Reforming and restoring big finance

30th July 2012

Here's a new measure to gauge the depth of the financial crisis. Look for the new growth industry, perhaps the only expanding activity as we face the prospect of a treble dip or even a double double dip. That growth industry seems to be telling investors and others just how bad the present system is and that it is in desperate need of reformation. 

There are several to choose from. Last week it was the turn of John Kay's report on what was wrong with the UK financial system.  And earlier this year,  Professor Robert Shiller from Yale University was touring the campuses and studios with his book Finance and the Good Society, whose basic theme is the need to democratise finance by making the financial markets work better for everybody.

Equally, investors can tell the system is under attack and needing more understanding and more love when conservative commentators such as Charles Murray, author of Coming Apart: The State of White America, 1960-2010 and the W.H. Brady Scholar at the American Enterprise Institute take to the Wall Street Journal to defend capitalism in a basic and  broad fashion – the equivalent of "why the system works and why it is good for you 101."

Out of control money begets out of control money

It is hard to disagree with the diagnosis of our ills from Kay, Shiller and similar sources. Big finance is out of control, it comes up with concepts that are purposeless except in enriching those who think them up,  that it serves its practitioners with bonuses at the expense of those who finance it, it concentrates on the short term to the detriment of projects needing more than mere months, and it has become too big to fail.

But where all these analyses are weak is in the cure. Is it more regulation?  Is it more ethics? Is it more long term thinking?  Or will the system be self-correcting?  Whether it one, more or all of these, the essential question is then "when?"

The past speed of reform in financial services has essentially two gears. It is fast forward when changes benefit the finance industry – "Big Bang" in the UK in the 1980s or the repeal of Glass-Steagal in the US during the 1990s.  Then the banks and brokerages embraced change with joy. But when it comes to trying to control finance (or pharmaceuticals or tobacco, for that matter) then the gear is slow, with a tendency to the hand brake and reverse. Companies which see their franchises under attack use every means at their disposal to prevent change.

The UK retail financial services area has taken the best part of a decade to bring in the Retail Distribution Review – due for operation on January 1, 2013 and still the subject of disagreement. The same industry refused to listen to critics arguing that personal pensions, endowments, split capital investment trusts, structured products, payment protection insurance and many others were mis-sold.  It stuck its heels hard in the ground over revealing commission payments.  In the long run, this use of the brake to stop progress cost it – as well as investors and policyholders – more than if there had been compromise and concession much earlier on.

New thinking to start the ball rolling

But change has to start with an analysis of what is wrong. Shiller says in  an interview that he wants to "democratise finance by making the financial markets work better for everybody."  

He says: "There's an increasing concern with unequal distribution of wealth, and finance is perceived as the villain in all of this. But I'm thinking it can't be the villain; finance is a technology that can, if it's properly applied, help reduce inequality if it's applied to everyone. So I think that people who are in finance today have a moral obligation to help advance the trend toward democratisation of finance. That means using the principles to really help people."

And one way, Shiller believes, is via product innovation. He disagrees with former Federal Reserve chair Paul Volcker's oft-quoted comment that the only worthwhile financial innovation was the ATM – the Automatic Teller Machine that gives him cash. He cites the benefit corporation, which was created in the United States in 2010. This is a novel structure –  halfway between profit and non-profit. It fills a need. It makes  profits and distributes them to shareholders just like a normal company but it has a charter with a purpose, social, environmental or charitable. 

He admits that this is all somewhat unclear but he says: "it is selfish, because focusing directly on profit is just not humane. I think everyone will feel better about these benefit corporations."

Prisoners in Peterborough

And in the UK, he likes the look of the social impact bond, which also started recently. This is a government bond which pays out only if a social goal is met. He cites a bond that that will reward investors in six years only if the re-incarceration rate of prisoners released from Peterborough-area prisons falls by 7.5%. The idea is the financial incentive will bring in new ideas and enthusiasm.

Charles Murray takes no prisoners. Investors know where he is starting from when his article starts with: "Mitt Romney's résumé at Bain should be a slam dunk. He has been a successful capitalist, and capitalism is the best thing that has ever happened to the material condition of the human race."

He continues: " Everywhere that capitalism subsequently took hold, national wealth began to increase and poverty began to fall. Everywhere that capitalism didn't take hold, people remained impoverished. Everywhere that capitalism has been rejected since then, poverty has increased."  Leaving aside the possibility of an alternative view that capitalism thrives when the conditions are right – innovation, raw materials – and declines when primary driving forces fade, he admits that while some such as Ray Kroc (of McDonald's) and Facebook's Mark Zuckerberg have been lauded as innovators, financial moguls attract more suspicion. 

He concedes that the word "Capitalist" has become an accusation. So what has happened?

Cronies, collusion and capitalism

One is the rise of collusive capitalism. Part of that phenomenon involves crony capitalism, whereby the people on top take care of each other at shareholder expense (search on "golden parachutes"). In this, he agrees with other criticisms. But he continues: "The problem of crony capitalism is trivial compared with the collusion engendered by government. In today's world, every business's operations and bottom line are affected by rules set by legislators and bureaucrats. The result has been corruption on a massive scale. Sometimes the corruption is retail, whereby a single corporation creates a competitive advantage through the cooperation of regulators or politicians. Sometimes the corruption is wholesale, creating an industry wide potential for profit that would not exist in the absence of government subsidies or regulations (like ethanol used to fuel cars and low-interest mortgages for people who are unlikely to pay them back). Collusive capitalism has become visible to the public and increasingly defines capitalism in the public mind."

He adds: "When great wealth is generated instead by making smart buy and sell decisions in the markets, it smacks of inside knowledge, arcane financial instruments, opportunities that aren't accessible to ordinary people, and hocus-pocus. The good that these rich people have done in the process of getting rich is obscure. The benefits of more efficient allocation of capital are huge, but they are really, really hard to explain simply and persuasively. It looks to a large proportion of the public as if we've got some fabulously wealthy people who haven't done anything to deserve their wealth."

He then goes on to decry "predominantly liberal" politics in high tech firms, news media, entertainment and "even leaders of the financial industry increasingly share the politics of George Soros."

Back to his apology.  He adds:  "Many senior figures in the financial world were appalled by what was going on during the run-up to the financial meltdown of 2008. Why were they so silent before and after the catastrophe? Capitalists who behave honorably and with restraint no longer have either the platform or the vocabulary to preach their own standards and to condemn capitalists who behave dishonorably and recklessly. And so capitalism's reputation has fallen on hard times and the principled case for capitalism must be made anew."

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