Monday, September 14, 2009

The More Money You Have, the More You Should Care About CSR

The more money you have at stake, the more should you care about CSR – corporate social responsibility.

CSR is a business philosophy and profit-making strategy that links a company’s value to all those who contribute to its success: customers, employees, owners, creditors, suppliers, community, environment.

CSR also stands for “company stakeholder relationships”.

Managing stakeholder relationships is the best and surest way to build value.

Those who have assets and those who hope to acquire assets need to worry a lot about value.

Some of their most valuable assets are in a company; others in land or real estate; more in securities and other contracts for investment return.

In every case, upholding the asset value of their wealth draws thoughtful concern.

This is especially true today after the meltdown of financial markets and the resulting global recession.

The vital insight here is that a focus on cash, on income, on short-term profit is not enough. Current income is only a step towards real wealth. For if income comes with too much risk or is vulnerable to new conditions, then the wealth underneath that earning power is not that valuable.

How can assets be enhanced to hold their value?

The first step is to reduce the risks association with earning a profit. Quality not quantity is important. Quality in a company and in any investment in that company; quality in the location of land and real property; quality in the reliability and safety of investment contracts like stocks and bonds.

This is where CSR comes in. CSR teaches how to secure customer loyalty, build up brand equity, and charge higher prices for value-added in the customers’ minds.

CSR teaches how to motivate employees and get loyalty and high productivity from them. This is increasingly vital for sustainable profitability in all service, high tech and other businesses that need know-how.

CSR teaches how to retain the trust of owners and investors and creditors so that financial strength is there when it is most needed and at a fair cost.

CSR teaches how to get the most from suppliers so that one’s quality is shock-proof.

CSR teaches how to take care of the environment and communities so that social capital is available in education and culture, public health, infrastructure, government is supportive and not corrupt, and the competitive and natural environments are fruitful for sustainable business.

What CSR teaches in each of these management arenas is how to maximize stakeholder value. Such value is in the relationship with each stakeholder constituency. Taking care of relationships builds long-term value and puts worries to rest.

As asset holders grow older, have less time to run the business and an investment portfolio, and think more and more about the financial needs of their children and grandchildren, they need to have long-term value locked in place. They don’t need assets that might collapse in value due to a breakdown in some key stakeholder relationship like loss of brand equity in the eyes of customers or suppliers.

Take millionaires for example: the more wealthy they become, the more they must rely on agents and managers. They need to trust investment advisors and asset managers; vice-presidents and division chiefs. They can’t do it all. And they don’t want to. After a point in a successful business career, the attractions of spending time in travel, study, collecting, social leadership, cultural entrepreneurship, etc., grow more enticing and distract some owners from hands-on management of their companies and business affairs. Age too has its impact on the inevitable need for us to trust others with stewardship of our wealth.

CSR values and CSR cultures promote trust. Wild-west, Bernie Madoff style, dog-eat-dog capitalism is neither friendly nor trustworthy. In such business environments, we are surrounded by potential cheats and thieves, rascals and schemers. Who can secure success under such conditions? Who can enjoy life when everything is always at risk of loss?

If we need to rely on others, we need to promote a moral capitalism. What goes around, comes around. If we insist on high standards of transparency, accountability, honesty and good work habits, we will benefit as others adopt those practices towards us. CSR is the win/win formula for social justice and all wealth is happier and more secure when society is just.

Old Wisdom

Minnesota’s business prosperity is not what it once was, and not just because of the current recession. Recently David Beal, the now retired business reporter for the St Paul Pioneer Press, analyzed the 2009 Pioneer Press 100, the paper’s ranking of the top Minnesota publicly traded companies. His conclusions do not make for happy reading.

This year for the first time in the list’s 27 year history no new company joined the list via an IPO stock offering to the public. From 2000 to 2009 only 29 companies going public made the list. But in 2009, it was easier than ever to make the list as the current fall in equity prices lowered the threshold for entry to only $12 million in valuation from a level of $45 million just one year ago.

In early 1970’s there were 350 or so publicly traded companies in Minnesota. Now there are less than 150, down from 260 in 1998.

Now, being publicly traded doesn’t necessarily make a company inherently better. No, privately held companies can still very profitably produce goods and services, hire employees, pay taxes and otherwise contribute to the community.

