A modern economy requires a very high level of trust in order to function properly. In recent decades, a number of factors, from baby-boomer morality to the rise in corporate leverage, have lessened the trust element in the economy, both in the United States and in Europe (in Asia, there has been a modest contrary trend.) The cost of this decline has not yet become fully apparent, but will undoubtedly be great.
In a primitive trading system, trust is limited, short term, and confined to people known personally to the businessman — if the truster moves in the same social circle as the trusted, he can enforce a cost for any defalcations, in terms of social ostracism and reluctance of others to do business with the defaulter. Shylock demands the pound of flesh from Antonio, not because he has any use for Antonio’s flesh, but because he knows that, if he allows Antonio to get away without repaying his debt, his default rate on debts to other merchants will go sky-high, since he is an outsider and cannot rely on social ostracism to collect on his debts.
Some businesses are more dependent on trust than others. It is no coincidence that the insurance business, for example, grew up in Britain after 1660, when it was clear that Britain had an efficient legal system, that could be relied upon to enforce insurance claims. Life insurance, in particular, where the original contractor is by definition dead when the claim is made, and the claimant may be a widow, possibly aged, and very likely inexperienced in business, is a contract that is particularly dependent on trust, so the first life insurance companies grew to prominence in the financial boom around 1720. Many of the early British life insurance companies are still in business, or were until very recently (there has of course been an epidemic of mergers in the 1980’s and 1990’s) demonstrating that corporate longevity is a big marketing advantage when selling this particular service.
Another economic activity that requires trust is equity investment. Bonds are the suspicious man’s security; if you don’t believe a company’s figures, then invest in its first mortgage bonds, because then you get the real estate if something goes wrong (of course, you have to have confidence in your ability to foreclose which is why, historically, home mortgages were regarded as more risky than industrial mortgages.)
Equities, however, require more trust, because the company’s managers legally don’t have to give you anything, and you are dependent on shareholder meetings to remove them if they don’t. In the 19th century, preferred stock, paying a fixed dividend, was the principal choice for outsider equity investment, because a company could not pay dividends on its common stock (presumably held by insiders) until preferred stock dividends had been paid up to date. Only in the twentieth century has true equity investment come to form a substantial part of investors’ portfolios, with investors attracted by the apparent higher returns available, and believing that the Stock Exchanges and the Securities and Exchange Commission would protect them against malfeasance and ensure they were properly informed. It should be noted, however, that historically share prices were much lower than even in the 1960s-1980’s, let alone today. Radio Corporation of America, for example, the Cisco of the 1920’s, never got above 28 times earnings during that fabled bull market.
However, the most basic requirement for a successful economy is a trusted legal system, both in terms of legislation and enforcement. The tragic economic failure of the former states of the Soviet Union indicates the need for this, the lack of which is probably the principal problem facing those countries. Like insurance, trust in the legal system was a product of the British late seventeenth century, with the Habeas Corpus Act of 1678, preventing arbitrary imprisonment, being perhaps the most important milestone.
All three of these lynchpins of a successful economy, and many others, have come under attack in the moral anomie of the last 20 years. Insurance fraud is now running at a level of $120 billion per annum, of which $80 billion is accounted for by health insurance fraud. Even more alarming to an honest consumer, not only are premiums being ratcheted upwards (quite legitimately) to reflect the cost of increased fraud to the insurance companies, but the insurance companies themselves have got into the fraud game, and are far more likely to dodge paying out legitimate claims on technicalities than they were twenty years ago — the rising popular clamor against the health insurance industry is clear evidence of this.
When distrust and unfair dealing are present on both sides of a contractual situation, the business breaks down. The consequence, in the case of health insurance, is likely to be its increasing socialization, with risks borne by the government (or, in other words, by us, the taxpayers) and claims decided on the basis of political attractiveness and “pull” rather than by true justification. The result will be a health system of poor service, ever-increasing cost, and still more widespread fraud of every kind.
