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Chapter 1
A New Capitalism?
The roots of the credit crunch and subsequent deep recession were set down during the birth of the new capitalism in the 1970s. Corporatism had had its day. The idea that economies worked best when managed, or guided, by an activist state â indeed when both sides of industry sat down together and agreed a way forward, creating the so-called âmixed economyâ â was severely criticized by Nobel prizewinning economists such as Milton Friedman of the University of Chicago.1 Such thinkers argued that the best way to achieve higher trend rates of growth, through encouraging entrepreneurship and investment, was to diminish the power and role of the state and free the market from as many external controls as possible.
On 11 September 1973, President Allende of Chile was overthrown by a military coup led by General Augusto Pinochet. The pogrom that followed against the supporters of Allende has been well documented.2 Many innocent people were killed, tortured and imprisoned either because they were members of alternative political groups, or because they belonged to trade unions or academic circles the new junta disliked. Some were arrested simply because they had been denounced by people who sought to curry favour in such circumstances from the new authorities.
What is less well known is what Pinochet then did to the Chilean economy. Like-minded economists, many former Chilean students of Friedman at the University of Chicago, were brought in to run the new administration's economic policy. The so-called Chicago Boys privatized state industries, cut public spending and within a year had ensured that 50 per cent of the Chilean working age population were unemployed.3 This was the beginning of the rise of the private sector over the public as the key economic agent â at least in ideological terms. In the Cold War battle of ideologies this made eminent sense. The free market was a western, American and democratic idea. Statist-driven economic policy was socialist, totalitarian and Russian.
In 1979, Margaret Thatcher came to power in the UK and in 1980 Ronald Reagan was elected as President of the US. Both leaders were fervent believers in the need to move towards a more free market, liberal economic agenda that had at its heart the idea of markets freed from state control. At that time, many markets in commodities, agricultural products, manufacturing and other industries were subject to tariffs, price controls and uncompetitive market environments. Dismantling this paraphernalia of state control would take time. But there was not such a problem with freeing capital. Getting rid of fixed exchange rates and allowing exchange rates to float, as happened in 1979, was the first major step on the journey. By freeing capital, capitalist activity could and would increase. Previously banks had been required to hold a cash reserve â often placed with the Bank of England in the case of the UK. Then when a downturn occurred this cash could be released back into the system to stimulate a quick economic recovery. In 1980, Thatcher symbolically abolished such reserve requirements. By the late 1980s, she had taken away nearly every control and regulation on lending and created a free market in financial services.4
Wall Street and the City of London soon became the epicentres of a new form of deal-based and faster-moving capitalism. Despite major recessions in the early 1980s and 1990s, the emergence of casino capitalism, led by a powerful financial services sector, increased the supply chain of smart people flooding into investment banking, commercial law and Wall Street trading houses. A young graduate from an Ivy League university in the US or Oxbridge or another Russell Group university in the UK, could become richer than their wildest dreams before they were 30. Philip Cook and Robert Frank in their book, The Winner-Take-All Society, argued that intense competition among able people for top financial service jobs had the effect of costing the rest of the economy by decreasing the pool of talent going into teaching, engineering and other useful occupations. They calculated that an increase in lawyers depressed real gross domestic product (GDP), whereas the same number of graduates going into engineering would increase GDP.5
Gordon Gekko, the fictional Ăźber trader of the 1987 film, Wall Street, was right to state that in this kind of world greed is good. Yet greed is not a rational emotion. Greed distorts perspectives. It leads to perverse risk-taking and it is fundamentally antipathetic to the types of collective action that underpin the best types of endeavour (on which more later). Moreover, it goes against the idea that economic man is above all else rational. And the 1980s offered only an apprenticeship compared with the rewards on offer to people in financial services during the noughties.
It is worth understanding the flaws in the neo-liberal economic argument in more detail. Free market theorists believed, and still do believe, that the mixed economy had got the balance between state and market fundamentally wrong. Markets work but states do not. The problems of inflation, low productivity and low levels of growth were due to the fact that the balance between state and market was wrong. The state should only intervene occasionally to temporarily correct market failures. The free market view is based on a number of assumptions that can be found in the âfirst fundamental theorem of welfare economicsâ. In essence, free market disciples believe that as long as markets are well populated with new entrants and everyone has access to the same information, then unbounded competition will result and this will lead to the most efficient allocation of resources.
The critique of this view is that it treats the free market as a static ideal. Basically, the argument is that markets should work and when they don't, it is a breakdown in the engineering rather than a fundamental design flaw. In reality, as the evidence of the past 200 years shows, markets are a bit like theories of the universe â many and several. Market failure is endemic to markets that thus need to be consistently remodelled and rebalanced. And it is the task of the state (i.e. us) to undertake this work. So in today's knowledge economy (on which more later), innovation is more important to marketsâ overall terms of success than say it might have been 100 years ago. Innovation is a component of a market economy but its relevant value does not stay static over time.
