As duas principais experiências de capitalismo de gestão em Portugal (BCP e PT) falharam apesar do seu sucesso inicial. Uma empresa considera-se integrada no sector de capitalismo de gestão quando a respetiva direção exerce o controlo efetivo da empresa apoiada apenas num grupo minoritário de acionistas. Tal é possível através de uma dispersão excessiva do capital e de modelos de governo societário propiciadores desse controlo.
Antes da sua queda, o BCP e a PT tinham mais de 175 e 80 mil acionistas, respetivamente, mas os maiores investidores (Teixeira Duarte e BES) detinham menos de 10% do respetivo capital.
Embora as duas empresas operem em setores regulados, tiveram origens e destinos distintos. O BCP foi criado de raiz pelo seu fundador e gestor enquanto a PT resultou da privatização de um monopólio estatal no setor das telecomunicações.
Ambas as empresas tinham uma liderança forte e muito personalizada (Jardim Gonçalves e Zeinal Bava, respetivamente) que acabou destituída por razões diferentes.
No BCP por um problema de sucessão. Jardim Gonçalves fez-se substituir por um acólito que se rebelou contra o seu protetor originando uma guerra de acionistas. Esse desentendimento permitiu que outros acionistas em conluio com os governantes da altura tomassem o controlo do banco.
No caso da PT por um problema de ambição. Zeinal Bava, com o apoio do BES e dos mesmos governantes lançou-se num projeto de fusão com a OI. Porém, os seus parceiros Brasileiros, alguns dos quais financiaram a aquisição da sua participação na OI com dinheiro da PT, aproveitaram o descalabro do Grupo Espirito Santo que trouxe a nu o “tunneling” que esse grupo fizera na PT para tomar o controlo da empresa resultante da fusão. Isto é, o caçador acabou caçado.
As mudanças de gestão e rearranjos nos grupos acionistas que controlam as empresas no setor de capitalismo de gestão são comuns e não são necessariamente más para as empresas e para os pequenos acionistas quando existe um verdadeiro mercado para o controlo das empresas cotadas.
Porém, à parte as histórias mais ou menos rocambolescas da intriga e guerras palacianas inerentes a esses “golpes de estado” que fazem a delícia dos jornais, tais golpes também são frequentemente acompanhados de perdas significativas para as empresas e para os investidores menos atentos.
Foi precisamente isso que aconteceu no BCP e PT. No primeiro caso as perdas dos acionistas de longa data foram superiores a 80% e no segundo caso os investidores perderam mais de 50%.
Importa pois interrogarmo-nos sobre se estas duas histórias são únicas ou inevitáveis num país como Portugal. Numa primeira análise podíamos ser tentados a culpabilizar apenas os intervenientes e os políticos que se imiscuíram na vida dessas empresas.
Porém, o problema é mais fundamental. Num país de capitalismo de estado como o nosso a intromissão política é inevitável e a existência de um mercado livre para o controlo das empresas é impossível O primeiro problema ainda pode ser atenuado se tivermos políticos responsáveis e menos intervencionistas mas o segundo não tem solução.
Em conclusão, para além destes episódios, interessa é debater se a falência das experiencias de capitalismo de gestão em Portugal não nos devia levar a questionar a continuidade do capitalismo de estado. Infelizmente, a maioria dos comentadores pensa que a solução está em reforçar ainda mais o capitalismo de estado através de “golden shares” e outras medidas semelhantes.
Friday, 24 October 2014
Wednesday, 22 October 2014
Capitalism and joint ownership
One of the fundamental freedoms under capitalism is the freedom of association to form business organizations. Joint private ownership is different from joint public ownership in the sense that the first is voluntary and the second is compulsory. Various types of organizations have been developed throughout history, ranging from the Assyrian partnership, the Roman societates and the medieval guilds to the compagnia e banchi of the Italian renaissance. However, the modern from of incorporation as a joint stock company, that we identify with capitalism, had its origins in the XVI century with the creation of the so-called charter companies.
Chartered companies were established by private promoters that were granted some concession or monopoly by the state. For example, in London the Muscovy Company was first established in 1555 with a monopoly over the trade of goods to Russia. Indeed, since the first boom in the establishment of joint stock companies around 1719 more than 140 years passed before this form of company settled with the new British Company Law of 1862, which introduced the main features of a modern joint stock company.
This is an organization engaged in business, recognized as a distinct legal entity from its members, with certain rights and responsibilities and acting as a mechanism to share risks and rewards. Most importantly, it replaced the personal liability of its shareholders by various forms of limited liability which would allow a larger number of shareholders to be organized and therefore able to undertake much bigger projects.
The law permitted companies to be established indefinitely (without any time limit) and not, as before, only for a limited number of years. So, big corporations could now be established by private investors under the new form of a Joint Stock Company.
This facilitated the public offering and negotiability of ordinary shares, essential for pooling funds and sharing the risk and rewards of investment. The issue of tradable shares had existed ever since the early Roman times when the Societates issued their shares or particulae. Even the chartered companies, such as the East India Company, were established by pooling together the capital of about 250 merchants. Yet, as they were typically placed among a limited group of people, mostly family or business acquaintances, they were not widely held by the public and were not actively traded in the early years of the Stock Exchange.
This was due to the basic distrust of issuers about disclosing their profits and sharing them with unknown people and risking the loss of control of the business to other people. Investors were also suspicious about any hidden reasons as to why a business owner should want to share their business. This was stimulated further by the recent memory of the occasional speculative bubble and other flotation scams such as the infamous South Sea and Mississippi companies in 1719-1720.
