making the case for free enterprise

The Case for Real Capitalismby Jesse Norman, Member of Parliament for Hereford and South Herefordshire

Contents

Executive Summary

1. The Case for Capitalism

2. Crony Capitalism

3. The Case of Goldman Sachs

4. Lloyds HBOS and the UK banks

5. Pay

6. The UK’s Real Economic Decline

7. Institutions: AWOL or MIA?

8. The Politics of Crony Capitalism

9. Free Market Conservatism

10. Lessons

About the author

Jesse Norman is the MP for Hereford and South Herefordshire, and a member of the Treasury Select Committee. He is a former Director of BZW, which he left in 1997; and of Institutional Shareholder Services, now the leading provider of corporate governance advice worldwide.

Executive summary

• Capitalism is the greatest tool of wealth creation, social advance and economicdevelopmenteverknown.*

• Weare living throughaperiodof cronycapitalism,ofwhich theGoldmanSachsflotationandLloyds-HBOSmergerarejusttwoexamples.

• Conservativesmustmakethemoralcaseforrealcapitalism,andtakeactionagainstcronycapitalism—andtheculturethatcreatedit.

* Pleasenotealongerversionofthispaperisinpreparation.

TheUSeconomy is stagnating.TheEurozone is in crisis.TheUKmay be draggedback into recession.Thiscrisis isnotamereeconomicdownturn,buta fundamentalshiftofvalue,causedbyexcessivefinancialspeculationandabettedbyfoolishpoliticaldecision-makingovertwodecades.Capitalismitselfiswidelyheldtobeatfault.

Infactcapitalismisthegreatesttoolofeconomicdevelopment,wealthcreationandso-cialadvanceeverknown.Incapitalism,ownersofintellectual,financialorhumancapitalhavepropertyrightsthatenablethemtoearnaprofitasarewardforputtingthatcapitalatriskinsomeformoffreemarketeconomicactivity.

Koreausedtobeonecountry.ThirtyyearsaftertheKoreanwar,GDPpercapitaincapi-talistSouthKoreawasfivetimesthatofcommunistNorthKorea;in2009itwassixteentimesgreater.

Butthecaseforcapitalismisnotjusteconomicandsocial; it isalsomoral.Formanydecades,capitalismhascomeunderattackonmoralgrounds.Itissaidtobeintrinsicallyimmoral,anddrivenbygreed;tobefoundedontheft,withthegreatestcapitalistsmere“robberbarons”;tocreateandperpetuateexploitationandinequality;eventobemorallyvacant.

Ofcourseabusesofcapitalismoftenoccur.Butthebiggertruthisthatcapitalismisatrootamoralforceforgood.Itrelieson,andsodemands:

a. Personal freedomand individualautonomy, the foundationstonesofpersonalmorality;

b. Thevirtuesofhardwork,creativityandthrift;

c. Social exchange: traditionsandpracticesbywhich intellectual, financial andhumancapitalcanbesharedtobesteffect;

d. Institutionssuchas theruleof lawand the family thatpreservepropertyovertime;

e. Effectivegovernmenttocreateandenforcethelaw,tosharesocialcostsand,Iwouldargue,tohelpthedisadvantaged;

f. A wider culture and a stable but fluid social order in which its virtues arerespectedandopportunityexistsforallofenergyandtalent,thatisforall.

1. The Case for Capitalism

Inshort,capitalismrelieson,andsodemands,trust.Itdoesnotexisttomaketherichricher.

But there is a hugeBut.This is real capitalism, capitalismas it’s supposed towork.That’snotthecapitalismwehaveintheUKatpresent.Whatwehavenow,inlargepartsoftheUKeconomy,iscronycapitalism.

Whatiscronycapitalism?Onecanidentifydifferentvarieties,suchasmonopoly,fran-chise,khakiandnarco-capitalism:

• Monopoly capitalismflourishedintheUSAattheendofthe19thcentury.AtthattimeindividualssuchasCooke,VanderbiltandRockefellerwereabletoamassenormouswealthbyagglomeratingnewindustriesinto“trusts”,whichexercisedmonopolyoroligopolymarketpowerwithinmarkets.

