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.
How is the sorry state of corporate governance a result of government? It seems to me it stems mostly from corporate by-laws that are one-offs for each company, and usually crafted by lawyers who know which side their toast is buttered on, by self-dealing executives and board members. To a large extent, that is because the concentrated interests of kleptocratic CEOs and their board cronies will always prevail over the diffuse interests of apathetic shareholders.
Government’s responsibility lies in omission, not commission here, e.g. by failing to impose statutory by-laws on public corporations to enforce shareholder rights.
It seems to be widely believed that the free-market is a natural economic state – I think this is wrong: Monopolies or cartels are now the natural economic state. In the past inefficiencies set in once companies reached a certain size, balancing the economies of scale. Use of computers have much reduced these inefficiencies in well-run corporations, changing the balance irrevocably.
It seems to me that markets are like gardens – they only remain diverse and interesting when they are well tended. If they are left to themselves a few varieties (the crushingly efficient ones) will dominate to an overwhelming degree.
Is that what we have in the financial markets now – a garden of weeds?
Fazal: The fact that shareholders cannot nominate directors is not a matter of corporate by-laws and it does not vary from one company to another. The SEC regulates the governance of public companies. The SEC regulates the extent to which a company’s entrenched management can control the shareholder list (typically there is no way for a shareholder wishing to start an expensive proxy battle even to locate other shareholders). A private corporation can tweak its by-laws as its shareholders see fit, but not a public company.
I have a simple solution that I think would work: impose a maximum wage ratio, and make it a moral issue. For example, society agrees that it’s wrong to force someone into labor (slavery). Moreover, society agrees that it’s wrong to pay someone less than a living wage (minimum wage laws). But why has society not deemed that no human being, no matter how smart or connected he may be, cannot be more than X times better than even the laziest and dullest human?
My proposal is that the ratio between the highest paid person in a company and the lowest paid person cannot be larger than, say, 100x. If the lowest paid person at MegaCorp makes $30,000 / year, then the CEO cannot make more than 3 million. If the CEO wants to make 5 million in a year, then he’ll have to ensure that the lowest paid employee makes $50,000 at his company.
Now, executives will try to find backdoor ways to increase their compensation. But that’s why we make it a moral issue and not a regulatory one. If an executive is caught trying to game the system, it’s a criminal offense, and off to jail he goes. That should be a significant enough deterrent. (Although, sadly, we don’t jail CEOs who use child labor in 3rd world countries, or who get caught hiring illegal aliens and paying them less than minimum wage.)
Investors have no power because – in bulk – they do not care. Surely investors are not forced to invest in badly managed companies. Yet such companies seldom have trouble attracting sufficient capital. Management has learned that capital is easy to come by, and does not need to be treated with respect.
As David points out, our usual notion of “free markets” are in fact well-regulated gardens, not some naturally occurring economic state. When a garden goes bad, it is easy to blame the gardener (and partly justified). But sometimes the cause is external.
I think what we have is a single overwhelming external cause that is throwing everything – all our old mostly-working regulation – out of whack. The single cause is a rapidly growing global pool of capital. The surplus comes of a century of compounded productivity improvements in the “developed” countries, in turn compounded by the rapid rise of new countries to “developed” status – who in turn start generating their own surpluses.
What happens to our prior working theories of economic organization when “capital” becomes huge, and grows at a compounding rate? Do we – really – have any notion how that can work?
Fazal,
Most controlling law is unfortunately not written by elder statesman and law givers who wish to create a fair and equitable market place free from fraud and abuse. Rather it is primarily themed and written by lobbyists who insert favorable clauses that are used to game the system.
Which is more like the economy: an English Garden or a jungle?
I submit the economy is more like a jungle. A jungle filled with Giant Parasitic Crabcrass, 6 ft tall with an IQ of 142. Trying to regulate the jungle is like sending a regiment of doughy Englishmen, armed with pith helmets and chainsaws, to kill the crabgrass. They might kill a few crabcrass, but eventually the crabcrass parasitize their brains, seize the chainsaws, and send them back to England to lobby for crabgrass Miracle-Gro subsidies. So you end up with a jungle filled with chainsaw wielding crabgrass hopped up on Miracle-Gro.