Securities fraud had become quite rare in the 1960’s and 1970’s. The Securities and Exchange Commission, by its draconian punishment of those involved in the Texas Gulf Sulphur and Equity Funding cases, injected a healthy note of fear into the system. Investment analysts genuinely tried (albeit normally unsuccessfully) to produce good investment advice for their clients, because stock exchange commissions were fixed, so good investment analysis was the main competitive weapon. Hence the various forms of financial statement manipulation, in particular the creation of extraordinary charges and the use of non-cash payments to executives, after a period of excess in the late 1960’s boom, became uncommon.
Whether the relatively virtuous Wall Street behavior of the 1950-80 period was a genuine clean-up of the excesses of the 1920’s, or whether it was an anomaly caused by the lack of a good roaring bull market, will only be clear once the dust clears from the recent bubble. What is quite apparent, is that it didn’t last. The abolition of fixed stock exchange commissions, which caused analysts to become shills for their investment bankers rather than genuine advisors to investors, played a big role here. So did the movement of Wall Street activities onto trading desks, the elimination of long-standing client-banker relations, and the growth of “own-capital” investing, that brought endless conflicts between clients and their bankers.
Outside investment banking, the virtual elimination of cash dividends, so tangible a return to investors, and so difficult to fake other than by an outright Ponzi scheme, also played a big role. So did the growth of stock options, encouraging companies to pay staff by a method that did not appear in the income statement — this inevitably encouraged other manipulations. So did sky-high price-earnings ratios — it becomes really worthwhile to falsify earnings if the market multiplies the falsification a hundredfold.
However, the final factor that caused the collapse of the market’s integrity was of course the Initial Public Offering boom of 1998-2000. When companies without earnings, and almost without sales, could be sold for capitalizations in the-billions, the temptations became too great for mere mortals on Wall Street to resist. And resist they didn’t. The result is a tsunami of class action investor legislation, still only in the early stages of building, that will tie up Wall Street in the courts for a decade, and will no doubt cause many worthy individuals to be punished along with the crooks.
Class action lawsuits themselves are the third area in which moral standards and predictability have declined, to the detriment of capitalism. A central principle of English common law, vital to the growth of the modern economy, was that a seller could only be sued to the extent of his actual responsibility. Hence, while the makers of the drug thalidomide were rightly sued in 1960 for tens of millions of dollars, in an English court McDonalds would not have been forced to pay $2 million for an overheated cup of coffee, nor BMW $4 million for a botched paint job.
Further, sellers of a legal product would not be liable for damage suits based on risks that were properly disclosed; even if asbestos companies might have been liable for the risks of their product (because the risks were for many years covered up) tobacco companies, which have disclosed since 1964 that theirs is a risky product, would not have been in danger.
Naturally, the growth in excessive damage awards has been fueled by a group with an economic interest in such awards, the trial lawyers. The true cost of such awards is the increased uncertainty to business, which cannot be sure that, with one precedent leading to another, their own products will not someday be next in line. Traditionally, such risks have been covered by insurance, and if damage awards were limited to actual medical costs plus a reasonable allowance for pain and suffering, this would still be possible. However, with the advent of huge plaintiff pools, and “punitive” damages, there is no way the risk can be quantified. Hence insurance companies, quite reasonably, will not provide coverage or, more perniciously, they pretend to provide coverage and then refuse to pay up when a claim occurs. Either way, normal economic activity is disrupted and, if the trial lawyers are allowed to succeed too often, may in some areas be made impossible.
The rise of “moral hazard” in normal business transactions may well in the future be seen as a principal cause of the ending of the 1982-2000 boom, and the onset of the 2001-2015 recession Writing in the Japan Times Monday, Teruhiko Mano, of Tokyo Research International, speculated with a certain amount of schadenfreude that the United States might be in a liquidity trap like Japan’s in the 1990’s. A great deal has been written about the evils of Asian “crony capitalism,” that are thought to have brought on Japan’s economic woes. Yet the “moral hazard” problems that have appeared in the United States in the last decades appear considerably worse, and may take longer to work out.
In the 1930’s and 1940’s, the moral excesses of 1920’s Wall Street, and of such phenomena as “snake oil” medicine men were purged, but at a fearful cost in socialization of the economy and retardation of growth. Let us hope that this time around, the purge is rapid and the costs avoided.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.