Agency Capitalism

When Karl Marx defined capitalism he meant an economic and a social system in which power rested with the owners of capital. In today's capitalism the owners have been usurped by a new class of executives.
The idea that a firm might be run for the benefit of its managers rather than the owners is not new. Economist refer to this as the "agency problem". In theory, the shareholders own the firm and appoint a board of directors to ensure that the firm is run well and profitably. Yet over time the professionals running the company manage to divert the company's resources to their own benefit - a more comfortable office, a car and driver, a company plane, a bigger salary, a performance bonus and share options.

My contention is that the agency problem has grown to such a stage that it now defines the nature of the economy. The outlandish levels of remunerations which bankers and executives in the financial sector award themselves is only the most blatant example of the new agency capitalism. In some cases, as much as half a firm's net earnings are paid out as bonuses. The obvious questions are: how has this happened and what is the alternative?

In the 19th century the owners of capital were largely wealthy individuals. They could take an interest in the firms in which they invested to ensure that they continued to develop and grow and provide a good return. Now individual shareholders are a small part (10%) of the stock exchange. In 2008, 42% of shares in the London stock market were held overseas. Of the remainder 40% are owned by financial institutions - insurance companies, pension funds, mutual funds etc. (Details here) So two-thirds of UK shares held in the UK are owned, not by top hatted capitalists, but by us - people who pay into occupational pension funds, private pension funds, insurance policies and ISAs.

Strictly speaking they are owned by the insurance companies, pension funds and other institutions; but it is our money they are investing ultimately for our benefit.

With 42% of shares owned overseas and 40% owned by institutions, the company owners are no check on the executives running the companies. It is no wonder bankers can get away with daylight robbery.

The problem is compounded by the idea that a company's purpose is to provide "shareholder value"; an idea which has reduced the shareholder's interest to whether the share price is going up.

What is the alternative? I believe that there is an alternative to agency capitalism. More on that another day.

Another Euro Crisis

We may all breath easier. The crisis is over. In Brussels yesterday the leaders of the 27 agreed to save Greece from the jaws of the bond market.

On the other hand the real Euro crisis is only just beginning. Germany has signalled its price for the Greek rescue: the EU must be able to expel errant members from the Eurozone. A way is sought to revoke the irrevocable union.

A new treaty will be needed and there is little appetite for that in European capitals. Still, Ms Merkel is pushing for it and the compromise language in the summit conclusions opens the door to treaty revision.

The root of the next euro crisis lies in the change made to the German constitution last year which requires a balanced budget. While Greece and Spain and Portugal are pushed to deflate their way to German levels of competitiveness, Germany will be deflating its way to a budget balance. That is why Germany wants to make an emergency exit available.

Until now we expected the borders of the Eurozone to extend to the east. It seems more likely that the southern border will retreat northwards.

Ruskin's Critique of Capitalism

An interesting article in today's FT quotes John Ruskin on the idea that the role of a business is the provision of goods:

“it is no more [the merchant’s] function to get profit for himself out of that provision than it is a clergyman’s function to get his stipend.”

It expresses something I have been trying to say. The purpose of a business is to provide a product or a service; "to provide for the nation" in Ruskin's words. The dominant idea of our time is that the purpose of a business is to generate shareholder value. The job of an executive in any business, whether it makes software or cleans offices or whatever, is to maximise the profit returned to shareholders.

John Kay, says something along these lines in The Truth About Markets. He claims that the idea that profit is the objective and business the means is wrong; doing business is the objective and profit the motive. (I'll check the quote when I get a chance).

This is on my mind because I'm wondering about what happens when the owners of firms no longer have control of them and the only measure of a firm's behaviour is its return on equity. I'll write more on this soon.

Obama Crosses the Line

A clear dividing line: some want to reform banking regulation, others want to reform the banks.

Yesterday the US administration crossed from regulatory tinkering to real reform. In Britain it is Mervyn King and Lord Turner, rather than the government, who want banks tamed.

The "Volcker rule" means that banks which take deposits will not be allowed into the Casino - an excellent first step.

Some institutions will try to escape by giving up their status as banks. Goldman Sachs and Morgan Stanley only became bank holding companies during the crisis. It is not politically possible for them to escape government rules. Obama's goal is to cut back financial firms to a scale where they can not threaten the stability of the system. He will need some version of the quack principle- if it quacks like a duck it is a duck.

I would like to see more. The authorities - possibly the Fed - should have powers to limit leverage (that is the total amount financial firms borrow) and certain types of derivatives should be banned.

Much of the commentary will be on the politics. Is this Obama's response to the defeat in Massachusetts? I think not; look at the cover of last week's Economist when it called for Obama to come out fighting. The FT had something similar this week.

Will Britain follow suit? I think so; fear of the City of London losing out to other financial centres has held the government back. Britain can adopt the same rules as apply in New York and push them through the EU so that they apply equally in Frankfurt.

Economics or B*ll*cks?

The pound has risen to a four-month high against the euro, after higher than expected UK inflation raised the prospect of interest rate rises, says the BBC.

Is that economics or is it bollocks?

Yes you are right. In economics higher inflation pushes a currency down not up. I previously told a little story to explain why that is. So why is the BBC talking bollocks?

Well inflation figures were higher yesterday and the pound did rise against the euro so perhaps lazy journalism put the two together. Coincidence doesn't mean one thing caused the other. In fact the euro fell against the dollar as well, so maybe the pound's rise has more to do with the economic news from euroland where Greece seems to be struggling at present.

Perhaps currency traders do care more about interest rates than economic fundamentals and so they did push up the pound as the story says. It is possible; day-to-day market movements are not explicable by economists. On the other hand, the rise in inflation is a blip caused by unusually low prices a year ago. The bank is not about to raise interest rates. Surely, even currency traders can work that out.

Update 20h00

Now the BBC says:
Euro falls against dollar and pound
The euro has hit a five-month low against the dollar as continuing concerns about the Greek economy weigh heavily on the currency.

That is a little more plausible. Incidentaly the latest inflation figures for euroland are up....