A radical reform of the financial sector can only be achieved if we know what kind of capitalism we want
Last week I delivered a lecture on my latest book to about 150 people from the financial industry at the London Stock Exchange. The event was not organised or endorsed by the LSE itself, but the venue was quite poignant for me, given that a few months ago I did the same thing on the other side of the barricade, so to speak, at the Occupy London Stock Exchange movement.
At the exchange I made two proposals I knew may not be popular with the audience. My first was that we need to completely change the way we run our corporations, especially in the UK and the US. I started from the observation that financial deregulation since the 1980s has greatly increased the power of shareholders by expanding the options open to them, both geographically and in terms of product choice. Such deregulation was particularly advanced in Britain and America, making them the homes of "shareholder capitalism".
With greater abilities to move around, shareholders have begun to adopt increasingly short time horizons. As Prem Sikka wrote in the Guardian in December 2011, the average shareholding period in UK firms fell from about five years in the mid-1960s to 7.5 months in 2007. The figure for UK banks had fallen to three months by 2008 (although it is up to about two years now).
In order to satisfy impatient shareholders, managers have maximised short-term profits by squeezing other "stakeholders", such as workers and suppliers, and by minimising investments, whose costs are immediate but whose returns are remote. Such strategy does long-term damages by demoralising workers, lowering supplier qualities, and making equipment outmoded. But the managers do not care because their pay is linked to short-term equity prices, whose maximisation is what short term-oriented shareholders want.
That is not all. An increasing proportion of profits are distributed to shareholders through dividends and share buybacks (firms buying their own shares to prop up their prices). According to William Lazonick – a leading authority on this issue – between 2001 and 2010, top UK firms (86 companies that are included in the S&P Europe 350 index) distributed 88% of their profits to shareholders in dividends (62%) and share buybacks (26%).
During the same period, top US companies (459 of those in the S&P 500) paid out an even greater proportion to shareholders: 94% (40% in dividends and 54% in buybacks). The figure used to be just over 50% in the early 80s (about 50% in dividends and less than 5% in buybacks).
The resulting depletion in retained profit, traditionally the biggest source of corporate investments, has dramatically undermined these corporations' abilities to invest, further weakening their long-term competitiveness. Therefore, I concluded, unless we significantly restrict the freedom of movement for shareholders, through financial reregulation, and reward managers according to more long term-oriented performance measures than share prices, companies will continue to be managed in a way that undermines their own viability and weakens the national economy in the long run.
My second proposal was that, in order to improve the stability of our financial system, we need to radically simplify it. I argued that financial deregulation in the last 30 years led to the proliferation of complex financial derivatives. This has created a financial system whose complexity has far outstripped our ability to control it, as dramatically demonstrated by the 2008 financial crisis.
Drawing on the works of Herbert Simon, the 1978 Nobel economics laureate and a founding father of the study of artificial intelligence, I pointed out that often the crucial constraint on good decision-making is not the lack of information but our limited mental capability, or what Simon called "bounded rationality". Given our bounded rationality, I asserted, the only way to increase the stability of our financial system is to make it simpler. And the most important action to take is to restrict, or even ban, complex and risky financial instruments through the financial world equivalent of the drugs approval procedure.
The reactions of my audience were rather surprising. Not only did nobody challenge my proposals, but many agreed with me. Yes, they said, "quarterly capitalism" has been destructive. True, they related, we've seen too many derivative products that few people understood. And, yes, many of those products have been socially harmful.
It seems that, as it is wrong to label the Occupy movement as anti-capitalist, it is misleading to characterise the financial industry as being in denial about the need for reform. I am not naive enough to think that the people who came to my lecture are typical of the financial industry. However, a surprisingly large number of them acknowledged the problems of short-termism and excessive complexity that their industry has generated to the detriment of the rest of the economy – and ultimately to its own detriment, as the financial industry cannot thrive alone.
The rest of us need to have a closer dialogue with reform-minded people in the financial industry. They are the ones who can generate greater political acceptance of reforms among their colleagues and who can also help us devise technically competent reform proposals. After all, without a degree of "changes from within", no reform can be truly durable.
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