Only after the first slave-trade mania between 1827 and 1836 were shares widely held and tradable in the Stock Exchange. Still, most of these shares were preference shares, a class of shares that dominated the issue of equity instruments until the early years of the 20th Century. Preference shares were clearly preferred by company managers as a way of keeping control of their companies.
The process to recognize by statute the existence of incorporated companies was also a long journey. Initially incorporation was seen as a very cumbersome process, which was only worthwhile if it involved the granting of some Government monopoly, as was the case with most chartered companies. For most businessmen the partnership form had the major advantage of avoiding interference of the state. Also, public opinion associated incorporation with promotions of speculative companies such as the South Sea and the Mississippi Companies.
Similarly, the process of raising capital by instalments also gave rise to scams and many investors were easy prey for unscrupulous issuers. The most common scam was to make big issues requiring little paid-in capital to attract less sophisticated investors and then run away with their money.
For many of the same reasons, the separation of ownership and control was also a long process. The overriding idea or obstacle was summarized in Carnagie’s motto that “what is anybody’s business is nobody’s business” and it is much more so when there is a large dispersion of institutional ownership.
Not surprisingly, the separation of ownership and control only reached a significant level between 1900 and 1920, with a clear separation of responsibilities into three distinct levels: the company, the shareholders and its directors. To these, one should now add a new layer made up of professional fund managers. This was partly due to the rise of investment trusts, holding companies and the result of better accounting (despite the standards of modern accounting having been developed only from the 1940s onwards).
The separation between shareholders and the company was instrumental to reach the widespread use of equity and the impressive growth in share dealing. Other factors highlighted in modern theories of the firm such as reduced transaction costs and information technology also played an important part. But, bearing in mind that the growth of big firms also implies the growth in non-market transactions, one must question if its trade destruction effects are smaller than the trade creation effects resulting from more investment and more activities being carried out by profit-driven organizations.
Marxists and other anti-capitalist thinkers in the late 19th century pointed out that capitalism had a self-destroying mechanism, since the untamed rise of big firms would cause so much trade destruction that competitive markets would account only for a residual share of total transactions, unless the growth and size of such firms was capped. This led to the introduction of antitrust laws in most countries, inspired in the US Sherman Antitrust Act of 1890. These laws were aimed at curbing anti-competive practices by prohibiting cartels, dumping and other collusion practices as well as laws to regulate corporate consolidations ending up in the creation of monopolies or oligopolies that would limit competition.
As usual, left and right wing interventionists (e.g. socialists and corporatists) wanted as much regulation as possible while right and left wing laissez-faire supporters (e.g. classical liberals and anarchists) wanted no regulation at all. So, the role of antitrust laws has been permanently questioned and changed. Yet, after more than a century we still do not have enough empirical evidence to define a "good degree of regulation". Nevertheless, a middle-of-the-road solution is to have tough anti-competition laws and flexible anti-concentration regulations.
In relation to the various forms of joint private property one needs to remember that many of the alternatives to joint stock companies like partnerships, mutuals, friendly societies, credit unions and so on, although still in operation, have been increasingly opting for corporate structures, in particular in the mortgage-banking sector.
Finally, it must be noted that joint private ownership could not develop without limited liability. Indeed, the size of large business operations needed a large number of shareholders which could be reached only if the partnership was not entirely dependent on the life of its main owner-shareholder or heirs and if the transfer of shares was possible. Moreover, this liberated the poor from their dependency on the state to invest their meagre savings. And, as a consequence, most large firms today are owned by institutional investors whose end-owners may be big or small investors. For instance, pension funds in the OECD countries accounted in 20111 for about 10% of the US$D 32 trillion invested by institutional investors in listed equities.
In conclusion, joint private ownership is an essential right under capitalism since it is one of the main drivers of its success as a wealth production machine. Nevertheless, it must be exercised mostly through regulated corporations financed by small and big capitalists alike so that capital accumulation can benefit from the pooling of resources without unnecessary damage to competitive markets.
Chartered companies were established by private promoters that were granted some concession or monopoly by the state. For example, in London the Muscovy Company was first established in 1555 with a monopoly over the trade of goods to Russia. Indeed, since the first boom in the establishment of joint stock companies around 1719 more than 140 years passed before this form of company settled with the new British Company Law of 1862, which introduced the main features of a modern joint stock company.
This is an organization engaged in business, recognized as a distinct legal entity from its members, with certain rights and responsibilities and acting as a mechanism to share risks and rewards. Most importantly, it replaced the personal liability of its shareholders by various forms of limited liability which would allow a larger number of shareholders to be organized and therefore able to undertake much bigger projects.
The law permitted companies to be established indefinitely (without any time limit) and not, as before, only for a limited number of years. So, big corporations could now be established by private investors under the new form of a Joint Stock Company.
This facilitated the public offering and negotiability of ordinary shares, essential for pooling funds and sharing the risk and rewards of investment. The issue of tradable shares had existed ever since the early Roman times when the Societates issued their shares or particulae. Even the chartered companies, such as the East India Company, were established by pooling together the capital of about 250 merchants. Yet, as they were typically placed among a limited group of people, mostly family or business acquaintances, they were not widely held by the public and were not actively traded in the early years of the Stock Exchange.