In fact, most employees work for small and medium size companies which are not publicly held. And, privately held, largely family owned, companies produce the lion’s share of GDP in most countries around the world. (Over 93% of GDP in Italy for example.)

But the great engines of Minnesota’s economic growth and reputation were those companies that went public and continued to grow – 3M, Honeywell, Northwest Airlines, Pillsbury, General Mills, Dayton’s, Medtronic, Supervalu, Best Buy, United Health, etc. Their profits partially ended up in financial support of important community institutions.

Though Cargill demonstrates how a closely held company can grow to strategic size, most privately held firms will hit a glass ceiling in mobilizing the financial investment necessary for reaching the big leagues of global market presence.

Minneapolis has lost its own investment banking firms that take local companies public. And, the liability risks of compliance with Sarbanes Oxley legislation is a deterrent to some in taking their company public.

But the decline in vitality of Minnesota companies attaining all the conditions favorable for a successful IPO indicates that something else has changed for the worse as well.

I think a kind of strategic leadership instinct is missing.

It is the common sense wisdom that was common place in an older generation of Minnesota business owners and executives.

In my work for the Caux Round Table on blending business success with ethics and social responsibility, I have run across pieces of sound advice from members of that generation. This home grown wisdom is now needed more that ever.

For example, I have an article from 1972 written by Wheelock Whitney, whose local investment bank (now owned by ING out of The Netherlands) once took many local companies public, that talks of the need for hard-working, sharp-minded boards of directors who are not rubber-stamps for management.

I have a 1975 letter from Whitney MacMillan, then CEO of Cargill and in the process of taking that family company to world class success, setting forth in one page the core ethical stance of the company: it would do business with honesty and integrity. Period.

And, I have several articles by Ken Dayton, who with his brother Bruce led the Dayton company to great wealth and profitability. Ken wrote on how business must take the lead in helping communities reach high standards of cultural achievement and social justice. Ken wrote too on the role of directors in providing strategic guidance to management.

What is the common theme put forth over three decades ago by Wheelock Whitney, Whitney MacMillan and Ken Dayton: high standards.

This is the very kind of “soft power” or “soft assets” that I wrote about in my July column.

From high standards comes growth and success. Lowering the bar for achievement, going with the flow, following the cautious advice of counsel, not sticking your neck out, covering for what the team or the boss is comfortable with – none of these approaches can ever build a great company.

Just read Jim Collins again in his book From Good to Great.

Mediocre standards and a focus on personal survival can indeed sometimes produce a business that survives, but not one that thrives, especially in hard times.

I think that every day we need to ask ourselves: is this the best that I can do?

Or, in the team setting: is this the best that we can do?

What can we do more and better for customers, for innovation, for better cost control, for more dedicated and motivated employees, for our brand equity, for the community? These are the standards of genuine business success.

What is a bit surprising to me is that the answer to how best to do business has been here all along. Like Dorothy returning to Kansas from Oz, Minnesota business people can learn much from our own legacy.

We don’t need to spend money on the latest consultancy fads or gurus or technologies. No, just seek out the human wisdom of what worked in the past to make Minnesota a great place to live, work and build a company.

Tuesday, June 16, 2009

Winning Through Soft Power

Winning Through Soft Power

One big lesson taught us all by the current financial meltdown and resulting recession is the importance of “soft” power to success.

Foreign policy mavens have been talking for several years about the relative advantages of “hard” versus ‘soft” power. Secretary of State Hillary Clinton spoke in her confirmation hearings too of the need for “smart” power.

In foreign affairs, “hard” power gets more attention and requires more money, but it doesn’t always do the job. “Hard” power took out Saddam Hussein and his henchmen, but wasn’t very well adapted to the challenges that came after regime collapse in Iraq. In the Vietnam War, American “hard” power won every battle. But, who, in the end, won the war? The “soft” power of political will evaporated in the United States but not in Hanoi so at the end of the day all the bombs and bullets used to defend South Vietnam, Laos, and Cambodia went for naught.

Similarly, George Washington didn’t win many big battles, but with help from French allies who were recruited through Ben Franklin’s diplomacy, he won the last one and that was all he needed to win the war.

