Is America Capitalist?

This is a question that is vexing me greatly right now. In a more pure capitalist system the linkage between capital, the investors in business, and management, the custodians of that investment, is straightforward. And results oriented. The message to management is obvious: make the right return or be replaced. This pressure to perform is, according to the textbooks, what drives the machinery of innovation and efficiency.

This current crisis has, however, demonstrated just how different our economy really is from this ‘ideal’ state.

Managers run companies largely without reference to shareholders. Or, more accurately, shareholders are now passive rather than active forces in the corporate structure.

There is nothing new in this. The literature is full of references to the ways in which management is now a profession – MBA schools have burgeoned in the past few decades – and of how the increasing complexity of business has rendered active participation by shareholders in the affairs of corporations ineffective. Stuff is just too hard for the average shareholder to understand so it’s better to leave it to the pros.

Over time the control that shareholders actually assert over their investment has eroded to near farcical levels. Besides which most investors nowadays are strictly stock purchasers: they have no intention, or conception, of ‘owning’ a company. Instead they view stock as an asset alongside other assets such as bonds or real estate.

And their appointed guardians, the Boards of Directors, have connived at this deterioration. Indeed if the evidence of this recession is anything to go by the average Board is nothing but expensive window dressing.

The shocking destruction of shareholder value in banking is a case in point. The huge drop in share prices as the incompetence of management was exposed by accumulated losses has scarcely raised the ire of any of their boards. Instead of wholesale firings and reorganizations we get small scale adjustments and cautionary words against rocking the boat at moments of delicate activity. The glacial pace of change at Citibank, whose stock has lost 90% of its value, is hardly a ringing endorsement of the vibrancy of capitalism. It smacks of something closer to Soviet era bureaucratic self-preservation.

Executive pay is at the center of this failure. Shareholders were evidently misled by bank managers for a while. The business model most banks adopted was adroit only in creating an illusion of wealth while insiders like CEO’s and high level traders extracted vast amounts of loot for themselves. Once the game was exposed the shareholders were left with a devastating diminution in their wealth while the perpetrators of the illusion walked away with mountains of cash.

The linkage between investor and control of their investment could not have been more clearly severed.

The redistribution of wealth from shareholders to managers amounts to wholesale pillage.

And if you think this is an academic matter consider your own retirement fund. Most of us have our money managed by an investment manager who is supposed to exercise fiduciary responsibility, not just to produce the gaudy annual returns they all advertise in their glossy brochures, but also to protect the original investment. Investment management is, or should be, a conservative, careful, and above all respectful activity. The protection of capital being foremost among its aims.

Where were these people?

Why were they not berating management and the boards? Why are they still not demanding stern action and perhaps even restitution? Why did they sheepishly vote to support management and director re-election year after year?

Because they are all interconnected. Many banks are themselves money managers. Many other money managers deliberately avoid confrontation with management, presumably on the basis of ‘professional courtesy’. Yet others are simply too small or lazy to undertake proper due diligence for their investments.

Boards are all a maze of relationships: my board has many of your board members. CEO’s patrol each others flanks and defend the brotherhood rather than get tough. Insiders dominate many boards. Outsiders are carefully chosen as figureheads or as meek followers. Very few act as independent watchdogs. If they do, they get replaced.

Furthermore, the network of advisors who could provide cautionary words have become mere shills for the stock market companies they all seem to work for. And it turns out that the rating agencies – Moody’s; Standard and Poor’s etc – were paid by management to rate assets favorably.

In other words the entire system upon which investors relied to protect their money failed. No. More than failed: it was complicit in the pillaging of wealth.

Naturally the really large investors, those who can employ their own analysts, did better. They could buy a board seat and therefore ask the awkward questions that no one else seemed willing to. But that only helped them.

What about the average retiree? Who looked out for them?

No one.

And this is where I become truly angry: only a few years ago we were being bombarded about the privatization of retirement investment. The virtues of capitalism were touted as a being so strong that the government sponsored retirement system was positioned as failing the average family: retirees were losing a fortune because he or she could not participate in the great game of capitalism through Social Security.

To think that all those folks would have had to place their money at the mercy of the exact industry that has just failed so spectacularly.

So is America capitalist in any true sense of that word? Or is it simply corporatist? Is it a vast interwoven network of bureaucrats whose objectives all coalesce around their own bonus pay?

The whole notion of our being a nation of investors is patently absurd if we have no mechanism through which to assert the rights of ownership.

The Reagan era deregulation swept away most of the protections investors had against potential looting by managers. The idea was to return us to the gilded age of capitalism. The problem was that the second coming of the gilded age was one of management, not capitalism, because there are very few large private companies any more. The new plutocrats are the executives of JP Morgan, not JP Morgan himself.

The funny thing is that economics has a whole theory – ‘Agency Theory’ – that exactly covers all these issues. They teach it at business school. Or at least they did in my day.

No wonder those clever MBA’s know how to game the system.