This was due to the basic distrust of issuers about disclosing their profits and sharing them with unknown people and risking the loss of control of the business to other people. Investors were also suspicious about any hidden reasons as to why a business owner should want to share their business. This was stimulated further by the recent memory of the occasional speculative bubble and other flotation scams such as the infamous South Sea and Mississippi companies in 1719-1720.
Only after the first slave-trade mania between 1827 and 1836 were shares widely held and tradable in the Stock Exchange. Still, most of these shares were preference shares, a class of shares that dominated the issue of equity instruments until the early years of the 20th Century. Preference shares were clearly preferred by company managers as a way of keeping control of their companies.
The process to recognize by statute the existence of incorporated companies was also a long journey. Initially incorporation was seen as a very cumbersome process, which was only worthwhile if it involved the granting of some Government monopoly, as was the case with most chartered companies. For most businessmen the partnership form had the major advantage of avoiding interference of the state. Also, public opinion associated incorporation with promotions of speculative companies such as the South Sea and the Mississippi Companies.
Similarly, the process of raising capital by instalments also gave rise to scams and many investors were easy prey for unscrupulous issuers. The most common scam was to make big issues requiring little paid-in capital to attract less sophisticated investors and then run away with their money.
For many of the same reasons, the separation of ownership and control was also a long process. The overriding idea or obstacle was summarized in Carnagie’s motto that “what is anybody’s business is nobody’s business” and it is much more so when there is a large dispersion of institutional ownership.
Not surprisingly, the separation of ownership and control only reached a significant level between 1900 and 1920, with a clear separation of responsibilities into three distinct levels: the company, the shareholders and its directors. To these, one should now add a new layer made up of professional fund managers. This was partly due to the rise of investment trusts, holding companies and the result of better accounting (despite the standards of modern accounting having been developed only from the 1940s onwards).
The separation between shareholders and the company was instrumental to reach the widespread use of equity and the impressive growth in share dealing. Other factors highlighted in modern theories of the firm such as reduced transaction costs and information technology also played an important part. But, bearing in mind that the growth of big firms also implies the growth in non-market transactions, one must question if its trade destruction effects are smaller than the trade creation effects resulting from more investment and more activities being carried out by profit-driven organizations.
Marxists and other anti-capitalist thinkers in the late 19th century pointed out that capitalism had a self-destroying mechanism, since the untamed rise of big firms would cause so much trade destruction that competitive markets would account only for a residual share of total transactions, unless the growth and size of such firms was capped. This led to the introduction of antitrust laws in most countries, inspired in the US Sherman Antitrust Act of 1890. These laws were aimed at curbing anti-competive practices by prohibiting cartels, dumping and other collusion practices as well as laws to regulate corporate consolidations ending up in the creation of monopolies or oligopolies that would limit competition.
As usual, left and right wing interventionists (e.g. socialists and corporatists) wanted as much regulation as possible while right and left wing laissez-faire supporters (e.g. classical liberals and anarchists) wanted no regulation at all. So, the role of antitrust laws has been permanently questioned and changed. Yet, after more than a century we still do not have enough empirical evidence to define a "good degree of regulation". Nevertheless, a middle-of-the-road solution is to have tough anti-competition laws and flexible anti-concentration regulations.
In relation to the various forms of joint private property one needs to remember that many of the alternatives to joint stock companies like partnerships, mutuals, friendly societies, credit unions and so on, although still in operation, have been increasingly opting for corporate structures, in particular in the mortgage-banking sector.
Finally, it must be noted that joint private ownership could not develop without limited liability. Indeed, the size of large business operations needed a large number of shareholders which could be reached only if the partnership was not entirely dependent on the life of its main owner-shareholder or heirs and if the transfer of shares was possible. Moreover, this liberated the poor from their dependency on the state to invest their meagre savings. And, as a consequence, most large firms today are owned by institutional investors whose end-owners may be big or small investors. For instance, pension funds in the OECD countries accounted in 20111 for about 10% of the US$D 32 trillion invested by institutional investors in listed equities.
In conclusion, joint private ownership is an essential right under capitalism since it is one of the main drivers of its success as a wealth production machine. Nevertheless, it must be exercised mostly through regulated corporations financed by small and big capitalists alike so that capital accumulation can benefit from the pooling of resources without unnecessary damage to competitive markets.
Wednesday, 15 October 2014
Capitalism and the rule of law
The rule of law is said to exist where all people and institutions (including law makers) are subject to and accountable to law that is fairly applied and enforced. That is, individuals, organizations and governments shall submit to, obey and be regulated by law, and not by arbitrary action of the authorities. Capitalism requires a substantive definition of the rule of law and the following institutions are needed: private property rights, the law of contract, an independent judiciary, and a constitution.
The rule of law concept was already known in some ancient and medieval societies, and it was well expressed in Cicero’s dictum that “we are all servants of the laws in order that we may be free”. Yet, only the capitalist economic system depends on a substantive rule of law to ensure that all trading parts have freedom of entry into a level playing market where contracts freely agreed between the parts can be enforced.
The importance of contract enforcement is easy to understand by imagining that someone at an auction had bided successfully for an item but before collecting it met somebody offering him an identical article for a lower price and decided to default on the previously agreed offer. Or, inversely, the seller asked for more money because meanwhile had found a buyer willing to pay more. So, whenever negotiation and settlement do not occur simultaneously, the parts have to rely on the law to enforce their agreement.
Obviously, legal enforcement presupposes freedom of contract and the existence of due process. For instance, if after a proper due process a legitimate Court had determined that the bidder in the example above was forced to raise his hand then it should declare the contract to purchase as null.
