Quarterly essays (in English and French) on the theme "Querying economic orthodoxy"
No. 53 - September 2011
Gold will be slave or master;
‘tis more fit
That it be led by us, than we by it.
Horace, Epistles, book I, no. 10, trans. John Conington (1869).
The primacy of politics over
the financial markets… must be re-established.
Angela Merkel, speech in the Bundestag,
An old tale foreshadows today's events
In Mary Wollstonecraft Shelley’s novel Frankenstein, the modern Prometheus (1818), the fictional scientist and alchemist Victor Frankenstein fashions a nameless humanoid creature which turns out to be an uncontrollable monster, terrorising Frankenstein, his family, friends, and neighbours, before retreating to a hiding-place in the remote Arctic.
That old ‘Gothic’ tale eerily foreshadows what has happened in our financial markets over the past thirty to forty years. Clever inventions such as hyper-complex bonds and derivatives, pseudo-scientific modelling of market behaviour, and ultra-fast electronic trading methods, encouraged by worldwide derestriction of market activities, have brought us markets that dominate and threaten our ‘real’ economies and societies; markets that seem all too often like anonymous, capricious, ungovernable monsters, given to concealing themselves in faraway offshore locations.
Financial capitalism and corporate profits
In recent decades, ‘financial capitalism’ has largely driven out traditional ‘industrial capitalism’, basically because financial institutions have become the dominant shareholders in public limited companies. These institutions include pension and insurance funds, investment or unit trusts, mutual funds, investment banks, private equity funds and hedge funds. All have one thing in common: they are financial, not industrial organisations, so their single objective is to invest profitably. They have, after all, no ‘product’ to offer except return on capital.
This is a different motivation from that of the better kind of old-fashioned industrialist, whose prime objective was to run, for example, a successful steelmill or brewery. He had to make adequate profits, but his basic interest was in turning out fine hot-rolled coil, or in brewing an excellent pint.
Financial institutions have become more demanding than they once were. That is because they now work in an extremely competitive climate. They are engaged in a race for the best returns, a race that has grown more gruelling, thanks to the spirit of intense competition that is fostered by current technology and ideology.
With the help of electronic techniques, we can now calculate the performance (return on capital) of investment portfolios quickly and often. With the publication of frequent performance comparisons, which look rather like race-cards, fund managers are under constant pressure to enhance and accelerate the returns on their investments. Moreover, within fund management organisations, very large bonuses can be earned by individuals who notch up fat profits for the funds they manage.
therefore push the managements of companies in which they invest to strive for maximum,
rather than adequate, profits,1 and to give priority to immediate profitability rather
than to long-term development. If a company fails to oblige, its shares may be
ditched by the fund managers. Its share price will tumble, and so may attract a
cheap takeover bid. Company managements live in fear of that.
Market pressures on business
businesses of all kinds find themselves under continual pressure from the
financial markets to enhance their profits. But they are also under relentless
countervailing pressure to keep their prices down, or preferably cut them.
Current economic ideology insists on maximum competition between businesses, in
the interests of consumers; it does not care about the interests of those who work
on the shop-floor or in the office. Therefore, companies are encouraged to
compete against each other as fiercely as possible. Any agreement between
competitors to stabilise prices is nowadays treated as a serious crime.
Businesses are being squeezed by the markets from both sides. They are expected both to keep their prices down and to drive their profits up. If any reader thinks I am shedding crocodile tears for executive fat cats and spoiled shareholders, let him recall that a business is not just its shareholders and top management; it is all the people who earn their living by working in it.
The obsession with cost-cutting
Under the two-edged sword of demand for higher profits and lower prices, companies respond with aggressive cost-cutting. This leads to redundancies, often via delocalisation; to worsening conditions of employment; to severe workplace stresses; to deterioration in quality of production, of research, of customer service; to inadequate attention to safety and environmental protection.