Business has been favorably compared to war. We have the book on the 48 Laws of Power giving guidance on how to succeed. We also have Sun Tzu’s thoughts on war, which present a different approach. According to Sun Tzu, so arranging your forces that the enemy commander retreats without a fight is the acme of military skill.

In business the “hard” power of finance gets most of the attention. Money talks and bottom lines drive decision-making, especially in stressful times like the present.

But “soft” power is far more strategic.

“Soft” power is customer loyalty.

“Soft” power is employee skill and commitment.

“Soft” power is having investors and creditors who believe in your business and will help you through hard times.

“Soft” power arises from all your intangible assets – relationships, good will, brand equity, unique value proposition, business model, supplier quality, long term thinking.

“Soft” power is all about people. Take care of people, and they will take care of you. Trust, reliability, being there for your customers, mutuality of benefit, win-win over zero-sum – these moral factors build business opportunity.

“Soft” power also is all about flow. Times change; markets are fickle. What works today may not generate so much value tomorrow. “Hard” power is better in the short term or in the immediate situation. But “hard” power lacks flexibility and may not endure.

Consider General Motors: how long did billions of “hard” dollars given by American taxpayers through government subsidies keep the company afloat and out of bankruptcy?

Consider Bear Stearns and Lehman Brothers: billions of “hard” dollars in assets could not save them from collapse when confidence in their future disappeared.

“Hard” power encourages illusions about how strong we are. “Soft” power is more realistic and adapts better to the course of events.

With “soft” power you play to where the puck is going, not to where it is. That insight helped Wayne Gretsky win many hockey games.

“Soft” power is right for dynamic conditions; “hard” power for static ones.

But the fundamental environment of business is flow and movement, twists and turns. Consider, then, the advantages of “soft” power.

Thursday, May 21, 2009

Is There an Agency Problem?

Is there an Agency Problem?

I want to call to your attention, as we turn from crisis management to building more viable global institutions of financial intermediation, a sophisticated cynicism that opposes more resolute commitment to business ethics and corporate social responsibility.

I am not referring to the common mistrust of private enterprise on the grounds that working for personal profit is inconsistent with securing a greater good for society. This is the perennial tension posed by philosophers and religious leaders between the claims of virtue and the attractions of self-interest. Rather, I am referring to a more academically polished elaboration of that argument which is called “the agency problem.”

Briefly put, the “agency problem” is said to be an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.

The “agency problem” exists on the agent side of the relationship: agents can’t be trusted to be diligent or faithful. They are always out for themselves and are constitutionally unable to put loyalty and service to their principals above their self-interest.

Thus, any business structure that relies on agency will always be a substantial risk to a principal, putting principals on their guard and forcing them to use tactics of fear and greed to keep their agents responsible.

The problem with this approach, however, is that the remedy feeds the disease.

Using self-interest to overcome self-interest has its limitations.

As long as we believe that the “agency problem” exists and is insurmountable, we have placed before us a conceptual roadblock to corporate social responsibility. Business is no more than a complex network of principal/agent relationships. Owners of corporations are principals to the boards of directors who manage them; senior company officers are agents of the boards and the companies; all employees are agents of their employers; banks, insurance agents, accountants, investment managers, lawyers are all agents to some degree for others. If the “agency problem” exists, then every relationship in this network is infected with the risks of negligence and betrayal. Social Darwinism or dog-eat-dog would seem to be the only rational approach to a life in business. It would be foolish or worse to expect such an environment to ever promote responsibility to the common good.

Advocates of corporate social responsibility must presume something other that the “agency problem” as an immutable fact of business life. Corporate social responsibility, corporate philanthropy, corporate citizenship, all ask of business and business decision-makers a showing of responsibility to others. Usually the responsibility of business is stated as having respect for the interests of stakeholders: customers, employees, owners, creditors, suppliers, competitors, and communities, including the environment.

The problem of faithless agents

If we want a more moral capitalism, we have to solve the “agency problem” or, at a minimum contain its virulence. Modern capitalism generates wealth through specialization of function and division of labor. This fact was Adam Smith’s great insight into the origin of the ‘wealth of nations” as he called it. But, as labor is more and more specialized, each component sub-unit of the economic system becomes more and more dependent on all the other parts. In today’s world of high technology, dependency on specialized machines and the skills of professional experts is higher than ever in human history. Our modern world is also completely subservient to reliable flows of electricity.

