REFORM - unfettered free market capitalism is creating more harm than good : a case for reform.

There is a powerful pro-market lobby

Free-market interests are powerful and their rhetoric is fulsome - one doesn't have to go any further than the financial pages or journals such as Forbes Magazine and 'The Economist' to enter a forest of axioms and assertions - the theme generally being that the system of global free markets, competition and the unimpeded flows of capital have been a boon to mankind, enriching people in all parts of the world and fostering efficiency and growth through unfettered competition. Some even postulate that now the Soviet system has lost the battle for humankind, the world is on the verge of a new golden age, when protectionist barriers will be swept aside and the power of capital unlocked to work its magic for all, rich and poor alike. Proselytisers declaimed that democratic free-market capitalism was the perfect end state of human development and that we have reached 'the end of history'.

Neo-Liberal free market ideas are not the 'truth'

Hearing the proponents of democratic free-market capitalism might lead the recipient to believe that their ideas represent the final state of human evolution. But these ideas are no more the truth than the ideas of Marx and Lenin, which led to the disastrous Soviet experiment in central economic planning. The history of mankind is littered with grand ideas that are always represented by their proponents as signposting the salvation of mankind. Many of these movements have originated in Europe and have been based on the idea that there is a body of absolute knowledge, which, once discovered, will enable mankind to dominate nature and eliminate poverty. The eighteenth century Positivitists believed that as societies came to be based on science they were bound to become more alike. Scientific knowledge would engender a universal morality in which the aim of society was as much production as possible. Through the use of technology humanity would extend its power over the earth's resources and overcome the worst forms of natural scarcity. Poverty and war could be abolished. Through the power given it by science, humanity would be able to create a new world. When the Soviet system collapsed, some in the West, especially in the US, believed that a final victory had been won for democratic global capitalism. Fukuyama and the neo-liberals believed that a final victory had been won - that the world would be transformed by the universal application of free-market principles.
Professor John Gray, in his book Al Quaeda and what it means to be Modern, says:
When the Soviet system collapsed, they (Positivist ideas) re-emerged in the cult of the free market. It came to be believed that only American-style 'democratic capitalism' is truly modern, and that it is destined to spread everywhere. As it does, universal civilisation will come into being, and history will come to an end.
This may seem a fantastical creed and so it is. What is more fantastic is that it is still widely believed. It shapes the programmes of mainstream political parties throughout the world. It guides the policies of agencies such as the International Monetary Fund. It animates the 'war on terror'.........
Through history, humans have generated strong convictions based on faith and promoted them as representing universal truth - and there is no reason at all to believe that neo-liberal free marketeers are any different from Marxists, Positivitists , fundamentalist Christians and Muslims, French Revolutionaries or any other bunch of 'universal-truthists'. So, we recommend that the assertions of global free-marketeers should be viewed with a sceptical eye.

Their assertions are very open to challenge

- for example, consider the effects of free-market economics on Russia.
Following the collapse of the USSR, Russia is a prime example of a country that was subject to the full rigour of free market liberalisation. The attempt to kick-start a free market, conceived by Western bankers, led to soaring consumer prices, and a rapid decline in real wages and pensions. Personal savings were almost wiped out.
The results were terrible - the old system of central control collapsed suddenly and completely, throwing the lives of millions into poverty and chaos. In a system that lacked an established enterprise culture or institutional arrangements to prevent fraud and corruption, 'entrepreneurs' ripped out the valuable parts of the economy in a sale of public assets that amounted to nothing less than grand larceny. The old systems of industry, public health and social support, already impoverished under the Soviet regime, simply disintegrated.

The gainers?

• Western bankers who led the way in constructing the grand new free market order.
• Opportunist oligarchs who appropriated vast swathes of public wealth and became immensely rich.
• The Russian central government, which has latterly used the chaos and misery created to re-consolidate its power and to act against those oligarchs who were foolish enough to buck the leadership. Russia is now seeing a re-centralisation of political and economic power that we in the West will come to rue as energy supplies become scarcer.

The losers?

