“To admire, and almost to worship, the rich and powerful, and to despise, or, at least, to neglect persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments.”
Adam Smith, The Theory of Moral Sentiments (1759)
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”
Adam Smith, The Wealth of Nations (1776)
“Follow the money.”
Deep Throat to Bob Woodward, 1973
If you want to understand why I shifted from Centrist Republican to Socialist, you need to think about Adam Smith and Capitalism. What we presently call Capitalism has spawned a massive division of wealth – gutting an entire Middle Class – because it leans upon a bastardized propaganda version of Smith.
Capitalism is a young concept relative to the history of the world. First elucidated by Smith in his 1776 The Wealth of Nations, it gained traction during the early 19th century with the Industrial Revolution. It spawned fortunes to a very few at the expense of the many. Early capitalism grew explosively during the technological upheaval of that period, fostered by weak legislative and judicial systems which not only permitted, but supported, a system free of any regulation. Toss in Western Civilization’s social and religious structure, recognizing and reinforcing class distinctions, and it was off to the proverbial races for the wealthy few. It was only through decades of muck-raking journalism, labor unrest and early legislative efforts that society’s ball was slowly moved forward on the field against the power of concentrated wealth. In the United States, these efforts largely failed during what we know as The Roaring Twenties as public sentiment bowed to the supposed acumen of the business and corporate class. When Great Depression congressional hearings uncovered just how badly that class screwed up, it was a series of regulatory actions and social programs that set the stage for the version of mid-20th century American Capitalism that most reflected the full range of Adam Smith’s work.
According to the International Monetary Fund, “Capitalism is an economic system in which private actors own and control property in accord with their interest, and demand and supply freely set prices in markets in a way that can serve the best interests of society.” In the event that you think that in the best interests of society is a socialist term added by some IMF pinko leftist, just remember that Adam Smith was a strict Scot Presbyterian who wrote The Theory of Moral Sentiments almost two decades before he penned The Wealth of Nations. While everyone gloms onto his phrase about the rational self-interest of the butcher and baker as justification for the inherent success of capitalism, they ignore the fact that in a sense, Smith was using the idea of capitalism as a means of raising the proverbial tide of all boats in the waters of society. Fine, says Smith, the best way to make money and improve their condition is to understand that people will act in their own best self-interest. But understand that fixating upon the accumulation of wealth is self-corruptive and ignores the larger obligations that we owe to society.
How did we manage to divorce capitalism from any concern for the welfare of society at large?
Start with the question, what exactly is Capital? We have an entire economic system predicated upon the word and I frankly doubt that many have even thought about it. Google the question what is capital? and the response can vary by site. Investopedia is the first response and defines capital as “…financial assets such as funds held in deposit accounts and/or funds obtained from special financing sources…Capital assets can include cash, cash equivalents, and marketable securities as well as manufacturing equipment, production facilities, and storage facilities.” Wikipedia (yeah, I know, I know…) defines capital as “human created assets that can enhance one’s power to perform economically useful work.” Most sites ignore the concept that people can also be capital; the Corporate Finance Institute notes that capital has a human component including social, intellectual, physical and talent skills. And this is the crux of our present issue. There is supposed to be a degree of balance between the various aspects of capital, a general equilibrium between the human, financial and physical assets with all of them coming together to create wealth and grow the economy. But in the four decades since the election of Ronald Reagan, that equilibrium has vanished and those who view capital as solely the purview of financial instruments have gained control of the economy.
The wealthy are like the poor in that they have always been with us, their power flowing and ebbing over the political events of generations and constrained by taxation, regulation and occasionally, the guillotine. Their most recent ebb came after the Great Depression, when Congressional inquiries revealed the depth and extent of their financial misbehavior. But they didn’t leave and they continually lobbied over decades for the lowering of taxes and the repeal of the regulations that held them in check. My kids have heard me say on multiple occasions that the seed for our era was planted by Ronald Reagan, who rode the promise of a renewed America and lower taxation into office in a landslide. Tax rates were cut and that freed money to sustain the pent-up demand unleashed after the problematic 1970s. But there were two singular changes in Reagan’s first term that set the stage for what has happened since.
