Caux Round Table - Charting a New Course

Winning Through Soft Power

2009-06-16T09:21:00.001-07:00

Winning Through Soft Power

One big lesson taught us all by the current financial meltdown and resulting recession is the importance of “soft” power to success.

Foreign policy mavens have been talking for several years about the relative advantages of “hard” versus ‘soft” power. Secretary of State Hillary Clinton spoke in her confirmation hearings too of the need for “smart” power.

In foreign affairs, “hard” power gets more attention and requires more money, but it doesn’t always do the job. “Hard” power took out Saddam Hussein and his henchmen, but wasn’t very well adapted to the challenges that came after regime collapse in Iraq. In the Vietnam War, American “hard” power won every battle. But, who, in the end, won the war? The “soft” power of political will evaporated in the United States but not in Hanoi so at the end of the day all the bombs and bullets used to defend South Vietnam, Laos, and Cambodia went for naught.

Similarly, George Washington didn’t win many big battles, but with help from French allies who were recruited through Ben Franklin’s diplomacy, he won the last one and that was all he needed to win the war.

Business has been favorably compared to war. We have the book on the 48 Laws of Power giving guidance on how to succeed. We also have Sun Tzu’s thoughts on war, which present a different approach. According to Sun Tzu, so arranging your forces that the enemy commander retreats without a fight is the acme of military skill.

In business the “hard” power of finance gets most of the attention. Money talks and bottom lines drive decision-making, especially in stressful times like the present.

But “soft” power is far more strategic.

“Soft” power is customer loyalty.

“Soft” power is employee skill and commitment.

“Soft” power is having investors and creditors who believe in your business and will help you through hard times.

“Soft” power arises from all your intangible assets – relationships, good will, brand equity, unique value proposition, business model, supplier quality, long term thinking.

“Soft” power is all about people. Take care of people, and they will take care of you. Trust, reliability, being there for your customers, mutuality of benefit, win-win over zero-sum – these moral factors build business opportunity.

“Soft” power also is all about flow. Times change; markets are fickle. What works today may not generate so much value tomorrow. “Hard” power is better in the short term or in the immediate situation. But “hard” power lacks flexibility and may not endure.

Consider General Motors: how long did billions of “hard” dollars given by American taxpayers through government subsidies keep the company afloat and out of bankruptcy?

Consider Bear Stearns and Lehman Brothers: billions of “hard” dollars in assets could not save them from collapse when confidence in their future disappeared.

“Hard” power encourages illusions about how strong we are. “Soft” power is more realistic and adapts better to the course of events.

With “soft” power you play to where the puck is going, not to where it is. That insight helped Wayne Gretsky win many hockey games.

“Soft” power is right for dynamic conditions; “hard” power for static ones.

But the fundamental environment of business is flow and movement, twists and turns. Consider, then, the advantages of “soft” power.

Is There an Agency Problem?

2009-05-21T02:10:00.000-07:00

Is there an Agency Problem?

I want to call to your attention, as we turn from crisis management to building more viable global institutions of financial intermediation, a sophisticated cynicism that opposes more resolute commitment to business ethics and corporate social responsibility.

I am not referring to the common mistrust of private enterprise on the grounds that working for personal profit is inconsistent with securing a greater good for society. This is the perennial tension posed by philosophers and religious leaders between the claims of virtue and the attractions of self-interest. Rather, I am referring to a more academically polished elaboration of that argument which is called “the agency problem.”

Briefly put, the “agency problem” is said to be an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.

The “agency problem” exists on the agent side of the relationship: agents can’t be trusted to be diligent or faithful. They are always out for themselves and are constitutionally unable to put loyalty and service to their principals above their self-interest.

Thus, any business structure that relies on agency will always be a substantial risk to a principal, putting principals on their guard and forcing them to use tactics of fear and greed to keep their agents responsible.

The problem with this approach, however, is that the remedy feeds the disease.

Using self-interest to overcome self-interest has its limitations.

As long as we believe that the “agency problem” exists and is insurmountable, we have placed before us a conceptual roadblock to corporate social responsibility. Business is no more than a complex network of principal/agent relationships. Owners of corporations are principals to the boards of directors who manage them; senior company officers are agents of the boards and the companies; all employees are agents of their employers; banks, insurance agents, accountants, investment managers, lawyers are all agents to some degree for others. If the “agency problem” exists, then every relationship in this network is infected with the risks of negligence and betrayal. Social Darwinism or dog-eat-dog would seem to be the only rational approach to a life in business. It would be foolish or worse to expect such an environment to ever promote responsibility to the common good.

Advocates of corporate social responsibility must presume something other that the “agency problem” as an immutable fact of business life. Corporate social responsibility, corporate philanthropy, corporate citizenship, all ask of business and business decision-makers a showing of responsibility to others. Usually the responsibility of business is stated as having respect for the interests of stakeholders: customers, employees, owners, creditors, suppliers, competitors, and communities, including the environment.

The problem of faithless agents

If we want a more moral capitalism, we have to solve the “agency problem” or, at a minimum contain its virulence. Modern capitalism generates wealth through specialization of function and division of labor. This fact was Adam Smith’s great insight into the origin of the ‘wealth of nations” as he called it. But, as labor is more and more specialized, each component sub-unit of the economic system becomes more and more dependent on all the other parts. In today’s world of high technology, dependency on specialized machines and the skills of professional experts is higher than ever in human history. Our modern world is also completely subservient to reliable flows of electricity.

The Turkish Airlines plane that recently crashed short of the runway at Schiphol Airport outside of Amsterdam did so because its altimeter was faulty. Nine people died as a consequence of the pilots’ relying on a mechanical device for guidance in landing.

If the “agency problem” is all powerful and all pervasive, then modern capitalism is constant at risk of failure because the dependency relationships that flow from specialization are prone to abuse on the part of those who dishonor the reliance and trust placed on their competence and their integrity.

A market place of lying sellers and conniving buyers will never grow very prosperous. When faith and trust evaporate, so does capitalist wealth. The current meltdown of global financial markets is a good case in point.

But, the seriousness of the “agency problem” has been overstated. If it were truly dominant in the business world, modern capitalism with all its relationships of interdependency and mutual benefits would not have emerged to produce the wealth that we enjoy today – even in these months of a serious global recession. Thus, we can infer that there are some countervailing forces that nibble away at the “agency problem”.

What can we do about faithless or negligent agents?

The problem is not a new one. In the Judeo-Christian tradition, the prophet Samuel warned the leaders of tribes of Israel not to put their faith in kings, for, as he predicted, kings would turn against their trust and abuse power for their own selfish advantage. Later, Jesus stated that one could not serve both God and Mammon.

The Common Law of England over the centuries fashioned many legal responses to minimize the effects of the “agency problem”. These rules and practices constitute what is called the law of fiduciary duties. Also, the English courts of Equity contributed to fiduciary law with their own set of procedures and requirements designed to remedy abuse of legal power and prevent fraud and oppression in the marketplace.

The basic device used by the Common Law to minimize the effects of the “agency problem” was to define what was expected from agents as duties to their principals and give principals specific remedies for breach of those duties. This was a practical approach that sought to structure incentives so that agents would be more inclined to stick to the punctilio of their responsibilities and principals would be induced to assume the risk of trusting agents. Other words used in the Common Law to resolve the agency problem were fiduciary, trust, and beneficiary of the fiduciary trust. The fiduciary or the keeper of the trust was, in effect, the agent and the beneficiary was, in effect, the principal.

First, the agent was burdened with duties of loyalty and due care. When the self-interest of the agent was suspected of causing harm to the principal, the burden of proving loyalty was placed on the agent. The agent had the burden of coming forward with sufficient evidence to prove his or her loyalty. With respect to negligence on the part of the agent, the principal had the burden of proof but could hold the agent accountable when an objective standard of care had not been observed in management of the business consigned to the agent.

The Common Law thus turned the relationship of principal/agent into a status for the agent. Agency was an office; so was being a partner, a trustee, a corporate director, etc. With office came specific responsibilities. Failure of performance was transformed from a difference of opinion between agent and principal into a notorious setting of public expectations. The behavioral theory used by the Common Law judges appears to be a conviction that when we are made accountable in public, our pride tends to keep us more scrupulous and diligent than when we can act in secret. Principals could deny their own liability for acts of the agent when the agent had acted contrary to the terms of the trust, leaving the agent exposed to face the consequences.

Exposure and transparency were devices used to reduce agency problems.

Second, in its courts of Equity, English jurisprudence fashioned a number of rules that principals and beneficiaries could use. They could seek an accounting of monies had and received, with the burden on the agent to account for every penny received; principals could ask for the imposition of a constructive trust on money and property in the agent’s possession and name when fraud and abuse had occurred; agents had to have acted with clean hands if they sought to recover from principals on their agency contracts; agents could be prevented (estopped) from entering claims and evidence in their favor if they had acted inequitably.

Use of self interest

A second basket of remedial responses to the “agency problem” lies in self-interest. It is in one’s best interest to avoid faithless agents. Over time, therefore, faithless agents will not find employment as their reputation for negligence or disloyalty becomes generally known. This is why reference checks are so frequently relied upon. Generally, market based solutions to the “agency problem” rely on this mechanism of self-help. But it can be of limited utility where agents or those upon whom we rely for professional expertise have market power or are polished performers adept in the arts of lulling our suspicions with their smoke and mirrors – like Bernie Madoff to his investors.

Use of character

The third approach to minimizing the “agency problem” is to promote good character, the habits of living up to the virtues of trustworthiness, integrity, diligence, transparency and reliability. This agenda for securing better prospects for corporate social responsibility and business ethics – for avoiding asset bubbles and financial bubbles – and for putting in place the cultural foundation for specialization of function and division of labor operates at the level of the individual.

We must engage individuals to act as we would want if we want responsible and faithful agents. Such socialization, obviously, begins in the family, continues in school, and is finished in conditions of social engagement. We are concerned for the “presentation of self” in everyday life and Irving Goffman wrote about our dysfunctions in organizational settings. We want a good self to be presented, not a greedy, abusive, stupid or negligent one.

Having good character is one reliable ground for good stewardship behaviors. The moral sense within us is a public good in that it promotes trust in our communities and reliance on our business performance. Trust and reliance form the substructure of successful modern capitalism.

That human persons possess a moral sense that distinguishes them from beasts and other earthly creatures is increasingly a postulate of evolutionary studies, neuro-science, and brain research.

Thus, we must not presume that the “agency problem” is intractable and a permanent obstacle to responsible business decision-making. Rather, we should assume in us all an inherent capacity for reliable agency performance.

Set the bar high and we will tend to jump higher; set it low and we will slack off and get away with poor performance.

social capital and Wall Street

2009-05-21T02:07:00.000-07:00

Social Capital and Wall Street

Stephen B. Young
Caux Round Table Global Executive Director
April 2009

A very important thesis about the dynamics of capitalism creating the wealth of nations holds that necessary cultural preconditions shape the scope and intensity of capitalist success. Where these preconditions are in effect, wealth is created; where they are missing, wealth is, relatively speaking, scarce.

The social nature of capitalism as a system, its manipulation of multiple interdependencies arising from specialization of function and the division of labor, demands an appropriate cultural context. Some values as carried into market and investment behaviors promote robust capitalism; other values don’t.

This observation honors the seminal insights of Max Weber, who a century ago, identified the rise of capitalism as an economic system new and unique in human history, with the social arrangements legitimated and encouraged by Calvinist religious beliefs. Weber argued that a peculiar set of values flowing from Calvinist convictions that individual salvation depended upon diligent and faithful application of one’s talents to the calling that God had provided here on earth. Frugality, discipline, confidence in the future, trust in others of the same faith, stepping up to personal responsibility in one’s relationship with God, and similar Puritan behaviors, thought Weber, all contributed to opportunities for investment in enterprise, reliable contracts and high savings rates to create financial capital available for investment.

While many have questioned Weber’s attempt to link particular aspects of Calvinist beliefs and practices to the capitalism that emerged in 16th century Holland and 17th century England, Scotland and British colonies in North America, few can deny the coincidence of capitalism’s first emergence in those Calvinist societies.

Now, if recent practices on Wall Street associated with sub-prime mortgages, mortgage backed securities, CDOs and CDSs have produced a loss in 2008 of some US$50 trillion in asset values, one would have to question how successful such a capitalism was in creating new wealth.

More than such losses, some of which will be restored as markets recover from the collapse, the market collapse caused the collapse of Bear Stearns and Lehman Brothers and the conversion of the remaining investment banks into more traditional depository institutions. The American government, through its Treasury and Federal Reserve system, assumed many trillions of dollars of financial obligations to keep the banking, credit and financial intermediation markets operating. At one point, the Federal Reserve was purchasing the commercial paper of American companies due to failure of the private market for such debt. This was an unprecedented failure of private sector decision making.

The outcomes of Wall Street’s marketing of these financial instruments were not beneficial for anyone and such marketing could not be sustained. This episode of financial intermediation was a failure from every point of view once “irrational exuberance” took over the markets. It should not be considered genuine capitalism but only speculation over the value of present contract rights to future income.

If the connection between cultural habits of mind and action and successful capitalism is to hold true, it must be that Wall Street lost some of its social capital as a prelude to this most recent round of irrational asset valuations.

The corollary argument to Weber’s thesis on a smaller scale appropriate to these financial market transactions would be that the kind of social capital needed for capitalist achievement was missing. And, moreover, that loss of social capital caused, or at least contributed to, the collapse of asset values in the crash of 2008.

If the thesis is to hold that loss of social capital correlates with the loss of wealth as the inverse of the proposition that accumulation of the same social capital leads to wealth creation, where was the erosion of social capital on Wall Street prior to the financial collapse of trading markets for sub-prime mortgages, CDOs and CDSs and the resulting collapse of global credit markets?