• The bulk of the Russian people, whose life expectancy, physical and psychological health have dramatically worsened since the Soviet era, and whose prospects appear to be little better. Life expectancy has plunged to 58.9 years for men, alcoholism has reached epidemic proportions, average incomes have plunged, the birth rate has plummeted and abortions exceed live births. Optimists will point to improvements in economic growth, but seldom mention the base from which these started, or that the benefits are not reaching the average Russian.
• All those that will become dependent on Russian energy supplies. If the post-Soviet economic changes had been managed with sensitivity and over a hugely longer timescale, it is possible that the Russian economy could have evolved into a mixed social market type, with a healthy balance between state and private enterprise. As it is, central government has been handed a golden opportunity to recentralise economic power and is already flexing its muscles.

An objective observer could not help reaching the conclusions that the introduction of the free market economy and unfettered market forces has not helped the average Russian and that the backlash is taking Russia back to authoritarian centralised government.

Free-market economics are undermining Third World development

The same might also be said of parts of South America, most of Africa and some regions in South East Asia. The system of global capitalism seems to have made the plight of poor economies worse, undermining local industry and agriculture as well as exploiting cheap labour - all in the name of progress. In South America we are witnessing a backlash against what is seen to be exploitation by developed countries.
The economic institutions that are supposed to help - like the World Bank and the IMF - seem to be more agents of the interests of wealthy countries, imbued with almost religious zeal to impose free market economics on poor economies that cannot develop without shelter from the full rigour of global market forces.
So the claims of free-market zealots are at the very least open to challenge in the developing world.

Inequality and poverty in the US

But what about the state of the developed 'Anglo-Saxon' economies; the power-houses that have spawned economic liberalism? Here again there are worrying signs. The United States represents the pinnacle of free-market success - or so some pundits would have us believe. But the US is not really a practitioner of free-market economics - it is probably one of the more protectionist countries going - sheltering and promoting large segments of its economy, using its mighty defense industries to cross-subsidise civilian ventures and its military might as well as influence on the IMF, World Trade Organisation and World Bank to foster strategies that will benefit its interests on the international stage. Even France, much denigrated for protectionism, cannot match the US for bending the rules in its favour.
There is another worrying dimension to the American free-market dream - one that was brutally displayed for all to see through the lens of the New Orleans disaster. The paralysis that followed the hurricane showed the almost total atrophy of the public service infrastructure. Subsequent events, which have left New Orleans a continuing disaster area, might lead to the conclusion that the US is a great place to live - provided that you are rich. It is not so good if you are poor and underprivileged, and the almost total lack of economic and social mobility means that if you are born poor the likelihood is that you will stay that way. So maybe the US dream is based on the necessary existence of an economic underclass, not a situation that would be tolerated in the prosperous and more egalitarian social market countries of Scandinavia and North West Europe, which do not buy the arguments of neo-liberal economists.

The UK financial system, based on free-market principles, is deeply flawed

Moving closer to home, what of the UK financial powerhouse, the City of London? Politicians, led by Chancellor Brown and Prime Minister Blair lose no opportunity to fulsomely praise the City as the jewel in the UK's economic crown. London is now probably the most lightly regulated of the major financial markets and as a consequence is beginning to attract some very dubious foreign companies, as their UK counterparts are broken up, merged and sold to foreign buyers. The flow of quality UK companies queuing to join the FTSE is drying up, leaving the field open to foreign entrants, some of which have very murky ethical track records and could be even be viewed as Trojan Horses for Russian political and economic ambitions. Companies mainly owned by the Russian government can afford to be cavalier about corporate governance codes.
So the reality is much less positive than these two politicians would have us believe.
Just consider:

