All posts by Gordon Pearson

Economics, Free Market Capitalism, Political Decision, Public Sector

The Cut – Recovery Dilemma

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The dilemmas facing the new British government, though not them alone, in dealing with the biggest ever peace-time indebtedness, are how much of public expenditure to cut, what to cut and how to cut it and above all when to start. Do too little too late and “the markets” won’t like it and that would bring untold disasters. Do too much too soon and we’ll be in for a double dip recession. And then “the markets” would forsake us for good and all. We need to reduce short term indebtedness before its costs bring the recovery to a shuddering halt. That mustn’t be allowed to happen since its only a recovered economy that will eventually repay the long term debt and finally get us out of this mess.

Well, where are the very clever economists who invented all this jargon about double dip recessions and “the markets”? It’s exactly the sort of conundrum their sophisticated mathematical models should be able to solve. They have the computational power at their disposal; why are they not doing their sums and coming up with the answers?

Media commentators are continually condemning politicians of all parties for not being straight up with us, telling us the bad news about what they intend to cut. But, till now, politicians have probably been 100% honest on this score if nothing else. The simple fact was they didn’t know what they were going to cut. Because the economists hadn’t come up with any coherent suggestions. Because they didn’t know either. Because their fancy mathematical models didn’t work any better on that, than they did on credit default swaps, or eliminating the risk on sub prime mortgages, etc etc etc.

Maybe it’s time for people controlling the real world – who Keynes referred to as ‘the madmen in authority’ – to ignore theoretical economists, and apply the lessons of experience and common sense instead.

Economics, Free Market Capitalism

Degrees of Inequality

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Economic progress has always had the unfortunate side effect of magnifying inequalities, between the rich and poor, the employers and workers, and between the providers of capital and providers of labour. These inequalities were accepted by some to be a necessary component of industrial progress and elaborate philosophical arguments were raised for their justification. Inequalities became so extreme in the nineteenth century, that they motivated protective legislation, regulating working hours and conditions as well as the rights of workers to combine in their own defence. They also motivated the communist manifesto and subsequent revolutions.

The mid twentieth century saw a move to a more equitable distribution of income and wealth, but since the 1980s, extremes of inequality have again been experienced. Judt opened his critique of today’s inequalities -‘Ill Fares the Land’ – with the following: ‘Something is profoundly wrong with the way we live today. For thirty years we have made a virtue out of the pursuit of material self interest; indeed, this very pursuit now constitutes whatever remains of our sense of collective purpose.’

That pursuit of material self-interest, justified by free market theory, seeks to minimise taxation and exclude wherever possible any government regulation and control aimed at inhibiting the strong from exploiting the weak, and especially anything which might seek redistribution of income and wealth on a more equitable basis, both within economies and between them. The degrees of inequality between nations experienced today will increase as a result of resource depletion, pollution and global warming since it is the poorer nations, especially those in Sub-Saharan Africa, that will be on the brunt end of such effects.

The free market dogma, which is espoused by both sides of the new UK coalition, frustrates any attempt to replace the amoral pursuit of money with a search for fairness and equity. But as evidence mounts of the ill effects of inequality – for example, Wilkinson and Picket’s ‘The Spirit Level’ – initiatives for a more equitable society may become irresistible.

Economics, Free Market Capitalism

Yesterday's Gods

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The “madmen in authority”, as Keynes characterised them, are still in thrall to “the markets” and the rating agencies. The people surrounding messrs Clegg and Cameron, as they struggle to an agreement, are more concerned that what they finally come up with will satisfy the markets, than that they will satisfy the electorate.

But, by definition, nobody understands the markets. That’s why speculative funds, such as hedges and private equity funds, can still make money out of them. Commentators can never predict future market moves, though they always explain in detail reasons for movements which have already occurred. Over the past few days it’s been repeated endlessly in the media, that the markets dislike uncertainty and want stability, but plainly that is the reverse of the truth: market volatility is what presents marketeers with the opportunity to make huge amounts of money, for which the tax payer will in the end pay. The question arises not so much as to why we still take markets seriously, but why markets should still be allowed such freedom to do damage. Surely the electorate should be given some protection.