Let us consider first a generic model of the social capital relevant to capitalist wealth creation.

There are of course innumerable varieties of social capital, each with different modalities of values and behaviors and each promoting different outcomes. The social capital that supported Egyptian Pharaohs and supported their construction of pyramids and temples was most likely different from the social capital that sustained Native American tribes in their pueblos, teepees and long houses.

The virtuous behaviors that Weber marked as sponsoring capitalist endeavors flowed from a social capital value set that had certain special characteristics.

This social capital supported longer time horizons for instrumental economic engagements. Investment more than trading was brought to the fore of business thinking. Expectations of rewards were stable and realistic. People were patient and delayed gratification in order to save and invest. Such people worked at their trades in a reliable fashion so that they became good credit risks and trustworthy stewards of moneys invested in their undertakings. Their work was their bond. There were clear laws and just enforcement so that promises and contracts were worth something as predictions of future events. Having a reliance interest in the success of others was justified. Financial intermediation was enhanced; money capital could be accumulated for use in joint enterprises.

All these reliable behaviors lowered risks and so interest rates and promoted transactions. Investment of time and money in production and delivery of goods and services with substance, with the power to leverage production of more and better goods and services and meet new needs was intuitively desirable. The future would be better and a commitment to progress today would realize that future tomorrow.

Next, this social capital placed a priority on learning, education and the introduction of new mechanics and technologies. It was comfortable with secular approaches and did not disdain the material world of chemistry, physics and biology.

People growing up in such conditions will be more thoughtful about the consequences of their actions on others. Externalities are brought home to the actor through an ethic of pride in one’s work and in one’s contribution to community.

Now, the opposite of these behaviors and commitments, we can infer, would most like not lead to wealth creation.

Social patterns where people focus on the immediate and will not commit now to benefits to be received much later, where they have no patience and do not trust the word and reliability of others, will promote higher levels of risk and so higher expectations of interest on money lent and returns on equity funds invested. There will be fewer transaction of substantive investment. The cost of business will be much higher. Savings will be rejected in favor of current consumption. People will seek cash money to use its power over those who are perceived to be and, in fact, are not trustworthy or reliable. Stewardship responsibilities will go begging for honest fiduciaries to accept them.

As there are lower standards of responsibility accepted, there will be lower standards of care in general and higher transaction costs in third party engagements as a result. Risks will be pushed off on others as much as possible.

Starting in 1980, Americans in general moved from a high savings culture to a high debt culture as the Baby Boomers came into full maturity and cultural leadership. New norms and behaviors came to the fore in many parts of American society. Assuming responsibility in civil society organizations, in politics, in anything outside one’s family, circle of friends or professional tasks linked to renumeration occurred less and less. Robert Putnam noted this trend in his seminal book Bowling Alone. Even in family life, parental responsibilities were sloughed off. Divorce became very common and schools were looked upon as the primary means of socializing the children. Seniors were encouraged to live out their last years on their own in retirement homes and facilities.
Wall Street and its practices were not immune from this cultural evolution.

As a result, the social capital embraced and accumulated by Wall Street shifted in its nature and its proclivities. For example, time horizons became shorter. Short term thinking became the norm. People lost loyalty to employers as they kept on constant lookout for new jobs with higher pay. Legal formalities replaced a personal standard of care for the well-being of clients and customers. Using debt to fund consumption and more pleasurable life styles demonstrated the power of short-termism among Americans. Delayed gratification was disparaged by Baby Boomers.

People looked more and more for higher short term returns. Few invested equity in companies for the long haul, preferring to profit from “renting stocks” rather than owning them and realize long-term capital appreciation from the company’s profits and retained earnings. Leverage became king so that higher returns could be enjoyed through the short-term use of other people’s money. The banking system converted from well-capitalized institutions that held risk to maturity to ones that merely traded risks back and forth for fees and spreads.

Investment banks went public and so lost the long-term perspective and caution that goes with partnership structures where the personal assets of the owners were always at stake in the risk level associated with firm activity. Professional mangers took over from owners as the drivers of firm strategies. Trading desks grew more powerful within the investment banks as their trading profits came to dominate firm income and the culture of traders took over from the older, more white-shoe culture of cultivating long term client loyalties and connections.

Personal responsibility for investment decisions was replaced with reliance on portfolio theory and mathematical algorithms. The Black-Scholes formula for calculating value when no market for a contract claim existed and the “chasing” of Alpha returns by institutional money managers were the most famous examples of this new intellectual environment on Wall Street. Companies were judged for better or worse on whether they “made the numbers” predicted by professional estimators. Trust in a company’s leadership was replaced with a more mechanical formulation of what constituted success.

The chase for higher returns – more fees and commissions – correlated with a decline in general levels of trust and commitment. Fund managers knew that to take risks and not earn returns within a peer group average would lead to the loss of money under management. Herd thinking was acceptable as it was “normative”.

Executive compensation was more and more linked to short term results, especially at senior levels where strategic commitments were made and cultural norms were adopted within firms for replication at lower levels of corporate hierarchies. Money results, not fiduciary quality, drove the decisions of many CEOs in all industries, not just Jack Welsh at General Electric.

While newer values promoted these structural changes in business models and practices, the new power arrangements solidified the intensity with which the new values could drive individual decisions and manipulate individual life choices in set ways.

Wall Street became captive to playing with other people’s money on a gigantic scale. Savings and reserves in exporting countries like China and the funds accumulating in pension funds, sovereign wealth funds, and hedge funds was there for the taking, or rather, the borrowing. Access to funds came through the sale of instruments that promised high returns.

Debt and short-term investing – largely tradable instruments to boot - took over from traditional equity as the criterion for financing capitalism; leverage ratios of banks and investment banks went to historic highs; structured financial instruments – mortgage backed securities and CDOs – were produced to fit new market demands for using short term leverage and trading in contract rights. CDSs were invented to provide risk reduction in lieu of tradition equity and capital reserves. Sadly, since many CDSs were only backed by legal documentation and not real money, the risk reduction they provided was illusory. It was use of pledges that had no reliable commitment behind them to give them “credit”. The words on a CDS, and on many CDOs, did not reflect that firm’s bond. Counterparty risk eventually caused the credit system to freeze and so become useless. Mathematics and formalisms drove trading in financial instruments.

An asset bubble was thus easily assembled by Wall Street firms and experts.

Any asset bubble is destined for collapse as financial wealth is destroyed and real economic activity retreats.

The factors that grow asset bubbles are inimical to the growth of genuine capitalism that produces the “wealth of nations”. When Wall Street produces such financial houses of cards, it only reflects social capital values and structures that are not supportive of good capitalism.

To improve the outcomes of financial intermediation, then, the social capital formation of financial centers like Wall Street needs scrutiny and attention.

If we want to restore robust creation of real wealth which can be enjoyed for many years and which can lead to creation of further wealth on the part of others – workers and investors alike, then we must - as the first item of such business - look to the values embodied in our financial firms.

When market realities are out in the open

2009-03-27T19:09:00.000-07:00

Here is what US Treasury Secretary Timothy Geithner said on Thursday March 26th about the US economy as it gestated the great financial crash of 2008:

"The system proved too unstable and fragile, subject to significant crises every few years, periodic booms in real estate markets and in credit, followed by busts and contraction. Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system. These failures have caused a great loss of confidence in the basic fabric of our financial system, a system that over time has been a tremendous asset for the American economy."

This is an indictment of an economic system, not praise for a relentless free market profit-taking.

Requim for Wall Street - where the past meets today

2009-03-20T18:24:00.000-07:00

Ozymandias

by Percy Bysshe Shelley

I met a traveler from an antique land
Who said: Two vast and trunkless legs of stone
Stand in the desert. Near them, on the sand,
Half sunk, a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal these words appear:
“My name is Ozymandias, king of kings:
Look upon my works, ye Mighty, and despair!”
Nothing beside remains. Round the decay
Of that colossal wreck, boundless and bare
The lone and level sands stretch far away.

Is there an Agency Problem?

2009-03-20T15:07:00.000-07:00

I want to call to your attention, as we turn from crisis management to building more viable global institutions of financial intermediation, a sophisticated cynicism that opposes more resolute commitment to business ethics and corporate social responsibility.

I am not referring to the common mistrust of private enterprise on the grounds that working for personal profit is inconsistent with securing a greater good for society. This is the perennial tension posed by philosophers and religious leaders between the claims of virtue and the attractions of self-interest. Rather, I am referring to a more academically polished elaboration of that argument which is called “the agency problem.”

Briefly put, the “agency problem” is said to be an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.

The “agency problem” exists on the agent side of the relationship: agents can’t be trusted to be diligent or faithful. They are always out for themselves and are constitutionally unable to put loyalty and service to their principals above their self-interest.

Thus, any business structure that relies on agency will always be a substantial risk to a principal, putting principals on their guard and forcing them to use tactics of fear and greed to keep their agents responsible.

The problem with this approach, however, is that the remedy feeds the disease.

Using self-interest to overcome self-interest has its limitations.

As long as we believe that the “agency problem” exists and is insurmountable, we have placed before us a conceptual roadblock to corporate social responsibility. Business is no more than a complex network of principal/agent relationships. Owners of corporations are principals to the boards of directors who manage them; senior company officers are agents of the boards and the companies; all employees are agents of their employers; banks, insurance agents, accountants, investment managers, lawyers are all agents to some degree for others. If the “agency problem” exists, then every relationship in this network is infected with the risks of negligence and betrayal. Social Darwinism or dog-eat-dog would seem to be the only rational approach to a life in business. It would be foolish or worse to expect such an environment to ever promote responsibility to the common good.

Advocates of corporate social responsibility must presume something other that the “agency problem” as an immutable fact of business life. Corporate social responsibility, corporate philanthropy, corporate citizenship, all ask of business and business decision-makers a showing of responsibility to others. Usually the responsibility of business is stated as having respect for the interests of stakeholders: customers, employees, owners, creditors, suppliers, competitors, and communities, including the environment.

The problem of faithless agents

If we want a more moral capitalism, we have to solve the “agency problem” or, at a minimum contain its virulence. Modern capitalism generates wealth through specialization of function and division of labor. This fact was Adam Smith’s great insight into the origin of the ‘wealth of nations” as he called it. But, as labor is more and more specialized, each component sub-unit of the economic system becomes more and more dependent on all the other parts. In today’s world of high technology, dependency on specialized machines and the skills of professional experts is higher than ever in human history. Our modern world is also completely subservient to reliable flows of electricity.

The Turkish Airlines plane that recently crashed short of the runway at Schiphol Airport outside of Amsterdam did so because its altimeter was faulty. Nine people died as a consequence of the pilots’ relying on a mechanical device for guidance in landing.

If the “agency problem” is all powerful and all pervasive, then modern capitalism is constant at risk of failure because the dependency relationships that flow from specialization are prone to abuse on the part of those who dishonor the reliance and trust placed on their competence and their integrity.

A market place of lying sellers and conniving buyers will never grow very prosperous. When faith and trust evaporate, so does capitalist wealth. The current meltdown of global financial markets is a good case in point.

But, the seriousness of the “agency problem” has been overstated. If it were truly dominant in the business world, modern capitalism with all its relationships of interdependency and mutual benefits would not have emerged to produce the wealth that we enjoy today – even in these months of a serious global recession. Thus, we can infer that there are some countervailing forces that nibble away at the “agency problem”.

What can we do about faithless or negligent agents?

The problem is not a new one. In the Judeo-Christian tradition, the prophet Samuel warned the leaders of tribes of Israel not to put their faith in kings, for, as he predicted, kings would turn against their trust and abuse power for their own selfish advantage. Later, Jesus stated that one could not serve both God and Mammon.

The Common Law of England over the centuries fashioned many legal responses to minimize the effects of the “agency problem”. These rules and practices constitute what is called the law of fiduciary duties. Also, the English courts of Equity contributed to fiduciary law with their own set of procedures and requirements designed to remedy abuse of legal power and prevent fraud and oppression in the marketplace.

The basic device used by the Common Law to minimize the effects of the “agency problem” was to define what was expected from agents as duties to their principals and give principals specific remedies for breach of those duties. This was a practical approach that sought to structure incentives so that agents would be more inclined to stick to the punctilio of their responsibilities and principals would be induced to assume the risk of trusting agents. Other words used in the Common Law to resolve the agency problem were fiduciary, trust, and beneficiary of the fiduciary trust. The fiduciary or the keeper of the trust was, in effect, the agent and the beneficiary was, in effect, the principal.

First, the agent was burdened with duties of loyalty and due care. When the self-interest of the agent was suspected of causing harm to the principal, the burden of proving loyalty was placed on the agent. The agent had the burden of coming forward with sufficient evidence to prove his or her loyalty. With respect to negligence on the part of the agent, the principal had the burden of proof but could hold the agent accountable when an objective standard of care had not been observed in management of the business consigned to the agent.

The Common Law thus turned the relationship of principal/agent into a status for the agent. Agency was an office; so was being a partner, a trustee, a corporate director, etc. With office came specific responsibilities. Failure of performance was transformed from a difference of opinion between agent and principal into a notorious setting of public expectations. The behavioral theory used by the Common Law judges appears to be a conviction that when we are made accountable in public, our pride tends to keep us more scrupulous and diligent than when we can act in secret. Principals could deny their own liability for acts of the agent when the agent had acted contrary to the terms of the trust, leaving the agent exposed to face the consequences.

Exposure and transparency were devices used to reduce agency problems.

