Capitalism under siege
Adam Smith taught us that self-interest leads an individual to seek the most “advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view.” Adam Smith’s magnum opus, The Wealth of Nations (1776), or even more importantly his earlier work, The Theory of Moral Sentiments (1759), are no longer required reading in most management schools. We have forgotten that Adam Smith was first and foremost a moral philosopher.
By omitting the moral foundations of Smith’s work, we have come to equate his concept of self-interest with a greedy disregard for others. Nothing could be further from the truth as Smith’s self-interest is directly linked with the common good. Smith quickly clarifies the link between the pursuit of individual advantage and the societal benefit by adding:
It is his own advantage, indeed, and not only that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.
History has vindicated Smith’s fundamental insight. Capitalism has made the world richer and healthier than previous generations could have imagined. An average person today lives in infinite luxury compared to the lives of our forebears, which Thomas Hobbes characterised in Leviathan (1651) as “poor, nasty, brutish, and short.” According to the World Bank, in 1981 1.93 billion people lived on less than $1.25/day, an indicator for extreme poverty. By 2008, the number of people in abject poverty had decreased by a third to 1.28 billion.
Why, despite the benefits of the capitalist economic system, is it under existential siege? The explanation for the widespread anger is not difficult to find. Over the last 30 years there have been serious dislocations which have been exacerbated by the recent economic crisis. Millions of manufacturing jobs have been moved from developed market economies to countries where labour costs are lower, and youth unemployment is alarmingly high, particularly in some of the European economies. Income inequality has radically widened in the US and the UK, and market pressures and management compensation structures have led managers to focus on short-term profits rather than on long-term wealth creation.
Finally, capitalism is suffering from an ethical crisis. According to the think-tank The Henry Jackson Initiative for Inclusive Capitalism, a broad-based acceptance of basic ethical norms is necessary if capitalism is to regain acceptance. Otherwise, the system itself will become discredited and ultimately destroyed, whether by internal failures or external pressures. To rebuild confidence in capitalism, there are two critical areas that need to be addressed: short-termism and business ethics.
Shareholder value maximisation became the norm in the 1980’s. There is nothing wrong with maximising returns for risk-takers as long as it is based on the sound strategic principles of long-term value creation. However, over the last 30 years investment markets have undergone a structural change that has caused capital and equity markets to become focused on short-term returns. In the 1960’s the average stock holding period in the UK and the US was approximately eight years. Today, it’s about four months. It is difficult to call today’s equity holders risk investors in the traditional sense of the word that they have an interest in the firm’s long-term survival. In fact, modern investors are more akin to speculators seeking quick returns.
This structural change in investor behaviour has pressured management to create value on a short-term, and even quarterly basis. Companies become fearful that investors will divest at the slightest wobble in the share price or if the firm misses its quarterly performance expectations. Under these conditions short-term fixes tend to win over the long term goals. The situation becomes even more exacerbated if management compensation is linked to short-term corporate performance.
Data is beginning to support the negative economic impact of short-termism. There is increasing evidence linking short-termism with a long-term decline in corporate investment as a percentage of GDP. Moreover, corporate investment activity tends to favour efficiency innovation that releases capital by reducing employment and cutting production costs. What is particularly worrying is that the released capital is not invested in R&D which could increase the rate of product innovation and thus have a positive impact on employment and economic growth. Instead, as the emerging evidence points out, capital is used for share buy-back schemes that artificially increase share prices. The end result is increased volatility, inflated asset prices, and stagnating long-term growth and employment.
Economic policy initiatives such as investment tax credits can be designed to counteract management short-termism. However, these measures alone will not be sufficient to change the prevailing market behaviour. A more effective means to encourage long-term investing is for businesses to stop providing quarterly earnings guidance for equity investors. Unilever, Merck, and GE have already shifted their investor guidance away from quarterly reporting to long-term performance indicators. Other firms have started programmes that reward equity investors who hold their shares for a longer period of time. There is also evidence that institutional investors such as pension and sovereign wealth funds, who collectively hold roughly 35 percent of the world’s financial assets, are beginning to redesign the performance and reward systems of their asset managers to reward long-term performance.