Is it a failure of capitalism or a weakened morality (breach of the “social contract’)?
My very astute social-worker daughter has pointed out to me that socialism is less of a dirty word in small, more homogeneous countries where folks tend to care more about fellow citizens – who are much like them. It’s harder for us to care about folks money or other folks who are ethnically different, especially since fire and brimstone judgment is passe.
Hi Phil,
philg wrote:
“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….shareholders have no voice in how a public company is run.”
Reading that, I couldn’t help but think of Teldar Paper:
“Now, in the days of the free market, when our country was a top industrial power, there was accountability to the stockholder. The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake. Today, management has no stake in the company!”
http://www.americanrhetoric.com/MovieSpeeches/moviespeechwallstreet.html
It seems that Gordon Gekko was prescient, and not in the way that most commentators would have people believe.
It’s also worth pointing out that not only is the lack of shareholder control government imposed, but so is the lack of shareholder liability. If shareholders could be held responsible for company debts and obligations, the shareholders might demand more control and more responsible management.
Travis: Removing the limited liability feature of corporations would be cruel and unusual punishment for investors. Shareholders can “demand more control” as you suggest, but under current U.S. law they don’t have any. Right now the management can steal 100 percent of a company’s value and leave the shell burdened with another 150 percent in debt, but the result for investors is that they lose, at most, what they put into the company (plus the opportunity cost on that capital for the length of time they hold the stock).
philg: I don’t really disagree with any of that, and I concur that removing limited liability would change the nature of equities substantially. Certainly government provision of limited liability provides a subsidy that inflates equity prices. Without limited liability, I would certainly be much more cautious about the stocks in which I would invest. Companies might have to take out insurance to protect their investors in the same way they take out insurance to protect their boards from the shareholders today. The insurance provider would have a keen interest in monitoring and ‘regulating’ the company to keep its own risk in check.
Limited liability creates misincentives for shareholders in the same way that malfunctioning compensation agreements create the wrong incentives for management. As an investor, I may _want_ to invest in a company that is going to over-leverage itself as far as possible, let’s say 10x. If the company’s bets go the right way, my return is enhanced 10x. If the company bets wrong, my loss is backstopped by limited liability. Heads I win, tails the creditors lose.
It’s worth considering that a system without limited liability may be more more just and moral. Today when a company over-leverages itself in search of higher returns, the losses are borne primarily by lenders and trade creditors, who had little to gain from the company’s leverage. Without limited liability, the losses from bad bets would be borne by the shareholders who would have seen huge gains if the bets had gone the other way.
Such a system would be more just and economical in another way as well. Today, lenders and trade creditors have to factor into their rates and prices the risk of a default in which they’ll pretty much be left with zero. In this way, responsible companies that don’t default end up subsidizing the companies that do. In a system without limited liability, the rate of default would presumably be lower, and the expected amount that creditors could recoup in a bankruptcy would be higher, leading to lower risk premiums.
@7 Christopher Rasch – great analogy, totally makes me laugh! Yes, we do have a garden of massive Giant Parasitic weeds hopped up on Miracle Gro — ironically, double-strengh Miracle Gro via the government bailouts/stimulus/etc.
Right on cue, Carl Icahn publishes an opinion piece in the NYT echoing many of your points, PhilG:
http://www.nytimes.com/2009/03/29/opinion/29Icahn.html
@8 Bob – I agree, many of these issues are a result of the weakened morality and it’s Social Contract. Moral values fill in the gaps in law – allowing a society to function without extreme regulation. As society becomes increasingly secular, the only way that we know something is ‘wrong’ is because it is ‘illegal’ so explicit laws and regulations must be enacted to control every event.
The Giant Parasitic Weeds with their massive IQs are well honed to exploit the gaps in the -law- in ways that would never have been done before as they certainly are immoral. Similarly, since we can no longer make value judgments, we no longer can use other social controls such as shame or shunning.
The old saying: Capitalism without Bankruptcy is like Religion without Hell. Well, we’ve done away with Religion and Hell – and seem to be well on the way to ending Bankruptcy…