By slashing costs such as payroll, research and development, or provision for pensions, a business can often boost immediate profits, leading to a rise in its share price. The wider and longer-term consequences of this cost-cutting do not concern financial investors, who realise quick capital gains. The old Anglican prayer-book describes memorably an ancient equivalent of this situation: I do also see the ungodly in such prosperity...therefore fall the people unto them: and thereout suck they no small advantage.2Speculative trading
Before the ‘reforms’ of the late twentieth century, professional trading in shares and
bonds was done mainly by Stock Exchange jobbers and by certain specialist companies
such as the London merchant banks and discount houses. We are talking here about
‘own-account’ trading, as opposed to trading on behalf of clients, which is
what stockbrokers do. Jobbers (nowadays called market-makers) are different;
they are firms that trade in shares or bonds on their own account, for their
business is reviled by some people as mere punting; but within reasonable
limits it does serve a useful purpose. If you need to sell some shares quickly,
you can normally do so without waiting for the appearance of another investor
who wants to buy them; you can sell, through your broker, to a jobber, who will
hold them until an investment buyer comes along.
Today, however, own-account speculative trading has swollen far beyond what is required to oil the market’s wheels. The huge growth of this type of trading by banks, hedge funds and other institutions has brought us to a situation where substantial proportions of company shares are held (temporarily) by speculators rather than by longer-term investors. And holdings can be very temporary indeed. ‘High-speed trading’ on computers means that buy and sell orders can be generated automatically and executed in milliseconds (thousandths of a second). A very different matter from old-style trading, with its face-to-face negotiation on the Stock Exchange floor!The virus of short-termism
Back in 1959, we could read in the Radcliffe Report that investment trusts…do not buy with the intention of re-selling…their investment policy is governed by long-run considerations.3 In 1992 Charles Handy, the famous Irish writer on business management, observed that financiers in Japan and on the Continent…are more like guardians, keeping a watchful eye, but not jumping ship just because there is a torn sail.4 But today, most of the world has become, to varying degrees, infected with the virus of market short-termism. Part-ownership of our major business concerns is now shuttled at lightning speed between investment funds, which may well be unregulated organisations hidden in remote islands. It makes Frankenstein’s monster look very tame.
reached this situation through a process commonly called ‘reform’, which does not always mean improvement. Under the
old regime, prior to the 1986 ‘Big Bang’ in
That wasn’t good enough, according to the ‘reformers’, the devotees of super-efficient global markets. For them, the restrictive, ‘cosy’, ‘club-like’ City, as they contemptuously called it, was hopelessly outdated. The big clearing banks, they insisted, must be allowed to buy up the jobbers and other trading firms, so that far more capital would be available for market operations.
In other words, the old exclusive specialisations should be abolished, in keeping with classic free-market philosophy, which has always loathed restrictive practices. That was duly done. As a result, and thanks to the rapid development of hedge funds, which largely escape oversight and regulation by market authorities, the volume of speculative trading has risen enormously.
Today’s arrogant traders are not content with bullying commercial firms; they treat sovereign governments in the same way. If a government is thought by market operators to be spending too much – perhaps because it needs to invest in infrastructure, or to support the unemployed during a recession – then that government will ‘come under attack’ from the markets. This means that traders aggressively sell the government's bonds, depressing their prices. This forces the government to pay higher interest rates on its borrowings, making the budget deficit even worse. The government then has to embark on an austerity programme, cutting its spending sharply and probably slowing down the economy.
In some cases, the market’s actions may be justified, where spending is indeed seriously excessive. But markets can also react in a panicky manner against governments that, in reality, are far from insolvent. This behaviour can only aggravate the problems.
In June 2010,
Hubert Védrine, former French foreign minister, complained of the latest ‘attack
It was market pressures, in the first place, that pushed governments into taking tough, probably premature, measures to tighten up their budgets. Now, markets are punishing us for doing just that. With these capricious markets, sometimes it is heads you lose, tails you don’t win. And sometimes, as in this case, markets by their perverse behaviour cause to happen that which they do not want.
