How to Fix Capitalism … Mark Thomas on inequality, stakeholder capitalism, and the need to create “clean, competitive markets”

January 31, 2020

Mark Thomas, a fantastic economic thinker, and a former colleague, wrote a great new book last year 99%: Mass Impoverishment and How We Can End It … Martin Wolf at the Financial Times said it was one of the best books of the year, saying:

“A call to arms, this book makes three main arguments. First, the middle class is under extreme pressure and may vanish. Second, many of the constraints on purposive action in response, such as presumed fiscal limits or the view that taxes should never be raised, are myths. Finally, the needed reset is possible without revolutionary change. We can ensure a growing economy from which everybody benefits. The time for assessing such arguments has now arrived. They matter.”

In recent months we’ve heard much, from Larry Fink at BlackRock calling in his Annual Letter CEOs for a new approach to finance, from World Economic Forum presiding over what they called “the funeral of shareholder value” in Davos, and the Business Roundtable in USA, demanding a fairer approach to all stakeholders.

Below, Mark offers his own view, in a recent seminar and article:

How to Fix Capitalism

Even The Economist, that bastion of free markets acknowledges that today’s capitalism has problems.

But opinions differ widely on the nature of the solution to those problems: some think that capitalism is such a negative force that it should be replaced completely; The Economist thinks that we just need more competition; and many CEOs think that the answer is to abandon the primacy of shareholders and ask businesses to look after the interests of all stakeholders.

The 99% organisation has a different answer: clean, competitive markets.

Real-World Capitalism vs the Story

The story of capitalism is compelling: where there is a need in society, there is a business opportunity. An entrepreneur can seize this opportunity by providing a product or service to meet the need. In producing this product or service, he or she will consume other products and services, raw materials and labour, and their costs to him or her, being set at market prices, will reflect their values for alternative uses.

If, after meeting these costs, the entrepreneur makes a profit, this means that he or she has found a higher-value use for the products and services consumed and simultaneously created value for himself and for society as a whole. In this way, enlightened self-interest automatically increases the benefit for society as a whole.

In this ideal story of capitalism, making profit is synonymous with working for the greater good. And any interference, for example by government, with profit-making will necessarily reduce the public good. It is on the basis of this story that many people say they believe in free markets.

Unfortunately, as a matter of real-world observation, making profit is not always synonymous with working for the greater good. When a tobacco company grows its profits by selling more cigarettes, it is not clear that this is for the greater good. When a company boosts profits by paying below a living wage – and gets the taxpayer to top up the difference – it is not clear that this is for the greater good. When a company is loaded up with debt, pays huge dividends and then goes bankrupt leaving employees, suppliers and the taxpayer out of pocket, it is not clear that this is for the greater good.

The failure of British Home Stores in 2016 is a case in point. The Conservative MP David Davis described it as: “… the dark side of capitalism: increased borrowing and payment of ever bigger dividends; risk transferred from the private to the public when the business fails; [with] the low-paid and the taxpayer left to pick up the bill.”

In brief, the story is as follows. In the year 2000, Philip Green, who was subsequently knighted for his services to retail, bought BHS for £200 million on behalf of his wife, Tina, who was resident in Monaco – a jurisdiction well-known for its low tax rates. Philip Green then argued that the business was worth more than he paid for it and wrote-back around £100 million of negative goodwill through the profit and loss account, thus making BHS appear surprisingly profitable. On the basis of this profitability, he was able to load the business with debt and to extract large dividends, rental payments and interest on loans estimated by the Financial Times at around £1.2 billion, before he sold BHS for just £1 in 2015, when the business ran into trouble.

Around a year later, BHS filed for administration, putting the jobs of its 11,000 employees at risk. At the time of Philip Green’s purchase, the BHS pension plan was in surplus (£17 million surplus in 2002); at the time of BHS’s failure, the plan had a deficit of £571 million.

As Davis commented: “The BHS story is a case study in many unpopular aspects of modern capitalism: exploitation of limited liability, loophole-ridden tax law and intricate accountancy.”

Sadly, this is not an isolated example of capitalism failing to follow the ideal. The Global Financial Crisis was precipitated by subprime mortgage-lending in the United States that caused losses to the US banking system estimated at almost US$1 trillion – very roughly equivalent to one year’s profits from all US quoted companies – and additional losses to the banking system around the world.

To achieve US$1 trillion of losses is a remarkable achievement: if we assume that the loss on each bad loan averaged US$100,000, then it would require 10 million bad loans to generate US$1 trillion of losses. This is industrial-scale bad lending – a system gone wrong; and its global impact has been devastating and is still being felt.

The financial system is still not fixed: banks have continued to behave unethically as shown by the more recent LIBOR scandal, for which many have received significant fines. Indeed, fixing the system has proven problematic: in the UK, for example, the Independent Commission on Banking recommended a package of measures to keep the world safe from a recurrence of the Global Financial Crisis but its chairman, Sir John Vickers, subsequently became concerned that in the face of persistent and persuasive lobbying by banks, the Bank of England is in danger of watering down the Commission’s recommendations to the point of ineffectiveness.