• Franchise capitalism developed inRussia during the 1990s.A generation of “oli-garchs”emerged,alongsidetheofficialapparatusofthestate,whosewealthderivedfromwinninglucrativenaturalresourcesfranchisesinoilandgas.

• Khaki capitalismhastakenrootincountriessuchasEgyptandPakistan,wherethearmedforceshavebecomelargeeconomicactors intheirownright. InEgypt,forexample,thearmyrunsroughly10percentoftheeconomy.

• Narco-capitalismhasbeenseeninrecentdecadesinMexicoandColombia,amongothercountries.Thedrugstradecreatedenormousillicitprofitsforitschiefs.Asthetradebecameasubstantialpartofa regionalornationaleconomy, itwas furtherentrenchedthroughcorruption.

Thesevarietiescananddooftenco-existinagivencountryorsociety.Theyallexploittheabsenceoflaworlawenforcement,marketmechanismsorculturewhichactelse-whereasconstraintsonindividualself-enrichment.

Moregenerally,onemightsaycronycapitalismhastwokeyfeatures:

a. Businessactivitylosesanyrelationtothewiderpublicinterest

b. Businessmeritisseparatedfrombusinessreward.

Bycontrast,realcapitalismisasystemwhererealpeopletakerealrisk,investrealtimeinrealworkandreaprealrewardsfortheirefforts.Aday’sworkforaday’spay.Marketsareused,butnotvenerated.Competitioniswelcomed,butmadesubjecttoproperregu-lationandsupervision.Peoplearerewardedandrespectedfortheiraspiration,energyandinnovation,notforwhotheyare.

Thiscountryisemergingfromatimeoffakecapitalism,matchedbyfakegovernment;atimewhenFredGoodwincoulddestroyanaugust200-yearoldfinancialinstitutionand

2. Crony Capitalism

squanderbillionsinshareholdervalue,thenwalkawaywithafortuneandhaveagov-ernmentministersignoffonhispension.

Cronycapitalismiswhathappenswhentheconstraintsoflawandmarketsandcultureceasetobeeffective.Entrepreneurshipandvaluecreationarereplacedbyrent-seeking,andcertaingroupsbecomeenormouslywealthywithouttakingrisk.Thesefactorsinturnleadtolong-termeconomicunderperformance,andsometimestosocialunrest.

TaketheinvestmentbankGoldmanSachs.Fewotherbusinessesofanykindhavebeensoconsistentlyormassivelyprofitable,with$20billionin2009profitsalone.Fewotherbusinesseshavebeenaspiousintheirofficialpronouncements.

Butfewotherfinancialinstitutionshavesoseriouslybreachedpublicnormsofbehaviourandethicsinrecentyears,asacknowledgedbyGoldman’spaymentinJuly2010ofare-cord$550milliontosettleanSECcourtcaseformisleadinginvestorsoverasub-primemortgageproduct.

The ironiesaremanifest, for historicallyGoldmanwas famous for being riskaverse,dedicatedtoitsclients,andshy.Itwasapartnership,whichsoughtwhereverpossibletoprotectthepartners’capital

Butoverthepasttwentyyearsthevaluesofrisk-aversion,clientfocusandlowprofilehavegonebytheboard.Duringthe1990sGoldmandevelopedamassiveproprietarytradingoperation.Overtimethisbecamesoprofitablethatitdominatedmanyaspectsofthefirm’stradingandmarket-makingoperations.Conflictsofinterestbecameendemic.Whenthesubprimecrisisstruck,GoldmanonlysurvivedbybecomingabankholdingcompanyanddrawingheavilyonvariousemergencyliquiditypackagesprovidedbytheUSgovernment.

3. The Case of Goldman Sachs

GoldmanSachs isnotmerelyacasestudyof institutionaldecline. Itshowshowvasttractsoftheglobalfinancialsectorhavebecomedisconnectedfromtheiroriginalpublicpurpose—thefirstmarkofcronycapitalism.Atthesametime,executivepayhasrock-eted—thesecondmark.

ThesameistruewiththeUKbanks,aswitnessthemergerbetweenLloydsandHalifaxBankofScotlandin2008.Lloydshadbeenbysomewaythebest-managedUKbigbankoftheprevioustwodecades.

