News, Announcements & Opinion Essays
|| Social Capital and Wall Street
||Stephen B. Young, Caux Round Table Global Executive Director
||If we want to restore robust creation of real wealth which can be enjoyed for many years and which can lead to creation of further wealth on the part of others – workers and investors alike, then we must - as the first item of such business - look to the values embodied in our financial firms.
A very important thesis about how to create the wealth of nations holds that certain cultural preconditions shape the scope and intensity of capitalist success. When these preconditions are in effect, wealth is created; when they are missing, wealth is, relatively speaking, scarce and hard to create.
Stephen B. Young
The social nature of capitalism as a system demands an appropriate cultural context. Some values as carried into market and investment behaviors promote robust capitalism; other values don’t.
The key point seems to be that individuals on their own can’t create much wealth. Sellers need buyers and buyers need sellers, for example. A business without customers is a failure.
If we extend that insight to the full range of capitalist endeavors, we arrive at conditions of social complexity and multiple inter-dependencies among investors, employees at senior, middle and lower levels of command and control, regulators, suppliers, researchers, customers at the high end and customers looking for bargains, and so on.
This observation honors the seminal insights of Max Weber, who a century ago, identified the rise of capitalism as an economic system new and unique in human history, with the social arrangements legitimated and encouraged by Calvinist religious beliefs. Weber argued that a peculiar set of values flowing from Calvinist convictions that individual salvation depended upon one’s diligent and faithful application of one’s talents to the calling that God had provided here on earth. Calvinist values and practices such as frugality, discipline, confidence in the future, trust in others of the same faith, stepping up to personal responsibility in one’s relationship with God, feeling certain of one’s salvation as a good and reliable person, thought Weber, all contributed to opportunities for investment in enterprise, reliable contracts, and high savings. This Puritan “work ethic”, on the one hand, increased the financial capital available for investment in enterprise and, on the other, enhanced confidence that such investment would not be abused or wasted by its recipients.
Calvinism created a synergy and mutual satisfaction between entrepreneurs and investors to kick-start modern industrialization in the late 16th, 17th, 18th centuries in Holland, England, Scotland and the British colonies in North America such as Boston, New York and Philadelphia.
While many have questioned Weber’s attempt to link particular aspects of Calvinist beliefs and practices to nascent capitalism, few can deny the coincidence of capitalism’s first emergence only in Calvinist societies. What Calvinism gave to the world was a special kind of social capital that made possible new economic undertakings and investment relationships.
Now, if recent practices on Wall Street associated with sub-prime mortgages, mortgage backed securities, CDOs, and CDSs produced a loss in 2008 of some US$50 trillion in asset values, one would have to question how successful such Wall Street capitalism was in creating new wealth. Did it have the values and practices that Max Weber found necessary for sustained, successful wealth creation?
More than triggering such losses, some of which will be restored as markets recover from the collapse, Wall Street’s meltdown last year also caused the collapse of Bear Stearns and Lehman Brothers, along with the conversion of New York’s remaining investment banks into more traditional depository institutions. The American government, through its Treasury and Federal Reserve System, assumed many trillions of dollars of financial obligations to keep banking and financial intermediation markets open and operating. At one point, the Federal Reserve was purchasing the commercial paper of American companies due to failure of the private market for such debt. This was an unprecedented failure of private sector decision making. Something had gone very wrong with free market financial capitalism.
Wall Street’s marketing of the financial instruments causing the asset bubble and resulting collapse was not beneficial for anyone in the long run and so such marketing could not be sustained. This episode of financial intermediation was a failure from every point of view once “irrational exuberance” took over those markets. What happened during the bubble and its collapse should not be considered genuine capitalism but only speculation over the conversion value of present contract rights into future income or capital gains.
If the connection between habits of mind and corresponding actions and successful capitalism is to hold true, it must be that Wall Street lost some of its social capital as a prelude to this most recent round of irrational asset valuations.
The corollary argument to Weber’s thesis on a smaller scale appropriate to these financial market transactions would be that the kind of social capital needed for capitalist achievement was missing from Wall Street in recent years. And, moreover, that loss of social capital caused, or at least contributed to, the collapse of asset values in the crash of 2008.
Where was the erosion of social capital on Wall Street prior to the financial crisis of 2008?
Let us consider first a generic model of the social capital relevant to capitalist wealth creation.