• There is increasing evidence to show that quoted investment institutions and companies are not producing superior returns and that privately held investment houses and non-quoted companies such as family businesses and partnerships are producing better results, especially for customers and employees.
  The argument that 'Market disciplines' will enhance the performance of companies by destroying the weak and badly managed and distributing assets to the most efficient doesn't hold water any more. Several long term (more than 20 years) studies by very respectable researchers show that the performances of companies in the FTSE 100 are in aggregate poor, with sales and profit growth barely keeping pace with advances in GDP.
  What has grown is the mortality rate of big British companies, the incidence of value-destroying mergers and acquisitions, and the sale of UK technology companies to foreign buyers. But the most spectacular growth (totally unrelated to performance) has been in executive pay and dividends to investors - the latter apparently at the cost of low investment.
• The level of investment by most large UK quoted companies in engineering and high technology sectors dismally trails international competitors. Research shows the marked unwillingness of UK investors to support long-term investment. However, their willingness to realise short term gain by selling companies with hugely valuable know-how, expertise and intellectual property to the highest bidder is placing the UK's future as a developed modern economy at serious jeopardy.
• The massive run of malpractice, deception and incompetence displayed by large parts of the financial services industry - starting with the personal pensions scandal and continuing unabated to the point that public trust in the financial and banking system is rightly at rock bottom - along with the politicians that praise it.
• The dubious record of the financial and investment system in providing a stable platform for savings and pensions. Ask members of final salary pension plans how they feel, and many will recount growing insecurity - some will report being grossly let down by the system and the government that they had believed underwrote it.
  People have a reasonable expectation that the investment system that supports their savings and pensions is run with responsibility and probity - equally that they should be able to trust government to advise them responsibly. The parliamentary Ombudsman and now MP's have castigated the government for misleading many pension fund members into believing that their assets were secure when they were not - and then refusing to accept responsibility for the misery that their poor advice caused.
• The explosive growth in unregulated speculation through Hedge Funds and derivatives trading which is beginning to worry even the Bank of England and the almost toothless Financial Services Agency. When the next cyclical downturn occurs it is almost certain to be exacerbated by the collapse of the frothier parts of the speculation industry - and once again, it is ordinary individuals who will suffer most.
• Margaret Thatcher had a dream - of a share and property owning democracy. To-day small individual investors had better take care in markets dominated by huge banks and mysterious speculators in Hedge Funds and derivatives. The financial market has become a jungle dominated by big players, who operate on whose behalf? Nobody really knows, despite the 'shareholder value' rhetoric.

A view from the inside

Here is a cool analysis of London's premier industrial investment vehicle, the FTSE 100, which once upon a time was supposed to be the stock market for the UK's 100 biggest and (the assumption was) best companies. It is by Max King, investment strategist at Investec:

Only 23 of the original FTSE 100 companies (of 1984) have been there throughout. A further three(Aveva, RSA and Glaxo) each represent the merger of two 1984 constituents, while Diageo was formed from the merger of Grand Metropolitan and Guinness, which controversially acquired Distillers, a 1984 constituent, in 1986.
Privatisation accounts for 15 of the present constituents, though the number is in steady decline (often through foreign acquisitions). A similar number of companies have been floated on the market from private hands.....nine of the present constituents are refugees from overseas, including six from South Africa...Antofagasta has always listed in the UK, having been a railway company until the early 1980's, but has never had any business interests here.
Partygaming (Gibraltar based) and Kazakhmys (Kazaksthan) are also refugees. With at least four (now many more) Russian companies lining up for flotation, London is well on the way to joining Panama and Liberia as a 'flag of convenience' location.
No fewer than 40 of the original 1984 constituents have disappeared through takeovers and a further seven absorbed through mergers. Others, including Bass, Racal and Thorn-Emi, were radically restructured and disappeared when some of their offspring were subsequently bid for.
In 1984, bids from overseas were rare. ......it is only in the last 10 years that takeovers from overseas have become commonplace.

The lesson for the investor is that the apparent permanence of the FTSE 100 is an illusion. The FTSE 100 is like Space Invaders: how ever many get zapped, there will always be (increasingly foreign) replacements crowding in from behind. Some of those that disappear in takeover bids do so in glory, leaving their investors well satisfied, but others slink off when well past their prime.
Unlike in the US, very few companies have achieved top 100 status through organic growth or technological innovation. Equating membership of the FTSE 100 with 'blue chip' status has always been a non-sequitur.
Globalisation has left the FTSE 100 in limbo. The FTSE does not represent the best of British companies, but it does not have the breadth or spread of the global indices either. It does not capture the growth opportunities of other markets and investment in it is not low risk......
A real danger is that the FTSE will be forced to continue with a lax regulatory regime, because as other forms of enterprise fail the UK economy is becoming dangerously dependent on the financial services industry. In order to attract foreign investment, London will indeed need to become a 'flag of convenience' location. This will hardly make it an attractive proposition for those who wish to know that their pensions and savings are in safe hands.