Combating short-termism is a start but it will not solve the crisis of confidence in capitalism overnight. Although we know that people tend to behave better when they are evaluated over the long-term, they will not behave ethically unless they work in an environment that fosters ethical behaviour. We should remember that the behaviours that led to the near collapse of the global financial system in 2008 were not the result of illegal behaviour. The financial crisis was largely precipitated by questionable moral and ethical behaviour. The reaction to economic crisis has been to increase the level of regulation. However, the danger of regulation is that rather than asking the question “Should I do this?,” the question becomes “Can I do this?”
Regulation creates rules-based behaviour that essentially removes an individual’s moral responsibility. If capitalism is going to survive in the future, we need to bring ethics back to the centre of commercial activity. Adam Smith would surely agree that commerce can not be separated from morality. As we seek solutions to the the 21st century problems of capitalism I will leave the last word to Adam Smith:
"When the happiness or misery of others depends in any respect upon our conduct, we dare not, as self-love might suggest to us, prefer the interests of one to that of many. The man within immediately calls to us, that we value ourselves too much and other people too little, and that by doing so, we render ourselves the proper object of the contempt and indignation of our brethren.”
The conscience of the constitution
The Conscience of the Constitution by Timothy Sandefur, is a new Cato book that can be read with profit by anyone interested in classical liberalism, not just Americans. Some regard the US Constitution as a great bastion of democracy, yet the word, says Sandefur, appears nowhere in it. What the Constitution actually enshrines is liberty.
This liberal purpose and foundation is expressed in very plain terms by the Declaration of Independence, which is, in Sandefur's term, 'the conscience of the Constitution'. Where the Constitution says how the power of government should be limited, the Declaration explains why. Not to empower majorities and their representatives, but to restrain them.
Sandefur's thesis is that over a long period of usurpations, the liberty role of the Constitution has been eclipsed by its democracy rule. Its principles go back to Magna Carta, which declared that rulers and officials themselves had were subject to the 'law of the land' – the deep sense of justice and fairness that grows up through the voluntary interactions of free people. Governments cannot pass any rule they like, no matter how arbitrary, irrational, unfair, unclear or contradictory, and properly call it 'law'. It is this that 'due process' is all about – laws and their execution must be substantively fair and just. Americans do not simply enjoy a list of 'rights' but are protected (or should be) by a general rule against exploitation and unfairness.
In any particular case, that general rule might of course outrage the majority. And in recent years, says Sandefur, the courts have come to place the majority decisions in the legislature above the principle of safeguarding liberty, hardly ever striking down official powers. It is called 'judicial activism' but actually it is a baleful inactivity. Justices claim that legislators are nearer to the public and therefore better equipped to know what is in the 'public interest'. But that, says Sandefur, gives legislators carte blanche to pass almost any law, covering it with some or other 'public interest' fig-leaf. Also, majority decisions are actually made through the rent-seeking of interest groups, pressuring politicians, as described so well by the Public Choice economists. And much law today is made by unelected regulators anyway, so the 'nearer to the public' argument is plainly a sham.
Deliberately upholding unjust laws, concludes Sandefur, is no less damaging than accidentally striking down just ones. The courts should be in no doubt that, as the Constitution and Declaration specify, liberty is the primary object of their actions. However much democracy we have, our rulers have no right to go beyond the Constitution and thereby put the liberty of individuals at risk.
Art museums are simply too expensive, sell everything and close them down
This is based on a recent piece in the NYT which I cannot now find so apologies both for the repeat and also for the possible garbling of the argument. But art is simply to valuable to be hanging in museums these days. We should sell the lot off and close them all down.