The Turkish Airlines plane that recently crashed short of the runway at Schiphol Airport outside of Amsterdam did so because its altimeter was faulty. Nine people died as a consequence of the pilots’ relying on a mechanical device for guidance in landing.

If the “agency problem” is all powerful and all pervasive, then modern capitalism is constant at risk of failure because the dependency relationships that flow from specialization are prone to abuse on the part of those who dishonor the reliance and trust placed on their competence and their integrity.

A market place of lying sellers and conniving buyers will never grow very prosperous. When faith and trust evaporate, so does capitalist wealth. The current meltdown of global financial markets is a good case in point.

But, the seriousness of the “agency problem” has been overstated. If it were truly dominant in the business world, modern capitalism with all its relationships of interdependency and mutual benefits would not have emerged to produce the wealth that we enjoy today – even in these months of a serious global recession. Thus, we can infer that there are some countervailing forces that nibble away at the “agency problem”.

What can we do about faithless or negligent agents?

The problem is not a new one. In the Judeo-Christian tradition, the prophet Samuel warned the leaders of tribes of Israel not to put their faith in kings, for, as he predicted, kings would turn against their trust and abuse power for their own selfish advantage. Later, Jesus stated that one could not serve both God and Mammon.

The Common Law of England over the centuries fashioned many legal responses to minimize the effects of the “agency problem”. These rules and practices constitute what is called the law of fiduciary duties. Also, the English courts of Equity contributed to fiduciary law with their own set of procedures and requirements designed to remedy abuse of legal power and prevent fraud and oppression in the marketplace.

The basic device used by the Common Law to minimize the effects of the “agency problem” was to define what was expected from agents as duties to their principals and give principals specific remedies for breach of those duties. This was a practical approach that sought to structure incentives so that agents would be more inclined to stick to the punctilio of their responsibilities and principals would be induced to assume the risk of trusting agents. Other words used in the Common Law to resolve the agency problem were fiduciary, trust, and beneficiary of the fiduciary trust. The fiduciary or the keeper of the trust was, in effect, the agent and the beneficiary was, in effect, the principal.

First, the agent was burdened with duties of loyalty and due care. When the self-interest of the agent was suspected of causing harm to the principal, the burden of proving loyalty was placed on the agent. The agent had the burden of coming forward with sufficient evidence to prove his or her loyalty. With respect to negligence on the part of the agent, the principal had the burden of proof but could hold the agent accountable when an objective standard of care had not been observed in management of the business consigned to the agent.

The Common Law thus turned the relationship of principal/agent into a status for the agent. Agency was an office; so was being a partner, a trustee, a corporate director, etc. With office came specific responsibilities. Failure of performance was transformed from a difference of opinion between agent and principal into a notorious setting of public expectations. The behavioral theory used by the Common Law judges appears to be a conviction that when we are made accountable in public, our pride tends to keep us more scrupulous and diligent than when we can act in secret. Principals could deny their own liability for acts of the agent when the agent had acted contrary to the terms of the trust, leaving the agent exposed to face the consequences.

Exposure and transparency were devices used to reduce agency problems.

Second, in its courts of Equity, English jurisprudence fashioned a number of rules that principals and beneficiaries could use. They could seek an accounting of monies had and received, with the burden on the agent to account for every penny received; principals could ask for the imposition of a constructive trust on money and property in the agent’s possession and name when fraud and abuse had occurred; agents had to have acted with clean hands if they sought to recover from principals on their agency contracts; agents could be prevented (estopped) from entering claims and evidence in their favor if they had acted inequitably.

Use of self interest

A second basket of remedial responses to the “agency problem” lies in self-interest. It is in one’s best interest to avoid faithless agents. Over time, therefore, faithless agents will not find employment as their reputation for negligence or disloyalty becomes generally known. This is why reference checks are so frequently relied upon. Generally, market based solutions to the “agency problem” rely on this mechanism of self-help. But it can be of limited utility where agents or those upon whom we rely for professional expertise have market power or are polished performers adept in the arts of lulling our suspicions with their smoke and mirrors – like Bernie Madoff to his investors.