If markets are free, protection might be expected through the credit rating agencies, Standard and Poor’s and Moody’s. But they contributed in no small way to the massive losses incurred by the electorate as a result of the credit crunch of 2007-8. The agencies gave AAA credit ratings (ie lowest risk) to the riskiest pools of loans, fuelling the sub-prime mortgage fiasco. Among many other cock-ups, they failed to notice the insolvency of the Icelandic banks and gave the Icelandic Government a clean bill of health till its economy imploded. If these were not cock-ups, they were something rather more sinister resulting from vested interests. The rating agencies offer no protection, and don’t deserve to be taken seriously.

What the “madmen in authority” need is a different economic perspective to replace the free market fundamentalism which still rules today. But there can be little expectation of that informing the Conservative / Lib-Dem negotiations.

Corporate Ownership, Economics, Free Market Capitalism

The Point about Profit

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Profit is wilThe idea of profit has caused much aggravation over the years and even today is still the source of heated debate. Marx borrowed Ricardo’s idea that profit was no more than the wages earned by labour but stolen by the providers of capital. This explained the grossly unfair divergence between the poverty of the labouring classes and the wealth of the capital owners. The neo-classical economists argued that the purpose of industry was to maximise profits, referring not so much to the theft of wages but the surpluses to be earned from industrial and business activity. Latterly, the free market fundamentalists, to which all three of the main political parties are to some extent in thrall, have argued that maximisation should apply to shareholder wealth rather than profit. This then seems to confirm again the inequity first argued by Ricardo, consolidating the position of the owner over that of the employee.

Clearly, none of these theoreticians have really understood the vital role of profit in industry and business. Adam Smith argued the self interest of the butcher, baker etc as vital to the effectiveness of their businesses, because that was how they earned a living and supported their dependents. The survival and long term prosperity of the business was what mattered, profit being some measure of that ability to survive and prosper.

The idea of maximising profit is based on a misunderstanding of business realities, which are concerned with, as Peter Drucker put it, the ‘real risk of ending up with an impoverishing deficit, and the need, the absolute need, to avoid this loss by providing against the risks’. But providing against the risks is anathema to the free market fundamentalist. They regard any such provisions against risk, such as spare or underutilised assets, as evidence of inefficiency and therefore grounds for replacing the business management with one that will maximise shareholder wealth, and this is most easily achieved through the firm being taken over and often being broken up..

Whatever profit is argued to be, it is a necessity for the survival of any business. Its theft by shareholders, or any other stakeholder, only serves to destroy the real economy.

Company Law, Corporate Ownership, Free Market Capitalism, Uncategorized

Protecting Real Economy Firms from Speculating Predators

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A number of issues relevant to postings on these pages have been raised during the campaigning for the UK general election. For example, following Kraft’s acquisition of Cadbury, the Labour government proposes to raise the voting threshold for such deals from a simple majority to two thirds of shareholder votes and to exclude from voting any shares acquired since the bid was announced. This would at least slow down some such deals, but as the Liberal Democrats claim, would go nowhere near re-imposing a ‘public interest’ test which would give ministers the power to intervene in deals deemed to be against the public interest. Such a test was abandoned in 1992 with the support of both main parties. But public interest is a vague and inadequate hurdle for such deals, especially when likely British governments will claim the preservation of free and open markets is the prime public interest. So electrical supply company Chloride, and bus and train operator Arriva, the latest targets of foreign bidders, can expect little protection. Unlike, for example, their German counterparts, whose employee stakeholders have 50% representation on the supervisory board and would be able to provide some protection against bids which were against the long term interests of the company, as opposed to the short term interests of its shareholders. UK law requires directors should take the interests of all stakeholders into consideration, not just what the government of the day regards as the public interest.

