Capitalism Under Siege

April 27, 2014 Updated: April 27, 2014

Mikko Arevuo, a senior lecturer in strategic management and Adam Smith Institute fellow, explains the moral foundations of capitalism and what is causing the current crisis of confidence in it.

Adam Smith taught us that self-interest leads an individual to seek the most “advantageous employment for whatever capital he can command.  It is his own advantage, indeed, and not that of the society, which he has in view.”  Adam Smith’s magnum opus, The Wealth of Nations (1776), or even more importantly his earlier work, The Theory of Moral Sentiments (1759), are no longer required reading in most management schools.  We have forgotten that Adam Smith was first and foremost a moral philosopher. 

By omitting the moral foundations of Smith’s work, we have come to equate his concept of self-interest with a greedy disregard for others.  Nothing could be further from the truth as Smith’s self-interest is directly linked with the common good. Smith quickly clarifies the link between the pursuit of individual advantage and the societal benefit by adding:

“It is his own advantage, indeed, and not only that of the society, which he has in view.  But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.”

History has vindicated Smith’s fundamental insight. Capitalism has made the world richer and healthier than previous generations could have imagined.  An average person today lives in infinite luxury compared to the lives of our forebears, which Thomas Hobbes characterised in Leviathan (1651) as “poor, nasty, brutish, and short.”  According to the World Bank, in 1981 1.93 billion people lived on less than $1.25/day, an indicator for extreme poverty.  By 2008, the number of people in abject poverty had decreased by a third to 1.28 billion.

Why, despite the benefits of the capitalist economic system, is it under existential siege?  The explanation for the widespread anger is not difficult to find.  Over the last 30 years there have been serious dislocations which have been exacerbated by the recent economic crisis.  Millions of manufacturing jobs have been moved  from developed market economies to countries where labour costs are lower, and youth unemployment is alarmingly high, particularly in some of the European economies.  Income inequality has radically widened in the US and the UK, and market pressures and management compensation structures have led managers to focus on short-term profits rather than on long-term wealth creation.  

Finally, capitalism is suffering from an ethical crisis.  According to the think-tank The Henry Jackson Initiative for Inclusive Capitalism, a broad-based acceptance of basic ethical norms is necessary if capitalism is to regain acceptance.  Otherwise, the system itself will become discredited and ultimately destroyed, whether by internal failures or external pressures.  To rebuild confidence in capitalism, there are two critical areas that need to be addressed: short-termism and business ethics.

Shareholder value maximisation became the norm in the 1980’s. There is nothing wrong with maximising returns for risk-takers as long as it is based on the sound strategic principles of long-term value creation.  However, over the last 30 years investment markets have undergone a structural change that has caused capital and equity markets to become focused on short-term returns.  In the 1960’s the average stock holding period in the UK and the US was approximately eight years.  Today, it’s about four months.  It is difficult to call today’s equity holders risk investors in the traditional sense of the word that they have an interest in the firm’s long-term survival.  In fact, modern investors are more akin to speculators seeking quick returns.

This structural change in investor behaviour has pressured management to create value on a short-term, and even quarterly basis.  Companies become fearful that investors will divest at the slightest wobble in the share price or if the firm misses its quarterly performance expectations.  Under these conditions short-term fixes tend to win over the long term goals. The situation becomes even more exacerbated if management compensation is linked to short-term corporate performance.

Data is beginning to support the negative economic impact of short-termism.  There is increasing evidence linking short-termism with a long-term decline in corporate investment as a percentage of GDP.  Moreover, corporate investment activity tends to favour efficiency innovation that releases capital by reducing employment and cutting production costs.  What is particularly worrying is that the released capital is not invested in R&D which could increase the rate of product innovation and thus have a positive impact on employment and economic growth.  Instead, as the emerging evidence points out, capital is used for share buy-back schemes that artificially increase share prices. The end result is increased volatility, inflated asset prices, and stagnating long-term growth and employment.

Economic policy initiatives such as investment tax credits can be designed to counteract management short-termism. However, these measures alone will not be sufficient to change the prevailing market behaviour.  A more effective means to encourage long-term investing is  for businesses to stop providing quarterly earnings guidance for equity investors.  Unilever, Merck, and GE have already shifted their investor guidance away from quarterly reporting to long-term performance indicators.  Other firms have started programmes that reward equity investors who hold their shares for a longer period of time.  There is also evidence that institutional investors such as pension and sovereign wealth funds, who collectively hold roughly 35 percent of the world’s financial assets, are beginning to redesign the performance and reward systems of their asset managers to reward long-term performance.

Combating short-termism is a start but it will not solve the crisis of confidence in capitalism overnight.  Although we know that people tend to behave better when they are evaluated over the long-term, they will not behave ethically unless they work in an environment that fosters ethical behaviour.  We should remember that the behaviours that led to the near collapse of the global financial system in 2008 were not the result of illegal behaviour.  The financial crisis was largely precipitated by questionable moral and ethical behaviour.  The reaction to economic crisis has been to increase the level of regulation.  However, the danger of regulation is that rather than asking the question “Should I do this?,”  the question becomes “Can I do this?” 

Regulation creates rules-based behaviour that essentially removes an individual’s moral responsibility.  If capitalism is going to survive in the future, we need to bring ethics back to the centre of commercial activity.  Adam Smith would surely agree that commerce can not be separated from morality.  As we seek solutions to the the 21st century problems of capitalism I will leave the last word to Adam Smith:

“When the happiness or misery of others depends in any respect upon our conduct, we dare not, as self-love might suggest to us, prefer the interests of one to that of many.  The man within immediately calls to us, that we value ourselves too much and other people too little, and that by doing so, we render ourselves the proper object of the contempt and indignation of our brethren.”


Republished with permission from the Adam Smith Institute. Read the original.

*Concept image of capitalism via Shutterstock

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

Mikko I Arevuo
Mikko I Arevuo