Use of character

The third approach to minimizing the “agency problem” is to promote good character, the habits of living up to the virtues of trustworthiness, integrity, diligence, transparency and reliability. This agenda for securing better prospects for corporate social responsibility and business ethics – for avoiding asset bubbles and financial bubbles – and for putting in place the cultural foundation for specialization of function and division of labor operates at the level of the individual.

We must engage individuals to act as we would want if we want responsible and faithful agents. Such socialization, obviously, begins in the family, continues in school, and is finished in conditions of social engagement. We are concerned for the “presentation of self” in everyday life and Irving Goffman wrote about our dysfunctions in organizational settings. We want a good self to be presented, not a greedy, abusive, stupid or negligent one.

Having good character is one reliable ground for good stewardship behaviors. The moral sense within us is a public good in that it promotes trust in our communities and reliance on our business performance. Trust and reliance form the substructure of successful modern capitalism.

That human persons possess a moral sense that distinguishes them from beasts and other earthly creatures is increasingly a postulate of evolutionary studies, neuro-science, and brain research.

Thus, we must not presume that the “agency problem” is intractable and a permanent obstacle to responsible business decision-making. Rather, we should assume in us all an inherent capacity for reliable agency performance.

Set the bar high and we will tend to jump higher; set it low and we will slack off and get away with poor performance.

social capital and Wall Street

Social Capital and Wall Street

Stephen B. Young
Caux Round Table Global Executive Director
April 2009

A very important thesis about the dynamics of capitalism creating the wealth of nations holds that necessary cultural preconditions shape the scope and intensity of capitalist success. Where these preconditions are in effect, wealth is created; where they are missing, wealth is, relatively speaking, scarce.

The social nature of capitalism as a system, its manipulation of multiple interdependencies arising from specialization of function and the division of labor, demands an appropriate cultural context. Some values as carried into market and investment behaviors promote robust capitalism; other values don’t.

This observation honors the seminal insights of Max Weber, who a century ago, identified the rise of capitalism as an economic system new and unique in human history, with the social arrangements legitimated and encouraged by Calvinist religious beliefs. Weber argued that a peculiar set of values flowing from Calvinist convictions that individual salvation depended upon diligent and faithful application of one’s talents to the calling that God had provided here on earth. Frugality, discipline, confidence in the future, trust in others of the same faith, stepping up to personal responsibility in one’s relationship with God, and similar Puritan behaviors, thought Weber, all contributed to opportunities for investment in enterprise, reliable contracts and high savings rates to create financial capital available for investment.

While many have questioned Weber’s attempt to link particular aspects of Calvinist beliefs and practices to the capitalism that emerged in 16th century Holland and 17th century England, Scotland and British colonies in North America, few can deny the coincidence of capitalism’s first emergence in those Calvinist societies.

Now, if recent practices on Wall Street associated with sub-prime mortgages, mortgage backed securities, CDOs and CDSs have produced a loss in 2008 of some US$50 trillion in asset values, one would have to question how successful such a capitalism was in creating new wealth.

More than such losses, some of which will be restored as markets recover from the collapse, the market collapse caused the collapse of Bear Stearns and Lehman Brothers and the conversion of the remaining investment banks into more traditional depository institutions. The American government, through its Treasury and Federal Reserve system, assumed many trillions of dollars of financial obligations to keep the banking, credit and financial intermediation markets operating. At one point, the Federal Reserve was purchasing the commercial paper of American companies due to failure of the private market for such debt. This was an unprecedented failure of private sector decision making.

The outcomes of Wall Street’s marketing of these financial instruments were not beneficial for anyone and such marketing could not be sustained. This episode of financial intermediation was a failure from every point of view once “irrational exuberance” took over the markets. It should not be considered genuine capitalism but only speculation over the value of present contract rights to future income.

If the connection between cultural habits of mind and action and successful capitalism is to hold true, it must be that Wall Street lost some of its social capital as a prelude to this most recent round of irrational asset valuations.

The corollary argument to Weber’s thesis on a smaller scale appropriate to these financial market transactions would be that the kind of social capital needed for capitalist achievement was missing. And, moreover, that loss of social capital caused, or at least contributed to, the collapse of asset values in the crash of 2008.