Like an Amazonian butterfly whose flapping wings spawn a Bangladeshi monsoon, the first of these changes was notable only in the stunningly dull pages of the B section of the Wall Street Journal. As a college business/economics student during that term, I was required to subscribe to the WSJ and read it regularly. My morning routine consisted of early classes followed by a walk to the post box for the paper and mail, and then to the cafeteria for a coffee and morning read. That read began with the stock results in the C section and then onwards to what I now recognize as the utterly schizophrenic A section editorial page, then the print counterpart to today’s Fox News. In each case, the news side was essentially reliable but the Editorial side was highly conservative and occasionally batshit crazy. What popped out one morning in the B section was a wonkish accounting article discussing a proposal to alter CEO pay packages to allow stock options in addition to the standard salary. The rationale was that the presence of equity options would provide a greater sense of ownership in the company and by extension, a greater willingness to accept risk. It was a shift of philosophy from company steward to company owner. There were a few articles afterwards and the practice was quietly adopted.
Score an early point for potential conflict of interest.
The second change was the innocuously sounding passage of SEC rule 10b-18 in 1982, which again legalized the practice of corporate stock buybacks. Buying back one’s stocks was once legal, but was abolished with the passage of the Securities and Exchange Act in 1934 when Congressional inquiries discovered that more than a few high-flyers of the 1920s markets used the practice to manipulate their share price upwards. The rationale behind the 1982 allowance was rooted ostensibly in the high interest rate environment of that period. In corporate finance, the idea is to invest in those projects which provide a sufficiently large rate of return relative to the cost of money or whatever management deemed the appropriate internal rate of return. In an environment where the cost of money was 15% and higher, there were few projects which could even come close that benchmark. The proposal was that instead of companies just sitting on cash, it was better to simply return it to the shareholders and let them use it to their own best advantage. The optimal way to do that would be the buyback of stock instead of paying higher dividends to gain the tax advantage of the buyback’s capital gains rate versus the dividend’s higher income tax rate.
Score another point for potential conflict of interest and manipulation.
After these two early acts set the stage for the later triumphant looting, events took place in distinct strands that ultimately came together to literally throttle the American Middle Class and contribute to our immense wealth gap.
The first strand was conservatism’s foothold through and after the Reagan years. Conservatives were no longer stodgy middle-aged lodge members that sold insurance and met for Wednesday league golf. They became acolytes to a gospel cult of Wall Street and profitability. I began working in the corporate office of a now-defunct multinational telecommunications firm in 1992. As a first entered the Treasury Group area, I met the prototype for the Young Republican capitalist: tanned and handsome with wavy sandy blonde hair, dressed in an impeccable suit with matching red power tie and suspenders. As he shook my hand and introduced himself, his next words were Y’know, Reagan is a God. I don’t recall my response apart from a mental note to the effect of well, this is special. Our subsequent conversation afterwards was an inquiry about my weekend and then a storyline about how wasted he had been at the beach the immediate weekend before. He was an avatar of what was to follow – supremely self-confident, narcissistic and completely vacuous.
Capitalism during the Reagan years began morphing into what is now termed shareholder capitalism, which was proposed and promoted by Nobel award economist Milton Friedman in the 1970s. Shareholder capitalism posited that executives were to work at the behest of shareholders to the exclusion of all others, including customers and employees. I don’t recall anybody pointing out the inherent conflict of interest as top executives were now shareholders as well. This was the point at which the concept of capital became the purview of financial instruments to the practical exclusion of all else.
Corporate finance shifted with the rise of corporate raiders such as Carl Icahn and firms such as Kohlberg, Kravis and Roberts. These adhered to the shareholder capitalism principles and readily used large amounts of debt – the so-called Other People’s Money – to acquire companies and dismember them, selling off profitable divisions. They then took their proceeds and left the surviving portion of the new firm with to deal with their massively increased debt load. More than a few companies perished because they were unable to cope and more recent examples of this include retailers Toys R Us and Neiman Marcus.
My beach capitalist former co-worker would have felt at home amidst these proceedings.
Assisting in this period was the creation and growth of conservative media, which paved the way with a new attack narrative questioning the role of government and painting the poor as lazy and undeserving.
The key event event for shareholder capitalism however was the 1999 repeal of the 1934 Glass-Steagall Act. This was the fundamental act which regulated the actions of the banking sector, effectively forcing banks to focus upon commercial banking. It was actively promoted by Limbaugh and his peers and permitted money center banks such as JP Morgan Chase and Citibank to again become involved in investment banking. They became active participants in the subsequent use and sale of Mortgage Backed Securities and other derivative instruments which ultimately led to the Financial Crisis of 2008 as they became actual threats to the stability of the entire financial system. They were now effectively Too Big to Fail.
