"Ready for dinner"
The outcry by shareholders over the $13 billion in fines and penalties levied against JP Morgan Chase by the U.S. Justice Department is totally misplaced. The failure to understand the urgent need for the imposition of such fines represents a failure to grasp the very underpinnings of modern capitalism.
To understand why this is true, let’s take a step back to the beginning of the modern era of capitalism. These concepts of capitalism, embraced and espoused by Milton Friedman and his disciples from the Chicago school, were inevitably built on one Zen-like premise.
Markets, these apostles said, are by their very nature efficient, imbued with self-correcting mechanisms that impose reason on an otherwise chaotic process. Furthermore, these concepts hold that market organizations will inevitably act in their own long-term self-interests.
According to this view, countervailing forces were embedded in market thinking, providing a governance process that would enable companies to avoid tendencies that are potentially self-destructive.
This was the guiding philosophy of America’s economic brain trust in the period leading up to the financial collapse of September 2008. It was championed by Alan Greenspan, but also embraced by economic thinkers on both the left and right of U.S. politics.
This brain trust worked diligently over the years to establish a governance framework that was designed to “let the markets work their magic.”
It did indeed turn out to be magic – black magic!
The events of 2008 represent a complete failure of the market-driven governance framework that had been so meticulously put in place starting in 1980.
The process was based on the primacy of the shareholder, who was fed by abundant disclosure in steering corporate policy.
The shareholder, however, played at best a passive role in shaping the activities of America’s largest banks in the run-up to September 2008. At worst, shareholders exacerbated the problem — by demanding more in the way of returns than their bank managers could prudently deliver.
Bank shareholders did not actually rob the banks. No, they drove the getaway car!
And that is precisely why the outcry over the fines JP Morgan will be required to pay are so misplaced. The fines penalize JP Morgan’s shareholders — and for a good reason.
Those shareholders need to understand that capital has, by definition, important responsibilities in our capitalist system. It follows that, when they fail to meet those responsibilities, shareholders must be held accountable.
And yet, doctrinaire free market thinkers, even after the events of 2008, continue unabashedly to promote an irresponsible view. They profess to believe that the shareholder is privileged, that his rights are sacrosanct and that he was an innocent bystander in the mortgage fiasco.
More importantly, they believe that the unbridled free market system they champion actually works efficiently and that there is little need for regulation or, for that matter, regulatory enforcement. This is indeed a frightening concept.
The shareholder has proven time and again through history that he is endowed with two primary characteristics: ignorance and greed. U.S. policy leading up to 2008 fostered ignorance and fueled greed, especially in the banking sector.
Ignorance was fostered through the misplaced concept that transparency would shine the light of reason on the activities of banks. Accordingly, the shareholder was invited into a veritable typhoon of disclosure.
This included conflicting data and information that would confound the organization’s CEO, let alone a casual investor several degrees removed from the heart of the action. Who, for example, could decipher the intricacies of the mortgage instruments banks issued willy-nilly in the run-up to 2008?
And yes, the free market ideologues believed in caveat emptor (buyer beware) as the central tenet of the governance process.
And they were convinced that full disclosure provided regulatory absolution to the vagaries of financial engineering. Instead, disclosure built a paper wall around banks’ activities.
This flawed concept was fueled by greed. Greed is a sad and misused term, because of its pejorative connotation. This is because greed is endemic to the human condition – it is, in fact, a normative component of human behavior.
Anyone who believes that greed is a self-correcting flaw in man’s economic imperatives is sadly mistaken. So, it should not come as a shock that greed, specifically among bank shareholders, played a pivotal role in the economic meltdown of 2008.
Shareholders demand a certain return on the equity capital they entrust companies. This return on equity is a comparative number; that is, all large banks provide the number and it is simple arithmetic to look at an average for the banking sector.
If a bank’s management fails to achieve or exceed that average, the bank’s management has failed in the eyes of its shareholders.
But it is an average, which by definition means that certain banks will fail to realize the acceptable return on equity. For banks, this dynamic sets in motion a race to the bottom when it comes to risk.
It is as simple as that. There is little room for discussion of the risks involved in meeting shareholder expectations. In 2008, shareholder greed literally forced bank managements to assume ever-greater risks in the mortgage sector in order to exceed the returns offered by their peers.
There is no simple answer to the question of how to stop coddling shareholders and make them accountable for their participation in the governance process. The imposition of fines on wrongdoers is one way. The enactment of more detailed regulation is another.
But in the end, to preserve the remarkably productive capitalist system now in place, the shareholder himself must step up and take a more active role in the governance process.
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