The freedom of contract is essential in a market economy regardless of the legal system prevailing in a specific jurisdiction – whether based on common or civil law. Although a civil law jurisdiction of the type prevailing in Continental Europe places more restrictions on the contractual terms that may be agreed between the parts to an exchange it does not follow that a common law legal system is indispensable for capitalism. Likewise in relation to the principles of classical liberalism. Although these have their own merits they are not essential features of capitalism.
However, the rule of law is critical to ensure a level playing field where arbitrary power is banned and the equality of all before the law is guaranteed. Thus excessive regulation or discrimination are not compatible with capitalism. For instance, compulsory purchases, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required under the rule of law. Nevertheless, in some circumstances, described next, it might be difficult to distinguish between fair and unfair treatment.
Take for instance the payment of wages. Under a freedom of contract rule firms should be free to negotiate wages in cash, kind or a mix of both. But if a department store were to pay his employees partly in food and clothing it would be preventing their freedom to buy the quantities they wanted wherever they liked. Even if the firm were to use the payment in kind to increase the workers compensation (rather than reduce it as is sometimes the case) it would still be an unfair exchange as long as workers had no option to be paid in a universal medium of exchange (money).
Often, governments engage in policies of rationing, price controls or subsidization that distort the prices even in markets that are typically competitive. For example, the price of bread, coffee, low skilled labor, medications, etc. may be controlled and yet in such markets there are thousands of buyers and sellers. The alleged reason is the protection of the poor and weak. Although these may be legitimate social objectives such protection should be given directly to those in need without affecting the functioning of free markets.
There are however special circumstances, activities and places where exemptions can be acceptable within a capitalistic system based on the rule of law. For example, during wars or other calamities that disrupt supplies it may be necessary to introduce temporarily rationing or administrative prices.
Note that such restrictions are different from price controls and similar policies applied regularly to state and regulated monopolies because the purpose of such policies is to prevent abuses of position by those granted such monopolies.
Similarly, there are cases where it is fair for sellers to discriminate among customers, as in the sale of alcohol to youngsters or to inebriated adults, but it would illegitimate to restrict access to a bar or restaurant on the basis of race or religion.
It is also important to note that although governments are entitled to special powers under the principles of the rule of law they should not be entitled to special privileges. Consider for example the collection of payments refused or disputed by debtors. While private citizens can only seize the debtor’s assets following a due process and ruling by a judge, some tax authorities (e.g. in Portugal) exercise the right to offset or dispose of the tax payers property without any due process through the judicial process.
To guarantee the rule of law essential for a capitalist systems it is also necessary the existence of an independent judiciary and a constitutional bill of rights that protect the smallest economic agent (the individual) from arbitrary actions of democratic and dictatorial rulers alike.
Again, the purpose of a constitution is to define the citizens’ rights and to limit the power of government to coerce and encroach upon individual rights, property and freedom; regardless of whether they are based on the philosophy that one is free to do whatever is not explicitly forbidden or it is only allowed what is explicitly permitted, notwithstanding the obvious advantages of the first philosophy.
In conclusion, societies that do not adhere to the fundamental principles of the rule of law cannot guarantee the basis for fair competition and usually end up with perverted forms of capitalism.
The rule of law concept was already known in some ancient and medieval societies, and it was well expressed in Cicero’s dictum that “we are all servants of the laws in order that we may be free”. Yet, only the capitalist economic system depends on a substantive rule of law to ensure that all trading parts have freedom of entry into a level playing market where contracts freely agreed between the parts can be enforced.
The importance of contract enforcement is easy to understand by imagining that someone at an auction had bided successfully for an item but before collecting it met somebody offering him an identical article for a lower price and decided to default on the previously agreed offer. Or, inversely, the seller asked for more money because meanwhile had found a buyer willing to pay more. So, whenever negotiation and settlement do not occur simultaneously, the parts have to rely on the law to enforce their agreement.
Obviously, legal enforcement presupposes freedom of contract and the existence of due process. For instance, if after a proper due process a legitimate Court had determined that the bidder in the example above was forced to raise his hand then it should declare the contract to purchase as null.
The freedom of contract is essential in a market economy regardless of the legal system prevailing in a specific jurisdiction – whether based on common or civil law. Although a civil law jurisdiction of the type prevailing in Continental Europe places more restrictions on the contractual terms that may be agreed between the parts to an exchange it does not follow that a common law legal system is indispensable for capitalism. Likewise in relation to the principles of classical liberalism. Although these have their own merits they are not essential features of capitalism.
However, the rule of law is critical to ensure a level playing field where arbitrary power is banned and the equality of all before the law is guaranteed. Thus excessive regulation or discrimination are not compatible with capitalism. For instance, compulsory purchases, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required under the rule of law. Nevertheless, in some circumstances, described next, it might be difficult to distinguish between fair and unfair treatment.
Take for instance the payment of wages. Under a freedom of contract rule firms should be free to negotiate wages in cash, kind or a mix of both. But if a department store were to pay his employees partly in food and clothing it would be preventing their freedom to buy the quantities they wanted wherever they liked. Even if the firm were to use the payment in kind to increase the workers compensation (rather than reduce it as is sometimes the case) it would still be an unfair exchange as long as workers had no option to be paid in a universal medium of exchange (money).