The next strand was woven within the political arena. Conservative principles of deregulation also led to the neutering of regulatory bodies such as the SEC via both defunding and executive direction to scale back investigations. The promise of lucrative private sector careers for cooperative regulatory officials put the cherry on the sundae of what is known as regulatory capture. The legislative branch was compromised by the failure to control lobbying and campaign financing. My own personal bugaboo is the growth of the American Legislative Exchange Council, which acts as a conduit of legislation between corporate beneficiaries and legislators, most at the state level. ALEC was a pre-Reagan entity but came into its own after Reagan came to office.
Score ten points for self-interest.
The third strand was a new attitude towards failure. A key feature of capitalism is that success is obviously met with reward and failure with loss; more power to you if you succeed but you had better be ready for the consequences of failure. But remove the consequences of failure and what begins to occur is moral hazard. Market participants begin to expect that they will be spared the cost of failure and are thus willing to undertake greater and more irrational risk. Perhaps the first financial event to evoke this was the collapse of a private fund named Long Term Capital Management in 1998. The gist of the firm’s strategy was to make money arbitraging the differences in interest rates of different instruments, a transaction with a very small profit margin. To maximize their return, the owners borrowed larger and larger sums of money to create a critical mass of capital to make the strategy lucrative. But when some of the supporting bonds defaulted, the remaining assets could not support their nosebleed levels. The government was forced to step in and arrange, through multiple large banks, an orderly winding down of the trades to prevent a collapse that would have likewise destroyed other firms interlocked via a web of financial relationships. Yes, the firm failed and people lost money but there was a lesson to those few paying attention.
Go ahead and engage in the excessive risk-taking, the system will be protected should things go south. I can argue that this was the precursor event signaling to shareholder capitalists that it was a new game. Hey…we can do all kinds of things now and take our rewards. The market will be fine and we can make money until then. We just have to get out first.
The final strand was a new philosophy about interest rates. The arrival of Ben Bernanke as Federal Reserve Chair in 2006 was a signal moment for the American financial sector. Bernanke’s academic focus was the study of the Great Depression and his premise was that the 1929 Fed exacerbated the collapse by raising interest rates and siphoning liquidity from the system. His proposal would be to lower interest rates and flood the markets with liquidity. The hiring was a tacit acknowledgment of market over-value and that a crash was to be expected. Any issues with the market would be met with a flood of liquidity. The 2008 collapse put this proposal to the test and rates were lowered to historic levels. This was additionally matched by Fed mechanisms, aka “the windows”, to flood the severely damaged financial sector with gob-smackingly stupid amounts of liquidity.
It was here that cheap credit became the new crack.
Significant market issues would be met with rate adjustment downwards and despite efforts in the twelve years since then, rates have not returned to pre-crisis levels. So how is this crack? Corporate executives saw the opportunity to use ultra-low rate debt to their advantage: they began borrowing signficant sums of money on their corporate books and using it…to buy back shares of stock. Cumulative growth of BBB rated corporate debt rose 400% between 2008 and 2018. The effect of this on cumulative Earnings Per Share has been a rise more than seven times higher than sales per share over the same period. Oh, and by the way, the executives are concerned that the market will tank if we ban stock buybacks.
The Federal Reserve has literally become the enabling mother of narcissist sociopaths.
So after Milton Friedman and Ronald Reagan, four strands were woven:
- Inherent conflicts of interest were legalized and allowed;
- A national narrative attacking government regulation occurred and the subsequent financial decline was blamed upon out-groups such as the poor and illegal immigrants;
- The legislative and regulatory processes were seized and neutered;
- Monetary policy and the Federal Reserve were co-opted by the practices of Mutually Assured Financial Destruction brought about by the first three bullet points.
These strands have been woven into the rope that is literally strangling the nation.
The tributes and nods to Adam Smith from the conservative media are a joke. The conservative movement has seized upon a singular work, cherry-picked it and beaten it like a drum to justify decades-long chicanery, theft and wholesale looting. They have helped to rig a system that purposefully strip-mines the wealth of large segments of American society and used their media allies to clothe it in respectability.
Smith would be appalled by what has happened and would likely say this: Read the other book.