If the thesis is to hold that loss of social capital correlates with the loss of wealth as the inverse of the proposition that accumulation of the same social capital leads to wealth creation, where was the erosion of social capital on Wall Street prior to the financial collapse of trading markets for sub-prime mortgages, CDOs and CDSs and the resulting collapse of global credit markets?

Let us consider first a generic model of the social capital relevant to capitalist wealth creation.

There are of course innumerable varieties of social capital, each with different modalities of values and behaviors and each promoting different outcomes. The social capital that supported Egyptian Pharaohs and supported their construction of pyramids and temples was most likely different from the social capital that sustained Native American tribes in their pueblos, teepees and long houses.

The virtuous behaviors that Weber marked as sponsoring capitalist endeavors flowed from a social capital value set that had certain special characteristics.

This social capital supported longer time horizons for instrumental economic engagements. Investment more than trading was brought to the fore of business thinking. Expectations of rewards were stable and realistic. People were patient and delayed gratification in order to save and invest. Such people worked at their trades in a reliable fashion so that they became good credit risks and trustworthy stewards of moneys invested in their undertakings. Their work was their bond. There were clear laws and just enforcement so that promises and contracts were worth something as predictions of future events. Having a reliance interest in the success of others was justified. Financial intermediation was enhanced; money capital could be accumulated for use in joint enterprises.

All these reliable behaviors lowered risks and so interest rates and promoted transactions. Investment of time and money in production and delivery of goods and services with substance, with the power to leverage production of more and better goods and services and meet new needs was intuitively desirable. The future would be better and a commitment to progress today would realize that future tomorrow.

Next, this social capital placed a priority on learning, education and the introduction of new mechanics and technologies. It was comfortable with secular approaches and did not disdain the material world of chemistry, physics and biology.

People growing up in such conditions will be more thoughtful about the consequences of their actions on others. Externalities are brought home to the actor through an ethic of pride in one’s work and in one’s contribution to community.

Now, the opposite of these behaviors and commitments, we can infer, would most like not lead to wealth creation.

Social patterns where people focus on the immediate and will not commit now to benefits to be received much later, where they have no patience and do not trust the word and reliability of others, will promote higher levels of risk and so higher expectations of interest on money lent and returns on equity funds invested. There will be fewer transaction of substantive investment. The cost of business will be much higher. Savings will be rejected in favor of current consumption. People will seek cash money to use its power over those who are perceived to be and, in fact, are not trustworthy or reliable. Stewardship responsibilities will go begging for honest fiduciaries to accept them.

As there are lower standards of responsibility accepted, there will be lower standards of care in general and higher transaction costs in third party engagements as a result. Risks will be pushed off on others as much as possible.

Starting in 1980, Americans in general moved from a high savings culture to a high debt culture as the Baby Boomers came into full maturity and cultural leadership. New norms and behaviors came to the fore in many parts of American society. Assuming responsibility in civil society organizations, in politics, in anything outside one’s family, circle of friends or professional tasks linked to renumeration occurred less and less. Robert Putnam noted this trend in his seminal book Bowling Alone. Even in family life, parental responsibilities were sloughed off. Divorce became very common and schools were looked upon as the primary means of socializing the children. Seniors were encouraged to live out their last years on their own in retirement homes and facilities.
Wall Street and its practices were not immune from this cultural evolution.

As a result, the social capital embraced and accumulated by Wall Street shifted in its nature and its proclivities. For example, time horizons became shorter. Short term thinking became the norm. People lost loyalty to employers as they kept on constant lookout for new jobs with higher pay. Legal formalities replaced a personal standard of care for the well-being of clients and customers. Using debt to fund consumption and more pleasurable life styles demonstrated the power of short-termism among Americans. Delayed gratification was disparaged by Baby Boomers.

People looked more and more for higher short term returns. Few invested equity in companies for the long haul, preferring to profit from “renting stocks” rather than owning them and realize long-term capital appreciation from the company’s profits and retained earnings. Leverage became king so that higher returns could be enjoyed through the short-term use of other people’s money. The banking system converted from well-capitalized institutions that held risk to maturity to ones that merely traded risks back and forth for fees and spreads.

