Friday, February 13, 2009

Risk Part 5: Capitalism 2.0

If the only lesson we get out of the current financial crisis is that we need to tweak the regulatory system, then we are in BIG trouble. Tax-payers in the western world are paying trillions of dollars to profit-taking corporations. This bailout may be necessary, but it is deadly dangerous. Every time we bail them out they get a little more complacent about taking risks that leave them needing more bailouts.

Make no mistake: these people have a mandate and it is to make as much money as possible. Their commitment to maximizing profits is as zealous as commitment can be. Like the creature on the late show, they will not stop. Like the Mississippi River, when they hit an obstruction they will overflow banks and find new routes. Even in the face of enormous pressure to act responsibly, after taking billions in bailout money they paid themselves billions in bonuses. The bailout became just another strategy to accumulate wealth, and that is just the nature of our current economic system.

Capitalism 2.0 is a change in basic principles: from "working to create value for shareholders" to "working to sustainably create value for all stakeholders". There are two key differences here:

Term - Decision making considerations need to move from short-term to long-term. Currently, the entire system is set up so that players make short-term decisions that put money in their pockets, and once there, they own it: there's no giving it back. Meanwhile, the decisions they make have long-term effects on everyone else. In the last few years the principle of short-term advantage was pushed to the limit by investment traders. The system encouraged them to make decisions that yielded short-term bonanzas but ulitimately caused the entire system to collapse.

Scope - The beneficiaries of business decisions need to move beyond a narrow group of the power elite. We charitably call this group shareholders, but in Cap1 a company is disproportionately run for the benefit of a handful of senior executives. (To get an idea of some of the extra remuneration head honchos give themselves, go to, type a stock symbol or company name in the "Get quotes" box, and then scroll down the page and click on "Insider Transactions" in the left column.)

One example: we have to nationalize parts of our banks. Nassim Taleb has been arguing for this. There is a "utility" function to banks, clearing cheques and the like, that is fundamental to the running of our economy but that is threatened by the risk-taking parts of the bank. I have to agree that the utility functions of banks should be nationalized, and that everyone must understand that the risky investment part of banks will never again be bailed out.

The need for nationalization goes beyond the banks. Over and over in this crisis we hear people saying that there are companies that are too big to fail. And when the Bush administration ignored that warning and let Lehman Brothers fail, chaos descended. The lesson has to be that the market cannot be allowed to handle everything.

The idea of nationalization may seem shocking to some, but it's really not a huge change from the present. Paul Krugman wrote recently, "not a week goes by without the FDIC taking several smaller banks into receivership. Nationalization is actually as American as apple pie." Most of the world's biggest oil companies are nationally owned. The move to privatize hydro operations is quite a recent phenomenon. Americans are horrified by the idea of "socialized medicine", but we in Canada are quite comfortable with a medical system that doesn't insert profit-takers throughout the process.

Another fundamental change required by Cap2 is the move from rule-based regulation to principle-based regulation. In Cap1, businesses can do anything that is not illegal. Business should be regulated in the way that driving is: you need to demonstrate fitness to participate. Part of this is rethinking what is legitimate business. For example, Robert Bonfiglio says, "Buying a Credit Default Swap that exceeds the actual amount of what you are protecting, or on something you don't own or have any money invested in, is gambling and should be subject to taxes and the laws of gambling in the state which the bet is placed."

The Cap1 concept of financial oversight is simply a joke. The watchdog for all the Wall Street hedge funds was a handful of inexperienced bureaucrats. And the models that are used in credit risk are a joke, analysing single transactions without looking at all the transactions of an organization. There needs to be so much more oversight that the concept of oversight reaches another dimension. We need a holistic approach to risk management. (See The Case for Collective Risk Reporting and the article "Integrated Risk Assessment", here.)

Capitalists have proved that they will act just as predicted by economic models, and that that means they can't be trusted. You may argue: what about corporate donations? But corporate donations are a way to create goodwill, which is just another line on the balance sheet. It reduces taxes, increases brand value, and makes shares worth more. It also gives personal advantages to senior executives who administer and fete the money they are giving away (which does not come out of their own pockets).

The ability of the Cap1 capitalist to find loopholes and routes around the rules are as powerful as the aforementioned creature on the late show and Mississippi River. Then once they get around the rules and make their money, our Cap1 value structure lauds them for being wealthy. A case in point is Conrad Black. Now in jail as a convicted felon, he was the cock of the walk for 25 years after being exposed as a con man in Peter Newman's best-selling "The Canadian Establishment". He was an important man because he was rich, even though we knew he was a crook.

For a long time we have known that the system is rotten, but have been told that while imperfect, it is the most efficient way to operate. The current collapse of the financial system has changed all that.

Part of our acceptance of Cap1 was a phony dichotomy between unfettered capitalism and state-centralized communism, as if those were the only options. Now that capitalism isn't working, it's clear that we need to find another option.

Capitalism has changed whether we accept it or not. We have entered a period of extreme business cycles. In the upswing there is enormous wealth-mongering that inevitably leads to a crash that requires bailout. Some call this corporate socialism but that is much too kind a word, as it is really a massive fraud perpetrated on the public by the power elite. The remuneration that senior executives at large corporations pay themselves has gone way beyond any fair amount required by competition to keep good talent - especially since top executives now get hundreds of millions of dollars a year even when the company loses money, and even (in the form of golden parachutes) when they are fired. It's not about attracting talent: it's about power rewarding itself. It has been going on for years, but recently has been on a sharp increase. There's only one word for it: egregious.

After all the scandals and all the trillions in bailouts, if we don't have the will to take real action now we'll never have it. And we need to strengthen our resolve to make some real structural change. Only when we accept the principle of Cap2 ("the purpose of business is to sustainably create value for all stakeholders") can we start to transform our political-economic system into something that works for the people.

The question is whether we can grab the monkey by the tail and get a harness on it. Every lobbyist in every national capital will be against this one, and the politicians are mostly part and parcel of the same community.

Update: Greenspan Backs Bank Nationalization

See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis
Risk Part 4: Regulatory Revision
Risk Part 5: Capitalism 2.0
Risk Part 6: Moral Hazard
Risk Part 7: Some Basic Accounting Problems


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