Wednesday, September 28, 2005


The trouble with socialism is socialism. The trouble with capitalism is capitalists.
That quote is attributed to the late Austrian analyst Willi Schlamm, as referenced by William F. Buckley in a column bemoaning the wayward path that executive compensation has taken in America. At a time when upper level executive salaries are at unprecedented levels (and growing) proportional to the salaries of other employees in the same company, Buckley decries the "capitalists" that are spoiling "capitalism."

Here and there efforts are being made to impose correlations of some sort between executives' compensation and stock performance. "The secret to linking pay to performance remains elusive," writes Claudia Deutsch of the New York Times. "Net income at Eli Lilly fell 29 percent and its return to shareholders dropped 17 percent last year, but its chief executive, Sidney Taurel, saw his pay go up 41 percent, to $12.5 million." There doesn't seem to be anything elusive about that: the boss aggrandizes.[...]

That money was taken, directly, from company shareholders. But the loss, viewed on a larger scale, is a loss to the community of people who believe in the capitalist free-market system. Because extortions of that size tell us, really, that the market system is not working - in respect of executive remuneration. What is going on is phony. It is shoddy, it is contemptible, and it is philosophically blasphemous. [emphasis added]
Perhaps such actions are "philosophically blasphemous" Mr. Buckley, but as Mr. Schlamm pointed out, there is an inherent weakness to capitalism - namely the greed of the actual capitalists who are themselves necessary components that cannot be removed from the equation. Compounding the problem, greed itself is often a short-sighted, impulsive and obsessive animal and rarely, if ever, does it consider posterity or even the next fiscal year. In other words, greed tends to create a system in which short term gain is valued over substantive, balanced, and sustained growth. This friction does not benefit society at large. As capitalist champion Milton Friedman said:

What kind of society isn't structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm...

So if we accept that the problem with capitalism is the greed of capitalists, then we should look to implement certain regulations that will create the types of rules that will channel the greed into positive manifestations and limit the tendency of the capitalists to derail the economic system in which they operate. The tradition of checking the excesses of capitalists is a storied one, from Teddy Roosevelt's antitrust policies that unwound the monopolistic entanglements constricting growth around the turn of the Century, to the recent enactment of the Sarbanes-Oxley regulations designed to monitor corporate malfeasance vis a vis securities fraud in the Enron/WorldCom/Tyco era.

Yet ironically enough, it is the modern GOP that is most dedicated to removing structural regulations and oversight. It is almost a fetish. The people that should be the most dedicated to maintaining the non-blasphemed philosophical purity of capitalism are themselves locked in a tango of near-sighted greed spurred on by the wurlitzer of corporate cronyism and fiscal recklessness punctuated by the motif of industry self regulation and repeated upper income tax cuts.

Just as those ideologically committed to democratizing the Middle East should have been the loudest critics of Abu Ghraib and other detainee abuse, rather than the apologists that most were (how better to undermine our ostensible role as liberators and bestowers of enlightenment?), so too should the GOP leadership be seeking to rein in the trend to trust industry to regulate itself, the exacerbation of vast disparities in wealth, shameless siphoning of corporate profits into the executive class and other such dysfunctions in the market place. If you value an economic system, a political ideology or an ethical concept, you don't honor it by ignoring its flaws, or rewarding those who would betray it, like a courtier or sycophant. Capitalism, like the modern GOP, needs honesty and tough love from those that value its continued health and existence.

Mark Schmitt discusses the recent revelations of improper stock sales by GOP Senate leader Bill Frist and places the scandal in larger context:

[When Frist learns of troubles in the health care sector] he takes a private action, and just dumps the stock. And not just any stock, this is his patrimony he's selling out. It's the stock of his own family's company. But he washes his hands of it. Leaves it to some bigger sucker.