Mervyn King, the former governor of the Bank of England, agrees. In his book, The End of Alchemy, he concludes that banks should hold at least 10 per cent of equity (the foundation of their risk buffer), as against 3–5 per cent, which is common today, and that the risk of a second Global Financial Crisis remains high until the system is fixed.

Nor is the problem limited to retailers and banks. The automotive industry is reeling from a series of disclosures relating to emissions, and many other sectors have their own scandals.

Why does all this happen? Are businesses run by psychopaths? Possibly some are, but there is a more systematic reason why such things tend to happen. Put very simply, the nature of market capitalism puts enormous pressure on those who run businesses.

The Root Cause: Externalisation

Corporate executives feel constantly under pressure to improve performance, and in particular to drive up reported profit. In practice, one of the easiest ways to do this is to externalize costs. Pollute without paying to clean up the pollution, pay below a living wage but still have living employees, avoid paying taxes, carry out transactions that look good in the short term (such as making unviable long-term loans). All these are ways of ensuring that reported profit is higher. Because of the possibility of externalizing costs, many of the levers available to corporate executives to improve profit are not synonymous with working for the greater public good. They are not even necessarily synonymous with working for the long-term benefit of their own shareholders.

Even worse, if there is a straight competition between two otherwise similar companies in the same sector and one of them aggressively externalizes its costs, it will be more profitable than its competitor. If the situation is allowed to continue, it will be able to take market share from its competitor and ultimately drive its competitor out of business. If externalization is widespread, the forces of competition will act to allow the bad to drive out the good – the precise opposite of the capitalist ideal. That is why, on its own, The Economist’ssolution will only exacerbate our problems.

Appendix IX provides a simple example of how this happens, and how companies that externalize their costs become an engine for mass impoverishment and for the destruction of the environment.

What about just being nicer?

In the US, the Business Round Table recently published a pledge by 181 CEOs of some of America’s top companies. The pledge said that they had developed a new definition of the “purpose of a corporation” that drops the traditional concept that corporations function first and foremost to serve their shareholders and maximize profits. The new purpose is all about investing in employees, delivering value to customers, dealing ethically with suppliers and supporting outside communities. Much more like The Story outlined above.

It sounds fantastic. But will it make a difference?

There have always been, in fact, many CEOs with high ideals who do seek to make their businesses a force for good. In the UK, for example, The Royal Society for the Encouragement of Arts, Manufactures and Commerce (RSA) has for many years promoted Tomorrow’s Company, with the aim of encouraging businesses to manage in the interests of all their stakeholders and society, and for the long-term. And many businesses signed up.

They have found it an uphill struggle:

“There are emerging trends in British business that we cannot ignore. Despite considerable success in many areas, companies in the UK suffer from under-investment, low productivity, low real wage growth, employees that are demotivated and disconnected from management and diminishing public support. The irony is that the returns to shareholders have also been poor. The good news is that an alternative business approach already exists. Instead of the current focus on short-term incentives, targets and profit, it focuses on purpose, values, relationships and the long-term.

We recognize that this is easier said than done and short-term pressure is formidable. However, twenty years of convening companies, investors and policy-makers has proven to us that change can be achieved when the business and investor community work together to achieve a common goal.”

After twenty years’ campaigning, they have found that CEOs are under such pressure to deliver short-term performance that other considerations too often become secondary.

So what will work?

Creating Clean, Competitive Markets

Creating a market in which externalization is not widespread is a vital role for government. In free markets, the bad will drive out the good; in clean, competitive markets the good will drive out the bad.

Regulation has a bad name and it is seen as interfering with businesses’ ability to generate profits. This interference is, however, essential if we are to have clean, competitive markets: without it, we will continue to see massive externalization of costs, which will have to be borne by society as a whole, and we will see good businesses systematically driven out by bad businesses.

All competitive sports employ referees to ensure fair play and to make sure that the best, rather than the most unscrupulous, competitors win. In many sports, there are strict and onerous regulations to prevent drug-taking. When these regulations are insufficient, as they were in cycling for many years, the distortion of competition can be dramatic – the Tour de France winners list shows a gap with no winner from 1995 to 2005, and there are several other years in which the original ‘winner’ was subsequently stripped of his title as a result of drug-taking.

The regulations that were subsequently introduced are indeed onerous and intrusive – but the only losers from them are the cheats. Honest cyclists now have a chance to win. It is the same in business: for capitalism to work for the benefit of society – to enable the RSA’s vision of Tomorrow’s Company to become a reality – there is a vital role for government (and the accounting profession) to play as a referee.

Arguing that business regulations represent unjustified interference in the ability of businessmen and women to make profit is like arguing that sporting regulations constitute an unjustified restriction on the ability of athletes to compete.

And once markets are clean, then The Economist’s argument becomes productive, rather than counter-productive. We need clean, competitive markets.