The events of the past 6 weeks should mean that the world realises the near end to free market capitalism of Adam Smith etc (and perhaps expressed in its most ugly form by Gordon Gecko in the film Wall Street). I have pulled together a number of articles that I wrote in the past and put them into one post. Read or skim where you wish.
The argument given by “traditionalists” that the market is best able to decide should by now be finished. The market is clearly not able to do so in some circumstances. Markets measure specific things and they are not always the things that matter to people. We should stop asking if the common good or free markets are the choice. Economic Darwinism is a falsehood and therefore we should move on and just say we want the greater good. If that means regulation then so be it. We are not in the 19th century anymore and we can do better.
I asked only a couple of weeks ago what people thought as they saw the beginning of the Depression in the late 1920’s. I believe Government (in a general sense) has learned quite a bit over the past 80 years. Crude attempts to apply the approach of Milton Keynes in the post WWII era resulted in bad outcomes for the poor. In th e1970’s and 80’s attempts to control inflation and other artifacts of Globalisation (in its infancy then) resulted in Government initiated unemployment explosions. In 200o-2002 the push for Government to be “hands-off” and allow the Free Market to make the right choices seemed to work but created another massive amount of unemployment and financial losses. The financial losses post Depression and up to the 1970’s were largely limited to the wealthy and corporations. Most ordinary people “Mums and Dads” knew stories about the depression and how the Stock Market was risky. After that time, that message seems to have been lost. Losses were felt by very ordinary people who were seduced into putting their savings into too-good-to-be-true investments in property trusts that offered interest rates 3-5% above traditional investment interest. My mother lost the equivalent of someone’s life savings from one investment 1which failed and delivered only 10% of the capital invested back to the shareholders when liquidated.
The Dot-Com bubble was a more extreme failure of investments that followed another path. This time, it was investments by “investment professionals” that were seduced into investing in stocks with “growth potential”. That potential was clearly only on paper and based on false or misleading assessments of the worth of companies.
The Japanese economic stall in the 2000’s was mostly about companies overstating the value of property to make their balance sheets better. When this was called into question, the companies that had been benefiting were suddenly without the capital to maintain growth in highly competitive and profitable businesses. The Japanese banks were the biggest losers. That meant that they had no ability to lend money to businesses to allow them to grow. The economy stalled even when the companies that made things continued to do well internationally. This is almost the exact opposite of what is predicted by free market economics.
I think it is useful to understand the difference between Capitalism as a philosophy, Capitalism as a form of social order and Capitalism at a personal level and Capitalism as a method of operating a Political Economy. It is also worth considering the difference between the rhetoric and practice.
As a philosophy Capitalism was described by Adam Smith (The Wealth of Nations – 1776) in the 18th century and developed by John Stuart Mill, Max Weber and others. It has been constantly compared with Socialism or the Communism of Marx and Engels since they came into prominence about the item of Ned Kelly. These philosophical constructs are born of an era that includes the USA Independence, Napoleon, American Civil War, Gold Rushes, The Wild West, “exploration” of Africa, rediscovery of the Third World and later, the emergence of electricity and telecommunications and fast transport. In recent years Capitalism is nearly always discussed in relation to Communism – but not as a philosophical stance.
The most usual discussion is around social order. There it is a competition between the “free world” and “Communism”. The rhetoric around this is Cold War and has mot moved much past that. We will leave that Pandora’s can of worms alone.
It has been said “Now, Everyone’s a Capitalist”. It was even Australian Government policy in the 1950’s and 60’s to encourage every family to buy their own home and thus become de facto capitalists. At a personal level and even at a small business level, capital is about having more money than just what pays for the necessities and investing that in something that achieves a good thing for you.
