Thursday, September 17, 2009

Have The American People Forsaken Capitalism?

It is with some bemusement that I watch the various factions in Washington, Wall Street and, of course, the media expound on the issue of ‘the socialization’ of America. Radical pundits on the right warn of the dire consequences of President Obama’s ‘apocalyptic’ move toward the political equivalence of Hitler’s Third Reich or Stalin’s despotic communist regime. Rush Limbaugh in his infinite wisdom stated: "This is a full-fledged attack on capitalism, and the leftist Democrats have been seeking this for the longest time…"

On the other side of the debate, politically engaged documentary maker Michael Moore warns of the evils of capitalism while contradictorily lamenting over the free enterprise economy of the 1950s—contrasting it to the recent debacle instigated by the financial alchemists of Wall Street. Although Limbaugh and Moore (feels weird to type those names so close together) represent the fringe of the debate, the more moderate voices have made compelling arguments in defense of their respective positions with regard to the state of political economy in America. But perhaps both factions are mistaken: The warning of impending socialism at the hands of the Obama Administration or the call for socialism to save us all from the evils of capitalism is missing the point. Could it be, as many headlines suggest, that the America people are abandoning capitalism?—or—is capitalism abandoning ‘The People”?

% of Stock Market held by Institutional Investors


Direct Ownership of Stock held by American Households
Since the 1950s individual ownership of equity in American corporations has declined precipitously and has been replaced by institutional ownership—mostly comprised of pension funds and money management firms, including mutual funds. As a result of the institutionalization of participation in the free market economy individuals have forfeited their right to participate directly in the process of corporate governance. The result of this change in participation has placed the onus of accountability and responsibility on the fiduciaries that are entrusted to manage individuals’ savings. As has been referred to in the previous blogs, Adam Smith opined that “being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.” Circumstances on Wall Street attest to the validity of Smith’s insightful observation and have highlighted the conflicts of interest inherent in managed financial services. For instance, fees associated with managing money have been shown to have a significant detrimental effect on returns over both the short term and long term horizons, while being a tempting reward for accumulating vast amounts of money under administration. For example, $10000 earning a compounded rate of 8% for 25 years will become $68500, whereas, if you deduct a 1.5% annual management fee the result is $48300. Conflict of interest, which can lead to a violation of the expected level of loyalty in a fiduciary relationship, is difficult to avoid in the securities industry since conflict plays an integral role in the economic nature of the business. John Boatright in his recent book Ethics in Finance summarizes the ubiquitous conflict of interest dilemma:
“The inhabitants of Wall Street are motivated primarily by self-interest and can be induced to serve any master only within limits. The challenge, therefore, is not to prevent conflicts of interest in financial services but to manage them in a workable financial system” (Boatright 2008: 51).

Another problem of entrusting ones savings to a management firm stems from the fact that there has been increasing pressure on money managers to focus on investment strategies that concentrate short-term returns in equity markets, rather than traditional long-term investing based on durable intrinsic corporate value. In a 2005 WSJ article John C. Bogle points out that from 1950 to 1965, equity mutual funds turned over their portfolios at an average rate of 17% per year; in 1990-2005, the turnover rate averaged 91% per year. In earlier decades ‘Joe Public’ would take pride in having his shares of GM, IBM, General Electric etc. in a safety deposit box at his local bank or in safekeeping at the regional brokerage house. Today, Joe Public’s savings are abstract holdings being managed by ‘experts’ in a distant locale. The individual’s intimate connection with American free enterprise has vanished into the annals of investment history. It seems that Wall Street has replaced investing in America's future with speculating on America's credit.

