At a birthday dinner for an economist a couple of nights ago, some folks were joking about how the financial collapse of 2008 proved that free markets don’t work. It certainly sounds reasonable to say that we need more regulation. It is worth remembering, however, that most participants in the financial markets were public corporations, which are chartered and regulated by the government in such a way that the long-term interests of shareholders are almost certain to be ignored.
In the old days on Wall Street, market participants were either individuals or partnerships. The people making the decisions had their long-term wealth at risk. By 2008, however, the big firms had become public corporations. The decisions were made by managers who were, in theory, supposed to act in the best interest of the owners. As discussed in my economic recovery plan, however. shareholders have no voice in how a public company is run. The existing management and Board nominates any future Board members.
Managers of the Wall Street firms that melted down had voted themselves particularly generous compensation structures. If they placed big bets that resulted in huge profits, they would take home billions of dollars for themselves. One risk of any big bet, however, is that it will result in a huge loss. The Wall Street firms had no provision for a clawback. An employee such as Stan O’Neal made $50 million per year while loading up Merrill with mortgage-backed securities and then was able to retire to his mansions and jets after he’d basically bankrupted the firm.
The meltdown occurred roughly 10 years after the completed conversion of America’s big investment banks from partnerships to public corporations. The Federales are now rushing to craft new regulations. According to Geithner’s testimony before Congress,
“The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market.”
Eric Falkenstein asks “When was the last time government implemented regulations that met these criteria?” A money guy friend said that a better question was”When was the last time government implemented regulations that met any of these criteria?”
Given our country’s rules regarding public company governance and the fact that Wall Street is dominated by public companies, is there a realistic hope for stability? What would any of us do if we had the chance to make $100 million per year by taking a 10 percent risk that our employer and its shareholders would be wiped out?
A free market in which participants risked their own money might work quite well, but that’s not what we tried. We had a market in which participants risked other peoples’ money and pocketed much of the upside but suffered no downside risk, all made possible by the government’s regulating away public company shareholder power.