The five strategies to make Capital work #forall #notforfew
Note: This article was selected as a Top 100 contribution to the St. Gallen Symposium Leaders of Tomorrow essay competition in 2019, responding to the theme, “Capital for Purpose”.
In the battle for hearts and minds of human beings, narrative often outperforms data in its ability to influence human thinking and motivate human action[1]. Thus, it should come as no surprise that despite improving lives of a broad swath of people and the well-being of humanity in general, the free market system of deploying capital to create a level playing field for all has made surprisingly few inroads into the hearts and minds of the people. It is because the images of impoverished workers let down by global meltdowns such as the one in 2008 resonate with people more than the statistics such as the one which suggests a decline in the rates of extreme poverty over the last few decades from 35% in 1990 to 9% in 2016[2]. Hence, even the sacred-est of data can lose out to someone else’s really good story.
However, those who contest the benefits of the current model of capital and its purpose are not completely wrong. Statistics on rising inequality in society and wages are shocking. Last year, 26 people owned the same amount of wealth as the 3.8 billion people who make up the poorest half of humanity[3]. Increasing episodes of crony capitalism and reckless treatment of environmental capital should also make us skeptical of continuing business as usual. The Harvard economist Larry Katz succinctly captured these ills through this analogy: “Think of the American economy as a large apartment block…The penthouses at the top keep getting larger and larger. The apartments in the middle are feeling more and more squeezed and the basement has flooded. To round it off, the elevator is no longer working. That broken elevator is what gets people down the most.”
The key challenge that I try to address in my note here is how to restore the apartment block to its full glory while fixing the broken elevator. I believe this can be achieved via the following five strategies working in tandem.
a) Overhauling the incentive structure to support long-term investing
While a larger ownership of businesses in today’s economy by institutions instead of individual investors has its own benefits, it comes with a key short-coming: short-termism. An agent managing money on someone else’s behalf trades for the quarterly results, more so when the incentive structure is skewed to reward short-term gains even if it comes at the cost of long-term benefits. In such an environment, the agents fail to avoid the traps of pro-cyclical investment (selling when prices are falling and vice-versa) leading to ‘institutional herding’ and misalignment with the owners of capital (i.e. concern with management fees and performance bonuses rather than owner’s genuine interest)[4].
To course correct the agents, adoption of guidance frameworks such as the Santiago Principles can be a good starting point. These Principles guide the investors to operate keeping long-term economic purposes in mind, with appropriate governance and investment disciplines. A push from the ultimate owner of capital, the individual investor, would help catalyze such a transition in investment strategy. Further, such a strategy benefits not only the owners of capital but also the investee companies. The capital owners by having a much more stable ‘risk appetite’ can ride out much of the short-term volatility in financial market prices and profit during periods of extreme risk aversion or outright panic. At the same time, the investee companies, confident in the knowledge that their investors are not flighty are freed from the requirement to focus on short-term earnings and profits and can instead set their sights on defining and executing strategies for the long-term[4].
In such a scenario, the environmental, social and governance issues also become more important for a sustainable success and it allows for a deeper and more meaningful engagement between the owners of capital and corporations ensuring better alignment in their goals, contributing further to market stability.
b) Protecting the fragile political foundations of free markets from the ‘incumbent’ capitalists
Having convinced the owners of capital and their agents to shun short termism, the next logical step would be to strengthen the political support required for functioning of large, arm’s length markets. Unfortunately, the very functioning of free markets undermines such a support. The institutions underpinning these markets are under constant threat from the economically powerful, the incumbent capitalists, as the competition stemming from market forces the incumbents to prove their competence again and again[5]. Thus, any infrastructure that tries to level the playing field by broadening access to opportunities would be hard to realize without the support of a strong political constituency.
The attacks on free and open markets can be thwarted by adopting a two-pronged approach of (i) reducing incumbent’s incentives to oppose markets, and (ii) reducing their ability to harm the markets. Reducing incentives includes ensuring that the economic power doesn’t get overly concentrated and that those who control economic resources are capable of using them efficiently. From laws such as the Glass-Steagall Act of 1933 that prevent a firm from growing big enough to have the clout in domestic politics to eventually suppress market forces to taxes such as the inheritance tax on transfer of control to achieve an efficient distribution of control, a variety of checks and balances can be implemented to curtail an incumbent’s incentives. Similarly, opening the domestic markets to international players creates competition from outsiders who the incumbents cannot control through political means. It is one of the most effective ways to erode an incumbent’s ability to harm the markets forcing them to abandon politics and focus on efficient utilization of resources.