Another issue that has caused some debate in the run up to the election is the Liberal Democrats’ proposal to again separate commercial banking from hedging and speculative activities, and to tax and regulate the latter differently from traditional banking. This would have the added benefit of breaking up some firms which are currently ‘too big to fail’. The two main parties are united in their objections to this approach, presumably for fear it would reduce London’s attractions as the world’s largest hedging base, and some might leave. However, hedge funds may find the United States even less comfortable. And most G20 nations are moving in that same direction. The days when ‘socially useless’ hedging enjoys total freedom may be numbered.

Accounting profession, Audit profession, Bank Bonuses, Company Law, Corruption

Going for Goldman

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The problem with the Securities and Exchange Commission’s long overdue pursuit of the potentially fraudulent practice in Goldman Sachs is that it is likely to take a long time to conclude, will cost an arm and a leg, and its outcome is far from certain. If and when the UK authorities follow SEC’s example, it would be likely to cost more, take longer, and be even less likely to produce convictions.

The problem is that such legal actions engage with the details of credit default swops (CDSs), collateralised debt obligations (CDOs) and the whole panoply of financial derivatives that have been deliberately invented to mislead and defraud. CDOs were invented so as to deliberately disguise the real extent of liabilities and so make a firm appear less risky and therefore capable of taking on more debt, which was done with the same deliberate intention to mislead and defraud. This is a minefield where the attribution of blame and intent is full of deliberately confusing and opaque detail.

It would be better to step back from the detailed machinations and simply take a view of the truth and fairness of a firm’s published accounts. It is not difficult to do with the benefit of hindsight. Where balance sheets have been seen not to reflect a true and fair account of a company’s position, the auditor who certified the balance sheet should be prosecuted. They are paid vast sums for their expertise and diligence in certifying company accounts. Auditors who are party to misleading accounts, are guilty of either incompetence or dishonesty. They should surely have to face the full force of the law and be struck off by their professional body. Similar treatment should be meted out to those who presented the misleading accounts. And those who gained through their deliberate misrepresentation and have taken large bonuses as a result, should be similarly treated, with their fraudulently earned bonuses being repaid.

This would be a major change in accepted custom and practice, but it is to be hoped the SEC’S action against Goldman Sachs is a first step in that direction.

Corruption, Public Sector

Fat Cat Corruption

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It was Peter Drucker who invented the 20 to 1 ratio, suggesting top executives wouldn’t be able to manage their firms effectively if they paid themselves more than 20 times their lowest paid employees, because of the ‘hatred’ and ‘contempt’ in which they would be held. Today, top executives in both public and private sectors pay themselves vastly more than 20 times, simply because they can, authorised by compliant remuneration committees of fellow fat cats.

The phenomenon results from what Bruno Frey referred to as the “crowding out” effects of extrinsic monetary rewards, the intrinsic motivations arising from the satisfaction of doing an interesting and hugely worthwhile job, being “crowded out” by the monetary rewards being pressed upon them or placed within their grasp. (The “socially useless” financial sector is excluded from these considerations – that’s another story!)

Executives in the real economy, and the public sector, may well have started out with intrinsic motivations to leave the world a better place for their brief presence in it. But these higher aims are “crowded out” in what becomes a mindless chase for more money.

But the person inside inevitably judges what others would think if they saw an act of theft, whether it’s picking up a £10 note on the street and pocketing it, or taking a multi-million pound salary. As Adam Smith indicated, it matters what others think; they would prefer others to think well, rather than ill, of them. Only when they know others think irredeemably ill, do they no longer care how their acts impact. Then there is nothing to lose, so they themselves become lost. They surround themselves with sycophants and hangers on, who insulate them from the hatred and contempt of their fellow humans. It’s a pity the sycophants include government ministers and politicans, for example George Osborne and Peter Mandelson notoriously meeting on a fat cat’s yacht a couple of years ago.

