Klarman, Fink and Grantham and the Threat to American Capitalism
An extreme, utopian political and economic philosophy has been embraced in America by a network of highly influential and well-placed apostles. Like an equally extreme and utopian philosophy before it – Communism – this philosophy has, to its core believers, strong appeal in theory but cannot work in practice. And just as Communism ultimately brought about the collapse of the regime that established it in its most extreme form, the Soviet Union, this new extreme philosophy threatens to bring about the collapse of American capitalism.
That is my very liberal reading of the undercurrent beneath a number of much-discussed recent documents: a new book by veteran journalist Steven Pearlstein, Can American Capitalism Survive?; the Q42018 letter distributed to Baupost hedge fund shareholders by its widely-respected chief executive Seth Klarman1; an article by British economist John Kay on “The Concept of the Corporation;” and recent writing by BlackRock CEO Larry Fink and GMO cofounder Jeremy Grantham.
Hardening the tip while the rest of the iceberg melts away
On September 13, 1970, The New York Times Magazine published what may be the most-cited article ever to appear in that newspaper, with more than 17,000 citations on the academic website Google scholar.
The title of the article was The Social Responsibility of Business is to Increase its Profits, and it was written by University of Chicago economist Milton Friedman.
Although the article was widely read and much-cited, it contains a fatal flaw.
In that article, Friedman begins by arguing that “…businessmen [who] speak eloquently about the ‘social responsibilities of business in a free-enterprise system,’” and who “declaim that business is not concerned ‘merely’ with profit but also with promoting desirable ‘social’ ends,” are “preaching pure and unadulterated socialism.”
Friedman then goes on to argue that generally the responsibility of the corporate executive is “to make as much money as possible while conforming to [the] basic rules of the society, both those embodied in law and those embodied in ethical custom.”
The question is, what are the basic rules that are “embodied in ethical custom” but not in law? If those basic rules “embodied in ethical custom” include that the corporation has a social responsibility – such as to be fair to its customers and employees and suppliers, even if it reduces profits – then the corporation has a social responsibility after all.
The way the followers of Friedman dealt with this conundrum was simply to drop the part about the rules “embodied in ethical custom.” The admonition to business became, “to make as much money as possible while conforming to the law.”
The rules of society as embodied in written law, however, are only the leading edge of a far larger issue . The bigger issue is all of the norms and unspoken contracts that we abide by every day; in the words of the legal scholar Lynn Stout, as quoted by Pearlstein, “Newspapers are left in driveways when no one is about; brawny young men wait peacefully in line behind frail senior citizens; people use ATM machines without hiring armed guards; stores stock their shelves with valuable goods watched over by only a few sales clerks.”
Countries in which people do not observe these norms, and countless others, do not do well economically.
What Friedman’s article encouraged – at least as it was subsequently interpreted, to get around its fatal flaw – was a reduction in the importance assigned to societal norms. One inevitable result of downplaying the many tacit and unwritten contracts of “social responsibility” was an increased focus on making more rules explicit and written; for example, bills passed by Congress contain many more pages than they did decades ago. But it also means that rules embodied only in “ethical custom” are taken less seriously than they were.
Seth Klarman, in his fourth quarter 2018 newsletter, makes a point of this distinction. “American democracy operates not just from a system of rules but also norms,” he says. Norms “reflect a core cultural aspiration of fairness, civility, and community that is more socially powerful, and broader in reach, than any statute or regulation.” He adds that “social cohesion is essential for those who have capital to invest.”
Friedman’s article served to harden the tip of an iceberg of societal norms that have since been slowly but inexorably melting.
The harm done by ideologies taken to extremes
Pearlstein cites startling figures chronicling the decline in faith in the American capitalist system, especially among millennials. “A decade ago,” he says, “80 percent of Americans agreed with the statement that a free market economy is the best system. Today, it is 60 percent, lower than in China. One recent poll found that only 42 percent of millennials supported capitalism. In another, a majority of millennials said they would rather live in a socialist country than a capitalist one.”
Pearlstein attributes this decline to three ideological principles taken to extremes: supply-side economics, maximizing shareholder value, and “market justice.” These could be collectively summarized as what has been called market fundamentalism. Pearlstein claims that “What the proponents of supply-side economics, maximizing shareholder value and market justice overlook – why their formula no longer works, why their ideas are no longer valid – is that they have produced a kind of capitalism that corrodes social capital by undermining trust and discouraging socially cooperative behavior.”
Friedman’s thesis has no room for “social capital”; nor does – according to John Kay – the new theory of the corporation developed by proponents (mainly at the University of Chicago), starting about 40 years ago, that the corporation is merely a “nexus of contracts” as opposed to a social organization with a purpose rooted in its capabilities and its history.