There are of course innumerable varieties of social capital, each with different modalities of values and behaviors and each promoting different outcomes. The social capital that supported Egyptian Pharaohs and supported their construction of pyramids and temples was most likely different from the social capital that sustained Native American tribes in their pueblos, teepees and long houses.
The virtuous behaviors that Weber marked as sponsoring capitalist endeavors flowed from a social capital value set that had certain special characteristics.
First, this Calvinist social capital supported longer time horizons for financial investment in others. Investment in more than trading on a village market day was brought to the fore of business thinking. One could partner in the productive capacity of others and so earn a return. Expectations of rewards were stable and realistic. Such people worked at their trades in a reliable fashion so that they became good credit risks and trustworthy stewards of moneys invested in their undertakings. Their word was their bond. There were clear laws and just enforcement so that promises and contracts became accurate predictions of future events. Having a reliance interest in the success of others was justified. People were patient and delayed gratification in order to invest today for a return tomorrow. Financial intermediation was enhanced; money capital could be accumulated for use in joint enterprises.
All these reliable behaviors lowered risks and so interest rates. Stable and lower interest rates promoted the use of long-term credit and equity investments. Borrowers were more willing to take on the risks of repayment and owners saw advantage in accepting equity investments and later sharing of their profits. Investment of time and money in production and delivery of goods and service, with the power through finance to leverage greater production of more and better goods and services in order to meet new needs, made good sense. The future would be better and capitalist business began to contribute to progress and modernity.
Second, the social capital of frugality, hard work for its own sake, and delayed gratification caused savings to grow. Money was accumulated to invest in the new, trustworthy opportunities.
Third, this Calvinist social capital placed a priority on learning, education and the introduction of new mechanics and technologies. It was comfortable with secular approaches and did not disdain the material world of chemistry, physics and biology.
Fourth, people acculturated to such conditions are more thoughtful about the consequences of their actions on others. Externalities are brought home to the actor through an ethic of pride in one’s work and over one’s contribution to community as a honorable citizen in good standing. The social construct under Calvinism is one of reciprocal mutuality in doing one’s best; it is not a Hobbesian, dog-eat-dog, world of rabid selfishness, mistrust, and rip-offs.
Now, the opposite of these behaviors and commitments, we can infer, would most likely not lead to wealth creation.
Social patterns where people focus on the immediate and will not commit now to benefits to be received much later and where they have no patience and do not trust the word and reliability of others, will promote higher levels of risk. Where risk is higher, the rates charged for interest and the minimum returns expected on equity funds invested will also be correspondingly higher. The cost of doing business will be much higher. There will be fewer transactions as a rule. Savings will be rejected in favor of current consumption. People will seek cash money to use its power over those who are perceived to be and, in fact, are not trustworthy or reliable. Stewardship responsibilities will go begging for lack of honest fiduciaries to accept them.
Where lower standards of responsibility are accepted, there will be lower standards of care in general. Risks will be pushed off on others as much as possible. It will take more courage to enter into contractual transactions with third parties. New participants will hesitate to join in market activity. Where they do enter into transactions, taking short-term advantage will be very much on their minds. Economic growth will stagnate.
Starting in 1980, Americans in general moved from a high savings culture to a high debt culture as the Baby Boomers came into full maturity and provided dominant cultural leadership for the nation. New norms and behaviors came to the fore in many parts of American society. Assuming responsibility in civil society organizations, in politics, in anything outside one’s family, circle of friends, or professional tasks linked to immediate personal remuneration occurred less and less. Robert Putnam noted this trend in his seminal book Bowling Alone. Even in family life, parental responsibilities were sloughed off to the other spouse, to day care providers or to schools. Divorce became very common. Schools and television were looked upon as the primary means of socializing children. Seniors were encouraged to live out their last years on their own in retirement homes and facilities.
Wall Street and its practices were not immune from this cultural evolution.
As a result, the social capital embraced and accumulated by Wall Street shifted in its nature and its proclivities. Calvinism lost and Boomerism won. For example, time horizons became shorter. Short term thinking became the norm. People lost loyalty to employers as they kept on constant lookout for new jobs with higher pay. Legal formalities replaced a personal standard of care for the well-being of clients and customers. Using more and more debt to fund consumption and more pleasurable life styles demonstrated the power of short-termism among Americans. Delayed gratification was disparaged by Baby Boomers.