Second, in its courts of Equity, English jurisprudence fashioned a number of rules that principals and beneficiaries could use. They could seek an accounting of monies had and received, with the burden on the agent to account for every penny received; principals could ask for the imposition of a constructive trust on money and property in the agent’s possession and name when fraud and abuse had occurred; agents had to have acted with clean hands if they sought to recover from principals on their agency contracts; agents could be prevented (estopped) from entering claims and evidence in their favor if they had acted inequitably.

Use of self interest

A second basket of remedial responses to the “agency problem” lies in self-interest. It is in one’s best interest to avoid faithless agents. Over time, therefore, faithless agents will not find employment as their reputation for negligence or disloyalty becomes generally known. This is why reference checks are so frequently relied upon. Generally, market based solutions to the “agency problem” rely on this mechanism of self-help. But it can be of limited utility where agents or those upon whom we rely for professional expertise have market power or are polished performers adept in the arts of lulling our suspicions with their smoke and mirrors – like Bernie Madoff to his investors.

Use of character

The third approach to minimizing the “agency problem” is to promote good character, the habits of living up to the virtues of trustworthiness, integrity, diligence, transparency and reliability. This agenda for securing better prospects for corporate social responsibility and business ethics – for avoiding asset bubbles and financial bubbles – and for putting in place the cultural foundation for specialization of function and division of labor operates at the level of the individual.

We must engage individuals to act as we would want if we want responsible and faithful agents. Such socialization, obviously, begins in the family, continues in school, and is finished in conditions of social engagement. We are concerned for the “presentation of self” in everyday life and Irving Goffman wrote about our dysfunctions in organizational settings. We want a good self to be presented, not a greedy, abusive, stupid or negligent one.

Having good character is one reliable ground for good stewardship behaviors. The moral sense within us is a public good in that it promotes trust in our communities and reliance on our business performance. Trust and reliance form the substructure of successful modern capitalism.

That human persons possess a moral sense that distinguishes them from beasts and other earthly creatures is increasingly a postulate of evolutionary studies, neuro-science, and brain research.

Thus, we must not presume that the “agency problem” is intractable and a permanent obstacle to responsible business decision-making. Rather, we should assume in us all an inherent capacity for reliable agency performance.

Set the bar high and we will tend to jump higher; set it low and we will slack off and get away with poor performance.

What is Moral Capitalism?

2009-02-24T06:14:00.000-08:00

Moral Capitalism is a field theory that integrates intangible moral considerations with traditional micro and macro economic postulates. In sum, Moral Capitalism asserts that interest and virtue are not necessarily in conflict; that virtue is an extension of interest rightly understood.

From the perspective of contemporary academic philosophy, the framework of Jugen Habermas most closely supports this approach to private property and free markets as preferable institutions for human civilization. Habermas points out that human actors engage a variety of realities in the course of performing their individual and collective discourses while alive in this Red Dust world.

One reality is what Habermas calls “Normativity” – the perceptional realities of the mind, the heart and the conscience. From dreams to ordinary thought in conventional languages, from mystical insight to scientific formulae, the realm of the mind and the spirit powerfully attracts the human being.

Another realm, equally compelling and controlling, is what Habermas calls “Facticity” – the material realities of hard and soft, night and day, steel and cotton. Habermas’s important suggestion is that human beings live in both realms and in the various dynamic interpenetrations between them. Ideas can be imposed on material conditions by human actions; material facts can change and so shape human ideas.

Moral Capitalism holds that business must partake of Normativity as well as of Facticity.

The role of Normativity

Material conditions alone do not suffice for business success. Most tellingly, capitalism did not arise in any of the worlds traditional cultures save one – Calvinism. This is the famous observation of Max Weber which has yet to be contradicted, if not yet fully explained. A religious context – a normative platform – consistently favored certain behaviors over others. Those behaviors provided for new social relationships of partnership, trust, and exploitation of technical inventions in order to produce new products and services in a dynamic of permanently expanding markets and economic opportunities. Thus was born the system which has come to provide the foundation for global human civilization.

Material conditions conducive to the birth of capitalism existed in China under the Sung Dynasty and in the city states of Tuscany in the 1400’s but neither China nor northern Italy converted such conditions to full-bore capitalism. Some necessary spark was missing; there was no prairie fire though the surrounding grass was dry enough.

Trust and confidence nourish business success. Reputational assets – good will and reliable, productive employees – attract custom and financial investment.

The expectations cultivated and preserved by good laws protecting rights of contract and free markets, punishing fraud and oppression and preventing theft, must be in place before business will be transacted in any significant scope and at levels of substantial risk.

Business and capitalism manipulate the impact of risk by providing rewards for those who invest and act in the present to achieve some benefit in the future. The mental state of taking risk, of gaining assurance that probable rewards offset present risk, is a function of mind in the realm of Normativity. To risk or not to risk draws on emotions and psychology as much as on rational analysis. It is a cognitive presence, not a material substance. Business cannot be without such mental efforts.

Now, risks and rewards turn on the actions of others. Business actions reach out to embrace the needs and motivations of others. Here again normativity comes into play. The actions of one are constrained by the need to comprehend and respond to the actions of others. Power in free market transactions is constrained by the need for mutuality and reciprocity. Our self-interest must be understood in a certain way: it must be understood upon the whole set of circumstances. It is self-interest placed within an ethical envelope.

Naked self-interest is quickly exposed and checked by others. Advantages quickly won through abuse of power can be as quickly lost. To do business on a sustained basis, ethical behaviors are sine-qua-non. A spiritual presence at the level of Normativity provides direction for such successful behaviors.

Successful capitalist business endeavor, then, is an infusion of spirit into matter through human agency, or a shaping of material conditions through human agency to reflect spiritual direction. Spirit gives meaning to matter and matter makes spirit manifest in the corporeal realm, objectifying it and reifying it.

Nowhere is this fusion more necessary than in the process of valuation of assets. The inducement to action and investment, the reduction of hopes to concrete measures, proceeds from placing value on some thing or course of action. The level of value ascribed – the value of a dollar, the price of a company – is purely normative and subjective. Yet the consequences of believing in a valuation are thoroughly factual playing themselves out in the realm of action and material circumstances.

The Role of Facticity

Factual circumstances contribute in their own independent right to a necessary moral dimension of successful private enterprise. Every successful business needs constructive relationships with its stakeholders – customers, employees, owners and other contributors of financial resources, suppliers, a strategy for market competition, and communities, including the physical environment. This state of affairs is effectively denoted by the Japanese concept of Kyosei –or the symbiosis that every living organism has with its supporting environment.

The factual reality of business is dependency on others: on customers for their trade, on employees for the quality and quantity of their productive efforts, on owners and lenders for working cash capital, on suppliers for appropriate inputs, on communities for conditions of law and order, trust, infrastructure, and other public goods. A business without customers is a failure; a business without workers is hardly worth discussion; a business without access to money is only somebody’s idea.

The wise business not only understands this reality, but finds opportunities to make a profit by serving the needs and desires of all its stakeholders. Business acumen is a kind of chemistry, mixing disparate elements to create new realities through dynamic interactions. The factual context is to advance one’s own interest by attending to the interests of others. This is one’s “self interest understood upon the whole”, which is an ethical state of mind. One’s use of power is constrained by consideration of its effects on others. Even a crassly calculated self-interest – if it considers all things upon the whole -rises above the “survival-of-the-fittest” egoism of brutish social Darwinism.

The approach of Moral Capitalism posits that stakeholder relationships each have a moral quality. That of customers is to set the value orientation of markets. That of employees is to be agents to a principal – fiduciaries. A company similarly owes fiduciary duties to its owners and similar obligations of transparency and accountability to its creditors. The relationship with suppliers partakes of a joint venture and its duties of mutual dependency. And, a company has an office – a set of responsibilities – to provide for the economic betterment of society.

When the range of key stakeholder relationships are considered, a theory of the firm under conditions of Moral Capitalism emerges. A moral firm takes as inputs five forms of capital – reputation capital, social capital, human capital, finance capital and physical capital. It converts these forms of capital into a product or a service, which is sold to customers for a price. Some proceeds of sales are returned as “rental payments” for the forms of capital used in production.

The stocks of necessary capital – factors than exist in the realm of facticity – each in its own way demands concern and consideration for the needs of stakeholders. Capital, then, is a social product, drawn from relationships of interdependency in a system of interactions. Capital cannot be created through selfish autonomy; it has a social or interpersonal essence and so transcends individual genesis.

Successful use of capital demands that its nature not be violated through excessive selfishness. Such exploitation reduces capital from an asset to a commodity that is consumed and not renewed. A business so destroying the source of its creative powers will soon be bankrupt.

The approach of Moral Capitalism is also informed by Adam Smith’s treatise on The Moral Sentiments, Catholic Social Teachings on human dignity, solidarity, and subsidiarity, Calvinist understandings of ministry and stewardship, common law requirements for fiduciary duties, Daoist writings on change, and Buddhist presentations on mindfulness.

A president accepts responsibility

2009-02-05T12:43:00.000-08:00

We had, to me, a very surprising development in Washington, DC yesterday, one right in line with some fundamental approaches advocated by the CRT and like-minded organizations.

A President of the United States quickly and without any spin took personal responsibility for a mistake. He held himself personally accountable and was transparent about the mistake his team had made on his behalf.

No obfuscations; no lame or evasive comments to infer that nothing untoward had really happened; no pointing to "enemies" or to a hostile 'liberal" or "talk-radio" media unbecomingly bent on making celebrity mountains out of irrelevant little molehills; no assertion that there was nothing more than mean-spirited, crass politics at the bottom of the embarrassing accusations.

No, just a statement that "I messed up." And even more to the point: "I screwed up."
A second high-level presidential appointment had became a liability because the individual appointed – this time former Senate leader Tom Daschle – had been too clever by half in paying, or really not paying, his taxes.

President Obama immediately took responsibility and accepted the blame. He did not try to duck or hide.

When we see good values of accountability and transparency modeled in powerful leaders, we should be grateful and express our thanks.

Would that there was more of this from political and business leaders.

What if some of those once powerful in the now collapsed Wall Street world of investment finance would also step up and say: "We messed up. It's our fault."

Franklin Roosevelt's 1933 Inaugural Address

2009-02-03T15:13:00.000-08:00

In his first inaugural address of March 1933, newly elected President Franklin Roosevelt, confronting a vast and frightening economic crisis, had these words to say:

In such a spirit on my part and on yours we face our common difficulties. They concern, thank God, only material things. Values have shrunken to fantastic levels; taxes have risen; our ability to pay has fallen; government of all kinds is faced by serious curtailment of income; the means of exchange are frozen in the currents of trade; the withered leaves of industrial enterprise lie on every side; farmers find no markets for their produce; the savings of many years in thousands of families are gone.

More important, a host of unemployed citizens face the grim problem of existence, and an equally great number toil with little return. Only a foolish optimist can deny the dark realities of the moment.

Yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because rulers of the exchange of mankind's goods have failed through their own stubbornness and their own incompetence, have admitted their failure, and have abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.

Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to our fellow men.

Recognition of the falsity of material wealth as the standard of success goes hand in hand with the abandonment of the false belief that public office and high political position are to be valued only by the standards of pride of place and personal profit; and there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, on unselfish performance; without them it cannot live. Restoration calls, however, not for changes in ethics alone. This Nation asks for action, and action now.

Public Goods and Financial Services: Can private interest produce a public good?

2009-02-03T15:09:00.000-08:00

The classical conundrum of human morality leaves us unsettled in thinking about ourselves. What is legitimately ours as moral agents and individuals possessing both will and purpose and what do we owe beyond ourselves to others? And, conversely, what do other selves owe to us in respect of our selfishness?

Can we systematically do right by community if the place from where we start is filled with egoism? Or, must egoism be vanquished in order for morality to flourish?

This to me is the moral framework which surrounds discussions of what economists call “public goods”. Such goods have special characteristics: they produce many positive externalities; because they can be used by many at no additional marginal costs to anyone, they support free-rider; since no one can capture all the possible profit from the good they yield, there is no selfish incentive to produce them.

Public goods are a blessing and a boon; they add to society’s stock of social capital, promoting interactions, growth in knowledge, cleaner environments, and trust. They are akin to the good that Adam Smith famously said was produced by an “invisible hand” when private market transactions yield positive benefits to third parties, indirect and sometimes intangible consequences not really intended by the buyers and sellers.

But since private interest is unlikely to invest time and money in the production of public goods, societies that seek to enjoy them turn to government to provide what private markets will not.

National security, law and order, education, public health, roads and bridges – these are the most common forms of public goods. And, generally most advanced societies tax the private sector to pay for such public benefits.

Interestingly, the conservative point of view in recent years has pointed out that such public good need not always be provided by government. Government can tax but then pay private sector entrepreneurs to deliver the desired services – vouchers for education, food stamps to feed the poor, private companies running prisons or providing security services in Iraq.

Many are skeptical that public goods can be produced in sufficient quality by self-interested private actors seeking to vindicate their own schemes. Adam Smith’s faith in “an invisible hand” is not shared by everyone.

And, the current financial crisis would seem to enshrine this skepticism as unchallengeable.

A financial service infrastructure of lenders, banks, traders, stocks and bonds, brokers, buyers of commercial paper, etc., is the heart and lungs of capitalism. Without financial markets, commerce and industry will struggle to fund their employees, their suppliers, and their plant and equipment. Few public goods are as needed as financial services.

Such services can be purchased, of course, and can be provided at a substantial profit. So, private firms in market arrangements can and do support the financial needs of advanced industrial societies and globalization.

And yet, as we have seen in this 2008 collapse of trust and confidence in such markets, private arrangements can lead to dysfunctional outcomes that erode the amount of public good provided. Such cycles of over-leveraging and then de-leveraging at the highs and lows actually produce “public bads.”