AllthispatientvaluecreationwasblownawaybythemergerinSeptember2008withHBOS.Lloydsshareholdershave lostsome85%of thevalueof theirshares.Thefi-nancialadviserstoLloydshaddonecatastrophicallybadduediligenceonHBOS,butcollectedlikelyfeesofhundredsofmillionsofpounds.Some24,000employeeshavesincebeenlaidoff.SirVictorBlank,thedeal’sarchitect,hasbeeninvitedtoguest-edittheprestigiousTodayProgrammeonRadio4thisChristmas.

4. Lloyds HBOS and the UK Banks

Butcronycapitalismisnotrestrictedtothefinancialsector.ItcanalsobefoundinotherpartsofUKPLC.Manyofourlargestpubliccompanieshavebecomesocomplacent,unaccountableandbureaucraticthattheyresemblebadgovernments.

Arecentlypublishedpapershowstheextentoftheproblem.The total remuneration of the average FTSE 100 company chief executive has risen by more than 400 per cent over the past 12 years, to £4.2 million.Take-homepayhasmorethandoubledto£2.5millionsince1999,movingfrom47to88timesthatofafull-timeUKemployee.

Itissometimessaidthatpayreflectsstockmarketperformance.ButthepayofFTSE100chiefexecutivesrose13.6percenteveryyearfrom1999to2010,whiletheFTSEitselfrosebyanannualaverageofjust1.7percent.

Overall,noreputablestudyhasfoundasignificantcorrelationbetweenseniorexecutivepay and long-term corporate performance.Butonecorrelationiswellknown:thebiggerthecompany,thebiggerthepaypackage.

5. Pay

WhatabouttheeffectsofcronycapitalismontheUKitself?

Theyears1992-2008havebeenwidelyfetedasagreatstoryofUKeconomicrecovery,andinparticularLabourpropagandistshavehailedthedecade1997-2007asamiracleofcontinuousgrowthunderGordonBrown.

Thetruthisratherdifferent.TheUKisbestcomparedwithcountrieswithasimilarcul-tural,politicalandeconomicbackground,likeAustralia,Canada,theUnitedStatesandNewZealand.Every single one of these countries grew faster over the period 1992-2008 than the UK.

Oncetheeffectsof immigrationarefactored in, it turnsout thatUKGDPperhead infactimprovednotby50%butby42%between1992and2008.Inotherwords,theUK’sgrowthrecordwasevenweaker thanappearedatfirstsight,andonly justabove theaverage40%growthofthe“sclerotic”Eurozone.

Our“economicmiracle”wasamirage.Itwasalsoadistraction.Therealeconomicstorywashappeningelsewhere,withtheriseofChina,India,RussiaandBrazil—theBRICs—theincreasingeconomiccontrolofGermanyovertheEurozone,andaglobalshiftofeconomicpowerawayfromtheUS,fromtheWestandtowardsemergingmarkets.While theUKcongratulated itselfon itsapparent localeconomicsuccess, inreality itcontinuedtolosegroundglobally.

TheUKeconomywasbloatedbyanenormousburstofborrowingand leverage.Be-tween1960and2000theloansthebanksmadetotalledabouttwentytimestheamountofshareholdercapitaltheypossessed.After 2000, they started to rise vertiginously, up to nearly 50 times capital in 2007-8. When the crisis hit, the banking system was already in a desperately fragile state.

Theincreaseinborrowinginturnfedthroughintoadisastrousassetbubbleinhousing,whichallbutdoubledinrealvalueovertheperiod,andintopersonaldebt,whichsoaredtonearly£1.5trillionin2007,higherthanBritain’sGDP.Eightypercentofthatdebtwassecuredonprivateproperty.

6. The UK’s Real Economic Decline

AssetbubblesandeconomicshocksarenotnewtotheUK,evenonthisscale.Cronycapitalismdidnotemergejustbecauseofthedifferentfactorsdescribedabove.Itwasallowedtodosobecausearangeofaugustpublicbodies,whichcouldhaverestrainedorshapedit,didnotdosoeffectively.TheseincludeHMTreasury,theBankofEngland,theFSAandtheCBI.

