Dick Cheney, November 2007
Throughout its history, capitalism has proven itself to be both remarkably adept, resilient, and ruthless in its never-ending pursuit of financial return on investment. It can rapidly shift capital into areas of greater demand, reduce the costs of production and labor, rebound back from financial collapse, and create entirely new markets and methods for generating profit. Capitalists have experienced times of both unprecedented freedom and binding regulation often depending on the quality of their political organization. In this essay I wish to discuss a brief history of free-market financialization which has led to directly exploitive and oppressive acts on the American public, creating the most unequal distribution of wealth since the 1920's and an economy whose foundation is at risk.
Capitalism and Its Distinctive Features
Production Capitalism
When I first began my research, I was under the impression that we were experiencing an entirely unique stage of capitalism unlike any in its past. While this may be true when looking at its size or cultural manifestations, the essential foundations of a capitalist economy have changed little. Capital is money invested into some project or activity with the hope of generating more money. In the early stages of mercantile capitalism, money was invested into the building of ships and the costs of a voyage to East India for spices. The initial return on investment, because supply was so low and demand so high, was 95%. Risks were high however because occasionally, a vessel would never return and the capital invested would be completely lost. To reduce such risk and generate more capital, stock markets evolved enabling one to invest in an entire industry or company instead of individual voyages (Fulcher 2004).
The shift to capitalist production had enormous trans-formative implications for society because it demanded wage labor and created two spheres of existence: production/consumption, work/leisure, labor/domestic. As individuals and families spent most of their time earning a wage in divided labor sectors, it became necessary to purchase in a market what was once self produced to survive. Though the initial investment returns on mass production were high, they could not be sustained however due to the introduction of competition. Keeping profits in mind, competition lead several tendencies to ensue. As other companies drove down prices in the market because of increases in supply, capitalists needed to keep returns high by lowering the costs of production. This was done in two ways: reducing labor wages and increasing efficiency of production through innovations in technology and micromanaging. Often this lead to exploitation of labor, what Karl Marx called "slave labor," as capitalism naturally drives wages to "stationary poverty" in attempts to maximize profits. These tendencies made risk an inherent presence in capitalist societies. As other companies employed the same techniques of cost reduction, the capitalists would reduce risk by buying out competition to create a monopoly or by establishing cartels in order to control supply and price levels. They also formed trade unions to create industry wide agreements on prices and labor costs. If the industry no longer seems profitable, capital will shift to new industries in hopes that speculation will generate greater returns at the total disregard for the real economic needs of the laborers within the production process of the industry where the capital is leaving. The laborers who experience this risk in the form of decreasing wages and unemployment would join worker unions to fight for better wages and working conditions.
Managerial Revolution
One distinctive feature of American corporations was the managerial revolution documented by Alfred P. Chandler. This shift lead by General Motors, put managers in charge of corporations who didn't actually own them and created a decentralized hierarchical structure with various divisions of operation. He argued that, this new "visible hand" was more of a driving force in capitalism than those usually cited in typical economic theory. Its success and adoption by other corporations is what gave the U.S. its world super power status (Chandler 1977). Management, with its Chief Executive Officer, called the shots of giant publicly traded corporations owned by masses of people (shareholders) through the purchase of shares. Since ownership became so widely distributed, corporations became republics in which a Board of Directors are the representatives elected by the owners. This board is intended to direct management to fulfill the corporations legal obligation of "maximizing shareholder value." While this change may have initially generated great efficiencies in the real workings of the corporation, during the final decades of the 20th century till now, this efficiency has deteriorated to a loss of agency not just on the part of the shareholders/owners, but mostly on the part of managers, accountants, lawyers, stockbrokers, underwriters, legislators and corporate boards of directors. This loss of agency is discussed thoroughly in The Modern Corporation and Private Property, which argues that a diffusion of ownership on all levels lends itself to a decline in fiduciary responsibility to owners (1991: Berle & Means). As a matter of fact, the notion isn't so new. Adam Smith, the father of capitalism wrote some two hundred years ago that "it can not be well expected that the directors of companies, being the managers rather of other people's money than of their own, should watch over it with the same anxious vigilance with which partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they very easily give themselves a dispensation. Negligence and profusion must always prevail" (Smith 1776: 330).
Financialization
The corporate need to continually achieve greater returns on investment has created what has become known as the "bottom-line" society. It is simply not sufficient to have a stable and consistent market share with stable and consistent profits. Coca-Cola, for example, could maintain their current business practices and consistently create wealth and income year after year for its employees, owners, and investors. But stability is not sufficient and greater wealth must be sought after. They will not be satisfied until consumers are drinking Coke for breakfast in addition to lunch and dinner (its in their management literature). Not only must one create profits, one must increase profits continuously year over year, quarter over quarter. There are limits to growth however. Within industries, demand does stabilize, innovation becomes limited, costs reach their lowest levels, and no more competitors are available to take over.