Take, for example, the mythical Vermeer, "Girl who has lost her ears let alone her pearl earring". This is worth, in these days of Russian oligarchs, $100 million. It is also hanging in a public museum in London, owned by some arm of the State.
So, how much does it cost for people to look at this picture? A reasonable discount rate might be 5%. That's what we could get if we flogged the piece and stuck the money into a stock market fund concentrating on yield. Maybe 3% for FTSE as a whole. But with 5% that means that not selling it costs us £5 million a year. Or £13,700 a day, which if museums are open for 10 hours a day means £1,370 an hour. A period of time in which this one picture might have, what, 10 people look at it? Thus, the cost to us of this one picture hanging in a gallery in London is £137 per viewer.
At which point we have to ask whether this is worth it. And we've a method of working that out to. Do we think that we could charge those 10 people an hour £137 each to be able to view the painting? No, clearly and obviously, we do not. Therefore the costs to us as a whole of our possession and display of this painting are less than the benefits that come from our owning and displaying this painting. Having costs higher than benefits is also known as destroying value, something which is properly known as "making us all poorer".
We should therefore sell off all such art and close down the museums.
If those who purchase it then wish to show it to the public all well and good. But they'll be doing that on their dime, not our.
Video: the state of the minimum wage debate
Last month I spoke on the minimum wage at LibertarianHome's meet-up, and they have uploaded the video of the talk, as well as a very good summary write-up of my comments. I had a great time at the talk and I'm looking forward to attending more of their meet-ups in future.
The sale of Royal Mail was well handled
The National Audit Office, some of the media, and the Opposition (of course) are saying that the sale of Royal Mail was "too cautious" and lost "hundreds of millions of pounds" for the taxpayer. This is nonsense, and its currency shows how little some people understand about privatization, or perhaps how much people have forgotten by not doing it.
It was the first major privatization in two decades, and the aim was not to raise the greatest possible sum for the government, but to turn a state-run corporation into a successful and flourishing private business. This was always the aim of the privatizations of the 1980s and 1990s. When the major state industries and utilities were brought to the stock market and put into private hands the aim was always to achieve a first-day premium so that investors would feel satisfied that it was a success, and feel confident about its future.
No-one knew what the "correct" price was for Royal Mail, any more than they did for BT, British Gas and the dozens of others. Since they had not traded in the private sector, or had to attract private investment, no-one knew how they would be valued. Government took expert advice knowing that it would be, at best, an estimate. It covered itself by retaining a proportion of the shares so it could gain later from any increase in value. In the case of Royal Mail it has retained 30% for later sale at a higher price.
The pricing was cautious, as it was in the earlier privatizations, because government wanted a successful launch into the private sector more than it wanted the highest possible price. Privatization was always a political as well as an economic act. Its major aim was to replace state ownership and direction of industry by commercial and (where possible) competitive private sector activity. It did so because the private sector is exposed to improving disciplines absent from nationalized industries.
The threat at the time of a Royal Mail strike cast more uncertainty over the company's valuation, even though that threat was later withdrawn. We now have a successful private company holding its own in a competitive market, a company that has become one of the UK's leaders, and one whose future prospects look good. This was a successful sale, and those who carp about not gaining the maximum possible price simply do not understand what privatization is all about. It isn't about selling off stuff for the top price; it's about building up companies that can thrive by providing goods and services in a dynamic competitive market.
Regulatory clampdown on regulators
New research today (1 April) reveals that errors made by regulators are persistent and predictable. Regulators misjudge key facts and are inconsistent, say behavioural economists, so greater supervision of regulators is needed. Fortunately the Regulatory Conduct Authority (RCA) is there to improve things.
Examples of regulators' mistakes includes over-simplifying the complex world of retail products, focusing only on prices and neglecting product innovation. They also over-discount the future, introducing regulations for immediate gratification. And they are overconfident in their ability to identify what customers actually want.