I have been thinking about how to provide public goods recently as I walk our little dog, Jolie, in Mears Park near our home in downtown Saint Paul, Minnesota.

Mears Park is a public park covering a square city block, owned by the City of Saint Paul. It is lovely and well designed: flower beds artfully placed along curving paths; an artificial stream flowing under aspen trees to take advantage of the sloping terrain; shade trees in nice rows protecting a grassy slope; classical music playing most of the time. The Park is cool and verdant on hot summer days in wonderful contrast to the streets all around it.

I enjoy this park without really paying for it or working on it. The share of my city taxes that goes to maintenance of Mears Park is so small as to be irrelevant to my sense of my annual income and expenses. This is true for everyone who uses and enjoys the park.

But I notice limits to the arrangements that make for this public good. First of all, maintenance can be desultory and at times negligent. Grass may not be replaced when bare patches appear not cut when it should be. Broken benches are taken away and not replaced. Litter can accumulate on the paths.

Second, owners who walk their dogs do not always pick up after them. The poop can accumulate as bad examples are set by a thoughtless few and then others let their behavior fall to that inconsiderate lowest common denominator. Then Mears Park suffers from a tragedy of the commons – what is common and a potential public good becomes trashed and ruined by heedless individual exploitation.

There are no rules and no policing so individual short-sightedness (on Wall Street it is referred to as greed) gets the better of the public interest and, in the long-run, we all suffer.

What to do?

Mears Park also benefits from a group of dedicated volunteers. For no money and under no compulsion from the City, they plant and week the flower beds and pick up the trash. Their personal commitment of time and money – for no market reward – really makes the Part a public good. Without them it would most likely be forlorn and run down; tawdry and off-putting; unappealing and derelict.

So as I walk Jolie (always trying not to forget bringing a plastic bag to pick up after her) I speculate as to why these volunteers give of themselves to bring to an anonymous public the charming good of a lovely part in the middle of a city.

Their commitment of their own labor, part of their values and personality, turns part of the public part into a private space. But a private space that is simultaneously shared with everyone who comes to the park. Sort of an invisible hand reaching out from them to all comers sight unseen. Only their work is very intentional and they know others can and will benefit from their labors.

It’s odd: only a personal, private commitment brings out the best in a public good. Why do they do it?

I really can’t answer the question. I only know superficially one or two of the volunteers. One loves flowers and to garden. Working in the park gives her pleasure and a sense of achievement that she can’t get in her neighboring apartment. The other just seems like a good person, a good citizen who goes out of his way to help others.

Some trait of personal character, therefore, something in the inner moral make-up of these two volunteers brings about a public good that I can enjoy without paying for it. I do, of course, always try to thank them when I meet them working on their allotted sections when I am walking Jolie. It seems the least I can do to reward and encourage their good citizenship.

It is a civic virtue I would say. And Saint Paul is better because of the energy of that private virtue. Such virtue is a profound public good that gives up many benefits.

What if all the volunteers just walked off the job and stopped taking care of the part? Should there be retribution for their thoughtlessness? We would all suffer some and be disappointed. Our expectations of what the Park could be would be dashed.

We don’t discipline volunteers do we? Just like we don’t discipline private entrepreneurs when they walk off the job of providing us with public goods that we have come to rely on.

But is there a point where the co-mingling of private efforts and resources with the production of a public good becomes so material that negligence in the private efforts should meet with some disciplinary consequence to vindicate the public interest?

There is actually law on the point. In the 1972 United States Supreme Court Case of Munn v. Illinois the Supreme Court held that when a private business is so conducted that it knowingly becomes “affected by a public interest” that business subjects itself to public supervision and control.

The case involved a monopoly of the grain trade through Chicago, affecting the price of wheat for farmers in the West and of bread for consumers in East. The monopoly was of grain elevators that received wheat from Minnesota and the Dakotas, stored it and then reshipped it to mills and bakers in eastern cities like Boston, New York, and Philadelphia.

The business of running the elevators was private, but the consequences of the prices charged for grain storage impacted the public. The business was, said the Supreme Court, affected with a public interest – it was providing a public good in facilitating wealth and commerce and good diets for consumers. The public good was external to the income statements and balance sheets of the grain elevator companies, but none-the-less was a real good in the lives of those who depended on the trade in grain.

If financial services provide vital public goods, then the public should have a say in the risks put upon the public by those who put their capital into financial services. Private property so used in a chain of consequences should be burdened with an easement in favor of the public so that excessive self-regard does not lead to a tragedy of the commons and the destruction of wealth.

Avoiding “Irrational Exuberance”: Using the CRT’s Ethical Leadership Profile

2008-11-18T09:22:00.000-08:00

The current collapse of asset values that started with sub-prime mortgages in the United States and flowed to global credit markets through the intermediation of CDOs and Credit Default Swaps is but another example of “irrational exuberance” at work in financial markets.

Allen Greenspan, former Chairman of the US Federal Reserve System, coined the cautionary term “irrational exuberance” to describe the asset bubble in dot-com and telecom equity stocks in the late 1990’s. That bubble burst when the accounting fraud scandals at Enron and WorldCom exposed many company values as illusory.

“Irrational Exuberance” takes over markets when prudent judgment and sound valuation methodologies lose traction in the minds of investors. Speculation, grounded on expectations of every rising equity values, drives out sound thinking and ushers into financial markets mere enthusiasm for self-advancement.

Certain styles of decision-making tend to favor the rise of “irrational exuberance” over more responsible approaches to valuation.

The Ethical Leadership Profile, developed for the Caux Round Table by Michael Labrosse and his associates, indicates that there are for most people, in general, four distinct decision-making modes of thought.

First is the Inquiring frame of mind. This approach to decision-making emphasizes analysis of data, conceptualization to see the “Big Picture” and future trends, to find meaning in facts by giving them weight and by putting them into patterns and categories. Here we find much of Barack Obama’s approach to decisions.

Second, and opposite to the approach taken by Inquirers, are the Pragmatists. These people look to experiences of practical success as the guide to their choices and recommendations. They are focused on immediate results within the context that is given them by society’s institutions. At their best, they have a dedication to craft and substance in what they do or produce. They tend to ask how can we complete the task and less why should we be doing this? The “why” question is of more interest to Inquirers than to Pragmatists. George W. Bush and his father, George H.W. Bush, both lean heavily towards pragmatism in their decision-making. George H. W. Bush became known for his cautionary mantra: “Wouldn’t be prudent.”

Third, on a different dimension than the continuum linking Inquirers and Pragmatists are the Unifiers. Their preferred approach to decisions is to find what is best for the organization to which they belong and for them as a loyal member of that structured community. They place priority on resolving issues of hierarchy and fairness within the organization; they place loyalty to their group over concern for outsiders; they stand up for their peers and reward loyalty with loyalty. They may often defer to the organizations rules and regulations and thus appear bureaucratic and happily bound up in red tape. Hillary Clinton with her passion for control and her distance from outsiders seems to have much of the Unifier orientation in her personal approach to the use of power.

Fourth, and opposite to Unifiers are the Entrepreneurs. They plan their moves with most concern for their own recognition and advancement. Their loyalty to the group responds to the group’s interest and ability to advance their careers and ambitions. Entrepreneurs are responsive to others, creative, intense and industrious. They are always drumming up some kind of profitable business for themselves. John McCain with his penchant for quick and decisive action would seem to embrace much of the entrepreneurial spirit in his approach to decisions.

But people are rarely active only at one of the paradigmatic poles; more frequently, they combine something from the Inquirer/Pragmatist axis and something from the Unifier/Entrepreneur axis. So, we might consider Bill Clinton as an eEtrepreneurial Inquirer – a man focused on his own opportunities but with strong intellectual gifts. Barack Obama would be an Inquiring Unifier, bringing conceptual clarity to the tasks and challenges of the organization and looking at the whole of the group and not just partisan sub-cultures. George W. Bush with his war in Iraq would be comfortable mixing pragmatic action with entrepreneurial risk.

Of these four dispositions, being an Entrepreneur is most conducive to promoting “irrational exuberance”, especially when compensation structures are commission or fee based so that deals done translate directly into personal reward and advancement. Entrepreneurs are less likely than Inquirers to consider the long term consequences for others of what they are doing. Entrepreneurs have a propensity to see the world in terms of sales; if you can sell it, do so and let the buyer beware of the consequences. You will move on to the next deal.

Nor are Entrepreneurs that considerate of the risks to their organization. They think of themselves not their organization as the vehicle of opportunity and success.

But when Entrepreneurs and Unifiers are mutually engaged in the same business, it can be a very risky combination. If the Entrepreneurs are “bringing home the bacon” for the organization, the Unifiers will stand by them, reward them, and not question the effect of their activities on those outside the organization.

In the case of Enron, both Jeffery Skilling and Andy Fastow were of the Entrepreneurial frame of mind. As long as they produced ever growing revenues for the Company, Ken Lay, the Enron Board, Arthur Anderson partners working in effect for Enron, and others loyal to the company had no complaints and rewarded them with high compensation and discretionary power. The conflict of interest rule was waived for Fastow so that he could be even more entrepreneurial for both himself and Enron.

In the companies that promoted the sub-prime mortgage bubble, the CDOs that derived from those mortgages, and the credit default swaps that were to give added security to those CDOs, Entrepreneurs and Unifiers came together with toxic consequences. Their business marriage of convenience led to a massive over-leveraging and resulting asset bubbles in housing and derivative CDOs.

Entrepreneurial mind sets kept up the deal flow for both sub-prime mortgages on more and more risky terms and CDOs which were sold in ever increasing amounts. Compensation for placement of mortgages and issuance of CDOs was fee based, an incentive system perfectly fitted to drawing out Entrepreneurial thinking and behaving in financial services.

As the asset bubble was growing and fees were being earned, Unifiers like the senior managements and boards of Merrill Lynch, Bear Sterns, Lehman Brothers, JP Morgan Chase, Citibank, AIG, etc., were loath to reign in their productive agents. Concern for the benefits to the organization trumped more strategic thinking about if and when the bubble should ever burst and prices would fall.

Largely left out of the decision-making dynamic that gave us the current economic crisis were the Inquirers and the Pragmatists. Inquirers were valued only to the extent that they could rationalize and justify with complex calculations and algorithms the deals that were being promoted by the Entrepreneurs. Pragmatists were thrown into the task of churning out more and more of the deals that could earn fees. Their reservations about the quality of what they were doing were mostly ignored.

Had the governance of these financial institutions been more evenly divided among Inquirers, Unifiers, Pragmatists, and Entrepreneurs, outcomes might well have been different.

More strategic thinking from Inquirers about long-term trends and consequences might have undercut the rush to “irrational exuberance”. More focus by Pragmatists on producing quality products that were reliable and durable would have slowed the deal flow and dampened down the accumulation of debt and the scope of the bubble in asset prices.

The possible learning from this reflection on the four decision-making tendencies highlighted by the Ethical Leadership Profile is that application of the Profile and seeking a proper balance of decision-making styles might have minimized the onset of this global crisis.

Global Prosperity at Risk The Current Crisis and the Responsible Way Forward

2008-10-09T02:50:00.000-07:00

Imprudent decisions on the part of US and European investment banks, banks, mortgage brokers, insurance companies, and consumers - all seeking profitable advantage - have brought the global financial network that sustains global capitalism to crisis.

Great American financial houses – even Lehman Brothers that survived the Great Depression of the 1930s - are no more; banks in America and Europe have been propped up by governments; and massive amounts of liquidity have been injected into the financial system by the US Federal Reserve System and other central banks.

This is not business as usual. Trillions of dollars in private wealth has been destroyed in a matter of weeks, some of it never to be regained. And governments have been forced to step in to protect the economically vulnerable where markets have failed.

Yet, ironically, inadequate regulation and government policies also contributed in various ways to risks being negligently addressed by financial markets, thereby paving the way for the current crisis.

Beyond dealing with the immediate crisis, the critical task will be to address the underlying causes through reforms to restore trust and confidence in financial markets. Functioning and sound financial institutions, despite their current failure to meet their fundamental responsibilities, remains of first importance for supporting a successful free market economy. Credit is now scarce and capitalism cannot properly function without it.

The triggers to this crisis were centered on a lack of: prudence in the extension of credit; rigor in valuations; and of transparency in management. This was compounded by the mispricing of risk via the bundling and sale of debt through collaterised debt securities and via complex derivative based credit default swaps. These failures reflected profound shortcomings in private sector governance both as prescribed and as applied. In short, risk was not appropriately managed; it was not even properly understood both by those creating it and by those bound to mitigate it.

Driving this lack of prudent management was a dysfunctional and shortsighted system of incentives and personal remuneration.

Compensation of senior executives, traders and fund managers was built on greed and self interest and was decoupled from long-term wealth creation. Compensation based on fees earned and other incentive-based benchmarks blinded otherwise intelligent managers to the long-term dire consequences of their decisions. Rewards rose with excessive risk taking and was provided in ways that has largely shielded senior corporate officers and fund managers from liability for their decisions.

As a result, the best interests of customers, owners, employees and communities have been systematically overlooked. Decision-makers, driven by short-term interests, paid too little to no attention to managing risk accumulation.

Short-term speculation dominated, with part of the market enriching itself by betting on and contributing to the destruction of wealth via short-selling. Not only did the regulators fail to halt the growth in systemic risk, some of the contributing market activity and behavior was allowed to remain unregulated.

This global financial crisis has further exacerbated the very low levels of trust which the global community places in business. The fact that the profits were in effect privatized to those who created the crisis through excessive rewards, and the losses are now being socialized to taxpayers has further outraged the community. Though justly perhaps, the shareholders of the ‘failed’ financial institutions responsible for the crisis have lost most of their ownership wealth.

