Barack Obama will soon face the extraordinary task of saving capitalism from its own excesses, much as Franklin D. Roosevelt had to do 76 years ago. Up until this point in the crisis, policymakers have appropriately applied the rules of triage - Band-Aids and tourniquets, then radical surgery - to keep the global financial system alive. Capital infusions, bailouts, mega mergers, government guarantees of unimaginable proportions - all have been sought and supported by officials and corporate chief executives who had until now opposed any government participation in the marketplace. But put aside for the moment the ideological cartwheel we have seen and look at the big picture: The rules of modern capitalism have been re-written before our eyes.
The new president’s team must soon get to the root causes of the mistakes that have brought us to the economic precipice. Yes, we have all derided the explosion of leverage, the failure to regulate derivatives, the flood of subprime lending that was bound to default and the excesses of CEO compensation. But these are all mere manifestations of three deeper structural problems that require greater attention: Misconceptions about what a “free market” really is, a continuing breakdown in corporate governance and an antiquated and incoherent federal financial regulatory framework.
First, we must confront head-on the pervasive misunderstanding of what constitutes a “free market.” For long stretches of the past 30 years, too many Americans fell prey to the ideology that a free market requires nearly complete deregulation of banks and other financial institutions and a government with a hands-off approach to enforcement. Those of us who raised red flags about this were scoffed at for failing to understand or even believe in “the market.”
Time and again, those who tried to enforce the basic principles that would allow the market to survive were told that the “invisible hand” of the market and self-regulation could handle the task alone. The reality is that unregulated competition drives corporate behavior and risk-taking to unacceptable levels. This is simply one of the ways in which some market participants try to gain a competitive advantage.
No major market problem has been resolved through self-regulation, because individual competitive behavior doesn’t concern itself with the larger market. Individual actors care only about performing better than the next guy, doing whatever is permitted - or will go undetected. Look at the major bubbles and market crises. All are classic demonstrations of the bitter reality that greed, not self-discipline, rules where unfettered behavior is allowed.
Those who truly understand economics, as did Adam Smith, do not preach an absence of government participation. A market doesn’t exist in a vacuum. Rather, a market is a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy.
One of the great advantages US capital markets have enjoyed over the decades has been the view - held worldwide - that there was an underlying integrity to the representations market participants made, because the regulatory framework in which they were made was believed to provide genuine oversight. But as we all know, the laws requiring such integrity are meaningless without a government dedicated to enforcing them.
Second, our corporate governance system has failed. We need to re-examine each of the links in its chain. Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves - all abdicated their responsibilities.
Institutional shareholders, in particular mutual funds, pension funds and endowments, must re-engage in corporate governance.
Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions. And the roles of compensation committees, of course, must be totally rethought. No longer can Garrison Keillor’s brilliant observation about our kids - that they are all above average - apply to CEOs and propel failed leaders’ paychecks through the roof. Today’s momentary public oversight and outrage over executive compensation, while long overdue, is no substitute over the long term for firm standards set by compensation committees and boards of directors.
Finally, we need to completely overhaul the federal financial regulatory framework.