Often, governments engage in policies of rationing, price controls or subsidization that distort the prices even in markets that are typically competitive. For example, the price of bread, coffee, low skilled labor, medications, etc. may be controlled and yet in such markets there are thousands of buyers and sellers. The alleged reason is the protection of the poor and weak. Although these may be legitimate social objectives such protection should be given directly to those in need without affecting the functioning of free markets.
There are however special circumstances, activities and places where exemptions can be acceptable within a capitalistic system based on the rule of law. For example, during wars or other calamities that disrupt supplies it may be necessary to introduce temporarily rationing or administrative prices.
Note that such restrictions are different from price controls and similar policies applied regularly to state and regulated monopolies because the purpose of such policies is to prevent abuses of position by those granted such monopolies.
Similarly, there are cases where it is fair for sellers to discriminate among customers, as in the sale of alcohol to youngsters or to inebriated adults, but it would illegitimate to restrict access to a bar or restaurant on the basis of race or religion.
It is also important to note that although governments are entitled to special powers under the principles of the rule of law they should not be entitled to special privileges. Consider for example the collection of payments refused or disputed by debtors. While private citizens can only seize the debtor’s assets following a due process and ruling by a judge, some tax authorities (e.g. in Portugal) exercise the right to offset or dispose of the tax payers property without any due process through the judicial process.
To guarantee the rule of law essential for a capitalist systems it is also necessary the existence of an independent judiciary and a constitutional bill of rights that protect the smallest economic agent (the individual) from arbitrary actions of democratic and dictatorial rulers alike.
Again, the purpose of a constitution is to define the citizens’ rights and to limit the power of government to coerce and encroach upon individual rights, property and freedom; regardless of whether they are based on the philosophy that one is free to do whatever is not explicitly forbidden or it is only allowed what is explicitly permitted, notwithstanding the obvious advantages of the first philosophy.
In conclusion, societies that do not adhere to the fundamental principles of the rule of law cannot guarantee the basis for fair competition and usually end up with perverted forms of capitalism.
Monday, 13 October 2014
Free Markets and Competition
Generally speaking, a free market is a contestable market with free entry. That is, a market where buyers and sellers are free to agree their exchanges without any undue interference on demand and supply.
To understand the importance of free entry let us imagine a remote small island community with a single store. Its population is not enough to sustain two stores and as expected the existing store is a natural monopoly. If one of the inhabitants decides to challenge the incumbent monopolist and opens a new store both will run their stores at a loss until one of them eventually is ruined and gives up.
While the two stores remain competing the islanders benefit from greater supply at a lower price, but once the monopoly is re-established they face reduced supply and higher prices so that the surviving store can recover the losses incurred while competing with the other store. Meanwhile, during the competitive period the two store owners engaged in both fair and unfair tactics to gain or keep market share through better customer service, credit terms, product quality, etc. Some of these sales tactics are considered beneficial while others disrupt the traditional rules of civility and trust in the community. Therefore, the islanders’ ruler received many requests to stop them or to let them fight to the end. Which are his options?
He can uphold the laisser-faire principle of no interference to ensure an absolute right to free entry. Alternatively, he may introduce a licensing system to grant the monopoly on a temporary or permanent basis. Both options could be improved to retain the benefits of competition and minimize its costs. For instance, he could ban unfair sales tactics or he could auction periodically the store license. These two options should be carefully assessed to determine which would be the most efficient in a Pareto sense. That is, which would allow competition to generate greater benefits.
This example is not a simple curiosity in remote societies. Indeed, we find many similar situations in developed countries. For instance, licensing is very common in public transport, pharmacies, funerary services, roads and other infrastructures, healthcare, telecommunications, etc. And, such licensing while often done under the guise of consumer protection is in fact used to regulate or limit competition.
In fact, free markets are only a foundation of capitalism as long as they contribute to enhance fair competition, that is to create competitive markets where prices are established in accordance with supply and demand.
The simplest form of a competitive market is a market without entry barriers and where there are many suppliers and buyers so that all parties are price-takers. But, this is not always required. For instance, Stanley Jevons (1871) one of the founders of the marginal utility theory of value, considered that a market could be made of only two counterparties.
Although one may idealize market structures that create a system of perfect competition, capitalism does not need such a stringent form of competition. Some imperfections or regulations are tolerable or even desirable to achieve what Churchill (1909) called the need for competition upward but not downward (e.g. competition that could drive labor into slavery or tax rates to zero).
Such departures from an idealized world of perfect competition may be more or less extensive depending on the nature of the market, e.g. largest in labor markets than in capital or in goods and services markets. Even among the latest one must distinguish between markets with prohibitive carrying costs (e.g. fish markets) and speculative markets where carrying costs are negligible. The second factor to bear in mind is whether the so-called market failures and divergences between private and social optimization are significant and susceptible of correction without secondary damages.
In modern capitalism the most relevant issue is whether monopolistic and oligopolistic markets still can be considered competitive. For instance, does the fact that the Coca-cola and Pepsico share of the soft drinks market has risen from about 50% in the 1960s to the current level of around 70% means that such market is no longer considered as competitive? Of course not, because there is no entry barriers in such market and in fact there are many small producers competing with these two giant firms. However, if their dominance had been achieved or preserved through licensing or any other form of government favoritism then we should not consider such market as competitive.
