Where angels fear to tread : the quest for real and responsible capitalism


“Do the Occupiers of Wall Street understand that, according to “pure” capitalist theory, firms like Goldman Sachs would not be allowed to exist?” Dr Woody Brock[1]




Many people, whether within or far beyond the protest movements which have sprung up across the developed world, believe that there is something fundamentally wrong with capitalism. This widespread perception is both correct and incorrect. There is indeed something very wrong, but not with capitalism as a wealth-generating philosophy. Rather, the system that we have now has deviated a very long way from capitalism. Protestors should be campaigning for the restoration of real capitalism, not for its overthrow.

If what we had now was genuine capitalism, it would serve the interests of all, not just the interests of a narrow coterie. There would be rewards for individuals and institutions which succeed, but penalties, and certainly not rewards, for those which fail. There would be transparency at all levels. Competition would drive best value for customers, employees, suppliers and shareholders. Capital would be deployed towards the maximisation of economic growth and social utility.

We advocate thoroughgoing reforms designed to bring capitalism-in-practice much closer to capitalism-in-principle. Fundamental capitalist principles – which include greater parity of bargaining power between market participants, a close alignment between rewards and results, maximum transparency and disclosure, the alignment of decisions with the ownership of capital, rational decision-making, long - as well as short-term incentives, and strong competition – are abrogated by the current, distorted variant of capitalism.

In pursuit of the objective of bringing capitalism-in-practice into better alignment with capitalism-in-principle, the greatest single need is for greater transparency. Businesses need to publish more information about total remuneration, and about the criteria used for determining success or failure.

In addition, government needs to develop a system of “internal bankruptcy” or “punitive support”, whereby, in the event of a state bail-out, the consequences for managers are every bit as savage as they would be in the case of “real” (external) bankruptcy.

We advocate addressing “interface” issues through the creation of an equity court empowered to set aside terms and conditions which are excessively onerous where customers, employees and suppliers are concerned. Finally, there is an imperative need to use fiscal reform in order to redress the balance between equity and debt capital in favour of the former. Ultimately, a market economy needs strong equity underpinning, both to avoid debt excess and to bring corporate objectives more closely into line with shareholder interests.

Where angels fear to tread

These are tough times for bankers, for business leaders more generally and perhaps for the capitalist system itself. In Britain, RBS Chief Executive Stephen Hester has turned down his bonus, pressured (according to press reports) by the prospect of a Labour-initiated vote in the House of Commons. Former RBS chief Fred Goodwin has been stripped of his knighthood. Opposition leader Ed Milliband has poured scorn on the idea that David Cameron’s “cabinet of millionaires” was going to lead “the class war against bankers”, the implication seemingly being that there would be (or at least should be) such a “class war”, even if it is not led by the current administration. Most recently, the Chancellor has warned about the development of an anti-business culture in Britain. Similar tensions are evident across the western world.

Opposition to the established order is by no means a new phenomenon, and the mass protests of recent times might remind older people of the Ban the Bomb campaigns of 1950s Britain, or of the anti-Vietnam and Civil Rights protests of 1960s America. In this instance, though, do the anti-capitalist protests betoken a progressive groundswell of opinion, or are they merely the ranting of the fringe? And, if the former, how should the capitalist system respond?

Our view is that the protestors do indeed have a point, but that the system which is arousing their ire is not really capitalism at all, but a distorted version of it. This theme is discussed by American economist Woody Brock in his new book, American Gridlock. Dr Brock sets out an argument which cuts to the heart of the debate about “responsible capitalism”. His view, with which we agree wholeheartedly, is that what we now have isn’t true capitalism at all. Rather, it is “bastardized capitalism”. Whilst capitalism is, as Dr Brock says, one of the great institutional innovations and successes of history, the bastardized hybrid departs from the real capitalist model in many very far-reaching ways.

History supports the contention that capitalism is the greatest economic growth engine ever discovered. But capitalism needs balance – balance between the interests of labour, capital and management; balance between businesses and their customers, employees and suppliers; balance between free markets and regulation; and balance between near- and longer-term objectives.
That this balance has been lost is evidenced by huge rewards for failure both at the individual and at the corporate level. Banks which fail are bailed out, and executive remuneration can often seem to be both out-of-kilter with performance and out-of-sync with returns to shareholders. These things anger the protestors, but they should be matters of grave concern to anyone interested in harnessing free market economics to promote prosperity, equity and the public good.

