Monthly articles (English and French) on the theme "Querying economic orthodoxy"

No. 26 - February 2008

The errors of financial capitalism


The workings of a logic that is economically ruthless and socially disastrous
Michel Delberghe, Le Monde 16 January 2008 (article French employers worry about the errors of globalisation and financial capitalism)

La moda, ribadisco, si è rovinata....mancano la sfida, la creatività e l'allegria. Ormai è solo un fatto di numeri. (1)
Valentino Garavani, at a press conference in Rome, see La Stampa, 21 janvier 2008

In any case, it's not the amount [of one's bonus] that matters, it's getting more than one's closest friends and colleagues.
City banker, in an interview with Le Monde, 16 January 2008

If railways were run in the way hedge funds and investment banks are run today, train drivers would be expected to ignore the timetable and "thrash the engine" to achieve maximum possible speeds, in relentless competition with each other. And there would be big bonuses for those who made the best running times. In those conditions, would we want to travel by train?

The race for the best returns

Why is "financial capitalism" driving out "industrial capitalism"? A basic reason is that financial institutions have become the dominant shareholders in most larger companies. These institutions include pension funds, insurance funds, British investment trusts and unit trusts, American mutual funds, private equity funds such as Carlyle and Blackstone, and hedge funds. All these have one thing in common: they are financial, not industrial organisations, so their objective is to achieve maximum financial returns on their assets.

This is a quite different motivation from that of the traditional industrialist who is primarily interested in running a successful industrial concern; its financial return is necessary, but is not the prime objective (2).

Financial institutions are engaged in a race for the best returns, a race that has become more arduous thanks to the spirit of intense competition that is fostered by current ideology. But thanks also to the greater transparency of most institutions (though hedge funds and some others remain opaque) and to the development of electronic techniques which allow us to calculate portfolio performance quickly and often. With publication of frequent performance comparisons, fund managers are under constant and intense pressure to enhance and accelerate the returns on their portfolios. Any manager whose performance is judged inadequate is soon replaced.

Consequently, these demanding shareholders push the managers of quoted companies to strive for maximum (rather than adequate) profits and dividends.

If railways were run in the way hedge funds and investment banks are run today, train drivers would be expected to ignore the timetable and "thrash the engine" to achieve maximum possible speeds, in relentless competition with each other. And there would be big bonuses for those who made the best running times. In those conditions, would we want to travel by train?

The "unique model" of business structure

Meanwhile, we are seeing a loss of diversity in business structures. Devotion to economic dogma that recognises only one acceptable pattern is leading us to adopt a "unique model" for all business activities. This model, the free-marketeers' ideal enterprise, is a company quoted on the stock market, most of whose shares are not in stable hands but are held by "active investors", who see all their investments as temporary, to be held only so long as a rise in their market value is foreseeable in the near future.

Such a company is wide open to the ambitions of the aforesaid institutions. It is entirely subject to the caprices of the market. Its shares are "highly liquid", always readily tradeable, alwys open to takeover offers.

Why should businesses be expected to live in this feverish atmosphere? Because the fear of dominant and rapacious shareholders, or the fear of takeover, forces company managements to be constantly on the alert, tireless in their quest for better returns on their capital. How do they achieve these? By enhancing productivity (producing more with fewer employees), by relentlessly grinding down their other costs, by more rapid production, by the launch of new (or seemingly new) products, by the conquest of new markets, by fresh inducements to buy their products....The free-marketeers' whip never stops cracking. They dream a world of acrobatic businesses. They want us all to embrace the Silicon Valley Attitude: stop for lunch and you are lunch!

Feverish excess

Alert management is good. But the frenetic pursuit of higher returns should not be pushed too far. An economy in constant tumultuous change, driven by voracious markets, risks destroying the quality of life in the quest for economic efficiency. And to what end?

This question opens up a fascinating psychological investigation. What are the free-marketeers' basic motivations? One can think of several.

*The productivity obsession. It is argued that productivity gains open the way to lower prices, thus enhancing consumers' purchasing power. The aim of economic policy, it seems, should be to enable us all to buy ever-greater quantities of everything. What a splendid idea, in an age when already we are exhausting the earth's resources through excessive consumption!

*The yearning for change. It is said that change is a sign of vitality, even the only real sign of it. And thus that the faster human society changes, the more alive it is. Free-market capitalism encourages ever-faster change; so it must be good! Too bad if many people, sick of the frustration, disorientation and resentment that follows too much upheaval, turn to political or religious movements that offer fundamentalist, reactionary philosophies!

*The obsession with efficient use of capital. Economists argue that capital is a scarce resource that it is our duty to use to best advantage, like a goldsmith with his gold or a furrier with his mink pelts. Wasting capital is a sin, said Carol Galley, former fund manager with Warburgs, later Merrill Lynch. Yet capital is not in principle a limited resource like crude oil. Nor is it even rare and expensive. On the contrary, the cost of "raw" capital, ie liquid funds, is measured by short-term interest rates, and for many years these have been generally low.

The boom in values of objects that yield no current return at all is well known. Damien Hirst's dead sheep in formaldehyde was sold at Christies (New York) in 2006 for $3,376,000; in the same year, the same house sold three bottles of Romani-Conti 1978 for $211,500. Is capital really so scarce when people spend it like that? What does Ms Galley think about the "sins" of the saleroom?

