Tweaking Capitalism
Contrary Evidence — Podcast also available
In this post, we are going to explore some of the challenges that we face with capitalism. We will look at some of the strengths and weaknesses of the system and discuss some changes that might address the shortcomings.
In the world today, there are two primary systems for allocating capital and resources. The first is a market based approach that we call capitalism. In this system, individuals and companies decide how to invest their capital and resources based on expected returns on those investments. The second system is a centrally planned and executed method for allocating resources and capital which is typically represented as Socialism or Communism. This system places trust in the wisdom and judgement of government leaders to determine the best investment opportunities. This model is ripe for government corruption as the government leaders have incredible power with minimal accountability.
In reality, all countries have a blend of these two systems. As an illustration of the blended approach, the US is primarily a capitalistic system but the government represents more than a fourth of the economy and as such, it allocates more than a fourth of all resources. In China, the government controls most of the fundamental industries but it allows a market based approach for private companies. In fact, China’s government expenditures as a percent of GDP are much less than the US even though it is a communist country.
One way of comparing countries and their blends of capitalism is to look at government spending as a percent of the GDP. In general, the lower the number, the more capitalistic the country is.
There are two key factors that must be considered when comparing the US to other large countries. First, the US allocates a much higher percentage of its government spending to defense. Second, government expenditures on healthcare in the US are less than half of the total healthcare expenditures. In most other large countries, the government owns most of the healthcare market. When you consider these two factors, the US government spending as a percentage of GDP is only about five to ten points less than other countries that are usually considered more socialistic than the US such as Germany, France and Sweden.
The primary argument against capitalism is that it drives a singular focus on profit over other societal priorities. This focus on profits is the reason that capitalism is the most efficient system for allocating resources. The financial markets are very effective in rewarding and punishing companies’ use of capital. As recognition that pure profit focus can be bad for society, the government tries to balance the profit drive with regulations and tax policy.
The two primary short comings that are raised about capitalism is that the system does not factor in environmental or worker impact. In other words, investors in an enterprise are rewarded solely based on profits and growth regardless of the amount of harm the enterprise does to the environment or how it treats its workers.
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In an ideal world, the capital markets would reward companies that generated the best combination of profitable growth, environmental impact and worker wellbeing. The government tries to impact the emphasis on environment and workers through regulations. Regulations, if designed and managed well, still only require companies to do the absolute minimum to meet government standards. If there is a regulatory limit on CO2 emissions, companies are incented to invest just enough to meet those standards. If the stakeholders of that company such as shareholders, customers and employees value low CO2 emissions, the company may make some incremental effort to lower its footprint in order to appeal to those stakeholders.
On the worker side of the equation, companies must first be able to compete for the talent that is required to run the business. Those companies must also compete against other companies for customers based on price, quality and support. Lastly, those companies must compete against all other publicly traded companies for investors. The net result is that companies will only compensate and provide benefits to workers up to a level that allows them to hire and retain the required level of talent. To pay more than is required is in direct conflict with the expectations of the shareholders.
There is considerable debate and focus on high CEO to worker compensation ratios. A couple of points. First, high CEO and executive compensation does not result in lower worker compensation. If companies did reduce executive pay, they would simply increase profits to shareholders. Second, since company boards are most interested in improving the stock price, they have very little incentive to risk alienating the executive team by lowering compensation. They are much more apt to overpay the executives versus their market worth in order to keep them happy. Boards also typically have a close relationship with the CEO and the executive team and that makes them less objective in determining executive compensation plans.
How might we alter the capital markets to incent companies to address environmental and worker issues? As mentioned before, the traditional approach is to tackle the issue through regulations. Regulations are established through the political process and as such companies spend tens of billions each year to lobby for regulations that provide competitive advantage or lessen regulatory costs. Lastly, regulations force companies to meet some minimum standards but they do not incent companies to optimize the combination of profitable growth, environmental impact and worker wellbeing.
An alternative is to use the free market to drive the desired balance. On the CO2 front, this is actually pretty straight forward. The EU, Singapore, Canada and Japan have all implemented a carbon tax system. This is a system that effectively taxes a company based on its CO2 footprint. As a result, companies are incented to optimize profits while minimizing CO2 emissions. It forces a balanced approach.
The worker side of the equation is more complicated. The interests of executives and shareholders are generally very aligned. Executive compensation is heavily tied to financial performance and stock appreciation. When shareholders do well, executives tend to do well.
For the average worker, higher compensation is at odds with shareholder’s interests. As labor costs rise, stock prices tend to decline. There is no practical way to completely eliminate this alignment issue but there are ways to improve it. Shareholders earn returns on their investments through dividends and stock appreciation. If public companies were required to establish bonus pools for workers tied to dividends and stock appreciation, the interests of labor and shareholders would be more aligned. And if distribution of those bonus pools to workers was per capita, in other words, everyone gets the same bonus regardless of pay level, the impact on front-line workers could be very meaningful.
This is not a perfect solution. These bonus pools would reduce company earnings which would impact shareholder returns. Workers would likely be choosier and biased to pick employers that are likely to see profitable growth. This would likely force lower performing companies to raise compensation which would be good for workers but bad for shareholders. Lastly, my proposed solution would not directly help workers who are employed by private companies or the government; it would indirectly help those workers as those employers would need to adjust compensation plans to be competitive with public companies.
These bonus pools would drag on companies like a corporate tax and would make US companies less attractive to global investors; however, workers would have more disposable income and that would drive economic growth in the US. If we are serious about aligning the interests of companies, workers and society at large, we need to try some free market tweaks to capitalism. Without some changes, we will see an increasing conflict between business and society. That is not good for anyone. Without change, we also might see some very onerous regulations that could be far more painful to companies and less effective in solving the issues.