Investment banks went public and so lost the long-term perspective and caution that goes with partnership structures where the personal assets of the owners were always at stake in the risk level associated with firm activity. Professional mangers took over from owners as the drivers of firm strategies. Trading desks grew more powerful within the investment banks as their trading profits came to dominate firm income and the culture of traders took over from the older, more white-shoe culture of cultivating long term client loyalties and connections.

Personal responsibility for investment decisions was replaced with reliance on portfolio theory and mathematical algorithms. The Black-Scholes formula for calculating value when no market for a contract claim existed and the “chasing” of Alpha returns by institutional money managers were the most famous examples of this new intellectual environment on Wall Street. Companies were judged for better or worse on whether they “made the numbers” predicted by professional estimators. Trust in a company’s leadership was replaced with a more mechanical formulation of what constituted success.

The chase for higher returns – more fees and commissions – correlated with a decline in general levels of trust and commitment. Fund managers knew that to take risks and not earn returns within a peer group average would lead to the loss of money under management. Herd thinking was acceptable as it was “normative”.

Executive compensation was more and more linked to short term results, especially at senior levels where strategic commitments were made and cultural norms were adopted within firms for replication at lower levels of corporate hierarchies. Money results, not fiduciary quality, drove the decisions of many CEOs in all industries, not just Jack Welsh at General Electric.

While newer values promoted these structural changes in business models and practices, the new power arrangements solidified the intensity with which the new values could drive individual decisions and manipulate individual life choices in set ways.

Wall Street became captive to playing with other people’s money on a gigantic scale. Savings and reserves in exporting countries like China and the funds accumulating in pension funds, sovereign wealth funds, and hedge funds was there for the taking, or rather, the borrowing. Access to funds came through the sale of instruments that promised high returns.

Debt and short-term investing – largely tradable instruments to boot - took over from traditional equity as the criterion for financing capitalism; leverage ratios of banks and investment banks went to historic highs; structured financial instruments – mortgage backed securities and CDOs – were produced to fit new market demands for using short term leverage and trading in contract rights. CDSs were invented to provide risk reduction in lieu of tradition equity and capital reserves. Sadly, since many CDSs were only backed by legal documentation and not real money, the risk reduction they provided was illusory. It was use of pledges that had no reliable commitment behind them to give them “credit”. The words on a CDS, and on many CDOs, did not reflect that firm’s bond. Counterparty risk eventually caused the credit system to freeze and so become useless. Mathematics and formalisms drove trading in financial instruments.

An asset bubble was thus easily assembled by Wall Street firms and experts.

Any asset bubble is destined for collapse as financial wealth is destroyed and real economic activity retreats.

The factors that grow asset bubbles are inimical to the growth of genuine capitalism that produces the “wealth of nations”. When Wall Street produces such financial houses of cards, it only reflects social capital values and structures that are not supportive of good capitalism.

To improve the outcomes of financial intermediation, then, the social capital formation of financial centers like Wall Street needs scrutiny and attention.

If we want to restore robust creation of real wealth which can be enjoyed for many years and which can lead to creation of further wealth on the part of others – workers and investors alike, then we must - as the first item of such business - look to the values embodied in our financial firms.

Friday, March 27, 2009

When market realities are out in the open

Here is what US Treasury Secretary Timothy Geithner said on Thursday March 26th about the US economy as it gestated the great financial crash of 2008:

"The system proved too unstable and fragile, subject to significant crises every few years, periodic booms in real estate markets and in credit, followed by busts and contraction. Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system. These failures have caused a great loss of confidence in the basic fabric of our financial system, a system that over time has been a tremendous asset for the American economy."

This is an indictment of an economic system, not praise for a relentless free market profit-taking.

Friday, March 20, 2009

Requim for Wall Street - where the past meets today


by Percy Bysshe Shelley

I met a traveler from an antique land
Who said: Two vast and trunkless legs of stone
Stand in the desert. Near them, on the sand,
Half sunk, a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal these words appear:
“My name is Ozymandias, king of kings:
Look upon my works, ye Mighty, and despair!”
Nothing beside remains. Round the decay
Of that colossal wreck, boundless and bare
The lone and level sands stretch far away.