7. Institutions: AWOL or MIA?

Anobjectionmightbe“Maybeallthisstuffaboutcronycapitalismistrue.Butifitis,isn’tittheConservatives’fault?Theyhavealwaysbeenthevoiceofcapital,justasLabourhavebeenthevoiceoflabour.AnditwasMrsThatcherwhoderegulatedtheCityofLon-doninthe1980s.Ourpresentproblemsspringfromthatdecision.”

ThisfamiliarlineofthoughtseemstohaveinspiredEdMiliband’s2011Labourconfer-encespeech,withitsdistinctionbetween“predators”and“producers”.Inhiswords“Pro-ducerstrain,invest,invent,sell…Predatorsarejustinterestedinthefastbuck,takingwhattheycanoutofthebusiness.”SothereareobviousoverlapsbetweenMrMiliband’sremarksandthepresentcritique.Doesthismeantheobjectionisright?

TheanswerhereisfairlyevidentlyNo.First,onthefacts.Cronycapitalismreallytookrootinthelate1990s,whentheBankofEnglandceasedtoberesponsibleforsystemicriskinfinancialmarkets,thedoctrineofinflationtargetingwasinstitutionalised,andthebankswereallowedtorampupborrowing.ThesethingsoccurredunderaLabourgov-ernment,tenyearsafterBigBangtookplace.

Secondly,onthepolitics.HistoricallyConservativeprimeministershaveinfacthadaverygoodrecordofstandingagainstcorporateandfinancialexcess.CurrentmythologycastsMrsThatcherasadevil-take-the-hindmosteconomic libertarian.ButasregardscronycapitalismshewasnoexceptiontotheearlierpatternofConservativeprimemin-isters.

Shehadlittletimeforfinanciersingeneral,andsawBigBangandthederegulationofthefinancialmarketsasameanstoincreasecompetitionandendrestrictivepracticesandcosydeals.Shewasintenselyhostiletomonopolyinanyform,andattackedtheman-agementofthenationalisedindustriesascronycapitalistsofakind.Hermantrawasthatownershipbroughtwithiteconomicandmoralbenefits,andshouldbespreadaswidelyaspossible:“everyearneranowner”,assheputit.Shewouldnothavehesitatedtoattackthepresentcronycapitalism,andinthebaldestterms.

8. The Politics of Crony Capitalism

Butthereisadeeperpoint.Conservatismistheproductofseveraldifferentinterlockingtraditions.Atitscore,itcontainsaprofoundcritiqueofthemarketfundamentalismnowprevalent inWesternsociety.But,politically, itdoessonot fromthe left,but fromtheright.Marketsarenotidolised,buttreatedasculturalartefactsmediatedbytrustandtra-dition,whichcanbeusedtoaddresssocialoreconomicproblems.Capitalismbecomes,notaone-size-fits-allideologyofconsumption,butaspectrumofdifferentmodelstobeevaluatedontheirownmerits.Idealismaboutwhatshouldbeachievedistemperedbyrealismaswhatisactuallypossible.

FrancisFukuyamahailedthefallofcommunismastheendofhistory.Buttherealbattleofthe21stcenturywillbebetweenfreemarketneoliberalismandfreemarketconserva-tism.Freemarketconservatismwilloftenoverlapinplaceswithaliberal,ifnotneoliber-al,viewoffreemarkets.Bothwillbeinnatelyhostiletomonopolyandstateinterference,forexample,andsupportiveofcompetitionandentrepreneurship.Butthetwoviewpointscanalsocomeapart,especiallyintheirrespectiveattitudestohumanbehaviour,exist-ingpractices,traditionsandinstitutions;andintheirviewofhowchangeoccurs.Freemarketneoliberalismismemoryless,sinceittendstoseetheworldmathematicallyandepisodically,intermsofpreferencesandincentivesoperatingatagiventime.Freemar-ketconservatismtendstoseetheworldasevolvingcontinuouslyandorganically.