Currently, there is a market – the market for corporate control - whose freedom is essential to preserve because of the growing separation between ownership and control. In most big firms the degree of capital dispersion is sufficiently large to facilitate collusion between managers and a small group of shareholders who introduce many obstacles (e.g. poison pills) to prevent others from challenging their power within the firm and to seclude them from hostile takeovers. Moreover, invoking the risk of short-termism and the speculative nature of such markets these groups of insiders often succeed in persuading politicians to enact legislation to obstruct the development of markets for corporate control which are indispensable to protect minority shareholders.
In general, the risk of collusion between sellers is the same whether the oligopolies exist in regulated or non-regulated industries. As Adam Smith reminded us long ago “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. It also common to find businessmen who were enthusiastic free-market supports when they were challenging the incumbents but transform overnight into the most determined protectionists once they join the incumbents.
In fact, this is the reason why capitalists are not always among the main supporters of capitalism and free markets. Only consumers remain always beneficiaries with the greatest interest in free markets. This is the reason why some argue that, if it was not for Marx, capitalism would be better named as consumerism.
However, consumers are frequently too numerous to organize conspiracies or to simply oppose those of the sellers. That is the reason why, in the end, the existence of free competitive markets depends on the rule of law and governments prohibiting or limiting non-competitive practices.
To understand the importance of free entry let us imagine a remote small island community with a single store. Its population is not enough to sustain two stores and as expected the existing store is a natural monopoly. If one of the inhabitants decides to challenge the incumbent monopolist and opens a new store both will run their stores at a loss until one of them eventually is ruined and gives up.
While the two stores remain competing the islanders benefit from greater supply at a lower price, but once the monopoly is re-established they face reduced supply and higher prices so that the surviving store can recover the losses incurred while competing with the other store. Meanwhile, during the competitive period the two store owners engaged in both fair and unfair tactics to gain or keep market share through better customer service, credit terms, product quality, etc. Some of these sales tactics are considered beneficial while others disrupt the traditional rules of civility and trust in the community. Therefore, the islanders’ ruler received many requests to stop them or to let them fight to the end. Which are his options?
He can uphold the laisser-faire principle of no interference to ensure an absolute right to free entry. Alternatively, he may introduce a licensing system to grant the monopoly on a temporary or permanent basis. Both options could be improved to retain the benefits of competition and minimize its costs. For instance, he could ban unfair sales tactics or he could auction periodically the store license. These two options should be carefully assessed to determine which would be the most efficient in a Pareto sense. That is, which would allow competition to generate greater benefits.
This example is not a simple curiosity in remote societies. Indeed, we find many similar situations in developed countries. For instance, licensing is very common in public transport, pharmacies, funerary services, roads and other infrastructures, healthcare, telecommunications, etc. And, such licensing while often done under the guise of consumer protection is in fact used to regulate or limit competition.
In fact, free markets are only a foundation of capitalism as long as they contribute to enhance fair competition, that is to create competitive markets where prices are established in accordance with supply and demand.
The simplest form of a competitive market is a market without entry barriers and where there are many suppliers and buyers so that all parties are price-takers. But, this is not always required. For instance, Stanley Jevons (1871) one of the founders of the marginal utility theory of value, considered that a market could be made of only two counterparties.
Although one may idealize market structures that create a system of perfect competition, capitalism does not need such a stringent form of competition. Some imperfections or regulations are tolerable or even desirable to achieve what Churchill (1909) called the need for competition upward but not downward (e.g. competition that could drive labor into slavery or tax rates to zero).
Such departures from an idealized world of perfect competition may be more or less extensive depending on the nature of the market, e.g. largest in labor markets than in capital or in goods and services markets. Even among the latest one must distinguish between markets with prohibitive carrying costs (e.g. fish markets) and speculative markets where carrying costs are negligible. The second factor to bear in mind is whether the so-called market failures and divergences between private and social optimization are significant and susceptible of correction without secondary damages.
In modern capitalism the most relevant issue is whether monopolistic and oligopolistic markets still can be considered competitive. For instance, does the fact that the Coca-cola and Pepsico share of the soft drinks market has risen from about 50% in the 1960s to the current level of around 70% means that such market is no longer considered as competitive? Of course not, because there is no entry barriers in such market and in fact there are many small producers competing with these two giant firms. However, if their dominance had been achieved or preserved through licensing or any other form of government favoritism then we should not consider such market as competitive.
Currently, there is a market – the market for corporate control - whose freedom is essential to preserve because of the growing separation between ownership and control. In most big firms the degree of capital dispersion is sufficiently large to facilitate collusion between managers and a small group of shareholders who introduce many obstacles (e.g. poison pills) to prevent others from challenging their power within the firm and to seclude them from hostile takeovers. Moreover, invoking the risk of short-termism and the speculative nature of such markets these groups of insiders often succeed in persuading politicians to enact legislation to obstruct the development of markets for corporate control which are indispensable to protect minority shareholders.
In general, the risk of collusion between sellers is the same whether the oligopolies exist in regulated or non-regulated industries. As Adam Smith reminded us long ago “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. It also common to find businessmen who were enthusiastic free-market supports when they were challenging the incumbents but transform overnight into the most determined protectionists once they join the incumbents.
In fact, this is the reason why capitalists are not always among the main supporters of capitalism and free markets. Only consumers remain always beneficiaries with the greatest interest in free markets. This is the reason why some argue that, if it was not for Marx, capitalism would be better named as consumerism.
However, consumers are frequently too numerous to organize conspiracies or to simply oppose those of the sellers. That is the reason why, in the end, the existence of free competitive markets depends on the rule of law and governments prohibiting or limiting non-competitive practices.