This is not the first time that market capitalism has so failed. Less than a decade ago, global markets lived through the bust of the dot-com and telecom bubble in equities and the accounting scandals of Enron and World-Com. Before that, world financial markets were upset by currency collapses in Thailand, Malaysia, Indonesia and Russia. And before that, the United States lived through the savings and loan/junk bond bubble and bust.

More fundamentally, the current crisis represents the latest, albeit the most severe, fallout from the systemic erosion within the corporate world of the importance of ethics and responsibility in business decision-making. Ideological commitments to laissez-faire free market fundamentalism, social darwinism philosophies, and shareholder primacy at the expense of other stakeholders, have divorced business leadership from standards of good faith, wise stewardship and care for the public interest.

As a result, capitalism’s immune system of market discipline fails every so often and the cancer of “irrational exuberance”, greed and narrow self interest metastasizes. The object of reform, obviously, should be either to eliminate this deep cancer within capitalism once and for all or to boost society’s market immune system of accurate pricing, risk management and valuation transparency in order to keep the cancer in long-term remission.

At the core of all these market shortcomings were the boards of directors of the corporations involved. They were not sufficiently encased in an environment of accountability and transparency and ultimate accountability. The market failure, therefore, was ultimately a failure of governance.

With respect to the current crisis in financial markets, there are no clear remedies on the table. Business leaders are largely silent; academics have little to say beyond the immediate; and politicians, regulators and central banks are putting out fires. No one is focused on designing a sustainable future that removes once and for all the underlying problem.

Interestingly, the recent movement promoting corporate social responsibility via CSR standards, monitoring, reporting and ratings, has not proved adequate in preventing these failures of capitalism. It is now apparent that much of the CSR movement remains on the fringes and too removed from core of business risk management and strategy. Compounding the problem, business education has been lacking with a general absence of teachings in responsible and ethical business practices.

Uniquely, the Caux Round Table (CRT) Principles for Business provide strategic ethical guidance which, had it been followed, would have kept those institutions that have triggered the crisis more faithful to their obligations of stewardship, good governance and stakeholder risk management. The CRT Principles go to the heart of constructive and ethical behaviors that enhance risk assessment and stakeholder management, boosting bottom-line valuations of business success and sustaining responsible long-term wealth creation for society.

The way forward to free markets that are consistently reliable in their capacity for robust wealth creation is through the imposition of higher standards of good governance and transparency. Lack of good governance and transparency, again and again, leads market capitalism down wrong roads. Such opacity and lack of accountability has long been a fundamental flaw in institutions of private enterprise.

The following remedial steps to take responsible capitalism from the fringes of the business model and firmly entrench it in the heart of corporate strategy deserve priority attention:

• First, the principle of “enlightened shareholder value” should be codified in company law via non-prescriptive minimum standards for responsible decision-making and good governance. (The UK Companies Act 2006 provides an example of such legislation.)

o Directors should be required to document and defend their stewardship over company affairs via specific disclosure of:

 the principle risks and uncertainties likely to affect the future development, performance and position of the company’s business; and
 material risks and impacts relating to environmental matters, employees, customers, suppliers and social and community issues.

• Second, members of corporate boards should be trained corporate governance including Board oversight of the full spectrum of financial, social and business risks.

o Business is not without consequence for society and should, therefore, be attentive to the demands for responsible execution of its private office of trust and profit.

o The CRT risk assessment process of Arcturus provides an example of what can be required of companies in regard to stakeholder, social and environmental risks.

• Third, corporate boards should establish a dedicated sub-committee responsible for strategic risk consideration across the full range of stakeholder, responsibility and sustainability issues.

o The environmental, social and governance risk assessment processes and outcomes, should be subject to third party assurance.

o Boards should make annual disclosures of the material financial, environmental, social and governance risks assessment in easily understood prose that is meaningful to stakeholders.

• Fourth, executive compensation must be reformed to ensure incentives are aligned to the achievement of long-term wealth creation and reward prudent risk management rather than excessive risk taking.

• Fifth, equity and capital market regulation and taxation should be reformed to incentivize sustainable value creation and to penalize / ban market manipulation, short-selling and other value destruction.

• Sixth, derivative markets need to be regulated, including the introduction of a fully regulated exchange for credit derivatives.

• Seventh, opportunities for companies and individuals to illegally hide income by utilizing tax havens and secrecy jurisdictions should be eliminated.

These reforms will not only address the causes of the current crisis, they will have a salutary effect on a broader and longer basis. Such reforms to eliminate the underlying, systemic flaws in the system should have as an objective promotion of global social responsibility on the part of all companies.

End

CRT Principles for Business and the Financial Crisis of 2008

2008-10-09T02:49:00.000-07:00

The best test of a principle, perhaps, lies in its effects, not always in its aspirations. Does it lead to constructive action? Can it influence and shape behaviors for the better, especially dysfunctional behaviors?

On the one hand we can judge the quality of a principle according to a moral calculus of abstract standards of right and wrong. But, on the other hand, we can also assess the practical worth of a principle by its power to achieve ethics in the field. This might be considered the inherent potential of a principle to obtain compliance with its preferences for better outcomes. As Karl Marx said in his Theses on Fuerbach, “Up to now philosophers have only interpreted the world. The point, however, is to change it.”

This seems especially relevant in the arena of corporate responsibility and business ethics.
Overcoming the functionality of greed and short-term self-interest is the goal of those who promote responsible decision-making in business. And a daunting task they have.

The Caux Round Table published a set of ethical principles for business in 1994, the first such set of principles for guidance of global business and the only set of such principles yet designed by experienced business leaders.

The current massive disruption of financial markets initially brought on by the collapse of the sub-prime mortgage market in the United States provides an opportunity to assess the relevance of the CRT Principles for Business.

weIf they had been followed, are there reasonable grounds to believe that the crisis could have been avoided, or at least mitigated in scope and intensity?

I think the answer is, yes, the CRT Principles might have made a difference had they been infused in strategic and tactical decisions on the part of those financial institutions which contributed to the current crisis.

First, let us consider the implications of the first CRT Principle for Business:

“The value of a business to society is the wealth and employment it creates and the marketable products and services it provides to consumers at a reasonable price commensurate with quality. To create such value, a business must maintain its own economic health and viability …”

Since the crisis is about the failure of major financial houses and banks such as Bear Sterns and Lehman Brothers, the sale of others such as Merrill Lynch and Washington Mutual, and the government rescue of Freddie Mac, Fannie Mae, AIG, Fortis, and others, we can quite quickly conclude that these companies failed to meet the ethical requirement of maintaining their own economic health and viability.

Their decision-making was wrong-headed in the accumulation of too much debt and in setting imprudent values on certain financial assets such as sub-prime home mortgages and CDOs. In their collapse, these firms caused a contraction of markets, thus erasing wealth and employment in violation of what the CRT advocates as the primary obligation of business firms.

Second, the current crisis was caused by a failure to provide quality products at a price commensurate with their inherent worth.

Sub-prime mortgages were priced inappropriately for many borrowers. Excessive and imprudent borrowings were offered to home owners. In the many cases where credit standards were waived or overlooked lenders and mortgage brokers knew or should have known as professionals that the borrowers were highly likely to default if economic conditions changed.

Borrowers were effectively sold defective financial products. Such mortgages were also sold in excessive quantities, creating an asset bubble that gave rise to perverse incentives on the part of home buyers to assume unreasonable risks of future default and foreclosure.

Similarly, the terms of many CDOs sold were not of the value that was represented to buyers. They carried more risk than was reasonable for the investment goals of those who purchased them. They were also issued in excessive amounts that undermined their long-term value.

This requirement to serve customers with respect for their needs is reinforced in Section 3 of the CRT Principles for Business with the requirement that businesses “provide their customers with the highest quality products and services consistent with their requirements.”

The first CRT Principle also holds that:

“Businesses have a role to play in improving the lives of all their customers, employees, and shareholders by sharing with them the wealth they have created.”

Here has been the greatest harm done by those who create the unsustainable markets in sub-prime mortgages and CDOs – they destroyed wealth and made worse the lives of many customers, employees, owners, creditors and communities.

Principle No. Three of the CRT Principles holds that:

“… businesses should recognize that sincerity, candor, truthfulness, the keeping of promises, and transparency contribute not only to their own credibility and stability but also to the smoothness and efficiency of business transactions, particularly on the international level.”

The current crisis in financial markets was caused by a lack of sufficient transparency in CDOs valuations which eventually undermined the smoothness and efficiency of international markets for credit and liquidity.

Principle No. Four of the CRT Principles holds that:

“[Businesses] should recognize that some behavior, though legal, may still have adverse consequences.”

It appears that in general, the provision of the financial products that gave rise to the crisis was legal. No laws were violated in lending to sub-prime borrowers or securitizing those mortgages and selling off interests in them through CDOs and in providing guarantees of payment through credit default swaps. Individuals here and there are being investigated for fraud in the sale of such products, but the products themselves were legitimate in concept. What went wrong was selling them to excess on unsustainable terms. That behavior, though legal, had adverse consequences that should have been foreseen and avoided.

With respect to their owners, those responsible for the credit crisis failed to meet other responsibilities set forth in the CRT Principles for Business. For example, they failed to “apply professional and diligent management” and to “conserve, protect and increase the owner’s/investors assets”. These failures lay at the heart of the dynamic that caused the crisis. There was strategically poor judgment exercised in the development of these markets. Risk was exacerbated to the point of destabilization; it was not properly foreseen or managed.

And, finally, those who caused this crisis failed to meet the CRT standard of enhancing community environments and standards of living. Where homes go into default when mortgages can’t be paid, communities suffer disinvestment and even blight as home prices fall and homes are abandoned to the lenders.

Had the boards of directors and senior managers of Bear Sterns, Lehman Brothers, Merrill Lynch, Citibank, Morgan Stanley, Goldman Sachs, Washington Mutual, Freddie Mac, Fannie Mae, and others who thrived for a while off the issuance of sub-prime mortgages and CDOs taken their CRT responsibilities more seriously – and insisted on products and sales strategies consistent with those practices – there would have been less risk injected into the global financial system and less provision of unsustainable financial products.

As I wrote a few years ago in Moral Capitalism, “Directors and corporate officers are hired to be agents not just for their fidelity but also for their skill. Their responsibility is to guard against high risk and imprudent courses of action.”

In that book, I also pointed to the intertwining of interdependencies and the need for trust in transactions. Capitalism breeds interdependencies through the specialization of function and the division of labor. Reliance and trust are essential for capitalism to thrive. Destruction of either leads to trouble in markets. People lose confidence and withhold their ideas, labor, and capital from productive exchange. The economy then contracts. That is what is happening now. The current crisis is really only a crisis of confidence; trust has been lost.

But how do you restore trust when it has been abused?

I wrote in Moral Capitalism that “where mistrust prevails, people fear entering into dependency relationships. Mistrust always raises the risks of enterprise. Who would invest where risks are excessive and returns uncertain?”

This dynamic explains the collapse of value in Bear Sterns, Lehman Brothers and Washington Mutual – they had billions of dollars of assets on their books but no one wanted to buy their shares. The value of Bear Sterns was $80 per share on the books, but only $2 per share in the market. Lehman Brothers went bankrupt and its owners could not realize the value of the company’s book assets as no one wanted to buy those assets encumbered as they were by debt and uncertainty.

I also noted in Moral Capitalism the sometimes negative effect of desire for money. “The interest of owners and investors in making money introduces a challenge to moral capitalism. Money is easily idolized, provoking heresy by turning us away from the things of God to the things of Mammon. There are times when we may sell our souls to gain what money promises in way of power and license. This is especially true in today’s culture of consumerism, where we have sanctified appetite over character.”

How much did this dynamic contribute to the current crisis?

I close these thoughts with a quote from an ancient Chinese text, the Annals of Lu Bu Wei, who wrote about 250 BCE

“In making judgments, the early kings were perfect, because they made moral principles the starting point of all their undertakings and the root of every thing that was beneficial. This principle, however, is something that persons of mediocre intellect never grasp. Not grasping it, they lack awareness, and lacking awareness, they pursue profit. But while they pursue profit, it is absolutely impossible for them to be certain of attaining it.”

Momento Mori: on Wall Street’s Death by Negligence

2008-10-09T02:46:00.000-07:00

What we have known as "Wall Street" is now stunningly no more.

Manhattan’s great investment banks are gone. The last two – Goldman Sachs and Morgan Stanley - are converting into banks, submitting to more intrusive government regulation in return for more secure sources of capital.

Communism couldn't kill this Wall Street; capitalism, however, did. Adam Smith won out over Karl Marx.

This "Wall Street" died at its own hands in a form of negligent suicide. It lived by the sword of extreme market capitalism and died by that same sword. It overdosed on toxic behaviors as did John Beluchi, Jimi Hendrix, Janis Joplin, and Jim Morrison.

The epitaph, I suppose, for "Wall Street’s" mighty rise and astonishing fall should be "Sic Transit Gloria Mundi" - "thus passeth worldly glory".

Street talk for what killed Wall Street’s investment bank titans is that it was “greed” that did them in. As in a Greek tragedy, excess and hubris worked through a cycle of boom and bust to humble even the best and the brightest. It’s an old story, really, new in its techniques of subprime mortgages, CDOs, and credit default swaps, but very old in its moral fundamentals.

But I don’t think it was greed precisely that was the cause of the losses and bankruptcies.

Greed - understood as seeking a profit, as pursuing one’s interest in business transactions – has not always been so terribly dysfunctional and hurtful to the common good. Indeed most of our modern life was devised, produced, distributed and sold by capitalist behaviors and motivations. There was a baby in Wall Street’s bathwater to be sure.

Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Sterns and their predecessors brought companies to life by raising capital for them. America’s growth and resulting economic well-being rested on robust capital markets. Without them there would have been no railroads, steel mills, General Motors, Ford, Boeing, Microsoft, or all the other Fortune 1,000 and smaller companies that ever sold stock or debt securities to finance their businesses.

So what went wrong? When did this “Wall Street” of once sound investment banking houses start walking on the wild side towards perdition?

The short answer is too much leverage – too much debt. Lehman Brothers, as an example, was leveraged 30 to 1 when it failed. When its chickens came home to roost in questions about how it was going to pay off its debt as the market turned sour, Lehman had insufficient capital of its own to be credibly self-reliant in down markets.

This answer raises a further question: why the need for so much leverage?

The answer to this question gets us closer to the culprit. Lehman wanted to buy securities and other tradable assets to resell them for a profit. It borrowed money to buy assets. It was not raising capital for other companies and taking a fee for the service. That was the traditional role for investment banks. No, Lehman had become a big trader on its own account as well. Lehman and the other investment banks were buying and selling any number of assets – short sales, currencies, options, puts and calls, stocks, bonds, many sorts of derivatives – to speculate on price movements.

When done well, such trading earned huge returns and permitted lavish bonuses and life styles on the part of its owners and employees.

The point to note is that trading is not real investing. It is playing in the space left open by other buyers and sellers. Trading is short term; it is not designed to hold rights to the income or the capital appreciation of companies over the long haul. The time frame for trading is “right now”.

Trading is not a special, distinct part of capitalism with its genius for engineering modern economic growth. Trading has been with us since the dawn of time. Markets predate capitalism by millennia. Capitalism is a recent evolution in human social practices, substantially starting in Holland and England only in the 1600’s.

In the ancient Chinese state of Qi before the time of Confucius, there was a famous Prime Minister, Quan Zi. His lord, Duke Huan, loved purple cloth but grew annoyed when the price for such beautiful cloth rose too high even for him. A shrewd judge of human nature, Quan Zi advised his Duke as follows: since the dye used to make the cloth purple left a smell, the next time someone approached the Duke wearing purple clothes, the Duke should hold his nose as if the smell was repugnant to him. The Duke did so and all the courtiers, suddenly fearful of offending the Duke by wearing purple, sold all their purple clothes. The price of purple cloth in the markets of Qi immediately dropped. Quan Zi bought up all the purple cloth for a song and gave it to his now very happy Lord.

Such trading in markets has a long history throughout human history. But capitalism seeks patient capital to invest over the long haul in companies that need the cash for working capital, wages, raw materials, plant, equipment, etc. For capitalism to succeed, the right kind of investment capital markets is very necessary. But it must be a market that attracts investment, not speculation. A market in speculation is a casino.

From the beginning of capitalism, old trading habits were brought over to finance and trade the new possibilities created by the new, emerging economic system. But trading habits loosed inside capitalism have been disruptive.

The first boom and bust irrational exuberance in capitalism was the tulip mania in Holland in the early 1600’s. That mania for buying tulip bulbs was not systematically different in its origins, dynamics or eventual losses from our current boom/bust cycle in buying certain financial products.

Trading and investing thrive on different and inconsistent incentives. Traders like to take a fee from every trade; investors look to dividends and the sale of appreciated ownership shares as a company becomes successful in its business for their returns.

Trading is akin to speculation: you pay money for a chance to win. You don’t always win so your winnings over time need to compensate for your losses and the risks associated with the gambles taken. Trading and speculation are inherently short term and limited in their consideration of consequences. Their spirit is at odds with the motivations and perseverance needed to grow a business.

Capital markets exist to accommodate traders and trading in financial instruments. Investment capital is raised by selling equity and debt contracts. We can’t, as far as I can tell, eliminate trading from capitalism. Providers of capital and companies need the liquidity which the ability to sell into a robust market of buyers permits; trading sets prices, which give vital information on values and trends, successes and failures.

But the goose that lays the golden eggs is not one that lives on trading alone. Firms need patient capital - investors, not speculators renting stock for a while in order to profit from market movements. Speculators can easily divert management’s attention away from long term strategies to short term manipulations of stock prices.

The most important role of financial intermediaries is to provide capital; therefore, short term trading in capital contracts should be subordinate to the mission of finding ways to raise money for companies so that they can create jobs, products and services – and, in consequence, the precious commodity of real economic growth.

From here on out, I suggest, that financial markets be so structured that trading beyond a certain band is burdened with responsibilities that will reduce the appeal of more and more speculative trading and so bring incentives in financial markets back to the provision of patient capital.

We need a trading regime that performs useful services without spinning out of control and throwing us into spasms of wasteful excess.

We might want to consider having different kinds of markets – one for trading and one for investing, or pricing arrangements that add to the purchase price of the trade as the risk associated with each new, incremental trade gets bigger and bigger. If risk were properly priced, the demand for financial instruments would contract as risk conditions change adversely given the growth of excessive supply. Too much supply financed with debt leads to a boom, which sets us up for the ensuing bust.

But, this strategy would require taking into account up front all the external consequences – both positive and negative - for consumers, society, workers, lenders, investors, suppliers, government – that will flow from the activities funded by the extension of credit.

Lehman Brothers, Merrill Lynch, AIG - what might it all mean?

2008-09-18T20:01:00.000-07:00

Markets are unforgiving; they expose truth and drive out chaff. As the Tao Te Ching says of Heaven itself, markets “treat all things as straw dogs”. They have no emotions, shedding no tears for losers and taking no pride in winners, for today’s winner may be tomorrow’s loser. And, markets refuse to subsidize idealisms.

Over time, free markets reject fraud, abandon products that have no sound purpose or accommodating price, and undermine false or misleading valuations.

That Bear Sterns with balance sheet assets worth $80 pre share was sold for $2 and then for $10 per share, that Lehman Brothers with billions in assets nonetheless went bankrupt, wiping out owner’s equity, and that Enron as an enterprise was gone within months of revelation regarding its true debt obligations and real income flows, testify to the cruel discipline of markets at work.

True, markets create liquidity and asset bubbles; but then they turn and destroy them if they are bubbles. Bubbles can’t last forever. Only well-supported valuations are sustainable.

It is better, I think, to say that market makers create bubbles and also that market makers break bubbles. Perhaps market makers are more irresponsible in making than in breaking bubbles for the breaking can only occur if bubbles have been created. And, the breaking gets us back closer to the reality of sustainable values, a salutary step towards truth.

But, in the breaking of bubbles, people get hurt as we see happen all around us in the continued destruction of wealth and value flowing from the subprime mortgage/CDO/credit default swap bubble and bust of the past 5 years.

The teaching of market makers when they lose faith in valuations and so refuse to buy more at that price, or sell to unload risk, or suddenly refuse to extend credit or guarantee an obligation, is that the valuations at play in the market have become unreliable. Prices will thereafter drop until valuations become more acceptable.

The bubble stretches credulity about valuations (“irrational exuberance” some call it) until confidence is lost and the search for “quality” and security begins.

So, in some sense the current crisis of American financial institutions is necessary and just. It is correcting a past injustice. Only, the pain of correction does not fall fairly on those who made the mistakes in the first place. They have most likely taken the money and run.

Prices go down, wealth is un-created, and the economy contracts. People lose jobs; families suffer.

The lesson of this current financial retraction is perhaps keener still. It may be telling us that the share of global cash flows appropriated by the financial services industry in general was excessive and unsustainable.

The value of the mortgage brokers, the investment banks, insurance companies like AIG, depended on their making hay while the cash was flowing. High fees, charges for all kinds of intermediation, huge bonuses, were converted into capital values. But such substantial and systematic extraction of commissions from the economy could not last if the financial intermediaries collectively were not providing real value-added to investors and players in the real economy.

And, perhaps the failed Wall Street intermediaries were not contributing enough to justify their returns. So, losing them – in the long run – is just treating them like “straw dogs” - useless playthings that will burn and disappear.

Some coldness is required to let companies and their fortunes decline and fade away as casualties of poor risk management and imprudent forethought.

Over time, market makers turn to second thoughts about values, then to third thoughts, and then to an endless series of different thoughts. It takes real worth to survive all these market-maker changes of attitude and desire more or less intact as Goldman Sachs and Morgan Stanley seemed to have done. Though they too were shopping themselves to avoid liquidation and loss of equity for their owners.

But the un-creation of value is not what we want from free markets and capitalism. We should hold the system and its leaders to the powerful capitalist standard of wealth creation on a grand scale so that the positive synergies of investment and production will flow throughout the economy improving lives for all.

The first Principle of the Caux Round Table Principles for Business sets this standard:
the purpose of a business is to create wealth, not destroy it. Other CRT Principles and stakeholder considerations add ethical obligations to the manner in which such wealth is to be created and its benefits distributed.

I would assert that the titans of financial intermediation which took the lead in building the investment bubble in subprime mortgages and subordinate contracts did not live up to this CRT ethical principle. Had they done so, the bubble would have been smaller and so its bursting would have caused less harm to society and far fewer financial losses to investors and owners.

If the CRT Principles for Business are to be assiduously implemented, there should be no bubbles at all – not ever - just a sustainable rise in valuations as a rising tide floats all boats. Such a sustainable rise would rest on sound, real value-adding, business activities of tangible, non-illusory benefit to stakeholders.

Catholic and Muslim Moral Commonalities

2008-09-16T02:32:00.000-07:00

How infrequently it seems that people find common ground across lines of religion, race and ethnicity. What do you suppose drives members of our species to accentuate the differences? To build walls and fight off whoever is on the “other side”.

Is this a recessive trait of primitive tribalism where the other is presumed to be taboo and a threat to our totems and our ancestors?

Even in the 21st century the fault lines within humanity are many and active: Tibet and China, Israel and Palestine, Christian and Muslim, Sunni and Shi’a, Basques and Spaniards. In the United States we have cultural trench warfare between the Blue states and the Red states. Muslim immigrants in France, many excellent speakers of French, don’t feel welcome in the land of liberty, equality and fraternity. Barach Obama’s candidacy for president in the United States only highlights the pervasive power of racism there for over 200 years. Jesus had a parable about the “good” Samaritan to set before us the issue of who deserves honor is it group loyalty or individual character?

We give privileges and rights to those we like and trust, mostly people who are like us. Modern jurisprudence gave us the concept and status of “citizen” where all who lived under a common sovereign authority were considered equal and the principle of non-discrimination would apply across the board.

Now we really can’t homogenize all humanity’s different value patterns, cultures, foods, styles of dress, modes of music, languages, senses of humor. And we shouldn’t. That would be discrimination and degradation of what is precious in individual lives. Our identities as persons are bound up in our ties to small communities of kin, religion, region, clan, trade, avocation, or what-have-you.

So how can we square the circle? How do we get to non-invidious discrimination? Can we live in paradox where differences abound but, at the same time, they aren’t really so serious as grounds for fear, suspicion, rejection, alienation, prejudice, or subordination?

Isn’t it a mark of the mature human person that wisdom and good sense prevail over thoughtless stereo-typing and self-referential standards of right and wrong?

I always like a plea of Oliver Cromwell when faced with a contumacious parliament. He exploded: “Gentlemen, I beseech thee; in the bowels of Christ, consider that ye may be mistaken.”

An admirable trait taught by so many religions is self-command and humility. Religion, which ties us to that which is more important than our own daily passions, irritations, quarrels and diversions, puts in context our tendency to think that we are more important than we are, or more righteous than reality can tolerate.

This past weekend I had the good fortune to participate in a surprising seminar at the International Institute of Islamic Thought and Civilization here in Kuala Lumpur.

In the presence of a Cardinal from the Roman Catholic Church, a number of distinguished Islamic scholars discussed with great erudition and much good humor the substance of Islamic ethics. It turned out that such Islamic ethics were really not very far from some core principles of Catholic Social Teachings.

Catholic ideas about the dignity of the human, the moral obligation to use private property responsibly, the need to trust family and social and civil organizations and not subject them to an all-powerful state, and the solidarity with others that is necessary to protect and promote their dignity resonate with many points of guidance given by the Holy Qur’an.

In our discussions it turned out that Catholic social thought and Islamic social thought are not that far apart.

This is a discovery of great importance for the world. Where we can see common concerns among different faith traditions, believers in one religion need not be so resentful of those who follow a different liturgy or read a different scripture.

In fact, both Catholics and Muslims share basically the same understanding of human purpose in that both faiths see human persons as created from God’s spirit and so animated with something transcendent in order to make this a better world.

We far short of what we are intended to perform and much suffering results from our failures to be our best. But the common teaching of both Catholics and Islam that we should aspire to do our duty as God intends could become a point of mutuality and solidarity between the faithful of both religions.

Great efforts must be made to inspire and guide humanity towards a future that will demonstrate greater submission to the fact of human dignity. But those efforts are well worth making. And the sooner the better.

thoughts in the Roman Forum

2008-09-01T17:43:00.000-07:00

Last Friday and Saturday I was in Rome. Not Rome New York, but the real Rome, the original Rome, the Rome that gave us so much of Western Civilization from words like “republic” and “senate” to the traditions of the Holy Roman Catholic Church.

CRT Chair Lord Brennan and I were there to call on Jean Paul Cardinal Tauran, the president of the Pontifical Council on Inter-religious Dialogue. A member of our World Advisory Council, Theodore Cardinal McCarrick had suggested the meeting so that we might brief the Council on our very exciting and constructive work on Qur’anic guidance for good governance with scholars at the International Islamic University Malaysia.

After our call on the Cardinal, John Dalla Costa very kindly came down from Tuscany where he is writing so that we could visit and catch up. John has been very helpful to the CRT and has written wonderfully insightful books on ethics and business.