The RCA plans to identify and prioritise the problems caused by regulators and to 'name and shame' the least competent. It is also attempting to discover whether it is just some, or all, regulators who mess things up. The RCA will then 'nudge' regulators into upping their game. Former water regulator Sir Ian Byatt and former gas regulator Claire Spottiswoode have both supported the RCA initiative.
Markets are the way to beat climate change
So we've been treated to the latest installment of climate science from the IPCC. And as they say, it's vitally important that we have well functioning markets to deal with this. Of course, we need well functioning markets to deal with anything but here, right from the horses mouth (in Chapter 10, here) is what they say about markets:
Well-functioning markets provide an additional mechanism for adaptation and thus tend to reduce negative impacts and increase positive ones for any specific sector or country (high agreement, medium evidence). The impacts of climate on one sector of the economy of one country in turn affect other sectors and other countries though product and input markets. Markets increase overall welfare, but not necessarily welfare in every sector and country.
And as they say in more detail in 10.9:
Computable general equilibrium models have long been used to study the wider economic implications of changes in crop yields (Kane et al., 1992). (Yates and Strzepek, 1998) show for instance that the impact of a reduced flow of the Nile on the economy of Egypt is much more severe without international trade than with, because trade would allow Egypt to focus on water-extensive production for export and import its food.
Yes, they say that international trade, even or especially in food, is one of the vital ways in which we can deal with this problem.
That is, that part of the solution to climate change is international trade and markets: you know, basically the neoliberal world order.
Yes, OK, believe the science or not about the effect of emissions as you will. But don't let go of this point that I've highlighted above. Even if all of what the scientists tell us about the effect of emissions on anything at all is correct this still means that the people who tell us we must have local food security, that we must become more self-reliant, those who tell us we must abandon the market and plan matters, they are still wrong!
As I once wrote a whole book about the solution to climate change is neoliberal globalisation plus a carbon tax. This latest report from the IPCC is saying exactly the same thing. No, not prescient of me, I just read the previous reports where they've been saying exactly the same thing all along. And don't let anyone tell you different.
(Yes, I know the date of publication of this piece. No, it ain't)
Apparently HFT is going to bring on the next crash or something
I confess, I do find myself a little puzzled by the coverage of finance and banking over at The Guardian at times. Are their writers actually inhabiting this same universe that we are or are they phoning it in from some parallel one? Tke this example, worrying about the perils of high frequency trading (HFT):
Cynics may conclude that Goldman's damascene conversion is a PR exercise designed to counter some of the more incendiary material that Lewis is expected to disclose. But they would be wrong. After playing a heroic role in the sub-prime mortgage scandal and Greece's economic ruin, Goldman, like all the big banks, is surely now turning over a new leaf. This is just as well. The consequences of a repeat of the 2008 financial crash, conducted at warp speed, are too terrifying for us mortals to get our heads around. History repeats itself first as tragedy, second as farce, Marx observed. But then he didn't have fibreoptic broadband.
My first confusion is that of course it wasn't trading, at high frequencies or not, that actually caused the crash. The markets that do have high turnovers, at high speed, are things like foreign currency, options, derivatives, and now moving into equities. None of these causwed the slightest problem during the crash. That was all about housing finance, the securitisation of mortgages into bonds that were then sliced and diced. Abnd, notably, very rarely traded after they have been placed with investors.Almost all of these bonds were nearly entirely illiquid, no one trading in them at all a month after issuance. And that's what caused the problems given that some banks had held onto healthy slices of these issues. How we can comare the perils of HFT with something that was hardly traded at all I'm really not sure.
As to why Goldman Sachs might not like HFT, can we at least start with the idea that GS is a greedy, profits hungry, capitalistic firm? Good, thought we could get agreement there. So, what's the effect of HFT? It reduces trading margins: reduces the difference between the buy and sell price of any particular security. Who would be unhappy if this happened? The people who make markets, the people making those buy and sell prices of course. A large part of GS's business is in making markets in things. And if margins collapse as a result of more trading and greater liquidity then GS isn't going to be happy, is it?