c) Leveraging the taxation system for more equitable distribution of wealth
With the right political support, the current system of income taxes should be reformed into a more robust taxation system having asset wealth as its focus. In some countries today, the poorest 10% are paying a higher proportion of their incomes in tax than the richest 10%[6]. When governments under-tax the rich, there’s less money for vital services like healthcare and education, increasing inequality and poverty. While progressive taxation is important, a tax based purely on the value of one’s asset (which itself is very tough to value in unlisted, private markets where the bulk of wealth is stored) might not be politically or logistically feasible. A better way of looking at this is a two-pronged approach towards asset wealth — high capital gains taxes through a global accord of cooperation and surveillance and secondly, estate taxes on wealth passed through generations. The key to implement such a reform would be global cooperation since the offshore banking system currently circumvents the will of any single government to implement this effectively[7]. Both citizenry and policy-makers will play an important role in persuading the governments to transition towards such a reform. The redistribution of wealth thus achieved will contribute both to the general well-being of society and to the stability of free market system by ensuring peace.
d) Re-designing the relief framework for the rehabilitation of the distressed
The process of ‘creative destruction’ unleashed by free markets triggers failures that are extremely painful for the people affected. Such episodes make these victims raise a very legitimate demand from the authorities to intervene and rescue them. Also, peaceful co-existence of the ‘winners’ and ‘losers’ created by the system is imperative for a stable market place to operate. Thus, relief needs to be designed for the benefit of those who have been disproportionately hit by the markets.
However, given the inherent dangers of manipulation by vested interests, the interventions should be designed before the event that prompts relief rather than after the event has happened. This prevents politicization of relief. Also, a well-designed relief gives greater comfort and security to people in general while eliminating the need for the distressed to organize to solicit support for relief. More importantly, a pre-agreed relief mechanism because of the veil of ignorance on who will be affected and how removes any incentive to distort the system one way or another. It ensures that the rules of the game are not biased to support a few at the cost of many. A crisis response framework deduced from such an exercise is most effective in terms of cost per unit of benefits[8].
e) Insuring people for a structural change, not only a cyclical one
The best way to predict the future is to create it. Human capital, the genesis of all other forms of capital, needs to be harnessed to its fullest potential to future proof humans. To ensure that there are fewer people on the periphery as long-term technological and competitive changes occur, the government must offer its citizens support to create and maintain flexible human capital. This in turn would require making education a continuous cycle and not a one-off occurrence.
In recent decades, despite an increase in life expectancy and an accelerated pace of technological change, the fundamental way in which people prepare to be productive citizens has not changed much. Education is still concentrated in the early stages of one’s life consistent with the economic theories that education has the greatest return the earlier it is undertaken[9]. However, these economic models fail to consider factors such as technological change, competition and greater job mobility, factors which may make a job obsolete. While most education today is geared towards the first job, it fails to take note of the fact that in today’s age, for most people, their first job, or even their first career, might not be the last.
Thus, to enable the transition from a linear progression from training to work to a cyclical progression from training to work to training to work and so on, throughout one’s life, several changes would be required. The duration and type of courses offered by universities and other institutions would need to change to require only a limited time commitment as learning becomes a life-time endeavor. Flexible and modular degrees that are offered on-demand and economically would need to become more ubiquitous. This would enable individuals to cope up with changes in their environment and preferences more effectively through these formal doses of reeducation whenever required.
Conclusion:
“Never let a good crisis go to waste”. These wise words by Winston Churchill spoken in context of the conditions post the Second World War that allowed for the formation of the United Nations remind us that in challenging times like those of today, one must question the accepted reality because things are going wrong, rapid answers are needed, and the solution may well be found outside the usual compass. The world is currently at a precipice and any further pressure on the bulk of the world population would lead to a massive uprising and bring us to a civil war. Events such as the yellow vest protests, Arab spring, the umbrella movement are early signs of what is to come. We need to correct this now or we risk either a rise of populist leaders who turn into deranged dictators (US, Philippines etc.) or governments who try to distract the masses through nationalist means — leading to global wars.
The free market system of capital as is practiced today might seem broken and to an extent it indeed is. However, we should not mistake the failure of the support infrastructure required for the system to flourish to be the failure of the system itself[10]. The five strategies suggested above will help us move closer towards realizing a world where not only political power but also capital is of the people, by the people and for the people.
Bibliography:
1. https://www.weforum.org/agenda/2015/01/how-narratives-influence-human-behaviour/
4. “Making Capitalism more inclusive”, Selected speeches and essays from the Participants at the Conference on Inclusive Capitalism, 2014
5. “Saving Capitalism from the Capitalists”, by Raghuram G. Rajan and Luigi Zingales
7. Conversations with Mr. Abhishek Gupta, Executive Director, Nomura
8. “Saving Capitalism from the Capitalists”, by Raghuram G. Rajan and Luigi Zingales
9. Schultz, T.P. (1988). Education investments and returns. Handbook of development economics
10. Conversations with Mr. Alemayehu Mengistu, Regional Director, South Asia, IFC