John took me to see a bronze statute of St Francis of Assizi near the Basilica of St John in the Lateran. Then we went to walk around the old Forum of Rome. John wanted to see the mural on the Arch of Titus where Roman soldiers after sacking Jerusalem are marching off with a sacred menorah. We reflected on all the sadness that has flown from that event, down to today’s bitterness, violence, and intransigence in the Holy Land.

We walked along the Via Sacra towards the Capitoline hill and stood by the Senate building. We walked where Cicero had walked and Ceasar, Pompey, Crassus, Cato, Brutus and Mark Antony too. In that building Cicero had called out Catiline and delivered his damning speeches on Antony’s brutal vulgarity and excessively covetous ambition.

We stood where, the story goes, Ceasar’s body was burned and riots broke out seeking vengeance against his assassins.

We stood where the Roman Republic was born and where it died.

Cicero in a casual letter to his friend Atticus put his finger on the cause of death. It was July 59 BC; the Republic was not yet dead, but the political cancer of military dictatorship that would finally kill it was already metastasizing among the Romans. Cicero in writing to Atticus pointed to a cultural change that opened the door to the growth of that cancer. He said that Romans were still free in their thoughts and words to criticize abuses of power, but that their “virtue was in chain” – virtutem adligatatem.

They had lost efficacious will and the resolve to stand up and do what needed to be done. The energy nourishing civic virtue was evaporating.

Loss of virtue is a disease of our time as well. The WTO can’t get agreement on elimination subsidies for agriculture; the G8 leaders can’t act on global warming; the EU is powerless in front of Russia’s hegemony over Abkazia and South Ossetia. Financial intermediaries have given us another round of turmoil, losses, and crisis in global credit markets.

Lord Brennan said to me in Rome that the developed world seems overcome by greed and the developing world by corruption.

So, how do we invigorate civic virtue? How do we keep our own personal virtue “unchained”?

The Caux Round Table can only succeed in a world where such virtue counts for something. Interest and material prosperity can only go so far as moral causes and they must, by the nature of their superficiality, fall short of giving us a foundation for genuine leadership.

Rome gave me some needed clues about the source of virtue. We get it through religion.

In the Forum John and I passed the temple of Vesta, the cult of a patroness founded by Numa Pompilius, Rome’s founding king who grounded community identity and culture on something divine. Religion, a cult, liturgy, prayers, flames guarded day and night by virgins from elite families, confidence, something to value and protect – Numa set in place a complex of reassurance, motivation, guidance through the use of religious inspiration and imagery.

So too the Athenians in their heyday had the cult of Athena in the Parthenon; Hammurabi grounded his code of laws on divine inspiration. More and more examples of similar human dynamics came to my mind as I looked at the surviving ruins of Numa’s little round temple.

Later Roman religiousity sustained the theme. Walking back to my hotel, I popped in and out of several great churches, including St Peter’s. Statues and pictures of Christian martyrs glorified in these churches somehow stood out in my mind. It was their religious faith that gave them purpose, courage and sustaining willfulness. The tomb of the founder of the Jesuit order seemed another case in point on the link between faith and dedication to service.

This conclusion is far from satisfactory. Religion is divisive; it gives rise to intolerance, to obscurantism, to the eclipse of reason and common sense; it seduces us into pride and hubris that we are righteous and select – saints chosen by our God to do his or her work here on earth.

Moreover, today, conversations about religion are uncomfortable and avoided. For some good reasons, may I add. Those who need virtue in lay and secular undertakings – say, business, politics, government, journalism, academia – are more and more cut off from public affirmation of the deepest and best source of meaning and purpose. We live with disenchantment and suffer for it.

I wonder what Cicero would recommend under the circumstances? After all, his efforts to save his republic came to naught.

the cost of greedy ambitions

2008-08-11T09:45:00.001-07:00

In his play Julius Caesar, Shakespeare has Mark Antony say " They say Caesar was ambitious, and if so, it was a grievous fault. But grievously has Caesar paid for it."

Capitalism is the same way: it punishes hubris and excess sometime sin grievous ways.

The business plans of those who promoted the subprime mortgage market and the CDO derivatives using such mortgages for support did not plan for great losses or that famous CEOs would lose their positions of power and influence. Nor did they plan for a global credit crunch that would lower asset values across the board and dilute the value of then ownership in big banks and investment banking firms.

But that is what happened.

Profits came in up front, to be sure, but at a cost.

To date, the score card on business success from these financial endeavors is:

Citigroup has lost or written down US$54.6 billion - that offsets a lot of past profits - and replaced its CEO.

Merrill Lynch took a US$51.8 billion hit and replaced its CEO.

UBS took a hit of US$38.2 billion and replaced its CEO.

Wachovia replaced its CEO and took write-downs and losses of US$22 billion.

HSBC took a hit of US$ 27.4.billion. The number for Bank of America was US$21.2, for Royal Bank of Scotland US$15.2 billion, for Washington Mutual US$ 14.8 billion, and for Morgan Stanley US$14.4 billion.

And, the prices for shares of all these firms dropped some 60% on average.

These market driven results do not add up to a glorious victory for business.

when leaders fail

2008-08-07T18:52:00.001-07:00

We have just observed two significant failures by some of the most important of humanity's representatives.

First, the leaders of the G8 countries - the biggest fish in the pond of sovereign nation states - waffled on doing anything about production of greenhouse gases. Second, trade representatives from a wider array of countries failed to reach a deal on global trade in agricultural products. Movement in further liberalization of trade has come to a halt at the insistence of the Indian government on special protections for its most vulnerable farmers.

My thought is that we live in an age of modest talents on every hand. The true grit of leader-ship is only rarely found in leaders. They are skillful, to be sure, but in small, conniving ways.

Vision and principles don't seem to matter. And, therein lies a worry.

If we take for our standard, the efficacy of our leaders, then the stuff of leadership is insubstantial. Anything that works in the short run will do.

Under such conditions, why should we take seriously, say, the Caux Round Table's ethical principles for business decision-making or for governing institutions of public power?

Principles don't count; executing a public trust is for the naive and the pious, not for the big boys of money and power who alone deserve our respect and emulation. One could come to this conclusion looking at who acts on our behalf these days.

But I would counter that only principles can fill leaders with leadership. We ignore wisdom, vision, high standards, self-control and fiduciary integrity to our collective and personal loss.

people and prices

2008-08-07T18:39:00.000-07:00

Is it bad or unhelpful that people respond to prices? Low prices bring out certain behaviors, high prices others.

The high price of gas is an example. It has changed people's behaviors. When the price was at its peak a few weeks ago, over US$ a gallon, people began to steal - from gas stations and even from syphoning gas out of the tank of someone else's car during the night. The car belonged to the wife of a local sheriff and was parked overnight in the family's driveway.

And, driving by Americans is down since gas prices rose. Car buyers have switched their preferences away from SUVs to more fuel efficient cars and fuel hybrids. This change in customer values brought on by price has brought great revenue losses to General Motors and Ford.

But if we as a species were not price sensitive, would the alternative be any more constructive? Consumers would have no power in markets to discipline producers and other sellers as to product and service preferences. The consumer is price sensitive as are the sellers. Both are therefore under discipline.

When price plays no constraining role in market decision-making, irrational exuberance can set in with harmful consequences.

Further, where administrative fiat not price determines what is produced and use, there is immediate recourse to political or theological tyranny and an evaporation of human freedom and personal dignity.

So, prices give markets and capitalism a bad reputation - turning goods, services, and individual hopes and ambitions into mere commodities, stimulating greed, forcing cost cutting and job eliminations or transfers to other communities - but we would pay a moral price for not having market prices I think.

Risk aversion - the instinct to get the best out of any situation - is a trait that does advance the cause of human civilization and happiness.

mis-pricing and asset bubbles: a sad connection?

2008-08-03T19:28:00.000-07:00

A habit of mine to turn hours spent in an airplane flying great distances into something more educational than just watching movies is to read something I would not otherwise have time for - like the Memoirs of the Duc de Saint Simon for example.

As with Boswell’s Life of Johnson, Cervantes’ Don Quixote, or Lady Murasaki’s Tale of Genji, the Duc de Saint Simon’s Memoirs were long ago recommended to me as part of the foundational reading of well-educated men and women. Just recently, I saw a reference to the Duc de Saint Simon in the New York Review of Books and so, before leaving for a long flight to Cape Town, South Africa, I went to a nearby college library to borrow a volume of his memoirs to read on the trip.

On the flight, I got through volume 3 of his Memoirs. I can recommend it to anyone interested in a lively, insider’s view of the dysfunctions of French royalty in the early decades of the 18^th century.

But the work contained a surprise – insights into the financial mismanagement that from time to time, on a regular basis, overtakes market capitalism with unseemly greed followed by panic sell-offs.

We have just come through two such episodes in the United States: first the stock-market bubble of the late 1990’s centered on dot.com and telecom companies which was busted by the Enron/WorldCom/et. al. scandals, followed, second and rather quickly, by the virulent bust of the subprime mortgage market and the related market for CDO s, a financial collapse that has yet to run its course.

The asset bubble and ensuing bust swirling around the Duc de Saint Simon in 1719 and 1720 arose from selling shares in the Mississippi Company. The project was the brainchild of a Scotsman, John Law, who proposed his scheme to the Regent of France as a way to earn money for the government. Sales of the stock were very successful; share prices rose to absurd heights; millions were made by those who bought early and sold early; losses, when they came with the collapse of the company, withered the entire economy of France, coming to roost most heavily on those who could least afford the cost.

Saint Simon, a landed aristocrat, never bought shares even when pressured by his friend the Regent to take up thousands for the cash equivalent of a pretty song. Saint Simon didn’t believe in the inherent value of paper assets.

He wrote in his diary:

One day M. le Duc d’Orleans (the Regent of France during the minority of Louis XV) made an appointment to meet me at Saint-Cloud, so as to take the air after he had been working there, and we both sat on the balustrade before the Orangery, looking down the slope of the woods towards Les Goulottes (fountains). He spoke again of the Mississippi Bank, urging me to accept stock from Law. I refused once more, but he continued to press me, producing one argument after another, until at last he grew angry, saying that it was mere vanity to refuse what the King offered (all was done in his name), when so many other persons of my rank and condition urgently desired it. I said that such a refusal would be stupid and impertinent, as well as conceited, and was not my way. Therefore, as he was so pressing, I would explain my true reasons. Not since the reign of King Midas had I heard of anyone who turn all he touched into gold, and I did not think that even Law had this talent. All his ability was, I believed, no more than clever trickery, a brilliant exhibition of juggling, a robbing of Peter to pay Paul, by which some people became rich at the expense of others. Sooner or later, I declared, it would be seen for what it was; enormous numbers would be made bankrupt, and then how, and to whom, would restitution be made? I added that I abhorred the idea of touching other people’s money, and that nothing on earth could persuade me to do so now, not even at second hand.

M. le Duc d’Orleans was at a loss how to answer.

At a later point in his Memoirs as the Mississippi Company was desperately writhing in its death spiral, the Duc de Saint Simon commented:

It had become necessary to substitute something real for the mirage of the Mississippi, converting to a new trading company the Indies Bank, capable of guaranteeing the exchange of 600 million in banknotes and have profits of tobacco monopoly and numerous other vast sources of revenues, but even so it was still unable to meet the demand for payments of its notes and this despite all the measures taken to lower their value which, incidentally, had ruined great numbers of the people by reduction of their savings.

All this known as of 1719 and still we have to suffer globally from the unsustainable issuances of subprime mortgages and CDOs derived therefrom.

Why can’t this great reoccurring flaw in capital markets be permanently corrected?

Is it all because of a greed that lies forever chained to the beating heart of capitalism and, from time to time, makes financial fools of us all?

Or, as I am coming to think, is it more a question of systematic distortion of pricing under certain conditions, leading to mis-pricing that opens the door of markets to “irrational exuberance” and supporting avarice for immediate cash profits.

My argument is the following:

First, when asset bubbles occur, the strategic good sense normally encouraged by micro-economic supply and demand curves does not operate. Under conventional supply and demand interactions, the marginal utility of additional amounts of supply is worth less and less. At some point it therefore becomes unprofitable to produce more of the good or service and so supply contracts and a market equilibrium at a sustainable value is reached between demand and supply. No asset bubble occurs. There is no “irrational exuberance” driving prices ever higher and higher.

Under these circumstances, the price/supply curve slopes downward to the right on the graph where supply is the horizontal axis and price is the vertical axis.

But when asset bubbles build up, the supply curve slopes very differently. It slopes upward to the right.

As price increases, so does supply, without any deterrent effect set in motion by declining marginal utility of additional units of the asset brought to market. This supply curve accurately represents the “irrational’ belief of buyers that more of the good or service deserves higher and higher prices. There is no diminishing demand curve to intersect with the supply curve at a point of sustainable equilibrium. Demand grows; supply responds; and prices keep going up. Each increment of the good or the service seems to have added value attached to it, at least in the eyes of potential buyers.

Everybody is happy; the nominal price value of the asset class keeps growing higher and higher as more and more assets are brought to market to enjoy higher and higher returns – like shares in the Mississippi Company or, in the subprime mortgage bubble, new houses built to take advantage of easy credit. There is no regulation of self-interest by price that cautions producers to keep more product off the market. There is no automatic governor on the engine to keep it from spinning out of control.

Markets for contract rights – shares, loans, mortgages, CDOs – are especially susceptible to such upward sloping supply curves. As prices paid by willing investors rise, more opportunities to buy the contracts are brought to market by creative sellers. Each additional opportunity to invest in these promises for future returns continues to have the same (or greater) utility to buyers than the previous opportunity. The marginal cost of bringing more contracts to the market is almost zero –mostly payment for secretarial formalisms. It was thus very easy for John Law and his Mississippi Company to issue more shares; very easy for Enron to create more special purpose entities with which to manage reported earnings, and very easy for banks to issue both more sub-prime mortgages and CDOs.