But over in Guardian world things seem to be different....
Higher food prices reduce poverty
It's a general assumption that higher food prices are bad for the poor. Clearly, it must be: the poor, the truly poor that is, spend some 80% of their incomes on food, if the price rises then obviously they must be getting poorer. Thus all that nonsense from the World Development Movement, Oxfam et al, about how food speculation in 2008 drove up food prices, impoverished more and thus we must ban capitalism etc.
Except that's not actually true. Poverty declined in the wake of that 2008 rise in food prices. Which leads us to, via Dani Rodrik, this paper:
Standard microeconomic methods consistently suggest that, in the short run, higher food prices increase poverty in developing countries. In contrast, macroeconomic models that allow for an agricultural supply response and consequent wage adjustments suggest that the poor ultimately benefit from higher food prices. In this paper we use international data to systematically test the relationship between changes in domestic food prices and changes in poverty. We find robust evidence that in the long run (one to five years) higher food prices reduce poverty and inequality. The magnitudes of these effects vary across specifications and are not precisely estimated, but they are large enough to suggest that the recent increase in global food prices has significantly accelerated the rate of global poverty reduction. The policy implications of these findings are therefore nuanced: short-run social protection is justified in the face of high food price volatility, but passing on higher prices to producers in the long run is an important means of reducing poverty in the poorest countries.
The most important word there is that "producers" in that last sentence. The poor in developing countries are the peasant farmers. They're also food producers: thus a rise in food prices benefits them. The mistake being made by those who insist that higher food prices impoverishes further the very poor is to assume that they are net food consumers. But, being peasant farmers, they're not: a peasant household is a net food producer. So of course higher prices will benefit them.
The situation is quiite different for the urban poor, of course, for they are net consumers. But given that the urban poor are richer than those stuck in the idiocy or rural life higher food prices are still poverty and inequality reducing.
All of which leads to an interesting conclusion. Assume that WDM and Oxfam are correct about the effects of food speculation (they're not), also that they both truly desire to reduce poverty and inequality (your options on that are open) then both organisations should be campaigning for there to be more speculation in food commodity markets.
I look forward to the new campaigns.
A very important point about climate change
As you all know I'm boringly mainstream in my views over climate change. The scientists tell us that we've got to do something, the economists that that something is a carbon tax so I say, great, let's have a carbon tax. And then we get information that rather changes this so far sterile debate:
It puts the overall cost at less than 2% of GDP for a 2.5 degrees Centigrade (or 4.5 degrees Fahrenheit) temperature increase during this century. This is vastly less than the much heralded prediction of Lord Stern, who said climate change would cost 5%-20% of world GDP in his influential 2006 report for the British government.
Here's what Stern did to reach his figure, the one that leads to that $80 a tonne carbon tax. He took the worst possible economic forecast of the next century, the one leading to the highest emissions path. Then he made that worse with a couple of other assumptions. Then he invented (on this, possibly rightly) a new method of calculating net present values. And he assumed thatt here was high sensitivity of temperature to emissions.
However, the essential heart of his argument was correct. We don't want to undertake actions that are more costly now that the damage they save in the future. The limit to our attempts to prevent climate change, and yes he does lay this out, must be the scale of that future damage. To spend more now than that damage then would be nonsensical.
Which is where the new numbers coming from the IPCC come in. We now think that climate senstivity is lower than Stern assumed. Thus the actions that we should take to deter future costs must cost less now. That is, we should rationally be doing less now than we were before.
And the thing about this finding is that it is the boringly mainstream finding too. Which is interesting really, because there seem to be only a handful of people (Matt Ridley and myself being among them, he shouting it from a much taller soapbox of ourse) who even grasp this point, let alone actively promote it.