When we start talking about capitalism as a political economic thing then we cross many meanings of the word. I recommend the wikipedia article for a fuller discussion of the subject. What is important here is the competition of who owns the Means of Production. The argument is largely a moot one these days. The near universal answer is private, semi-private or mutual ownership arrangements that closely model the way companies were established in England in the 17th century. 2
After the shocks to the capitalist system in the Great Depression and subsequent recessions, the free market, laissez-faire approach (do nothing by Government) gave way to regulation of the banking industry and Governments understanding the need to strategically invest sometimes and keep reserves at other times. Arguably, the reason for recessions since Milton Keynes has been Governments forgetting that the capitalist system is flawed and that they need to do their own part to keep things going. Arguably, it is also caused by self-deception at many levels. While they are arguable, the evidence is there for us to know. The best way to know if a theory is valid 3is to look at what it predicts and if the predictive power is high then it is a good theory.
On this measure, laissez-faire approaches clearly only work when you are prepared to bail the unregulated companies out if something goes wrong and the consequences of the failure are against the interests of the people a Government is there to protect. This has been seen in car industries, textiles etc. Recently it has been seen in the Banking and Finance industries.
Where things become more difficult are in the free market economics. Supply and demand so obviously explain the way prices and availability of goods and services really operate that we take it for granted that this is how things are. We forget that it is a model and that there are actually constraints that are not market driven, although those constraints do appear in the market cost-availability analysis results. External factors do have significant effects on how things really happen that are not factored into the intuitive models. Chaos theory is all about how these non-intuitive factors produces startlingly different results in a way that cannot be forecast specifically. 4
The outstanding success of capitalism has lead to blind spots for those who love it so much. I believe that this is why people who should and do know better still allow ridiculously stupid things to happen. Is there a better explanation?
“Nobody could have predicted …” – well plenty of people did and they were equated with Chicken Little.
“It was a failure of the regulators …” –we are talking about free markets here; do nothing is what they say is best
“It was only a few rogues …” – Then why did nobody do anything about it?
Media and Advocacy
I have included a previous article on something I saw earlier this year.
We see a lot of Advocacy groups with websites these days. I came across an article http://www.cis.org.au/POLICY/summer 07-08/summer 07-08.html – Why Capitalism is Good for the Soul and its latest offerings are somewhat typical of the kind of research institute that gained funding from the previous Government by grants of consultancies to produce research for the Government. As you can see form what they have in their publications, the result of that research is not likely to be balanced.
Equating the success of supply and demand economic theory to free markets is one of the ways that pro-capitalist organisations try to discredit perfectly legitimate criticisms of the laissez-faire proponents who as often as not argue for companies to be bailed out “for the public good” when things go bad. Having read the books that they condemn out of hand, I must say that I interpreted them differently. I saw them as giving a clear way out of the mess that capitalism is in and PREDICTING what has now happened rather than commentating after the fact.
I refer to this article in particular because I think the thinking that goes into this kind of publication is part of the problem with capitalism and conservative thinking. You have self-referenced research and it is acceptable to use the argument that the result of a debate where the majority of the audience agreed with the argument that “Capitalism is Bad for the Soul” requires a call to “all those who believe that capitalism offers the best chance we have for leading meaningful and worthwhile lives …” to stand up and be counted. Apologising for capitalism’s lack of romantic appeal compared to socialism. Equating his opponent with Lenin and Hitler and suggesting that it is a kind of “bier hall” rabble rousing to suggest that the open market (newspeak for free market). There are many biblical quotes that are out of context and even a quote from Encyclopaedia Britannica about Soul Music (of all things) to justify some kind of argument that the reason capitalism has bad press is not because the evidence says it has demonstrably failed.
All sorts of fuzzy reasons, questions of degree and doubt are raised to eventually ask the reader to come down with a sentence that it is intellectuals at fault for giving capitalism a bad name. Shades of Kristallnacht – a thought raised by that article’s reference to the same Nazi era.
This is an important question Why has all this happened? Why does it keep happening in cycles? The answer to it is where the solutions lie. Lie is a good word to use. The root cause of the financial crises (perhaps better described as failures of Capitalism) is probably to do with lying. Misrepresentation, Misinformation, damn lies and statistics.