But rising prices for assets can only be supported by rising supplies of money with which to buy them. Here is where the price of credit seems to become dysfunctional. In a bubble, as the price of the asset rises, the supply of credit expands as well. Another supply curve sloping upward to the right. Under conditions of “irrational exuberance” official bank interest rates do not rise with the amount of credit being made available as you would think. More and more credit is made available to buyers when bubbles are growing. The buyers, using mostly borrowed money, pass the resulting cash on to sellers.

The dynamic expanding the supply of credit for subprime mortgages was the proliferation of CDO sales. Global capital markets bought up CDOs and the cash from those sales was passed back to the originators of subprime mortgages, who then lent the money out on more subprime mortgages, which kept buyers in the market for houses at ever rising prices.

In the dot.com/telecom bubble, stock prices had been kept high by the arrival of day-traders in the market, using their equity plus borrowed funds to take advantage of rising prices for stocks.

As the risk/return tradeoff inherent in the extension of credit would have it, you would think, that as more and more credit is extended, the most reliable debtors would be taken care of first, so that later extensions of credit should carry more risk, and therefore be harder to sell. One might say that the marginal utility of additional credit carries higher and higher risk for the usefulness of the money lent.

The market for credit should stabilize at the point where investors providing new credits at the margins where new lending is offered and accepted begin to question if the returns and the security they are promised will support the risks they are to undertake. At that point of decreasing returns to credit, lending investors will demand so much for use of their money, that providers of the underlying assets will balk at the price demanded for credit and the market will slowly stabilize around sustainable prices of assets.

But in bubble environments, pricing does not reliably lead to sustainable asset valuations. Rising prices bring on speculation and then growing speculation brings on yet higher prices until buyer’s remorse finally sets in at the margin, new supply is not taken up, and the market suddenly collapses.

Normally as the supply of credit expands, the price charged for increments of credit rises. The normal curve here is one sloping upward to the right. But when an asset bubble is underway, the curve is more flat; as the supply of credit expands, the price for credit does not rise substantially. Credit becomes, relatively speaking, cheaper than it should be. The gap between the thoughtful price for credit (high) and the actual price for credit (low) exposes the market to risk of future collapse.

One reason for this odd pricing of credit is the financial security seemingly provided by rising asset prices. The nominal higher and higher values of the asset offered for sale by the bubble market provide a vision of security protecting the money borrowed to own the asset. The owner/borrower feels confident that he or she can sell the asset at a moment’s notice to repay the debt and the investor/lender feels confident that the asset can be acquired from the owner and sold if necessary to repay the debt.

But when the market collapses, asset values collapse and the credit appears in truth as having been essentially unsecured. It has long been said prudentially that lending too much money to an enterprise makes one take the risks of an equity investor – in for a dollar of risk as well as for the actual dime lent on security.

As asset bubbles expand, another gap in prices emerges to undermine the sustainability of nominal asset values. Under thoughtful analysis, the value of an asset should stay reasonably steady or decline some as more and more assets are brought to market. The value/supply curve is then largely level or sloping downward to the right. This assessment of value is largely sustainable.

But, in a bubble, the value of the asset rises and rises ever higher as more and more assets

come to market. The value/supply curve slopes upward to the right. The growing divergence between the thoughtful curve and the “irrationally exuberant” curve is the gap between sustainability (thoughtful valuations) and collapse (irrational valuations). At some point, the gap between the two valuations becomes so large that it can’t be ignored. Upon the discovery that “irrational” valuations are at risk, nominal asset prices start to drop towards the level of sustainability and the market collapses.

Mis-pricing drives financial markets first to excess and then to collapse. Greed may sustain the mis-pricing and its resulting bubble, but mis-pricing gives to greed its sometime power to trump thoughtful analysis of risk and sound valuations.

Discouraging mis-pricing of both assets and credit would seem to be essential to improving the level of economic justice provided by free capital markets to all participants, but especially to the less well capitalized ones.

If we could better understand the mechanics of how mis-pricing begins in any cycle of excessive accumulation of assets, especially the contract right assets favored by financial markets, we might be able to better eliminate such erroneous pricing signals. Better pricing would tip the odds away from speculators towards genuine value investors.

Two factors, it seems to me, contribute to the onset and the maintenance of mis-pricing.

First is the fact that most providers of contract rights (equity securities, debt obligations, derivatives, etc.) take a fee out of the deal on the sale of the right and leave town so to speak. They have no incentive to price accurately for the sustainable long run. They price to sell in the market at the time. They feed speculation and they feed off of speculation.

Second, and related to the way in which originators of contract rights get paid, is the fact that those who originate contracts rights to sell in financial markets very frequently assume no long-term ownership risk for sustaining the value of the asset. These originators do not retain an interest either in the tradable contract right sold to investors or in the underlying asset, if there is one, which supports the right to future income that is sold to the investor via the contract.

If the fees charged for selling contract rights became less and less profitable as the market for such securities grew, or if ownership responsibilities became more and more unavoidable as the risk of market collapse accumulates, then market-wise, enlightened self-interest would find ways to dampen speculation and to protect asset values.

Ubuntu - what is community, really?

2008-07-20T19:03:00.000-07:00

It is Friday July 19^th, 2008, and Nelson Mandela’s 90^th birthday. I am in Cape Town, South Africa, and can see from my hotel Robben Island where Mandela spent 27 years in prison.

His crime: opposing a regime using the powers of a police state to impose an ideology. Ideology is conformist; it is communal righteousness that can brook no challenge from independent thought or mere personal whim. Certain truths apparently so brittle that they can’t survive a rough passage through the storms of human needs, passions and perceptions.

Mandela had a more indefatigable truth than the white Afrikaners did. He rose above communalism and racism – and the feelings arising from 27 years in prison – to lead South Africa away from a dark past.

Here among Mandela’s people – the Xhosa – the cultural frame for building community is “ubuntu”. The Cape Town paper this morning printed an essay from a journalist who visited Mandela’s home village, one rather isolated among hills and fields that was restful and open to the play of natural powers. “Ubuntu” thrives in such villages where you are what your surroundings make you. Expressed in you are others – ancestors, parents, friends, drumbeats, ceremonial honors, childhood games and hard work.

I had come to Cape Town for the quadrennial meeting of the International Society for Business, Economy and Ethics (ISBEE). Several of the scholarly paper presentations that caught my attention discussed African philosophy and ethical traditions. “Ubuntu” was described and highlighted as an anti-dote to Western self absorption with striving and getting ahead of the Joneses.

I could see the point. But one of the presenters – an American teaching in an African business school – made another point as well. “Ubuntu” like any community ethic comes with a price. The price is some degree of stultification and conformity to what the community believes and stands for. If there is too much “we”, what role can there be for the “I”?

“Ubuntu” also leads to fragmentation and rivalries as the circumference bounding the community expands to take in new communities. The question comes quickly: with whom do I experience “Ubuntu”? Just who is part of my “we”.

“Ubuntu” outside the mind and skills of Nelson Mandela seems no check on the divisiveness of tribalism. In Rwanda the “Ubuntu” of the Hutu did not extend to the Tutsis during the genocide.

Now in South Africa, Mandela’s legacy is being challenged by more limited spheres of “ubuntu”. Mandela and his successor, Thabo Mbeki, are Xhosa. The newly elected head of their political party – the ANC – is a Zulu. This man, Zuma, has been brought to trial for corruption and also accused of rape. As I arrived in Cape Town a few days ago, the papers reported that Zuma’s new team at the head of the ANC had sacked for no apparent reason the head of the Cape Town provincial administration. And the head of the ANC youth league, a Zuma ally, had called for the “killing” of a rival party seeking more constitutional checks and balances. What is needed, it was said, was a kind of cleansing, a transformation of the old ways into new ones, power structures more authentically African. Coming under instant criticism for his policy stance, this leader quickly backtracked and said he was only talking of “eliminating” such people.

My thought is to ask in seeking an authentic “ubuntu” based regime for South Africa after Mandela, who will be on the inside and who on the outside?

The View From Mountain House

2008-07-11T08:38:00.000-07:00

In real estate the agents say that what counts is “location, location, location”. Sometimes that may be true for our understandings of the world as well. Our location can frame the path of our reflections. Consider walking along an ocean beach or setting in a mountain meadow. For many of us that context can lead to deeper, more inwardly centered, perceptions or, in a similarly restorative way, to looser flows of mental associations that lead us to more fundamental and lasting impressions of what is.

Mountain House in Caux, Switzerland, is such an influencing location. It is where the Caux Round Table started in 1986 and where, much earlier, retreats hosted in the Belle Epoch hotel perched high above Lake Laman (or to some, Lake Geneva) brought about new levels of acceptance between French and Germans, paving the way to a united Europe.

I was just there with some CRT colleagues in a retreat for scholars on Tuesday and Wednesday. They left on Wednesday night or early Thursday morning and I stayed on for a day before going to Warsaw. Thursday was a beautiful day – blue skies, a few touches of clean white clouds, warm sun- but not hot, breezes. And the view from the patio at Mountain House was magnificent; not so spectacular that you forgot yourself, but great (“magnus”) in vistas of high Alpine mountains, towns along the lake shore, the blue of the lake, and in clarity of light and perception.

And the sounds were of birds and the breezes in the leaves.

The hustle and bustle of humanity, the nitty-gritty, the details that provide cover and sustenance for the devils in our lives, were far away from consciousness. One felt a kind of open-ended, natural superiority in life. You could breathe in encouragement and breathe out doubts and anxieties, just as masters of meditation advise for our better health and well-being.

The view from Mountain House on such a day provides scope for our proper ambitions, making us once again masters of our fates and captains of our souls in a world that is conspiring to reduce us to trivia.

The view took me back to Robert Frost’s poem “Birches” which ends thusly:

Earth's the right place for love:

I don't know where it's likely to go better.

I'd like to go by climbing a birch tree~

And climb black branches up a snow-white trunk

Toward heaven, till the tree could bear no more,

But dipped its top and set me down again.

That would be good both going and coming back.

One could do worse than be a swinger of birches.

what is corporate philanthropy?

2008-06-29T10:38:00.000-07:00

The roots of the word “philanthropy” are “love” and “man”. A philanthropist, therefore, is a lover of mankind, someone who loves his fellow humans and exerts himself or herself for their wellbeing.

Philanthropy is defined by the Oxford English Dictionary as “practical benevolence towards men in general; the disposition to promote the well-being of one’s fellow-men.”

Thus, while philanthropy has taken on a general meaning of charity out of a compassionate disposition, its underlying meaning points to a much more strategic scope of endeavor.

Philanthropy in gross would encompass any action aimed at improving the well-being of humanity. Philanthropy would therefore include solving problems such as disease, lack of education, poverty, war, famine, global warming, excess consumption of natural resources, tyranny, and so on.

Corporate philanthropy would be the appropriate efforts of business to address these problems and challenges. It implies more than just making charitable donations in an effort to share wealth with the less fortunate.

Corporate philanthropy is then the responsibility of business to make our world better, even through the products and services offered for sale and the ways and means of bringing those products and services to market..

But given the primary social office of business to create wealth on a profitable and sustainable basis for the amelioration of social conditions, corporate philanthropy should have its proper role and function. Business should never seek to substitute for bad government; rather, bad governments should be changed and new, more responsible institutions of public power should take their place. Nor, on the other hand, should business assume responsibility for non-profit operations which seek to provide public or quasi-public goods that do not respond well to market incentives.

Corporate philanthropy can embrace strategic responses to the material concerns of a business’ stakeholders, bringing the demands of corporate social responsibility within its fold. The case can thus be made that corporate philanthropy is not merely optional volunteerism, unrelated to core business functions. No, corporate philanthropy is merely another way of framing the fundamental requirement of business to meet the terms of its contract with society. Under that contract, business must enhance the social capital, the human capital, and the reputational capital on which it depends for successful market performance in order to get back from society those necessary capital inputs.

Who is responsible for global warming after all?

2008-06-07T14:23:00.000-07:00

Standards of corporate social responsibility do not make business decisions any easier. In fact, they most likely complicate the decision-making process by adding on to more focused concerns for costs and prices a range of more intangible factors involving analysis of many circumstances outside the enterprise - like the future price of oil or the real demand functions of customers.

A recent article I read on global warming is a case in point. William Balgord recently wrote an op-ed commentary pointing out a link between sunspot activity and temperatures on earth.

It seems that past periods of cool temperatures on earth correlate in time with low sunspot numbers. And to the contrary, high sunspot activity leads to warmer temperatures here.

When there is weak solar activity - few solar flares sending "solar wind" to bath the earth protecting it from cosmic radiation, more cosmic rays (high energy protons) penetrate through and ionize oxygen and nitrogen molecules in our atmosphere. These ions then become nucleating sites for water vapor that so condenses into clouds. With weak sunspot activity, more clouds form on earth and reflect back more sunlight into space, cooling the earth.

In 2007 there were abnormally few sunspots. From January 2007 to January 2008, the average global temperature fell by nearly 1 degree fahrenheit. Rare snowfalls struck Buenos Aires, Cape Town, and Sydney. China was hit by a huge blizzard. Floe ice spread in the Arctic Ocean into the Bering Strait.

The inference for corporate social responsibility of all this would seem to be that, if sunspots are a major determinant of earthly warming and cooling, what is business to do about that? And, how much effort should be made to reduce emissions of green house gases from the factories and usages of human civilization in order to prevent global warming?

From whom should business learn how best to consider its long-term self interest upon the whole set of material considerations impinging on its prospects for success or failure?