A relatively recent development threatening the conventional concept of capitalism is the advent of Sovereign Wealth Funds. (SWF) SWFs are becoming a major force in international capital markets and will become increasingly important as globalization becomes an entrenched reality affecting both the culture and economy of many nations. Tremendous international wealth transfers, as exhibited by the recent global econometrics, portend further pressures being placed upon the structure of corporate ownership. This in combination with the foreign exchange reserves being held by countries such as China ($2132 billion) will continue to diminish the levels of direct domestic participation of the individual in the free market system

The cover story of Business Week in September 2000, during the boom times before the bust, indicated that Americans think business has gained too much power over too many aspects of their lives. Deregulation, globalization and corporate consolidation have contributed to the concerns expressed by individuals. It can be safely assumed that in light of the 2008 financial meltdown, individuals’ trepidation toward corporate control of their lives has only increased. Further aggravating the diminution of individual participation in the economy is the increased predominance of corporate lobbyists who have influenced politicians to the extent that government legislation often equates to de facto corporate policy, superseding policies directed towards the enhanced well-being of the individual.

The concept of free market capitalism envisioned by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations was intended to enhance the lives of individuals by facilitating the pursuit of ones own self interest, encouraging innovation through the division of labour and distributing wealth through freedom of trade. Smith did not intend that globalized corporate conglomerates were the ‘shopkeepers’ when he stated that: "To found a great empire for the sole purpose of raising up a people of customers, may at first sight, appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers, but extremely fit for a nation whose government is influenced by shopkeepers." Smith would have contested the contemporary capitalist paradigm due to the concentration of economic power and the diminished role of the individual in the distribution of the wealth gernerated by free markets. He certainly would not have considered a corporate plutocracy as being the equivalent of a shopkeeper. Smith would likely concur with Noam Chomsky's view on who are the antagonists of individual liberty:
"An array of mega-corporations, often linked to one another by strategic alliances, administering a global economy which is in fact a kind of a corporate mercantilism tending toward oligopoly in most sectors, heavily reliant on state power to socialize risk and cost and to subdue recalcitrant elements."

Libertarians are ideologically committed to the belief that individual liberty is both the intrinsic and normative primary concern of a free society. It is bewildering to see the right wing of the American political spectrum, who claim to embrace the principles of liberal individualism, condone the Darwinian transformation of a system of free market capitalism—intended by Adam Smith to distribute wealth amongst hard working innovative individuals—into an economic system that marginalizes and alienates the individual from the economic process.. The American people have not abandoned capitalism: Capitalism has abandoned the American people—abetted by the politicians they elected to represent their collective and individual interests.

Tuesday, September 8, 2009

Credit Rating Agencies and the Abandonment of Excellence

As the ramifications of the 2008 financial panic continue to illustrate the extent of the damage inflicted upon the global economy, it is indeed reassuring to see that Wall Street has not lost its sense of humour. The hilarity stems from the fact that desperate, yet imaginative, lawyers on behalf of the major credit rating agencies (CRA) presented arguments that investors can’t sue the firms over deceptive ratings of private-placement notes because those opinions are protected by free-speech rights. A U.S. District Judge in New York rejected the arguments, forcing them and Morgan Stanley, which was also sued, to respond to fraud charges in a class-action by investors claiming the raters hid the risks of securities linked to subprime mortgages. Anyone familiar with the workings of Wall Street knows that—like lunches—nothing is ‘free’. If the judge had accepted the defense argument, an entirely knew cottage industry could have sprung to life—perhaps it would be coined as “Slippery Slope Defense Attorneys.” Financial Advisors that enticed clients to invest in ‘unsuitable investments’—the catch all phrase for contraventions of fiduciary duties—could claim that the opinion was just the FA exercising his right to free speech. The CPA firm, after signing off on the financial statements of a bogus company, could clamber into court with their attorney claiming that rendering their opinion was simply a matter of applying their first amendment rights. Perhaps the once venerable Arthur Andersen would still exist if this bizarre legal strategy had been accepted by the courts.

Blaming the credit rating agencies for the demise of the commercial mortgage-backed securities (CMBS) market and the ensuing destruction that occurred in global financial markets is pointless since there is ample culpability to be apportioned throughout the social order. However, the individuals who contributed to the alleged transgressions of the CRAs exemplify the individual’s role in creating the moral morass that has permeated Western culture.