Takemarkets:freemarketneoliberalsvaluemarketsassuch.Butfreemarketconserva-tiveslookatmarketsasinstitutions,andseeanimportantdistinctionbetweenprimarymarkets,wheregoodsandservicesarefirstsold,andsecondarymarkets,wheretheyaretraded.Primarymarketstendtosatisfyhumanneeds,asitemslikefoodandcarsandinsurancearesoldforcash,whilesecondarymarketsarepronetospeculation.Sotheconservativewillinstinctivelypreferprimarytosecondarymarkets,andwillwanttofreeuptheformerandregulatespeculationinthelatter.Theneoliberalhasnoprincipledmeanstopreferonetotheother,andwillbehostiletoregulationinboth.

CronycapitalismarosebecauseBritishculturechanged,undertheinfluxofaneoliberaleconomicideologyoffreemarkets.Itsemergenceshowswhy,inthebattlebetweenfreemarketliberalismandfreemarketconservatism,wemustchoosefreemarketconserva-tism.

9. Free Market Conservatism

Whatarethelessonstobelearned?Herearenine:

Lesson 1: Conservatives need to turn up the volume on crony capitalism.

InrecentyearstheConservativepartyhasdevelopedwhatamountstoastrongcritiqueofcronycapitalismanditseffects.Attackingcronycapitalismisnotanti-business,itispro-business.Nowisthetimetoturnupthevolume.

Lesson 2: Culture matters.

TheEfficientMarketsHypothesisisnotHolyWrit;humanbeingsarecreaturesofhabit;thesocialorderisbasedontraditions,practicesandinstitutionswhichescapeeconomicspecification.Culturematters:inthebankingsystem,intheUKeconomy,inoursociety.

Lesson 3: Excessive pay is a serious issue.

Payisalitmustestofsocialnorms,andexcessivepayisahallmarkofcronycapitalism.ThereisnothingConservativeaboutcronycapitalism,andthereisnothingspecificallyleftwingaboutconcernatexcessivepay,ineithertheprivateorthepublicsector.

Lesson 4: Corporate governance isn’t sexy. But it is vital.

Addressingtheissueofexcessivepaydoesnotmeandirectcapsonprivatesectorpay,anincomespolicyorsimilarquackremediesofsocialism.Itdoesmeanafundamentalrethinkofthemechanismsofcorporategovernance.

Lesson 5: The banks should temporarily restrain, and perhaps cease, dividend and large bonus distributions.

TheUKbankingsystemisfarbettercapitalisedthanitwasin2007-8.Butitremainsinanextremelyprecariousposition,asthemoneymarketsaredryingupinEuropeandtheUS.Thereisastrongcaseforthebankstorestrain,andperhapscease,dividendandlargebonusdistributions,toprotecttheircapitalbaseandlending.

Lesson 6: We need a fundamental rethink about competition.

Asustainedattackoncronycapitalismdemandsanewanddeeperlookatcompetition,andatcompetitionpolicy,toinhibitregulatorycaptureandrent-seeking.

10. Lessons

Lesson 7: Key public institutions require better governance.

OverthepastdecadekeyBritishinstitutions,notablytheBankofEngland,theTreasuryandtheFSA,didnotdischargeadequatefinancialoversightandsupervisionoftheUKfinancialsystem.

Lesson 8: The new Financial Policy Committee must have a range of tools to control asset bubbles.

Inflationtargetingwasnotsufficientbyitselftopreventassetbubbles.TheBankofEng-landmustbeabletomonitorareasofgrowthandinterveneproactivelywhereappropri-ate,inawaythatisaccountablebutfreeofeverydaypoliticalinterference.

Lesson 9: We need to love our savers.

Savingisavirtuoushabit.Butithasbeendestroyedbytherecentcycleofboomandbust.Whatcanbedone?Thebankscouldstartbyrestoringtheoldrulethatrequiredpeopletosaveforaminimumoftwoyearsinordertogetamortgage.ThegovernmentshoulddustofftheideaofaLifetimeSavingsAccount.

Tosumup:realcapitalismisonething,andcronycapitalismquiteanother.Settingtherighteconomicincentivesisimportant.Butsoarevirtuoushabits.Ifwearegoingtogetbacktorealcapitalism,weneedtofocusasmuchattentiononourcultureandvaluesasonoureconomy.

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Contact: Jesse Norman MP on 020 7219 7084 or jesse.norman.mp@parliament.uk

Elizabeth Truss MP on 020 7219 7151 or elizabeth.truss.mp@parliament.uk

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