For a free market model to work several conditions need to be fulfilled. Failure to do so will most likely lead to a market failure. Information must be transparent and equally available to all market participants at roughly the same time. Even with the advent of the internet, is there anyone who really contrasts and compares all the prices of each and every good and service they purchase? If information really were the core element it is argued to be, why do we have brands?
Next, prices in an efficiently working market should reflect all economic costs. There should be no âexternalitiesâ that impose either costs or benefits on others that is not captured by the transaction. Do we, for example, capture the entire costs of producing, shipping and selling any given traded good? Costs such as the pollution from carbon dioxide (CO ) emissions when the good is transported, for example? In free market theory, people are entirely rational. They are capable of exercising restraint today for gains tomorrow. They can defer gratification. They can weigh up the time and quantity involved to gain the optimum outcome for themselves in each and every case.
However, this belief flies in the face of the evidence. People are irrational and short-sighted. They don't defer gratification or weigh up options. This is why we have phrases such as âimpulse buyâ. This is why people rack up credit card debts, fail to save for retirement or don't bother to invest in their education and training. Individuals will accept bias through ignorance, laziness, not having enough time or whatever else gets in the way of calm rational decision making. Governments need to consistently manage the fallout and calibrate the incentives to encourage people to behave more in their longer-term interests.6
Moreover people are very good at what is called âgamingâ the system. For example, a typical worker may want to maximize their reward by encouraging the manager (who is less knowledgeable than they are about their work and job) to set easy performance targets in order to be paid more. This is why individual performance-related pay on the whole rarely delivers the performance boost it is designed to do; and it is why average finance sector workers were paid alpha rates of pay. Far from being rational, many people behave instinctively, emotionally and irrationally much of the time.
Whatever the flaws in the thinking, the US and UK moved away from a mixed economy to a neo-liberal free market form of capitalism that emerged throughout the 1970s and 1980s.7 For businesses this meant putting âthe dealâ rather than âthe enterpriseâ at its heart. By so doing, the task of building sustainable businesses was mislaid. The chief executive officers (CEOs) of major companies around the world knew that they had little time to grow a business. Private equity funds, hedge funds and private investors such as Philip Green were ever-ready to pounce on any firm that showed a less than optimum return to investors.8 Meanwhile, these investors, from individuals to the far larger and more potent pension funds managed by professional investment firms, looked on passively. So passively in fact that one shareholder activist, Robert Monks in the US, has described the process of management returning ever-greater shares of corporate wealth to themselves as the capture of the productive capital of these firms by the management not the investors.9
By the early 2000s, it was apparent that trader-driven, deal-based capitalism was driving a new, more vigorous, form of financial services innovation. This was based on two factors. The ability of private equity to borrow vast sums of money to finance the purchase of companies and the need for banks to continue to grow returns to their investors through âhedgingâ their risks by inventing new forms of financial products. Both processes were driven by cheap money. Capital became ever more available and its cost dwindled at the same time. The laws of supply and demand were working well.10
Private equity (PE) companies tapped resources from a growing pool of international investors and by borrowing from banks. Typically, PE firms reverse the debt/equity ratio. Where a firm may be carrying one-third debt to two-thirds equity, PE companies will reverse that ratio. The assets the company formerly held, such as property, will have been sold off and often then leased back. In many cases these lean, mean firms are then sold on with an overhang of enormous debt. The knock-on effect of such deal making reverberated across the âreal economyâ.11 Boards and CEOs felt renewed pressure to cut costs and return higher levels of dividend to investors. Performance cycles grew shorter and shorter. The important thing to note is the psychological and cultural impact private equity had on companies beyond their reach. What mattered was the deal not the business.
Private equity partners at largely no, or little, risk to themselves, were able to generate returns of hundreds of millions of pounds in a very short time. This was the privatizing of wealth on a grand scale. At no other time in history has speculation offered so much gain to so few.12 And standing on the sidelines watching were governments, regulators and us. We fiddled while Rome burned and watched the system fail.
However, private equity was merely the minor symptom of the disease. The global banking system, but particularly banks in the US and UK, were the real engines of the new capitalism. For it became apparent to the boards and senior executives running banks way back in the late 1980s that money could be worked harder. Rather than just be a bank, taking in deposits and offering loans to customers, they could become the objects of speculation themselves. By bringing together their retail banking operations and their investment banking operations they could gain access to more capital and equity.13 The repeal of the Glass-Steagall Act by President Clinton in 1999 opened the floodgates to such activity in the US.14
The banks encouraged the brightest and the best minds in maths and science to work for them, inventing new forms of financial products. These products, usually labelled derivatives, bundled different types of risk together in packages that could then be rated by ratings agencies and sold on to other investors. The Wall Street banks were literally hiring rocket scientists from Pasadena to develop such products.15 Anything could be turned into a derivative from insurance risks on weather to mortgages.
Of course not every bank followed such strategies. For every Lehman Brothers, Royal Bank of Scotland and Bear Stearns, there were other financial institutions such as some of the more venerable mutual societies, such as the Cooperative Bank or the Liverpool Victoria Friendly Societ...