Many of the executives of the CRAs have the designation CFA after their name. Attaining the esteemed designation of Chartered Financial Analyst is acknowledgment that an individual has the utmost level of knowledge in the securities industry. To become a CFA, an individual must not only demonstrate superior knowledge of advanced investment strategies and financial acumen, but he must also exhibit acute awareness of the ethical dimensions affecting the investment industry. An important goal of CFA Institute is to ensure that the organization and its members develop, promote, and follow the highest ethical standards in the investment industry. The CFA Institute Code of Ethics and Standards of Professional Conduct is a set of principles that define the professional conduct that the CFA Institute expects from its members. Rules and standards of practice are admirable initiatives and should be vigorously promoted, but perhaps Plato best expressed the reality of regulation in society: “Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws.”

To become a CFA one has to be adept in what Aristotle would call techne (technical knowledge or skill of a craft) and areté (virtue or excellence as defined as a mean between two extremes of excess and defect in regard to an action determined by rational principles.) It would appear that some executives of the CRAs did not only demonstrate a lack of techne—whether by intent or by ineptitude—but at the same time totally disregarded the concept of areté—whether induced by malicious intent or imposed necessity.

For the credit ratings agencies, techne or effectiveness, manifests itself as a drive towards maximized profitability accomplished via ruthless competitiveness. Wall Street, which has become exclusively directed by consequentialist principles, has found a substitute ethical base in the concept of effectiveness. In commerce today the ‘ethic of effectiveness’ concerns itself with ‘getting the job done’ and is often achieved in a Darwinian or Hobbesian manner. Profit maximization has become the exclusive factor in management decisions. The concept of ‘good’ has become solely based on effective achievement of a defined external goal without consideration being given to the virtue of excellence—areté.

From an Aristotelian perspective, individuals and corporations have a telos or end. For individuals this means achieving a good life partially through rewarding, fulfilling work and contribution to the polis.(community). The ‘good’ for a corporation consists in contributing to making the good life possible for the community’s members through the generation of wealth, creation of employment and provision of services. Our life narrative is what connects the individual to the community. How we conduct our lives, honing our intellectual virtues whilst habituating our moral virtues, will determine our life’s narrative. An individual’s narrative is a crucial factor in sustaining the traditions of the community since our individuality is both socially constituted and socially situated. We are all members of several communities, whether it is situated in an individual company, neighborhood or town, as part of a social institution or in society as a whole. Our self-interest is for the most part identical to the larger interests of the group and when an individual’s actions reflect an imbalance between effectiveness and excellence the community as a whole inevitably suffers. If the intellectual virtue of techne is not balanced with the moral virtue of areté, skill will become corrupted and the individual will ultimately succumb to the vices of excess and/or deficiency.

It is ironic that the CRAs were ostensibly promoting a service that was critical in providing information to allow the investment community to construct balanced portfolios of CMBS, while the individuals responsible in providing this information neglected to find a balance of intellectual and moral virtue in their professional lives. These imbalances—both in the resultant CMBS portfolios and in the character of CRA executives—were significantly instrumental in triggering the largest loss of wealth the global community has ever experienced—an event that will reoccur with increasing devastation until the concept of areté is habituated in the actions of individuals in financial community.

Thursday, September 3, 2009

Bank Executives & The Concept of Risk Reward

Imagine the following scenario: You are an avid supporter of your hometown professional hockey team and over the last several years the general manager initiated a policy of trading away his skilled defensive players in order to produce a team with highly innovative but undisciplined offensive players. Upon enacting this new initiative, the team not only fails to make the playoffs but finishes the season at the bottom of the league standings. As expected the team’s failure was due to a total lack of defense leaving the team vulnerable to any offensive attack from the opposing teams. Furthermore, suppose at the end of the season it became known that while the average player on the team was earning $1.9 million per season, the General Manager was earning a salary of $606 million. Furthermore, imagine if when the season finished the team announced that due to the team’s poor performance that there would be a surcharge on ticket prices that would effective triple the cost to attend a game for years to follow. Would you be outraged? Would you demand that the manager be fired, or at the very least, adjust his compensation to reflect his performance? In all likelihood there would be insurrection and a boycott of the team.

