Time for retribution

We have become accustomed to hearing stories about banks behaving irresponsibly both prior to and after the great financial crisis of 2008. Regulators have often not prosecuted the banks. Instead the banks have paid "voluntary" fines without admitting any wrongdoing. Left-wing politicians have noted that the capitalist system is prone to crashes. Further, that the banking elite is unfairly taking advantage of the situation for personal gain (e.g. the Fed's low interest policy). Now, these politicians have further ammunition against capitalism: It seems that normal companies producing goods and services are also engaging in fraudulent activities. Just to list two stories that broke this week:.

• Volkswagen has installed a software defeat-device to make its diesel engine appear more environmentally friendly when it is being tested by regulators (here). Apparently the software senses movement of steering wheel, movement of the car, etc. The share price went from EUR 160 to 110 in two days - a 31% drop.
• Google charges fraudulently for advertising. European researchers uploaded videos to Google's Youtube and bought advertising using Google's Adwords. Subsequently, they let robots "watch" the videos. Youtube detected a robot, but Adwords did not detect any robot. So for each time the robot "watched" the video, Adwords charged the customer for advertising (details here). The share price hardly moved after the news broke.

There is something rotten in the state of capitalism. Gone are the days of responsible CEOs that cared about honesty. Well, that golden age never truly existed, but executives did not use to game the stock market. One recent study showed how CEOs of lagging firms manipulated earnings per share by cutting investment and spending the money repurchasing shares (here). The shameless willingness of Volkswagen and Google to deceive its customers is a consequence of bad leadership. In both cases it would have been impossible for one rouge employee to engage in fraud alone. The activities must have been sanctioned by senior management, which has been chosen by the CEO.

What many commentators are missing is the difference between companies and capitalism. That individual companies can get overly greedy is just an extension of human nature. For capitalism to function properly there has to competition, transparency, and accountability. If companies break the law or a commercial contract, there must be consequences (read retribution). Since a large portion of a company's value consists of intangible assets, the value of a misbehaving company should be substantially reduced. During the financial crisis that happened to Lehman Brothers and AIG, but not other banks. This week, the market sent a message to Volkswagen, but not to Google. (While retribution is good, the US government has a tendency to be harder on foreign companies, compared to the European Union policy. This is a problem, but much less important.)

We live in a regime with CEOs being rewarded hundreds of millions irrespective of their performance and institutional shareholders (i.e. fund managers and exchange traded funds) taking only marginal ownership responsibility. Until this is changed, capitalism can still work as long as there is final accountability in the system. Such accountability is currently being being weakened by many governments. It often pays off for companies to not adhere to laws and contracts, and then try to wiggle out of any obligation if their practices are exposed. Lobbying activities in the US help tremendously by letting members of the Congress go hard on the regulators. Where ever US policy goes, European policy follows, but with less retributive power. The "new" company Google is fairly safe in the US, but the "old" company Volkswagen is not. Lobbying in Europe is also helpful. Companies in the diesel-technology eco-system have constituted one of the largest lobbying blocks in Europe. In fact, the European Union had been aware of the defeat-devices for two years. Expect a necessary blame game, which does not result in any EU regulator being fired

Now we can understand why Volkswagen's share price tanked, while Google's share price hardly moved. The US regulator has teeth, when it is not corrupted by lobbying. The European regulator produces reports, but has no teeth. Google is important for the US economy so the US regulator stays away.

Unless the regulators take a hard stance against misbehaving companies, capitalism will suffer. If capitalism suffers we will have fewer, more fraudulent companies and more left-wing politicians wanting to resuscitate socialism. Politicians and regulators must be pro-capitalism and not pro-company. Individual companies must be forced to pay heavy fines for severe breaches of laws or contracts. Capitalism can be what Nassim Taleb called an antifragile system, i.e. a systems that becomes stronger when stressed, but only if politicians stop softening the blows. Currently, we are en route to a more fragile type of capitalism.

53 years ago, Milton Friedman made essentially the same point. His statement is as valid today as it was half a century ago. Many lesser minds deviously only remember the first half of Friedman's sentence.

There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.                                                 (Source: Capitalism and Freedom)

The capitalist society will perform better than alternative systems if companies are held responsible for their actions. However, for a capitalist society to really prosper, the owners need to take a long term perspective. Fund managers (and worse, exchange traded funds) as owners is a very bad choice, but that is another story.