The future of capitalism has been brutally thrust onto centre stage in the aftermath of the global financial crisis. It’s not so much a question of whether capitalism will survive but a question of in what form.
Dr Noel Purcell
The one thing that became increasingly clear as the world was cast headlong into the global financial crisis was that capitalism’s so called immune system of laissez-faire market discipline simply didn’t work. The very processes needed to counter the excesses and destructive behaviours and to protect the financial system and the economy more broadly simply failed to kick in as the storm clouds gathered. And out the door went the ideology that unrestrained markets are self regulating.
The so called laissez-faire market discipline owes a good deal of its philosophical underpinnings to nineteenth century Social Darwinism - a philosophy whose essence was that human societies worked best when the principle of ‘survival of the fittest’ was allowed to operate with minimal constraint. But as have again seen with the global financial crisis, when Social Darwinism gets applied to the capitalist system, greed and narrow self-interest get elevated to the status of a core values.
As a result, rather than act as an immune system in protecting the health of the system, the unfettered free market system functioned more like autoimmune disease. It fed the greed, excesses and irresponsible behaviours and ultimately sparked the global recession and smashed public trust in the financial system. As the Australian Prime Minister, Kevin Rudd, said in the lead up to the April 2009 G20 Leaders Summit, “unfettered free markets became worshipped as a god and we know now that god was false”.1
With trust and confidence shattered, very painful economic and social consequences followed and they continue to flow. And as with any diseased organism, the recovery process is proving to be both slow and challenging.
Little surprise then that restoring confidence and rebuilding trust were at the top of the priorities coming out of the G-20 Summit in April 2009 as they struggled to deal with they saw as “the greatest challenge to the world economy in modern times”.
To date, however, political and regulatory action has focused by necessity on and ‘putting out the fires’. But dealing with just the symptoms can only take us so far. Fundamental reforms are urgently needed to repair capitalism’s immune system and get it back onto a sustainable basis.
We need to get the ‘free’ market working again in a way that fulfils the promise of Adam Smith, the father of capitalism, that individual gain can lead to collective gain. Smith in fact described a market immune system based on ‘enlightened self interest’ (the “invisible hand”) and he underpinned his system with the virtues of justice, fairness and honesty. Smith saw neither selfishness nor greed as virtues and regarded the spheres of human conduct - economic, social, moral, and political - as interwoven and mutually dependent.
In considering how to reshape capitalism and repair its immune system, it is helpful to reflect briefly on how the seeds of the global financial crisis, and the ultimate collapse in trust and confidence, were sown.
The experience of the “new economy” dot-com stock market boom and bust should have taught us all that ongoing double-digit returns are not sustainably possible. Certainly, the so called financial masters of the universe should have understood the illusion of risk-free speculative finance.
But instead, spurred on by obscenely large financial incentives, bankers and others enthusiastically developed and promoted innovative financial products and investments promising above normal returns at apparently low risks – many coming with the so called comfort of AAA ratings. In reality, the risks were anything but low.
As this irrational exuberance storm gathered, transparency and concern for the underlying risks quickly went out the door. Rational value and risk signals simply got ignored as the exuberant led the blind in a climate of greed and excess. And to make matters worse, the originators themselves, let alone the regulators and investors, often didn’t fully understand the risks sitting inside the complex and opaque structures.
As a result, the unsustainable promised high returns on capital proved to be just that – unsustainable. The risks ultimately mattered, and the prices of these so called high yield investments collapsed. And with it, trust and confidence in the market collapsed.
To put it bluntly, the so called immune system of laissez-faire market discipline failed to control the speculation and the resultant asset price bubbles. It failed to stamp out the greed and narrow self interest. And it failed to stamp out blinkered ignorance of two key investment fundamentals, namely that: returns on capital have to be appropriately in sync with real economic growth rates; and that asset prices have to correctly reflect the underlying risks.
The one positive that we can take out of all this is that it has finally shattered the naïve belief that ‘unfettered’ financial liberalization, in a market driven by greed and self interest, can be a path to securing sustainable economic prosperity and social progress.
Certainly the public has had enough. Trust in business is at an historic low. According to the Edelman 2009 Trust Barometer2, only 49% of the informed3 public globally now trusts business to do what is right. In the United States it is only 38% and in Australia only 39 %.
And the informed public doesn’t trust the market much either - only 47% globally say they trust the information they get from financial analysts. And if that’s not enough of a worry, only 29% globally trust the information coming from CEOs and only 17% in the US.
And the killer for any CEOs and boards still in the corporate denial bunker; by a three to one margin, those surveyed favoured stricter government regulations and greater controls over business to restore stability and public trust.
All of this should have sent shudders through the board rooms. But, judging by actions and behaviours to date, many must have had the corporate windows closed when this information came out.
Despite the resistance of business, already the landscape has changed dramatically with widespread socialization of the veins of economy via the bail-out or guarantee of banks. And politicians and regulators are seeking to enact reforms aimed at preventing the types of excessive behaviours that precipitated the global financial crisis.