The lies are rarely because of some rogue individual like Barings Bank portrayed Nick Leeson or the National Australia Bank portrayed its Foreign Exchange traders. Yes, it takes people with low ethical standards to engage in fraud. However, it also takes a corporate culture of allowing that low ethical standard for the fraud to go undetected and even be supported by the managers. Alan Bond, Christopher Skase and others will be remembered as people who defrauded others of savings. They were also Heroes of those investors before they fell. Heroes because they appeared to deliver high growth and profits.
The cause of the lies are more to do with how companies, Governments and the world financial markets are set-up than the individuals. Water runs downhill. Money goes where it makes more money. Water is real and eventually reaches the bottom of its journey. Money is an abstract thing and is subject to entirely artificial and abstract laws.
I often put myself in the position of another person when attempting to understand why they might do something. It is not hard to see what kinds of choices you might make if you are being told to make a bigger profit this month than you made last month and that you will be paid double if you achieve this. If you do not then they will look for someone else who is prepared to “do what it takes”.
People do what you reward most.
Allied Irish Bank, Barings Bank (Nick Leeson) and the National Australia Bank all had foreign exchange fraud on a huge scale. These are only some of the ones that are known. Many more frauds are known only to the companies and individuals involved. HIH Insurance, Worldcom, Enron and several companies associated with Al “Chainsaw” Dunlap all falsified company reports. Financial planners in the 1980’s were very happy to recommend that you buy into unlisted Property trusts and to put your whole savings into them.
There were warnings about these people and companies. Most of the warnings were ignored. The thing that matters most for this discussion is that in every case there was a strong financial incentive to do exactly the wrong thing for the long term benefit to the investors and employees.
Foreign exchange traders were given daily targets or weekly objectives. Tomorrow was long term and still is in this industry. To make side investments and “bet” on a hunch could pay off in a big way – or be a really bad thing. If you can hide the bad things and promote the good things then you look better.
Turnaround Specialists had a simple method. Sell things and cut back. Move future earnings forward to make the short term look good and declare the company highly profitable again. Then sell the company before the long term effects of this strategy can be seen in the following year’s annual report. This is when you make an exit and put the money in the bank. Sometimes 10’s or hundreds of millions of dollars – see Al Dunlap.
Financial advisers got paid a commission on each “sale” of an investment in the unlisted property trusts. Some of them paid higher commissions than others. Which one do you sell? In the 1980’s disclosure of your involvement with or receipt of commissions when advising a client was at best a loose arrangement where the adviser would be required to give you a prospectus document that had fine print somewhere that said that an adviser “could receive a commission”.
I think there is more than enough to strongly suggest that the smoking gun is probably a combination of personal greed or ambition and a culture of condoning un-ethical behaviour if it achieves this month’s objectives. When all is going well, who is going to want to know about a problem anyway?
Long Term or the Short Term?
Here is a scenario. You are in a board meeting and you have to present to them your proposal. You prepared two of them and discussed with your closest confidant. The first one gives a growth in the company that is steady over five years and costs a lot to begin with. The second one gives profits well above average for the next three months but then there will be a decline after two years.
You know that the board are focussed on short term profits and that at least half of them want to set the company up to sell it and make a big gain on their shareholdings. That intention is not shared with all shareholders, many of whom are small shareholders granted their shares as a company benefit.
Which one would you put forward? Would you propose both and let them choose? You have 15 minutes and you will be judged on your performance in that time.
It is hardly surprising that the answer will nearly always be the one that has short term gain. The counter example is so rare that they would probably do a documentary film about it. Company reporting cycles are short so that the company can keep an eye on the bottom line. That is a good thing. Incentives to staff are also aligned with the reporting cycle and that can be good too. Incentives help focus people on what they should be doing.