Wednesday, 8 October 2014
The Profit Motive and Capitalism
The pursuit of self-interest is the second pillar of capitalism and it is expressed by the profits attained. Without profits companies would not know whether an item or service is worth producing and could not measure their success. As remarked by Adam Smith (1776), “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 interest”.
Profits, or net income available to common shareholders to use the accountant’s terminology, are the difference between revenues and expenditures. The outlays include the compensation to suppliers, the taxes paid to governments and interest charged by creditors. This residual amount belongs to shareholders and may be distributed as dividends or kept in the firm as retained earnings.
Contrary to what some finance theories imply, profits may not be considered as a cost to be minimized but rather as a gain to be maximized. Yet, many still see profits as immoral or as something to be curbed rather than maximized because they encourage selfishness and greed.
The immorality of profits is preached by Marxists and some religious leaders. The later invoke arguments similar to those used in the Middle Ages to condemn charging interest on loans. The first appeal to Marx’s mistaken labor theory of value postulating that all goods, considered economically, are only the product of labor and cost nothing except labor. Both doctrines have been refuted by theory and history.
Nonetheless, the need for profit maximizing capitalists or firms is repeatedly debated and needs to be clarified. The debate involves three main topics – whether humans are really optimizers or satisfiers, if it is indispensable for optimal competitive markets and the likelihood of degenerating into a socially unacceptable concentration of wealth.
In relation to the first, recent research on human behavior shows that humans are often driven by motives that cannot be considered as self-interest. However, the proponents of self-interest maximization claim that such deviations are minor and that maximization is still a good proxy for human behavior. The risk of wealth concentration is real, but it is naturally bounded through diseconomies of scale and may be socially constrained through inheritance and income taxes. So, we focus on its indispensability for an optimal allocation of resources through competitive markets.
The idea that the profit motive is dispensable or at least is not foremost in modern capitalism stems from the widespread view that in a world where ownership is very removed from control companies have many stakeholders and that shareholders are merely one of them.
However, in competitive markets, the interests of other stakeholders are better served by shareholders pursuing profit maximization motives. One does not need to endorse Ayn Rand’s (1964) reclassification of selfishness and greed as virtues rather than evils. We can rely on Aristotle’s concept of mean or on Keynes (1936) statement that “it is better that a man should tyrannize over his bank balance than over his fellow-citizens” in the pursuit of his money-making passion subject to rules and limitations aimed at creating a levelled playing field.
Indeed, the profit motive is indispensable in both competitive and oligopolistic markets but the prevalence of one type of market over the other is not indifferent.
Let us illustrate first why the shareholders profit motive is indispensable, despite the current trend in finance theory to focus on firm value rather than shareholder value. Under such theory the manager’s role is to maximize the present value of future cash-flows discounted by the weighted average cost of capital. Assuming the possibility of risk-free arbitrage between debt and stock securities issued by a company or that stocks always sell at book value then the structure of capital would be irrelevant to determine the value of a firm. Thus the managers objective should be the maximization of operating profits (EBIT) rather than the shareholders profit (net income). Moreover, managers could ignore the owners’ desired debt/equity ratio because they can achieve whatever level they wished by leveraging their equity portfolio.
However profit maximization cannot be pursued regardless of who has claims on operating profits, that is, debt holders, tax authorities, shareholders and managers (retained earnings). In what concerns debt holders and taxation the company has a duty to minimize their share by procuring the cheapest source of financing and reducing its tax bill. Retained earnings could be a maximization objective. However, if we accept the proposition that the capital structure does not affect the value of the firm, then even managers trying to maximize the size of their company should be indifferent about whether its growth was financed with internal or external funding and may not feel compelled to maximize retained earnings. Therefore, only shareholders have a genuine and unequivocal interest in profit maximization, regardless of the degree of separation between ownership and control.
That is, shareholders are indispensable for profit maximization irrespective of whether they prefer capital gains or distributions (dividends and stock repurchases).
This is an important conclusion because, theoretically, a corporation could be established by any of the so-called stakeholders - employees, managers, clients, governments, creditors, entrepreneurs and shareholders – interested only in maximizing their own return (e.g. salaries or executive compensation) and minimizing that of the other stakeholders. Even if we consider the so-called serial entrepreneurs, who are successful at finding and developing new business opportunities and are driven more by the entrepreneurship thrill than capital gains or control, they still need the profit motive of passive shareholders to compel management to pursue profit maximization and secure the success of their ventures.
Finally, let us discuss if the profit motive is efficient and indispensable in all human activities and organizations, and in particular for big businesses operating in oligopolistic markets. In the case of public goods and services it is normal that the objective is not the maximization of the financial return for those who provided the funding (taxpayers), but rather the minimization of the cost for the consumers of such services. Likewise, in the case of philanthropic and other non-profit organizations, the objective is not to maximize the donors satisfaction but to maximize the beneficiaries benefit. Although in these organizations we may find many instances where the interests of the ultimate beneficiaries have been hijacked by the interests of the insiders (e.g. politicians, directors, officers or employees) they still cannot be driven by the profit motive.
Fortunately, most human needs are better fulfilled by for-profit organizations. Yet, except under special circumstances, the pursuit of profit maximization does not guarantees Pareto efficiency in the case of markets dominated by oligopolistic firms capable of securing monopolistic rents. So, while profit maximization is an essential foundation of capitalism it needs to be complemented by competitive markets.