Divergent capitalism – theory and practice

The analytical path taken here is to measure the current reality against the principles of ‘pure’ capitalist economics, to identify divergences between the ideal and the current reality, and to explore measures which might bring the reality closer to the ideal.

In doing this, we need to accept that no system ever conforms wholly to the philosophical ideal, but also that this inevitable divergence does not constitute a valid reason for accepting the status quo.
We need to be clear also that, left entirely to its own devices, unfettered market capitalism always seeks to destroy its own first principles. Businesses, if allowed to do so, pursue concentration and market dominance, thereby reducing competition. Businesses seek to drive down real wages (costs), but they destroy demand if they do this successfully. Management seeks to appropriate the income streams and the influence that properly belong to the owners of capital (and nowhere has the prioritisation of executives over shareholders been more extreme than in banking). Revenue maximisation at the microeconomic (firm) level can tend towards an escalation in overall societal levels of debt.

The self-destructive tendencies contained within the capitalist ideal necessarily call for regulatory oversight. Thus seen, the aim of regulation is always ‘to save capitalism from itself’ by protecting important balances. If balance is lost – as, clearly, it has been – then the conclusion has to be that regulatory processes have failed.

None of the predicates of capitalism ever operates perfectly. Free market theory requires that parties have equal bargaining power; that knowledge is equally available to all participants; that rewards and achievements are correctly aligned; that decisions are always rational; that capital is controlled by its owners; that risk is priced correctly; and that there are no monopolies or monopsonies[2].

In practice, none of these predicates exists in perfect form. Indeed, they never can. But the scale of the departure from capitalist principles is now alarming.
Contracting parties do not have equal bargaining power. Market participants do not have equal access to information. Rewards and achievements are not in alignment. Decisions are not made by the owners of capital, but, rather, by managers, whose objectives may differ drastically from those of owners. Decisions are not always rational. Risk has not been priced correctly (sub-prime mortgages are an example of the lethal mispricing of risk).

An analytical reform agenda

If – as it is argued here - the reform of capitalism must involve bringing the system closer to its basic principles, aims should include:
1) Levelling bargaining-power between participants.
2) Aligning rewards with success, and penalties with failure.
3) Ensuring maximum transparency.
4) Enhancing the power of the owners of capital vis-à-vis those who manage capital.
5) Encouraging rational decision-making.

How would this five-point menu of reforms play into current issues?

1) Levelling bargaining-power between participants.
We call this “the interface issue”. We have to accept that participants are not equal, for instance where an individual customer or an employee, or a small supplier, is negotiating with a multinational (or, for that matter, with a state-owned entity). There is extensive abuse of contract, notably through the interpolation of “terms and conditions” which, de facto, the customer, the supplier or the employee has no choice but to accept.
One solution to this would involve the creation of an equity court empowered to overturn unduly onerous (“unfair”) terms and conditions.
In theory, a contract is an agreement entered into by two or more parties negotiating freely from positions of equal strength and equal knowledge. This is not – and, indeed, can never be – the reality. An equity court would check the wider excesses of contract imposition, getting the weaker participant (worker, customer or supplier) a better deal. Businesses would need to write their terms and conditions in the knowledge that excessive bias could open them up to equity court review. This would address the issue that Ed Milliband has highlighted correctly with his attack on the “surcharge” culture.

2) Aligning rewards with success.
It is abundantly clear that rewards are not aligned with success in the system as it operates currently. Incentive schemes are designed in ways which pay bonuses or rewards with little real relationship to underlying achievement or to shareholder value. A bonus for success is reasonable – indeed, it is an essential component of an effective incentive structure - but a bonus for failure is an abuse of the system, and tends to discredit the system as a whole.

A second form of misalignment concerns state support. Under a pure “capitalist” system, RBS and many others would have gone bankrupt in 2008.
Reluctantly, we conclude that a much more extensive regulatory disclosure framework is required where remuneration is concerned. There should be complete (though anonymous) transparency over all remuneration packages above about 10x average income (in the UK, £230,000).
Bonuses should be paid only where “success” is demonstrable, and long - as well as short-term measures of success should be used in tandem. Companies should publish the benchmarking system used in the calculation of bonuses.

In principle, state support for failing enterprises is anathema to capitalist principles. The outcome of severe failure should be bankruptcy. Part of the anger rightly felt by protestors is that high rewards are being paid by institutions which, in the absence of taxpayer support, would long ago have ceased to exist.
As we have explained before, the state support distortion makes the separation of investment and retail banking imperative. But thought should be given also to a concept which we term punitive support.
If the investment banking division of a bank fails, requiring the state to bail out the bank in the public interest, the consequences for the leadership both of the parent bank and of the investment banking division should be the internal equivalent of bankruptcy. Failed leaders should be dismissed, their deferred bonuses should be cancelled and their pension rights extinguished in processes which mirror general bankruptcy outcomes. In other words, what is required is the internalisation of normal (“external”) bankruptcy sanctions.