One can scarcely deny that certain governments have themselves to blame, if they are pushed around by the financial markets; these governments have handed power to their creditors by borrowing too much. Nevertheless, it is galling to be tyrannised by markets that behave in such a wayward, irrational and panicky fashion. They do so because they are dominated by operators who care about nothing but making short-term gains and avoiding short-term losses; whose outlook is purely myopic and self-interested.
markets in mortgage finance have fuelled property price booms in
Too much market freedom
It would be a good idea for economists and market ‘reformers’ to talk to electrical engineers. Then they might learn that there is a type of electric motor, traditionally used in trams and suburban trains, which must be run only under certain restrictive constraints. If such a motor is in the workshop for overhaul or test, it must never be allowed to run free on full power. For, without the restraining inertia of the train or tram, the motor will accelerate without limit till its rotating centre flies to pieces.That does not mean that the motor is faulty. It simply means that this kind of motor, when unconstrained, has a natural tendency to unlimited self-feeding acceleration; it is self-destructive. Yet, when linked to the wheels of a heavy vehicle, whose inertia restrains its acceleration, it is a useful, reliable workhorse. That has been proved by more than a century of worldwide use of such motors in transport and industry.
analogy fits today’s financial world well. Markets and banking systems, freed
from ‘outdated’ constraints, have run amok and landed us in very serious
trouble. But that does not prove, as some people think, that capitalism is
fundamentally rotten. It simply proves that capitalism can only function well
under strict restraints; without them, it becomes self-destructive, and
destructive of human society too.
Taming the monster
We have seen how institutional changes and new technologies have facilitated huge growth in the volume and rapidity of market trading, together with faster and easier comparison of portfolio performance – and hence an exaggerated obsession with near-term profitability. We cannot simply go back to the Lord Radcliffe’s more tranquil age. So what can we do?
A primary problem today is that, as Handy observed in a more recent interview, shareholders in the Anglo-American scheme of capitalism have far too much power…and no responsibility.7 Half a century ago, restrictions on the powers of holders of publicly-traded shares were quite common. The founding family of a firm, normally long-term shareholders with commitment to the business, might hold special shares carrying a majority of votes; so the shares traded in the public market did not confer control over the company. Such arrangements, vilified by the free-marketeers, have largely disappeared. Other possible limitations are government-held ‘golden shares’, conferring strategic powers, and restraints on the acquisition of large shareholdings.
Paul II gave us a vital clue: he argued that each employee should be fully entitled to
consider himself a part-owner of the great workbench where he is working with
everyone else.8 This ideal has been put
into practice through the European principle of co-determination, widely used in
explains Norbert Kluge of the European
Trade Union Institute in
For many years now, prevailing political, business and legal opinion has favoured the removal of limits on shareholders’ powers. This is in keeping with the libertarian belief that economic power should be handed over to the markets, with a view to curbing the power of the state. But now we see that markets, given too much power, can easily become tyrannical monsters. The time has come to seek a more humane and equitable distribution of economic influence.
* * * * *
1See my essay Maximum or adequate profits? in this series, November 2009 .
2 Book of Common Prayer, psalm 73, verses 3 and 10.
3 Report of the Committee on the Working
of the Monetary System (chairman Lord Radcliffe) (HM Stationery Office, London, 1959), pp 93-94.
Handy, Priorities and purpose in Financial Times (
6 Hubert Védrine, France-Allemagne, le malaise in Le Monde (Paris), 29 June 2010.
Handy, Leader’s Edge in Ivey Business Journal (
8 Jean Paul II, encyclical Laborem Exercens (1981), para. 14.
9 Norbert Kluge, Worker participation in boardrooms throughout Europe, in Rebecca Page (ed.),
Co-determination in Germany - a beginner's guide (Hans-Böckler-Stiftung, Düsseldorf, June 2011), see www.boeckler.de/pdf/p_arbp_033.pdf, page 40.