And that, to me, is telling, and it's about more than Frist's despicable character. Because it goes to the great paradox of what is currently called "conservatism." The central constituency of the modern Republican machine is, broadly speaking, business. Yet there are dozens of policies, passive as well as active, large and small, that are going to be a disaster for American business in the medium- and long-term. Some are disasters for specific companies and sectors, others for business generally: the fiscal debacle, the burden and unpredictability of health care costs, climate change, income inequality, short-sighted energy policies designed only to boost supply, chaos in the Middle East, hostility to the U.S. everywhere, lack of access to higher ed, collapsing infrastructure, etc. Somehow, in a way that would not have been the case in previous decades, business leaders and many investors seem bizarrely unconcerned about these trends.
They are unconcerned because nothing compels them to take pause. All incentives are moving in the opposite direction. Without some type of external and/or regulatory pressure on the marketplace, this death spiral consisting of former lobbyists in cabinet positions overseeing industry, endless tax cuts for the upper brackets, environmental myopia, infrastructural deterioration, educational malaise, and near-sighted greed will bring about a calamitous crash. It is in those times that capitalism is most vulnerable. Though many free market zealots remain antagonistic to FDR's New Deal model (treating it as socialistic anathema), it is important to remember that capitalism itself might not have survived had not FDR applied the vaccination. Schmitt goes on:

I suspect it's integrally related to the "pump and dump" culture that has infiltrated business, a mutation of the cult of "shareholder value." (Pump and dump refers to the practice of talking up a stock or making earnings appear high, then selling just before the inherent weaknesses in the company become apparent. On the Yahoo! Finance message board discussing HCA, Frist is referred to lovingly as the "Pump and Dump Drama Queen.") Investors as well as executives don't look at a company as something to build for the long term; they need to beat their numbers in the current quarter. And for the most part they assume that by the time things get tough, they'll be out. The insiders will bail out before the suckers; the CEO will move on to some other company. Or, if worst comes to worst, he'll retire with a nice package guaranteeing health care, use of the company plane for life, and a nice package of stock to sell when someone else turns the company around.

So true. In my own legal career I have experience with certain aspects of the "Pump and Dump" culture. Allow me to explain in what I hope is not overly esoteric language.


During the halcyon days of the Internet boom, IPOs (short for "Initial Public Offerings" - meaning the first time a company sells stock in the market to the public at large) were a hot commodity for investors. This is because, almost without fail, stock purchased in an IPO would go up in value at break-neck speed - the same day even - because everyone assumed every new stock was the next big thing. In other words, if you got in on an IPO and the initial price was $5 a share, you might expect the stock to be trading at $25 or $30 a share later in the week. Now imagine if you had purchased 100,000 shares. If you sold at $25-30 a share, that would be a profit of between $2-3 million dollars. In one week. Got your attention?

Well, it got a lot of people's attention and the certainty of the return on the investment began to corrupt the process. Eventually, the investment banks began to abuse the power they had to allocate shares in the IPOs [ed note: in an IPO, or any subsequent offering, a large investment bank underwrites the offering (for a fee) by securing buyers for the stock (often times purchasing the stock itself for resale), distributing the stock through the markets and other services - in essence managing the process for the company selling shares]. While normally an I-Bank has to solicit buyers for an offering, the climate had changed dramatically. As you can imagine, many large investors were clamoring to get in on the ground floor of the myriad IPOs and the I-Banks were actually inundated with investors - with the number of buyers exceeding the shares available.

So the I-Banks began to push the parameters of their new found leverage by engaging in many dishonest and ultimately illegal practices, one of which is known as "laddering." Laddering is when an I-Bank requires an investor in an IPO to agree to purchase more of the stock throughout the week at predetermined prices. So, in order for investor X to get 1,000 shares of the IPO at $5, X has to agree to buy 500 more shares in the aftermarket at, say, $10 a share. The reason the I-Banks did this was to create artificial demand for the stock that would inflate its price beyond what the free market would pay. All of a sudden, as the stock price would normally be hitting its natural equilibrium, there would be an injection of overly zealous buyers willing to pay a premium. This created a feeding frenzy, a self-sustaining upward cycle. They were "Pumping." But eventually, before the dust settled, the I-Banks and investors in the know would be "Dumping" - one step ahead of the suckers.