THE AGENDA FOR CHANGE - capitalism in the service of people

Forces for change

• The essence of enterprise is changing radically. Current capital markets were founded when the priority was providing capital to fund asset-hungry heavy industry and railways. Now new forms of enterprise are based on knowledge, not physical assets. New forms of organisation are emerging, which are based on networking and often part-time or temporary relationships. The capital markets cannot cope with these changes as their core skills still lie in valuing physical and financial assets, and they do not understand organisations that are virtual networks of collaborating interests. New forms of investment are needed, that will match dedicated long-term funding to the interests of those most closely involved in the enterprise.
  The nature of ownership and control will have to change as people and their skills become the dominant source of value creation. The old premise that the providers of capital are the sole owners of enterprises and can dispose of their assets as they wish is already highly damaging to enterprise and the public interest. In the future, capital providers will have to take their place alongside employees, collaborators and suppliers or enterprise will continue to suffer.
• High technology and knowledge-based enterprise is a long-term game, needing commitment and understanding from innovators and investors alike.
  Future success will require more and more investors who have commitment to and understanding for the enterprises in which they invest. The current mainstream of UK investors is totally financial in orientation and psychologically distant from their investments.
• Companies are living human institutions. The best managers recognise this, and elicit high levels of commitment from their people. This is in stark contrast to the values and objectives of the bulk of institutional investors, who regard companies as bundles of assets to be bought and disposed of at will. At the moment, investors have precedence and the law is on their side. The collision of the worlds of living enterprises and financial speculators is already causing huge destruction and will become increasingly dysfunctional as knowledge industries become the norm.
• Increasing the diversity of investment sources and opportunities. The current financial market arrangements create uniformity and herd behaviour on the part of the bulk of institutional investors. There is a need to encourage a greater diversity of people into the investment industry -especially those who understand from the inside how business really works and what it takes to create and sustain successful companies, especially in complex technology industries.
• Creating new and better forms of enterprise. There is good information that some partnerships, family companies and social purpose enterprises out-perform quoted companies. There is an urgent need to encourage the formation and growth of more companies whose primary purposes are to serve the needs of their employees, customers and suppliers and in turn, the community.

Barriers to change

• Greed and self-interest. Free markets are not value-neutral, they are, if not rigorously controlled, the natural media through which human greed and excess can flourish. The nexus of big companies, huge banks and their political hangers-on contain most of the wealth and power in many developed economies, but particularly in the UK and US. The gravy train that is the current system enriches those who are 'players' and excludes the bulk of the populace.
• Centuries of cultural conditioning, the roots of which go back to feudal times.
  The core of these beliefs is that the possession of property is the main source of power. People are therefore subordinate to property.
  The primary form of medieval social organisation was based on the ownership of land, which rested with the crown. Feudalism involved a hierarchy of authority, rights and power that extended downwards from the monarchy. Beneath the crown, an intricate network of duties and obligations linked royalty, tenants-in-chief (such as barons), and under-tenants (knights).
  At the bottom of the pile were the villeins (serfs), who had no rights and were bound to the lord's manor lands.
  It should not take too much imagination to see the origins of the passionate beliefs that ownership of financial assets has precedence over other forms of right and that investors own companies and have superior rights over employees.
• Massive systemic inertia. The organisations that make up the global investment markets are huge. The City of London employs hundreds of thousands of people working in a confined area and networking constantly with millions more across the world. They live in a febrile atmosphere dominated by greed, fear and excitement. It is well known that such environments are immune to unwelcome perspectives or views from the outside. In this context, herd behaviour is rife and insiders who fail to toe the line in terms of their values, behaviour and views are expelled or excluded. This kind of system is almost immune to reflection and learning, and extremely resistant to change.
• Simple ignorance. The City knows what it knows very well and has not the faintest idea about, nor cares a jot for what it doesn't know. The bulk of the populace has little understanding of how the vast and complex world of finance and industry works - and how could they - it is not taught at school and it is not in the interests of the financial services industry to enlighten them - in fact the opposite is the case.
  Many politicians are equally ignorant - only understanding how the system might benefit them, during and after their political careers.

Themes for Reform

Lord Percy, chairman of the Board of Education wrote in 1944:

Here is the most urgent challenge to political invention ever offered to statesman or jurist. The human association which in fact produces and distributes wealth, the association of workmen, managers, technicians, and directors, is not an association recognised by law.
The association which the law does recognise - the association of shareholders, creditors and directors - is incapable of production or distribution and is not expected by law to perform these functions.
We have to give law to the real association and withdraw meaningless privileges from the imaginary one.

As Lord Percy recognised, great power is bestowed by the mere fact of financial and legal ownership and not for producing anything of value.

