When the Financial Crisis Inquiry Commission issued its reports in January, they raised significant issues about systemic accountability, oversight, governance, justice, ethics and leadership. Those issues are so serious that they raise questions about the future of both capitalism, as envisioned by Adam Smith, and the American Dream.
Capitalism is a market-based economic system. Adam Smith, who is considered the father of capitalism, viewed it as both competitive and cooperative, a societal system based on self-interest, self-restraint, morality and justice. Adam Smith's version of capitalism was not what led to the greatest financial crisis since the Great Depression. To understand what went wrong, it is crucial to differentiate Adam Smith's model from the mutated form of capitalism that has evolved in the U.S. over the last 25 years, which I call financialism.
Adam Smith never espoused the beliefs that control our capitalist system today, that the only purpose of a business is to create shareholder value and that the unfettered market will effectively regulate itself. These two views have been widely adopted, without empirical foundation, by many influential financial and political policy-makers. They have been used to justify systemic deregulation and a maniacal focus on generating short-term earnings that are not necessarily real economic earnings.
Over the last 25 years American capitalism has become financialism, which is primarily transactional, unrestrained greed. Financialism embraces the view that the only purpose of business is to create shareholder value, measured primarily by short-term results. The dominance of short-termism is evidenced by the magnitude of institutional stock "renting" for terms of 12 months or less, the volume of high-speed, high-frequency algorithmic short-term trading, the short average tenures of chief executive officers and the dominance of executive compensation tied solely to short-term results.
Short-termism has resulted directly or indirectly in corporate earnings games, the deferral of investments needed for long-term competitiveness and the transformation of investment and commercial banking from a capital-facilitating agency service business into a principal proprietary trading business.
Financialism's rise in the U.S. has fueled the growth of the financial services sector in the economy. With that growth has come economic and political power. As a result, it is not out of the question to hypothesize that Wall Street's views control U.S. business and economic policy.
As financialism has come to prevail over the last 25 years or so, the economic condition of the U.S. has in many ways weakened, with middle-class income stagnation, increased income inequality, the exporting of jobs and our manufacturing capacity and increased risks of financial volatility.
I am concerned that the wise men of Wall Street have lost sight of or forgotten a fundamental point: that no economic system can survive if it doesn't produce reasonable results for most of its members. That doesn't mean income equality, but it does mean that the system has to work well enough to keep most of its citizens believing in it and playing in it.
If Wall Street and big business are to continue to prosper over the long term, capitalism must work well enough for most people to keep the American dream alive as a viable aspiration. The opportunity for upward social mobility is fundamental to the preservation of our capitalist system. Upward social mobility is linked to jobs, because it is business that gives most people the opportunity to achieve a better life for themselves and their families.
There is some good news. In spite of the dominance of Wall Street short-term financialism, not all businesses operate that way. Successful companies including
The fact is that there is no empirical basis for financialism's underlying fundamental principles--that a corporation has no obligation to society other than to maximize short-term value for its shareholders, and that the capital markets should be their own sole regulators.
Capitalism is not broken. But the financial industry achieved a 25-year creeping acquisition of it that led to the recent financial crisis, and today financialism controls our economic system. It appears that its leaders have forgotten the underlying premise of capitalism, that the marketplace needs to work reasonably well for all participants. At stake is the American dream and ultimately social cohesiveness. Long-term societal value creation needs to replace the short-term sole stakeholder model.
Ed Hess is professor of business administration and Batten executive-in-residence at the University of Virginia's Darden Graduate School of Business and is the author of Smart Growth (Columbia Business School Publishing, 2010).