Unfortunately most incentives are crude and often lead to undesirable behaviour. The classic example is a sales representative changing the month of an order so that it counts in a month that they prefer and gives them more commission. The customer often has poorer service because of it and the administrative costs increase. The company is not better off but the sales rep is. the same applies as you go up the management chain.
Al Dunlap made his name doing corporate turnarounds by using extreme methods to manipulate a company bottom line to make it look like the company was doing well. Many others have gone to jail for doing the same – probably a smaller proportion than those who have been jailed for petty theft.
Growth and mythology
Capitalism grew out of mediaeval mercantile growth. Trading, selling and buying goods for profit rather than because of a need for the goods or services yourself. The Agrarian revolution started to produce surpluses that could be traded for something you might want but not ordinarily have. Until this time, any wealth belonged to the monarch or nobility in a feudal system. Private and not necessarily inherited wealth became more common and the rise of a class of people who cared a lot about money followed. Capitalism was not far behind as Philosophy of The Enlightenment.
The Industrial Revolution provided a growth path for capitalism. Making AND selling something provided even more money and therefor surpluses to use for capital be used for other purposes. Capitalism said “use money to make more money” and so they did. The growth of banking and international finance produced an increasingly abstract way of understanding money. Links between the physical asset (coins and notes or gold) and your wealth became more tenuous. The current state of financial markets is very different to what it was even 50 years ago, pre-computerisation. What is more important for this discussion is that capitalist theory considered resources and labour to be essentially unlimited. Later modifications still consider resources to be constrained mainly by cost of production rather than running out.
The myth that surrounds capitalism is that it is a continuous steady state where things just grow for ever. “Corrections” are just something that happens while the market adjusts to some external change. You will see that mythology embedded in a lot of the commentary lately. Denial of climate change (it supposedly limits growth if you cant consume whatever makes more profit) and that there might be an oil crisis or a water shortage still happen. The mythology says something like “somehow we will find a technological solution. We always have”. It sounds rather like the Norse people in 15th century Greenland starving in their cathedral and writing In God we Trust while refusing to hunt and fish like the Inuit for “cultural reasons”5.
There is another part of growth to consider too. What if demand does not increase to meet the supply of capital? If you have all this money but nothing to do with it then there is a problem. Henry Ford had a solution; create demand by financing it and making your own employees want to buy the thing you make by paying them more.6
It seems that capital has run out of markets (demand) and the people with surplus money have been trying to do a Henry Ford and create a market. The Dot-Com bubble was partially a result of investors looking for a place to invest money at a high yield when there were no better (more secure) investments available. This is much the same as property bubbles and similar things pre-dating the Great Depression and 1980’s recession. In the mid 2000’s the problem that financial institutions faced was what to do with all the money invested in superannuation and other compulsory savings for retirement.
The answer was NINJA loans to people who not normally qualify on the basis of being able to pay the loan. Instead, the formula relied on rapid growth in the property prices so that even if the borrower could not pay then the property could still be foreclosed and resold without loss. There was no complaint from the real estate industry about an arrangement like that and most people with property were quite happy for it to increase in value. Plenty was said about this distorting the free market, but it was capital driving it and not Government so it must be ok. That is a simplification but not so simple as to lose its relevance.
Due Diligence, Prudence and Duty of Care
ASIC Report Financial Statement Fraud – Corporate Crime in the 21st Century. June 2005. This report shows quite clearly that there is and will be for the anticipated future, false reporting of company financial positions. It also refers to, but does not discuss, the causes of the fraud and what kind of culture exists in the places where fraud occurs. Due Diligence is what a Director of a Company is required under recent law to undertake to ensure that the company is looking after the best interests of all its shareholders and not a select few or personal benefit. A prudent manager should ensure that risks are acceptable and understood; that allowances are made for things not going according to plan. Those who are charged with looking after someone else’s money owe a duty of care to ensure that it is properly managed.