People looked more and more for higher short term returns. Few invested equity in companies for the long haul. Investment preferences changed to “renting stocks” to profit from market speculation rather than owning them in order to realize long-term capital appreciation from the company’s profits and retained earnings. Leverage to permit more and more “renting” of stocks and other investment vehicles became king. This way higher returns could be enjoyed through the short-term use of other people’s money. The banking system converted from well-capitalized institutions that held risk to maturity to ones that merely traded risks back and forth for fees and spreads.
Investment banks went public and so lost the long-term perspective and caution that goes with partnership structures where the personal assets of the owners were always at stake in the risk level associated with firm activity. Professional mangers took over from owners as the drivers of firm strategies. Trading desks grew more powerful within the investment banks as their trading profits came to dominate firm income and the culture of traders took over from the older, more white-shoe culture of cultivating long term client loyalties and connections.
Short-term rewards encouraged engagement with the speculative side of financial markets. In every market, speculation is at work. Some traders look only to the desires and understandings of others as the key to pricing; long term fundamentals are of little concern to these market makers. Calvinist preferences for real investment where bit by bit eaten away by the cancer of immediate speculative indulgence.
Personal responsibility for investment decisions was replaced with reliance on portfolio theory and mathematical algorithms. The Black-Scholes formula for calculating value when no market for a contract claim existed and the “chasing” of Alpha returns by institutional money managers were the most famous examples of this new intellectual environment on Wall Street. Companies were judged for better or worse on whether they “made the numbers” predicted by professional estimators. Trust in a company’s leadership was replaced with a more mechanical formulation of what constituted success.
This reliance on analysis provided a boost to hubris which was the doorway into “irrational exuberance”; the hubris was that intellectual ingenuity knew no faults and needed no bounds. Calvinism had been much more skeptical of human rationality and had kept its followers much more grounded in God’s real order of creation.
The chase for higher returns – more fees and commissions – correlated with a decline in general levels of trust and commitment. Fund managers knew that to take risks and not earn returns within a peer group average would lead to the loss of money under their management. Herd thinking about where to invest became acceptable as it was “normative” within peer groups and necessary to chase speculative purchases and sales in the immediate time horizon.
Executive compensation was more and more linked to short term results, especially at senior levels where strategic commitments were made and cultural norms were adopted within firms for replication at lower levels of corporate hierarchies. Money results, not fiduciary quality, drove the decisions of many CEOs in all industries, not just Jack Welsh at General Electric.
Wall Street became captive to playing with other people’s money on a gigantic scale. Savings and reserves in exporting countries like China and the funds accumulating in pension funds, sovereign wealth funds, and hedge funds was there for the taking, or rather, the borrowing. Access to funds came through the sale of instruments that promised high returns.
Debt and short-term investing – largely tradable instruments to boot - took over from traditional equity as the criterion for financing capitalism; leverage ratios of banks and investment banks went to historic highs; structured financial instruments – mortgage backed securities and CDOs – were produced to fit new market demands for using short term leverage and trading in contract rights. Pricing of these rights according to mathematics further removed markets from underlying realities. CDSs were invented to provide risk reduction in lieu of tradition equity and capital reserves. Sadly, since many CDSs were only backed by legal documentation and not real money, the risk reduction they provided was illusory. Most CDSs used pledges that had no reliable commitment behind them to give them any genuine “credit”. Counterparty risk eventually caused the credit system to freeze in the fall of 2008 and so become useless.
An asset bubble in financial instruments was thus easily assembled by Wall Street firms and experts. And they took their inventions to global markets.
Every asset bubble is destined for collapse. Then, when panic sets in, the real bottom line emerges as financial wealth is destroyed and real economic activity contracts. People lose jobs.
The factors that grow asset bubbles are inimical to genuine capitalism that produces the “wealth of nations”. When Wall Street produces such financial houses of cards, its capitalist social capital is thin at best.
To improve the outcomes of financial intermediation, then, the social capital accumulation of financial centers like Wall Street needs scrutiny and attention.
If we want to restore robust creation of real wealth which can be enjoyed for many years and which can lead to creation of further wealth on the part of others – workers and investors alike, then we must - as the first item of such business - look to the values embodied in our financial firms.
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