Bank Bonuses, Company Law, Economics, Free Market Capitalism

Devastating Mistakes of Economics

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In 1792, William Pitt told parliament that Adam Smith’s “extensive knowledge of detail … will …furnish the best solution to every question … of political economy.” Since then it’s been downhill all the way. For Smith, the industrial firm (his famous pin factory) was the key to economic progress, with the market only serving to enable the division of labour. But economists have always given primacy to the market, almost ignoring the industrial firm, because they don’t begin to understand it. In late nineteenth century, economists adopted differential calculus to model the economy, which meant describing the firm as a “production function” comprising two variables, price and quantity, and seeking to maximise profit. This was not just stupid, but hugely damaging. Maximising one thing requires the neglect of everything else, which has done great damage to Anglo-Saxon industry. Finally, in the 1980s, still completely unable to conceive of what a firm involves, they adopted the agency idea, claiming that the managers of a firm were the agents of its shareholders and should not therefore be maximising profit but maximising shareholder wealth. It is a lie. Managers have no contract with shareholders, but with the firm which is a legal entity in its own right. Shareholders do not own the firm – if they did they would not enjoy limited liability. They own shares which entitle them to dividends and capital growth, both at risk. Maximising shareholder wealth, as required by Friedman and followers, requires neglecting everything else. When specific decisions have to be taken, notably in the case of hostile takeovers, this is crucial. It has destroyed much of what remains of Anglo-Saxon industry, the latest British example being Cadbury. It has also justified the obscenity of top executive share option bonuses, which unless reversed will be the source of what is called euphemistically, social unrest.

Accounting profession, Audit profession, Corruption

Auditing Repo 105 Deals

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John Lanchester, writing in last Saturday’s Guardian, explained the essence of the Repo 105 deals which Lehman Bros did to create the false impression in their accounts that the company was fit and well. And Lehman’s accountants, Ernst & Young, were happy, as Lanchester explained, to ‘sign off on the deal … It was all within the rules.’

But it wasn’t. Company accounts, in Britain and in America, are intended to reflect a true and fair picture of the company’s position – otherwise what is their point? It doesn’t matter that custom and practice has become so fraudulent in financial circles. The only reason why auditors are still required in Britain to certify the accounts as “true and fair” is to be sure that the various clever creative ways of accounting to disguise the true picture, which in themselves may be perfectly legal, are not used to deceive. At the end of the day the accounts must give a “true and fair” account. If audited accounts are not “true and fair”, then the accountants responsible, and the auditors who signed them off, should be struck off and locked up.

Co-operation, Corporate Ownership, Economics, Public Sector, Uncategorized

The Political Appeal of Co-ops and Mutuals

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George Osborne announced the Conservatives proposal to mutualise and co-op the public sector, describing it as the ‘biggest social revolution since Thatcher sold council houses’. But their proposal just shows how little they understand the essence of those movements. Mutuals and co-ops operate within the for-profit sectors but instead of paying surpluses over to external shareholders they pay some to their members and accumulate the rest within the business. That’s the whole point. That was how the great mutual financial institutions and building societies got to be so big and so successful. The rape and destruction of so many, almost including the Co-op itself, was sanctioned and encouraged by the Thatcher government.

So how would mutuals and co-ops operate in the public sector with no surplus to distribute and accumulate? What would be the point? Well, George Osborne says, they would be able to work without the central controlling bureaucracy. So, was he saying there would be no central regulation or control? Well, not quite that, Osborne admitted, there would still have to be performance standards. So what did this social revolution amount to, other than confusion? Well, it was a reply to Gordon Brown’s earlier announcement that mutualism and co-ops would be at the centre of Labour’s election manifesto. But not a very convincing reply. No more convincing, in fact, than Brown’s own commitment. It would be rather better if politicians thought through their policies before deciding on the accompanying sound-bite.