the PE ratio (PE = stock price over accounting earnings) as an explanatory variable in addition to the risk measure beta. But PE too contains a risk measure. Current financial theory interprets PE as a combination of two effects. Ceteris paribus higher perceived risk would lower the PE ratio and higher perceived growth would raise the PE ratio. Empirical studies are complicated by a high collinearity between PE and beta. There are other problems with asset pricing studies that have to do with the time series nature of the data and the methods by which the concept of risk is rendered and we review these concerns in a another paper.


Sample sizes in financial research are typically very large. For example the Fama French (1992) paper on asset pricing models is a study of monthly stock returns from over 2000 firms in the period 1962 to 1989. This represents over 672,000 observations. When we treat these observations as a sample we get a sampling distribution with a tiny standard deviation. For instance, The degrees of freedom is approximately 670,000 whose square root is 818. In this case the standard devaition of returns was 52%. This means that the standard deviation of the sampling distribution is 0.0636% or about 6 basis points and a difference as small as 12 basis points might be considered significant although no fund manager would pursue a policy to take advantage of such a small effect. Many of the empirical investigations of the determinants of capital structure cited in this paper have proposed regression models that were found to be statistically significant at r-squared values of 1 to 5%. That is to say 95 to 99% of the sum of squares in the sample remain unexplained and are considered by the model to be random backround noise.


Black (1993) observes that although there are many researchers in finance, perhaps thousands, there is only one history, and therefore, pretty much just one set of data. Researchers use past studies to formulate new hypotheses and models. They then test these models on the same data that were used to test the past hypotheses. Recall that classical hypothesis testing is formulated on the basis of a priori hypotheses and the probability of the data given the null. But in finance we find ourselves repeatedly testing the probability of the data given the hypothesis given the data; i.e. testing for pattens ex poste.

In this sense classical statistics is a failure in financial research and I would like to propose a re-evaluation of our research agenda and methodology and an emphasis on well designed case studies on small samples and even anecdotes.


Variable sample statistic Rejection status
United Kingdom spot rate 0.3619 – forward rate -0.2821 – risk premium -0.8977 **
West Germany spot rate 0.2299 – forward rate 0.4454 * risk premium -0.4544 *
Switzerland spot rate -0.2643 – forward -0.0340 – risk premium -1.6703 ` **

Rejection status: – = fail to reject, * = reject at alpha=10%, **=reject at alpha=5%


t-Test: Ho: µ = 0 Ha: µ ≠ 0

y1 :Sample Mean = -0.11183675 t-Statistic = -1.342 p=0.1828 –
y2 :Sample Mean = -0.18801382 t-Statistic = -1.995 p=0.0487 **
y3 :Sample Mean = -0.04132946 t-Statistic = -0.438 p=0.6621 –
y4 :Sample Mean = -0.21933539 t-Statistic = -2.112 p=0.0372 **
y5 :Sample Mean = -0.05426054 t-Statistic = -0.533 p=0.5953 –
y6 :Sample Mean = -0.04306246 t-Statistic = -0.469 p=0.6403 –
y7 :Sample Mean = -0.05917902 t-Statistic = -0.712 p=0.4780 –
y8 :Sample Mean = 0.14411801 t-Statistic = 1.308 p=0.1939 –
y9 :Sample Mean = 0.15260649 t-Statistic = 1.570 p=0.1197 –
y10 :Sample Mean = 0.18155813 t-Statistic = 1.804 p=0.0742 *


MODEL: Vt = Bo + B1D + B2t
Vt = ratio of on-market to total market value traded on day t
D = 1 after screen trading was implemented
D = 0 before screen trading is implemented
t = time in days

(coefficients and t-statistics)
Bo 0.3135 18.2
B1 0.1444 4.7
B2 0.000139 0.35

Simulated data
1 0 0
2 0 0
3 0 0
4 0 0
5 0 0
6 0 0
7 0 1
8 0 1
9 0 1
10 0 1
11 1 1
12 1 1
13 1 1
14 1 1
15 1 1
16 1 1
17 1 1
18 1 1
19 1 1
20 1 1

Pearson Product-Moment Correlation
time dummy1 dummy2
time 1.000
dummy1 0.867 1.000
dummy2 0.795 0.655 1.000


note: a negative effect supports the DeAngelo Masulis theory
Study Direction Statistical test
Bradley Jarrel and Kim: positive significant
Kim and Sorensen: negative not significant
Boquist and Moore positive significant
Bowen, Daley, and Huber negative significant
DeAngelo and Masulis negative significant


F-value of the test: 44.392
R-squared: 0.334
Number of observations: 800

AAA rate regression weight: -0.004382
t-value for beta: -2.504
probability t<-2.504 0.0125


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