Thursday, May 21, 2009

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.


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