Our first theme is:

Enhance the rights of long-serving employees to have a hand in the determination of the future of their enterprises. The best way to do this is to give them rights of ownership, a significant minority of issued shares being allocated at a substantial discount according to service and contribution. Employees would have privileged access to all vital company information and be able to vote on critical issues like the sale or merger of their enterprise.
Allied to this, the automatic vesting of share options on change of control must be abolished. The temptation to accede to takeover bids can be irresistible to directors with millions to gain from vesting options over shares that were granted free. Employees, including directors, should only be able to realise gain on their shares if they had purchased them at full price. Otherwise, options and 'shadow shares' would cease to have any value on change of control.

Second:

Reward long-term investment - it is evident that gambling and constant churn in shareholdings de-stabilises companies and doesn't create superior returns. Serious incentives for investors who hold shares for the long term could have a marked effect on the behaviour of the investment industry.
These incentives would be graduated tax advantages depending on the duration of holding of shares, starting at three years. Long-term holders should have enhanced voting rights over speculative short-term investors and the right to enhanced access to strategic information about the company. Large long-term holders should be collectively entitled to appoint a non-executive director.

Third:

Take action to regulate the investment industry world-wide and penalise tax avoidance and offshore, unregulated financial havens. This will require international co-operation, but the two central powers are the EU and the US. It is likely that US governments will be ready to co-operate following public outcry after the next one or two inevitable financial scandals. The EU is well placed to act, as most member states value social market principles. Assuming the US is willing to co-operate, this would leave a recalcitrant UK government in international isolation.

Fourth:

Improve company law to make managers and investors in quoted companies accept a duty of care towards companies and their employees and not act in a manner that would needlessly damage their long-term prospects.
But, most important, encourage through financial , tax and legal support the creation of a more diverse range of enterprises to serve customers and involve employees and suppliers in the ownership and direction of the business. Too long has enterprise in Britain suffered from the tyranny of the financial markets and supposed financial 'owners'. Ownership in many parts of the economy has to be shared with those with a real stake in the enterprise.

Fifth:

Make the investment industry properly responsible for the impacts of their actions on their clients.
Two major vehicles could be:

• Making the possession of a 'license to operate' a condition for individuals at all levels in the industry. The license would be removed if individuals, or in the case of leaders, their enterprises were guilty of malpractice. We have them for driving and flying, surely those who lead and practice in the financial services industry can cause severe damage to people's lives also?
• Making a significant proportion of the fees earned by advisers for M&A support dependent on the value created by the deals over 5 years.

Sixth, and last:

The UK government emphasises the vital importance to Britain of industries that are driven by advanced knowledge and high technology, yet it does little to protect and promote British interests..
Every other government in the world acts directly and indirectly to protect the capability of its economy to compete in the modern world. Only the UK government stands back and bleats, like Bambi in the forest, about competitors ignoring market forces, whilst vital UK technology exporting industries are gobbled up by foreign predators. Britain's foreign trade deficits are a testament to disastrous government inertia.
UK governments must act directly to support high technology ventures and incentivise investors by matching their finance. Certain industries should also be made special cases and the sale of intellectual property and companies made subject to a test of national interest. The government still owns 'golden shares' in BAe Systems and Rolls Royce - it must extend this practice to other vital areas of technology.

Government has a vital role to play.

Governments are supposed to reflect the will of the people and to represent the vital interests of society as a whole.
Government was a vital element in helping to create the capital market system. Change in the current dysfunctional arrangements will not happen without some intervention by government. Given the multi-national nature of the huge financial institutions, there is also a place for institutions such as the European Union, which given the social market values of many members should be well placed to act. That and acting as a political counterbalance to the US are sufficient reasons to support the EU, as financier George Soros has recently pointed out.
What is encouraging are indications that many people are becoming disillusioned by the current state of the financial services industries and the sleazy actions of politicians. There is a sufficient sense that they are being exploited at the altar of the greed of the privileged few to make the ground swell for reform stronger. Enron, Worldcom, the dot.com bubble and the mal-practice involved caused a public backlash in the US - and it is likely that worse is yet to come from the system in its current form.
The climate is becoming right for significant change - it needs leadership, integrity and courage from political leaders to convert disillusion into positive energy for change.
It is time for them to rise to Lord Percy's challenge.