3) Ensuring maximum transparency.
Capitalism, as a theory, requires complete transparency. In reality, perfect transparency is an unrealisable counsel of perfection. But it is reasonable to pursue maximised transparency. Appropriate measures would include:
- Reporting of all remuneration packages above a specified level, on an anonymous basis. If compensation packages are appropriate, there can be no objection to public and shareholder scrutiny.
- Publication of the criteria on which bonus awards are made.
- Disclosure of itemised comparisons between shareholder returns (dividends plus capital gains or losses) and senior employee remuneration.
- Notification of customer and supplier terms and conditions (necessary so that weaker contract participants can seek redress through the “equity court”).

4) Enhancing the power of those who own of capital vis-à-vis those who manage it.
One of the most risible aspects of pre-crisis regulation was the assumption that banks (and other corporations) could be trusted always to act in the best interests of their shareholders. This ignored the well-known “divorce between ownership and control”. Beginning in the early nineteenth century, businesses became too large to be managed by their owners, meaning that management was interpolated between businesses and their owners. Ever since, tensions have existed between managers and owners, since the objectives of both can by no means be assumed to be coterminous.
This raises two key issues. First, and as the British government has observed, measures need to be taken which improve both transparency and shareholder involvement. Second, however, government needs to improve the general standing of the equity investor.

One of the gravest distortions which disadvantages equity capital is that, whereas interest paid on servicing debt capital is tax-deductible, dividends paid to equity owners are not. This needs to be addressed if we are to move to a lower-leveraged, equity-dominated corporate structure.
As an interim measure, we recommend:
- Limiting interest expense tax-coverage to 50% of PBIT (profit before interest and tax).
- Using the proceeds of interest deductibility limitation to restore dividend income tax exemption for pension funds.
Longer term, the objective needs to be the creation of a fiscal balance which, as a minimum, confers equality between equity and debt capital.

5) Encouraging rational decision-making through long- as well as short-term outcome measurement.
As remarked earlier, we believe that far greater transparency is required where both remuneration and performance measurement are concerned.
If – as we believe to be the case - many corporate incentive structures are over-geared to the short term, the requirement to disclose benchmarking systems would enable both shareholders and regulators to assess the balance between short- and longer-term strategic planning.

Conclusion – saving capitalism from itself

As this report has sought to demonstrate, the “crisis” of capitalism lies not in the unfitness of the free market ideal itself, but in the distortion of that ideal into a “bastardized” variant.
The aim, therefore, needs to be the restoration of fundamental principles which include greater transparency, a better balance between businesses and the broader economy, a better balance between managers and shareholders, and a closer alignment between risk, reward and achievement.
At the same time, we need to recognise that the self-destructive tendencies implicit within capitalism mean that effective regulation is an economic as well as a social and political imperative.

In pursuit of the objective of bringing capitalism-in-practice into better alignment with capitalism-in-principle, the greatest single need is for greater transparency. Businesses need to publish more information about remuneration, and about the criteria used for determining success or failure.

In addition, government needs to develop a system of “internal bankruptcy” or “punitive support”, whereby, in the event of state intervention, the consequences for managers are every bit as severe as they would be in the case of “real” (external) bankruptcy.
We advocate addressing “interface” issues through the creation of an equity court empowered to set aside terms and conditions which are excessively onerous where customers, employees or suppliers are concerned.

Finally, there is an imperative need to use fiscal reform in order to redress the balance between equity and debt capital in favour of the former. Ultimately, a market economy needs strong equity underpinning, both to avoid debt excess and to bring corporate objectives more closely into line with shareholder interests.
Fortunately, the idiocy of “light touch” regulation was an unlamented casualty of the banking crisis. Governments and regulators, with the importance of their role underpinned by recent experience, should set themselves the task, not of undermining the capitalist ideal, but of restoring it.

[1] http://www.johnmauldin.com/images/uploads/pdf/mwo020612.pdf
[2] Monopoly = concentrated control over sales. Monopsony = concentrated control over purchases.

Dr Tim Morgan
Global Head of Research

Tullett Prebon
www.tullettprebon.com.

Thursday, February 16, 2012 | where angels fear to tread

Vendredi 24 Février 2012
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