When corporate growth began to stabilise in the midst of a slowdown in the economy during the 1970's, the hunger for consistent growth in profits did not go away. Creative corporations began to move their vast mountains of surplus capital into the industry of investment banking. This shift has been called the "financialization of capitalism." Instead of a corporation simply focusing on their primary business objective within the real economy, they realized that they could use their excess capital to invest in other corporations. In most cases, they hire financial institutions to do the work for them at the cost of managerial fees. This trend has since become the standard way of managing excess capital (Foster 2007). Ford for example, was able to offset losses in their production business because its investment division generated such huge profits.
Another major turning point leading to the massive increase in financialization occurred when GM invested its pension plan into its stock portfolio. It began a trend within corporations that has flooded the financial institutions with money to be managed by professional investors. In the pension plan, the risk of investment is placed on the corporation and not on the individual employee because a pension is contractually guaranteed. In realizing this risk, corporations have turned to defined contribution plans where individual employees have the option of contributing to retirement funds such as a 401K through major financial institutions. Because of reduced risk, even more corporations have these retirement fund options for their employees which has lead to even greater cash flows into the money markets. These financial institutions are now some of worlds largest corporations.
Market Theory
Money markets "are markets whose product is money itself...[which] serve the crucial function of joining investors with entrepreneurs" (Kuttner 1996: 159). While the financial industry is ideally intended to reflect perfectly the strength or weakness in the real economy, in actuality, it strays radically away from doing that because it lacks perfect information and has heavy psycho-social aspect to it. Money markets are more like spot markets whose prices represent educated guesses about the potential of an industry and the likelihood of other people investing in that industry. The consideration of how others will respond to industry news and information is more important to current investors than what it actually means for the profitable capacity of the corporations within the real economy. Assets have the tendency to move into new fad markets, displacing incumbents, and in the process greatly enriching middle men. The markets increased volatility in recent decades is the result of short-term investment strategies at the cost of long-term steady and stable growth. Investors see numbers, not people. While financial investment can provide needed capital for underfunded growth industries, it can also shift necessary capital away from more established and healthy markets causing major disruptions in communities and employment within the real economy.
The question is one of efficiency. Are the markets most efficient without regulation or are they more efficient if they are regulated. Commenting on Thorstein Veblen, Robert Kuttner suggests that "financiers were useful to the extent that they supplied capital; they were parasites to the extent that they were mere speculators" (Kuttner 162). If Veblen is right, then we should tax financial transactions or profits actualized through quick returns in order to tame the wild beast of speculative short-termism. Proponents of deregulation will proclaim the "Efficient Market Hypothesis," which insists that the stock market possesses perfect information about the value of any given company at any given time. Stock market crashes however (1929, 1987, 2000) seem to suggest otherwise. On October 19th 1987, the market lost almost a third of its entire value. To suggest that the prices in the market were accurate readings the real economy on both the day before and the day of the crash is quite preposterous. The truth is that it was way over-valued one day and then under-valued the next. In fact, had it not been for regulatory intervention, the "rationale" market would have continued its irrational plummet despite the fact that assets of the corporations had changed little.
The argument I wish to make is that the market fails when it no longer serves the purpose of providing needed capital to real corporations that employ real people resulting in sustainable economic growth. When on the other hand, in a unregulated environment, markets become a place for short term trading and gambling rather than long term investing, the economy will suffer in several ways. Corporations will become less efficient and profitable in the long run, wages and labor costs will be driven down, conflict of interest will be prevalent, inequality rises, and market crashes will cost taxpayers billions when the government bails out the abuses of money managers.
Lessons from the Past
Prior to the great depression there were rampant abuses which lead to grave inequalities and a complete market crash. "In the 1920's, speculative schemes, largely unregulated and increasingly reliant on dishonest books and borrowed money, drove up the price of stocks even as the insiders who organized the schemes pulled out their own money and gulled small investors" (Kuttner 2007: 83). Stock Pools and Holding Companies were the mechanisms to achieve these schemes in which organizers bought securities at cheap prices, than ran campaigns to sell more securities to outsiders. The outsiders were not only promised that it was a sure investment, but were also offered loans to buy them in the first place. When the insiders cashed in, the outsiders were cleaned out.
In 1934 the Securities and Exchange Commission was a federal agency established to enforce a series of financial reforms that were intended to prevent abusive practices used to manipulate stock prices and also to prevent bankers from risking other people's deposited money. Activity intended to deceive investors into purchasing securities was made illegal by requiring banks and corporations to fully disclose all pertinent information an investor would want to know. Financial statements had to be performed by independent auditing firms and corporations became subject to court hearings if they were suspected of not fulfilling their fiduciary duties to clients or shareholders.
During the 1920's, commercial banks were able to partake in just about any type of highly speculative investment to generate profits. After the crash of 1929, over four thousand banks collapsed, each holding over $900,000 in depositors money, causing millions of Americans to lose their life savings. At this point it became clear that banking was not just another type of business that involved risk like any other financial activity. In response, the Roosevelt administration implemented regulations on commercial banking so tightly that banks were almost seen as a public entity. The activity of a commercial bank was strictly forbidden from the more speculative and risky realms of investment banking. Not only did they have restrictions in the amount of interest they could charge borrowers, they also had caps on interest offered to depositors. This was designed to prevent bidding wars to attract customers. The logic was that higher interest rates on deposits would require bank investments to yield greater returns, thus leading to higher risk with the life savings of American citizens and the potential for another crash. Additionally, to prevent banks from over-lending, they were required to maintain minimum ratios of loans to total capital which was periodically examined (Kuttner 1996).