However, this is not how Wall Street works according to the 16th Annual Executive Compensation Survey published September 2nd 2008 by the Washington based Institute for Policy Studies (IPS). In 2008, the year taxpayers rescued the financial industry, chief executives at the top 20 financial recipients of bailout dollars earned 37 percent more than their CEO counterparts elsewhere in the U.S. economy. The pay gap between CEOs and rank-and-file employees has also continued to extend: in 2008, according to the study, top executives averaged 319 times more in pay than the average American worker, compared to 30 to 40 times in the 1980s. CEOs at the 20 top bailout banks earned 436 times more. Is there anything wrong with this picture?

CEO Compensation/Average worker wage.

Libertarians, such as Robert Nozick, appealing to his Wilt Chamberlain analogy, would claim that there is nothing wrong with bankers receiving this level of compensation since it is a rationally achieved outcome as a consequence of the free market mechanism. He would claim that “no end state principle or distributional patterned principle of justice can be continuously realized without continuous interference with people’s lives”—which would be antithetical to his concept of liberty. (Nozick 1974) The problem here is that, shareholders of the bank and ultimately the citizens who bailed them out did not participate in any explicitly rational process in allocating the funds to the executives. The concept of the pursuit of rational self-interst is different than the rationalization of self-love. Nozick's argument that the compensation packages are a result of the free market competitive process to retain skilled talent tends to become farcical when the consequences of their 'skills' are assessed. If these talented gentlemen did this to the global financial system, it boogles the mind to imagine what 'less skilled' talent would have done. It is disheartening to note that morality is not considered a 'skill set' on Wall Street.

Friedrich Hayek, the quintessential proponent of free markets and liberal principles, defends rising social inequality as the opportunity cost of maintaining an efficient market order. However in The Mirage of Social Justice (1982/93) he makes an interesting comment:
It has of course to be admitted that the manner in which the benefits and burdens are apportioned by the market mechanism would in many instances have to be regarded as very unjust if it were the result of a deliberate allocation to particular people. But this is not the case. Those shares are the outcome of a process the effect of which on particular people was neither intended nor foreseen by anyone.

Does the granting of stock options and 'generous' compensation packages qualify as 'deliberate allocations to particular people'? When individuals grant themselves options-- ironically, as an incentive to ensure the growth of the company-- on a stock that they are largely responsible for destroying, it is tantamount to the actions of some backwater stock promoter. Where has the concept of risk reward gone, or does that just apply to the general public. Is this concept not one of the prinicples of free markets? You lose you pay: You win you play...or does this basic tenet not apply to the individuals at the helm of the financial system? You cannot claim that these financial virtuosos dont have chutzpah!

Adam Smith did not have a great deal of respect for managers of joint stock companies, describing to a tee the recent actions of Wall Streets bankers.

The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.

As far as the wages of labour is concerned, Smith tied one’s wages to the amount of trust place in him by other citizens:

We trust our health to the physician: our fortune and sometimes our life and reputation to the lawyer and attorney. Such confidence could not safely be reposed in people of a very mean or low condition. Their reward must be such, therefore, as may give them that rank in the society which so important a trust requires. The long time and the great expense which must be laid out in their education, when combined with this circumstance, necessarily enhance still further the price of their labour.

What happens when that trust is tarnished? Does an individual or individuals who have squandered trillions of depositor’s money still command the trust of the investing public? —especially when they are picking up the bill in the form of a taxpayer bailout, which their great grandchildren could possibly still be paying off.

Clearly, self regulation has proven ineffective in scrutinizing the actions of many of Wall Street’s policies and business models, while at the same time, politicians have proven incompetent and/or reluctant at confronting the abuses of trust perpetrated by companies who have been bailed out by the taxpayer. It is time shareholders of these corporations assert their rights of ownership and demand that some semblance of responsibility and accountability be maintained if executives of failed banks are to continue to reap benefits from a system that they have virtually destroyed. Unfortunately the shareholders of many of the rescued financial institutions are now represented by politicians who are busy hastening the ideological polarization of American society in the venue of healthcare.