But regulation in itself cannot repair the market immune system and make it resilient to future attack. At the end of the day, you cannot regulate good behaviour. And you can’t comply yourself to greatness. The reality is that trust and confidence are fundamentally ethical and behavioural issues that go beyond compliance. And ‘free’ markets can’t be sustained without that trust and confidence.
This is why the first step in repairing the market immune system must be to get business leaders to embrace and enact ethical principles consistent with responsible stewardship and citizenship, enlightened governance, and sound risk management. Both the CRT Principles for Responsible Business4 and the UN Global Compact5 go to the heart of constructive and ethical business behaviours through which capitalism can flourish and through which sustainable and responsible prosperity can become the foundation for a fair, free and transparent global society.
Beyond the embracing of ethical principles for business, additional reform measures covering corporate governance, executive remuneration, financial and banking regulation, and the functioning of multilateral institutions are urgently needed to rebuild a resilient market immune system.
At the heart of the problem are dysfunctional and short-sighted systems of executive incentives and remuneration. Put bluntly, the way most performance based remuneration is structured simply provides executives with greater incentive to do the wrong thing than to do the right thing. In the chase to secure the short term performance bonuses nothing much gets in the way of self interest as we have all seen time and time again. The long term interests of shareholders and other stakeholders rarely get a look in.
Of particular concern is that the compensation of senior banking executives, traders and fund managers has been built around short-term rewards that can only be maximised via increased risk taking. This sowed the seeds of the sub-prime crisis. Adding fuel to the fire, the rewards are provided in ways that largely shield executives from any liability for the impacts of their decisions.
Boards and regulators need to urgently correct this systemic misalignment of incentives. An appropriate starting point to overcome the inherent conflicts and misalignment of interests when compensation derives from the issuance or sale of risk based financial products would be to require the key executives to provide a personal annual statement on the product risks and responsibilities. If such statements had been provided on sub-prime mortgages and related mortgage securities, the market would have been informed on: borrowers’ capacity to repay particularly when loans reset; the sustainability of the boom in housing demand; whether the rate of house price appreciation was sustainable; and so on. If such disclosures had existed, it is unlikely that the sub-prime crisis would have eventuated in the first place.
Adequate and timely public disclosure of all material information is an essential prerequisite for accurate and reliable investment analysis and valuation has to be a part of the new market immune system. When all relevant material facts are in intellectual play, valuation analysis has a high probability of getting the price right. But opacity of risk, combined with greed and narrow self interest in a rising market, is a toxic mix for serious mischief.
It is clear that on the back of the global financial crisis, if market capitalism is to survive, and so sustain itself for global prosperity, it needs to be both responsible and moral. The business of business cannot simply be business – and certainly not business divorced from any accountability for its impacts on society.
Put simply, business needs an ethical compass in addition to its practical reliance on measures of profit and loss. Good ethics is simply good risk management. And the interests of business must be balanced with the aspirations of society for mutual and sustainable prosperity.
In line with this and in the lead up to the G-20 Summit in April 2009, the Caux Round Table (CRT) laid out a reform plan to reshape capitalism and repair its immune system.
The CRT’s seven point reform plan takes responsible capitalism from the fringes of business behaviour and firmly entrenches it at the heart as to how good business is done. Importantly, the proposed reforms address the key underlying causes of the global financial crisis and the critical need to restore the soundness of financial institutions which remains of first importance for a successful market economy.
In summary, the CRT’s proposals would:
- Require board directors to consider interests beyond shareholders, which may affect the company’s success, by codifying the principle of “enlightened shareholder value” in company law.
- Require minimum standards of corporate governance knowledge and expertise for corporate board directors.
- Require corporate boards to have a dedicated board committee responsible for risk oversight across the full spectrum of risks - financial, governance, social, and environmental.
- Regulate executive remuneration structures to ensure that they are consistent with prudent risk management, align with long-term shareholder wealth creation, and do not reward poor performance.
- Implement stronger and globally co-ordinated financial and banking regulatory reforms to prevent systemic risk build-up or market manipulation.
- Regulate all financial markets instruments and investment activities that materially impact on financial system stability and on superannuation and pension system viability.
- Reform and adequately resource the IMF and other multilateral institutions to ensure they are effective forces for economic and social justice globally.
Full details of the proposed reforms within each of the above seven reform areas can be found at http://www.cauxroundtable.org.
The CRT seven point reform plan provides the path forward to responsible capitalism. They are necessary steps for fundamentally restoring society’s market immune system of strong ethics, responsible stewardship, enlightened corporate governance and sound risk management. And they are necessary steps for eliminating this deep cancer within capitalism of “irrational exuberance”, greed and narrow self interest.
1 The Australian, April 01, 2009
3 ‘Informed’ public means tertiary educated with household income in the top quartile.
4 The CRT Principles for Responsible Business can be accessed at http://www.cauxroundtable.org