In return for these regulations, the government reduced competition and insured the depositor's money. A bank could not be opened without applying for a government charter, and if the region already appeared over-banked, the charter would be denied. Banks were also unable to branch out and become multi-state conglomerates, preventing monopolistic practices. The insured deposits came in the form of FDIC insured accounts which returned public trust in the banks helping to revitalize the economy. This however, did not reduce the benefits of competition all together. Banks maximized profits and gained customers through efficiency, high loan standards, and customer service, providing both a stable and quality environment for 40 years. A joke in the savings and loan industry followed the '3-6-3' rule, "take in deposits at 3 percent, make mortgage loans at 6 percent, and be on the golf course by 3pm" (Kuttner 1996: 21).
The intellectual justification for this mixed economy came from John Maynard Keynes, who argued persuasively that government regulation, federal spending, and a commitment to full employment would create the strongest economy with the greatest equality. To date, the 30 years following the war have been the most prosperous times in all of U.S. History. During the 70's, the combining effects of a more a vibrant individualism, with a stagflating economy lead to the election of right wing politicians who championed the free market policies of Milton Friedman. This was the beginning of the big shift away government involvement in the American economy.
Demise of the New Deal
Robert Kuttner argues that "the broad causes for the shift were the new prestige of laissez-faire markets, the globalization of the financial economy, and the invention of institutions that circumvented the tight regulatory strictures on banks and thrift institutions. The immediate cause was inflation" (Kuttner 1996: 169). The rise of inflation in 1974 was 11 percent and the interest rate limit was 5.25% causing depositers to complain. As pressure grew, interest was soon allowed to be paid on checking accounts, and the savings account interest rate caps were removed. Another innovation and threat to banks was the money-market mutual fund from Fidelity which was backed by investments in short-term money-market securities. Such funds were not insured but were "safe enough" and had 7% rather than 5% interest rates. This was problematic because the banks were losing customers to money market accounts which were the essential assets needed to back their mortgage liabilities. Soon enough, corporations were no longer taking their credit from traditional banks and even started financing divisions of their own with extremely low rates to promote sales. Banks too were finding loopholes to invest in securities by having unregulated off shore divisions or their corporation. The hands off policy by legislators in response to these innovations lead banks to invest in more speculative areas in light of their need to compete for higher interests rates on deposits.
"Congress behaved as if banks were just another entrepreneur, without special fiduciary duties, without taxpayer-insured deposits. In a spectacular lapse, Congress and the Reagan administration deregulated nearly everything but deposit insurance, effectively inviting bankers to gamble with government insured money...when the reckoning finally came, this experiment in the marketization cost the taxpayers $160 billion" (Kuttner 1996: 173). In other words, the Glass Steagal Act from the New Deal, which separated specific lines of business from commercial banks and investment banks was being assaulted and banks began engaging in any type business it saw as profitable. It was eventually completely repealed under President Clinton in 1999 and the emergence of financial conglomerates who possessed the same conflicts of interests as in the 1920's began to flower.
Sure enough, in the years of 2000 through 2002, financial scandals came to the forefront with Enron and Worldcom (assisted by the big banks) making the most headlines. The run up to their collapse was filled with insider deals, lack of transparency, hyping up stock values, unsound financial reports, and total lack of agency. Interestingly, much of the lack of transparency in accounting was the result of a new accounting standard authorized by the Bush Administration. Despite these scandals that cost taxpayers billions and hardworking employees their life savings, the bells of deregulation are still ringing. The Sarbanes-Oxley act of 2002 has hardly had any effect as loopholes are being exploited and systemic risk only growing. In fact, pressure from lobbyists and Bush appointed financial regulators are already attacking the Act decrying its assault on the efficiency of the free markets. The following quote summarizes what is to follow.
In the 1980's and 1990's, however, every element of agency failed. Deregulation and lax enforcement of the regulations that remained eroded professional norms that had constrained rank opportunism. Supposedly independent auditors colluded with management to dress up corporate books. Ostensibly fair-minded securities analysts serving investors turned out to be stock touts looking to bring their firm underwriting business on their success in running up a client company's share price. Boards of directors that allegedly represented shareholders helped crony CEO's reap astronomical compensation packages largely disconnected from actual company performance. Corporate boards promoted stock options that gave executives incentives not to optimize true performance but to inflate the share price in the short run. Mutual funds, rather than serving as the agents of investors, took huge transaction fees and invariably voted their shares with management. Brokers and investment bankers helped themselves and their favorite clients to new stock issues (IPOs) at preferential prices not available to the public. Institutions of self-regulation, such as the National Association of Securities Dealers, the American Institute of Certified Public Accountants, and the New York Stock Exchange, went after minor infractions but not the deeper corruption. What all of these insiders had in common was a self-interest in manipulating share prices (Kuttner 2007: 75).
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