In a world where most people is to a greater or lesser extent a passive capitalist increasingly removed from the control of his investments and there is a growing oligopolization in many industries we need to understand how capitalism depends on the preservation of free and competitive markets.
Profits, or net income available to common shareholders to use the accountant’s terminology, are the difference between revenues and expenditures. The outlays include the compensation to suppliers, the taxes paid to governments and interest charged by creditors. This residual amount belongs to shareholders and may be distributed as dividends or kept in the firm as retained earnings.
Contrary to what some finance theories imply, profits may not be considered as a cost to be minimized but rather as a gain to be maximized. Yet, many still see profits as immoral or as something to be curbed rather than maximized because they encourage selfishness and greed.
The immorality of profits is preached by Marxists and some religious leaders. The later invoke arguments similar to those used in the Middle Ages to condemn charging interest on loans. The first appeal to Marx’s mistaken labor theory of value postulating that all goods, considered economically, are only the product of labor and cost nothing except labor. Both doctrines have been refuted by theory and history.
Nonetheless, the need for profit maximizing capitalists or firms is repeatedly debated and needs to be clarified. The debate involves three main topics – whether humans are really optimizers or satisfiers, if it is indispensable for optimal competitive markets and the likelihood of degenerating into a socially unacceptable concentration of wealth.
In relation to the first, recent research on human behavior shows that humans are often driven by motives that cannot be considered as self-interest. However, the proponents of self-interest maximization claim that such deviations are minor and that maximization is still a good proxy for human behavior. The risk of wealth concentration is real, but it is naturally bounded through diseconomies of scale and may be socially constrained through inheritance and income taxes. So, we focus on its indispensability for an optimal allocation of resources through competitive markets.
The idea that the profit motive is dispensable or at least is not foremost in modern capitalism stems from the widespread view that in a world where ownership is very removed from control companies have many stakeholders and that shareholders are merely one of them.
However, in competitive markets, the interests of other stakeholders are better served by shareholders pursuing profit maximization motives. One does not need to endorse Ayn Rand’s (1964) reclassification of selfishness and greed as virtues rather than evils. We can rely on Aristotle’s concept of mean or on Keynes (1936) statement that “it is better that a man should tyrannize over his bank balance than over his fellow-citizens” in the pursuit of his money-making passion subject to rules and limitations aimed at creating a levelled playing field.
Indeed, the profit motive is indispensable in both competitive and oligopolistic markets but the prevalence of one type of market over the other is not indifferent.
Let us illustrate first why the shareholders profit motive is indispensable, despite the current trend in finance theory to focus on firm value rather than shareholder value. Under such theory the manager’s role is to maximize the present value of future cash-flows discounted by the weighted average cost of capital. Assuming the possibility of risk-free arbitrage between debt and stock securities issued by a company or that stocks always sell at book value then the structure of capital would be irrelevant to determine the value of a firm. Thus the managers objective should be the maximization of operating profits (EBIT) rather than the shareholders profit (net income). Moreover, managers could ignore the owners’ desired debt/equity ratio because they can achieve whatever level they wished by leveraging their equity portfolio.
However profit maximization cannot be pursued regardless of who has claims on operating profits, that is, debt holders, tax authorities, shareholders and managers (retained earnings). In what concerns debt holders and taxation the company has a duty to minimize their share by procuring the cheapest source of financing and reducing its tax bill. Retained earnings could be a maximization objective. However, if we accept the proposition that the capital structure does not affect the value of the firm, then even managers trying to maximize the size of their company should be indifferent about whether its growth was financed with internal or external funding and may not feel compelled to maximize retained earnings. Therefore, only shareholders have a genuine and unequivocal interest in profit maximization, regardless of the degree of separation between ownership and control.
That is, shareholders are indispensable for profit maximization irrespective of whether they prefer capital gains or distributions (dividends and stock repurchases).
This is an important conclusion because, theoretically, a corporation could be established by any of the so-called stakeholders - employees, managers, clients, governments, creditors, entrepreneurs and shareholders – interested only in maximizing their own return (e.g. salaries or executive compensation) and minimizing that of the other stakeholders. Even if we consider the so-called serial entrepreneurs, who are successful at finding and developing new business opportunities and are driven more by the entrepreneurship thrill than capital gains or control, they still need the profit motive of passive shareholders to compel management to pursue profit maximization and secure the success of their ventures.
Finally, let us discuss if the profit motive is efficient and indispensable in all human activities and organizations, and in particular for big businesses operating in oligopolistic markets. In the case of public goods and services it is normal that the objective is not the maximization of the financial return for those who provided the funding (taxpayers), but rather the minimization of the cost for the consumers of such services. Likewise, in the case of philanthropic and other non-profit organizations, the objective is not to maximize the donors satisfaction but to maximize the beneficiaries benefit. Although in these organizations we may find many instances where the interests of the ultimate beneficiaries have been hijacked by the interests of the insiders (e.g. politicians, directors, officers or employees) they still cannot be driven by the profit motive.
Fortunately, most human needs are better fulfilled by for-profit organizations. Yet, except under special circumstances, the pursuit of profit maximization does not guarantees Pareto efficiency in the case of markets dominated by oligopolistic firms capable of securing monopolistic rents. So, while profit maximization is an essential foundation of capitalism it needs to be complemented by competitive markets.
In a world where most people is to a greater or lesser extent a passive capitalist increasingly removed from the control of his investments and there is a growing oligopolization in many industries we need to understand how capitalism depends on the preservation of free and competitive markets.
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