The free-marketeers' capital motive

There are some of the ideological attitudes that underpin free-market practice. But pratitioners do not spend much of their time contemplating such theories. In their day-to-day business, what motivates them is simply the prospect of gain. As it happens, in an economy where many businesses are in the form of the "unique model" described above, and where markets are largely deregulated, the pursuit of maximum return on capital is very lucrative. Not only for those who own capital, but also (perhaps even more so) for those who manage it.

For by slashing business costs, such as payroll, or research, or provision for pensions, one can greatly increase a company's immediate profits, leading to a rapid rise in its share price. The consequences of redundancies, of deterioration in customer service, of damage to the company's future development, do not concern financial investors, who realise quick capital gains. In the pungent language of the old English prayer-book (3), thereout suck they no small advantage.

Financial capitalists conceal these unpleasant facts with their patter about the virtues of productivity, efficiency and enlivening change. Or about the sacred freedom of entreprise; they keep quiet on the real meaning of this phrase, which too often boils down to the freedom of financial cowboys to damage industrial or commercial businesses, and the underlying fabric of society, for their own benefit.

The alternatives

Over the past thirty years or so we have engaged in a thoroughgoing experiment with financial capitalism. We have allowed many businesses, even entire industries, to become the playthings of fluid, speculative, frenetic global markets. And we don't like the consequences. So it is time to look at other business models. There is no lack of possibilities; there are plenty of viable business formats other than the "unique model" that we have descibed.

*There is nationalisation. Since I would like you to read the rest of this article, I am not going to spend time on that topic. Nobody wants to wear yesterday's fashion. Even Labour leader Gordon Brown, considered fairly left-wing, is unwilling to nationalise the failing Northern Rock.

* There is the company with non-voting shares. This allows the management, and/or founding family, to retain control of their business without providing all the risk capital. Through the stock market, the general public and the institutions provide the rest, without however having much, or any, voting power. This model permits the company to be run for industrial rather than financial motives. It is out of favour at present because it offends against the principle of market dominance, and because it seems logical that control should follow shareholding.

Nevertheless, this method has been used successfully by many companies, and is very flexible. Non-voting shares can benefit from preferential dividends. They can have limited voting rights, or full rights if their dividend is unpaid. One can restrict the number of votes, or shares, that can be held by a single shareholder.

*There is the mutual or cooperative structure which makes a business the property of its customers. In some countries, this system is widespread in banking, insurance or retailing.

If we compare a mutual bank with one owned by shareholders, we generally find that the mutual is less likely to feel driven to pursue growth for its own sake. If Northern Rock had remained a traditional mutual building society, it would very likely have avoided the present disaster. If certain American banks, leaders in sub-prime lending, had been mutual institutions, they would probably have behaved more prudently.

*There is the mutual structure which makes a business the property of its employees. Though this is rare, some very good examples can be found. The Spanish group Mondragon, founded in 1956 by Father José Maria Arizmendierrieta, is today one of Spain's biggest industrial groups with interests in a dozen other countries. Its French subsidiary is the leading French manufacturer of domestic electrcal appliances. This is a cooperative firm whose employees elect the management and share the profits.

In Britain, the John Lewis Partnership owns 26 department stores (4) and 157 Waitrose supermarkets. It is one of the country's most successful and respected businesses. In 1949 Spedan Lewis, son of the founder, handed over his business to a trust which holds it for the benefit of all its employees. A move which could perhaps be followed by some of those American entrepreneurs who have philanthropic leanings, and who prefer to leave their children with enough money to do what they want to do, but not enough to do nothing, as Warren Buffett so neatly put it.

* There is the private, unquoted company, owned by a limited number of people, normally those who run it. Businesses like this are often family concerns. We are all aware of the difficulties of keeping a business in the family. It has become more problematical with the small size of most families today, making it all the less likely that an owner will have among his children some who are able and willing to carry the firm forward.

However, one of the oldest businesses in Britain - and indeed in the world - is anything but a family business. This is a Scottish transport concern which was chartered in 1498 and bears a curious name, The Shore Porters' Society, because its original main function was to convey goods arriving at the port of Aberdeen to merchants in and around the city. Today it is an important removal contractor and transporter of valuable goods such as antiques and works of art. It has long followed a policy of not admitting to the partnership any son or daughter of an existing partner. The aim has been to avoid nepotism; and this strategy has been notably successful!

Preserve business diversity!

Clearly, businesses can be set up in many different forms, each of which has its advantages and its weaknesses. To favour one single form, as is the fashion today, is to make the world suffer from the defects of that form while depriving it of the advantages of the others. It is a risky and short-sighted strategy.

Let us not forget the consequences of the loss of bio-diversity. A horrifying example is the Irish potato famine of the 1840s. At that time Irish farmers cultivated, almost everywhere and in great quantities, a single variety of potato called the 'lumper'. The arrival of a blight that destroyed plants of that variety plunged the whole country into a disastrous famine, which could probably have been avoided (5) if potatoes of various varieties had been grown.

We should avoid making our entire economies suffer from being totally exposed to the vagaries of the financial markets. Rather we should encourage other forms of enterprise which offer greater stability and reliability.