Tearing Down The Wall

Within the major investment banks, there are various divisions. One such division handles the underwriting duties, and another conducts market research on various companies on a sector by sector basis. In theory, and in practice for many years, the research and banking branches were separated by an internal firewall. After all, it is in the interest of investors, the markets, the companies themselves and our economy in general if there is a knowledgeable investor class that can rely on objective research and corporate transparency mandated by disclosures in filings made with the Securities and Exchange Commission. But with all that easy money churning around during the expansion of the Internet bubble, the wall began to crack. In fact, the I-Banking divisions began pressuring the research division to issue inflated "buy" ratings on stocks and author favorable reports of companies in order to acquire or maintain the banking business of the companies being lauded. There was a conspiracy to "Pump" in order to keep the business relationship in order.

In many cases, the researchers were privately deriding stocks they were extolling to the unsuspecting public through institutional reports, TV appearances and other media. If you recall, this was the era of the celebri-analysts who began popping up on the cable TV outlets, the most notorious of which was probably Merrill Lynch's Henry Blodgett who infamously called a stock he was publicly recommending a "piece of shit" in a private email. Unfortunately, the unsuspecting American people trusted these "objective" analysts, and continued to pour money into companies that the analysts and I-Bankers themselves knew were hollow shells and lost causes. In the end, countless Americans were financially wiped out, or set back considerably, while the bankers and executives absconded with windfall profits.

Yet despite the parameters of these financial scandals, and their potential impact on the integrity and attractiveness of American financial markets, the Securities and Exchange Commission (populated by industry insiders) was lax in maintaining oversight and uninterested in pursuing charges against any of the wrongdoers. It took the Attorney General of New York State Elliot Spitzer's own pursuit of justice to shame the SEC into action - and even then, a lackluster effort at that. These abuses, and the culture of deregulation, tie in to what Mark Schmitt was discussing above.

Despite what supposed free market aficionados might claim when discussing the dreaded bugaboo of regulation and oversight, it is, in fact, in the best interest of capitalism, and America's brand of it, to maintain open and transparent markets with a free flowing of reliable information for potential investors. The only way to achieve this is to require it through regulation. You cannot trust industry to monitor itself. Greed does not provide those incentives. Just as business will be served by a healthy environment, functioning infrastructure, quality public schools, single-payer health insurance and a whole host of programs that "capitalists" take a hostile stance toward, so too does business thrive when there are umpires on the field to make sure the rules are being adhered to. The best features of capitalism lie in its creation of conditions conducive to rewarding the worthy, efficient and innovative. Of course, that depends on the market's ability to recognize such and society's ability to produce them. Greed can either help or hinder that process.

But the "Pump and Dump" culture of greed threatens to break the system beyond anyone's ability to put it back together again. And it's not just capitalism. Schmitt again:

And what is our political culture except another version of pump and dump? Everything from war to tax policy to energy policy to the Medicare bill is a short-term effort to boost the president's political stock, with the long-term costs left to some bigger sucker.
I might not agree with the totality of Schmitt's indictment, but I would say it's about time for citizens on both sides of the aisle to demand more from the Republican Party that is at the helm of all three branches of our government. Not because we are hostile to capitalism, Bush or from some latent anti-American, but for the opposite reasons. Rod Dreher pleaded with his fellow conservatives, to too many deaf ears no doubt:

I don't at all get this attitude among many on the right that our sworn duty is to back anything President Bush and the GOP choose to do. We are conservatives before we are Republicans, are we not? [...]

At some point, we conservatives have got to ask ourselves if we stand for principles, or merely maintaining power. We have got to ask ourselves just which conservative goals are being served by the Republican governing status quo. We have got to ask ourselves if our conservatism stands for much more than The Democrats Must Lose.
Good questions all. Hopefully some answers before we all have a big fall.

<< Home

This page is powered by Blogger. Isn't yours?