Says Kay, “Because the corporation is a social organisation, and a continuing entity with a history and a future, it is able to operate largely on the basis of implicit contracts with employees, with suppliers and customers, and with the communities in which it operates. These implicit contracts – shared understandings rather than legal documents (although legal documents, irrelevant unless the relationship breaks down, often exist in parallel) – are enforced by their association with personal relationships and by the common intention to develop continuing economic relationships. Such agreements create the capacity to secure ‘consummate’ rather than ‘perfunctory’ cooperation – willing adherence to a common objective rather than enforced compliance with detailed rules.”
The principle that “maximizing shareholder value” is the proper role of the corporate executive leads to cost-saving measures that often destroy the trust between the corporation and its employees. Pearlstein believes these measures can actually serve to lower shareholder value by reducing the productivity of the workers.
As he says, “I have yet to hear a plausible story explaining how the productivity of frontline workers has not been hurt by a prevailing business ethic that explicitly seeks to keep their wages as low as possible so that shareholders and top executives can capture an ever-increasing share of the increased profits.”
The theory espoused by those who advocate market fundamentalism – who are often those who style themselves “wealth creators” – is that greater incentives for wealth creators will fuel more economic growth.
But would greater incentives for frontline workers not also create more incentives for greater productivity and therefore economic growth – especially greater incentives as compared to those above them in the hierarchy, for whom the marginal utility of greater wealth is less? How do we measure the importance of these incentives compared to those offered to the supposed “wealth creators”?
The pushback against market fundamentalism
Pearlstein defines “market justice” this way: “No matter how unfair it might seem to cut taxes for the wealthy, no matter how ruthless a company might have to be in its dealings with workers and consumers, no matter how unequal the distribution of income and wealth might become, we must ignore and dismiss such moral concerns as naïve and ultimately self-defeating.”
There is, of course, some truth in this. Countries, governments, corporations, and teaching institutions in which it’s impossible to fire anyone stagnate or become less productive. Creative destruction, much of it due to market forces, is necessary for an economy to be continually refreshed. But when it goes too far and begins to destroy the body of social norms, the “ethical customs” underpinning the whole economy then it becomes more than creative destruction, it is simply destruction.
And “market justice” often involves self-delusion. Those who radically embrace market fundamentalism – when questioned over the typically outrageous salaries commanded by chief executives in the United States (where they are 88 percent higher than in Europe) – would argue that high salaries are “how the market values those executives, and are therefore accurate.”
But anyone who has sat in on a board discussion of the CEO’s salary, as I have, knows that it isn’t “the market” evaluating the CEO. It is a form of subtle, or accidental, cronyism – something that the fundamental theory of perfect markets disallows.
What happens is that the board hires a consulting firm to create a matrix of executive pay in the same or similar industry in comparable geographic locations. The matrix includes average, high, and low levels of compensation among those the consulting firm surveyed.
Then the board uses that to discuss the CEO’s compensation. Of course, it doesn’t want to insult the CEO (unless the board actually wants to get rid of her) by calling her performance only average or less than average. So they choose a compensation level in the above average range. And of course, some of the board members are CEOs themselves.
This process inevitably causes a spiralling of CEO pay – which is what has happened. Where do we see a free market pricing process in this scenario? And yet market fundamentalists tend to believe, Milton Friedman among them, that as long as there aren’t constraints on business in the form of regulation, anything that happens is due to market forces.
Many – in fact, most – CEOs themselves now decry this process; incredibly, they are almost powerless to do anything about it. To decline a raise would be unusual and might embarrass other board members who themselves have received high levels of compensation by a similar process. Somehow, this practice, which almost everybody believes is wrong, continues – not least because it continues to be justified by the extreme market fundamentalist view.
There has been considerable pushback, even from some top executives in the financial field, where profits are the greatest, against the idea that the only purpose of a corporation is to maximize profits. Klarman, in a recent address to the Harvard Business School, said, “does anyone really believe that shareholders are the only constituency that matters: not customers, not employees, not the community or the country or planet Earth?” And in that talk he quotes Jeremy Grantham, cofounder of the global investment firm GMO, as saying “We face a form of capitalism that has hardened its focus to short-term profit maximization with little or no apparent interest in social good.”
In Blackrock CEO Larry Fink’s 2019 letter to CEOs he argues for elevating the purpose of a corporation above its pursuit of profits. He says there that, “Purpose is not the sole pursuit of profits but the animating force for achieving them.” This is consonant with an article by Financial Times chief economics commentator Martin Wolf titled, “We must rethink the purpose of the corporation.” In it, he argues that the idea that businesses only pursue profits leads to dire outcomes. I have also argued that investment, too, should be driven by purpose, not profit maximization.
It is salutary that major figures in the business world like Fink, Klarman, and Grantham are pushing back against this philosophy. If its extreme version is not soon moderated, Pearlstein is suggesting, it will continue to contribute to the corrosion of the fabric of the social infrastructure in America – or perhaps worse yet, cause a pendulum swing to the opposite extreme.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
1 This is a private letter intended for distribution to only Baupost’s clients. However, it was widely circulated at the Davos World Economic Forum, after which Advisor Perspectives was given a copy.