The evidence is that these three things expected of managers are not always seen to be done. It may only be 5-10% of organisations that fail these tests but that has a big impact. The flow on effects are significant, as we have seen recently.
Individuals vs Herd Instinct
What happens if you see all the other investors making money from some new thing and you are not? It is a bit like the antelope that stands there bewildered while the rest of the herd run from a cheetah. Herd Instinct is a survival mechanism in the wild and the high jungle of finance has many of the same stresses that produce similar responses. It causes people to behave in the same way rather than choose to be on their own and risk being wrong. Individuals can know quite well that they are taking unacceptable risks, potentially acting fraudulently and failing in their duty of care safe in the knowledge that they are not alone. They will probably not be the one caught if it all blows up.
Company structures are something to be considered too. Directors who are Managers, often CEO or CFO are not independent and if there is not a strong independent Board to actively oversee what is happening. Directors who are hands off and let the Managers Manage run the risk of letting them manage for their own interests. The culture you create determines your results.
Aggressive growth means high risk in some form but is that communicated to the shareholders and staff? The best answer is not often and not well.
Penalties? What penalties?
A Bank robber will get 10 years jail for stealing for $50,000 compared to CEO who gets 5 years for participating in the fraudulent loss of $800million of shareholder funds. Does this mean that white collar crime is not as serious as blue collar crime? Does it mean that the legal system treats the two differently?
Regardless of the reason, it means that any dis-incentive for white collar crime is lessened considerably. It is also far less likely that you will be publicly disgraced because the crime will not be publicised to protect the name of the company.
Regulate or not?
So, where does this lead?
The question of regulation is the key. Free Marketeers say to let industry regulate itself. Government should confine its activities to promoting industry and providing essential services (ie the ones needed but not profitable like sewerage, public transport and hospitals). Then when things go bad, it is the Government’s responsibility to make it all good again.
It is acknowledged that there is a need to have some regulation to prevent fraud. That lesson was learned 30 years ago. Prudential regulation is accepted to prevent the failure of banks like in the Great Depression. Fiscal control over the way that companies and financial institutions behave might be the next step. With great power comes great responsibility. Financial institutions have great power. It has not shown the same amount of responsibility.
So is capitalism dead?
Not in all its forms. It is clear that the way we think of capitalism and its association with laissez-faire regulation will have to change. We will still have the things that work but balanced by regulation and mechanisms that take into account the common good. I mean this in the sense of Aristotle and not in any more recent ideas.
The Economy is not the plaything of the wealthy. It is part of life and if anyone owns it the Government does on behalf of the people who make it exist in the first place and depend upon it for their lives. The artificial divide between capitalism and socialism should be forgotten. Marx was part right and part wrong, as was Weber. What we NEED is something of both. An economic model that lets understand the reality of the world today and that understands that the future matters as much as now; that understands that growth is not unlimited and all good; that factors in the common good; that understands that decisions are not made in one place and confined to national boundaries.
Capitalism is not dead but it needs a lot of renovation work to ensure that it is beneficial rather than a burden to society in its old age.
- Recommended by a “friend of the family” who had just setup a business doing Financial Advice that month. ↩
- Incidentally, companies were a way of protecting an individual from bankruptcy if the company failed! This is why the people who cause a collapse of a company only legally lose what they invested in shares or unsecured loans. Any profits or other earnings are retained. Recent changes to company law in most countries allow Directors to be prosecuted to recover money. ↩
- Scientists conduct experiments to see if a theoretically predicted result happens in reality. In the space of social theory and economics, the experiment is real life and not easily controlled which means we have to rely on circumstances to validate our theories. ↩
- This is totally different to risk management where a prudent manager makes sure that they do not expose the company/themselves/society to unacceptable danger WHEN something unpredicted happens. ↩
- Jarrod Diamond, Collapse ↩
- Interestingly one of the reasons for Governments tolerating trade unions was because they encouraged growth by increasing wages for workers. Without them Governments could not force employers to pay more ↩