How Capitalism Must Change

Originally published on Jheconomics.com

The Covid-19 pandemic has exposed fundamental fault lines in the reigning business model of the past 40 years. Though financial markets have been on a Panglossian rebound the last few weeks, the longer-term implications of the crisis will be profound for the United States and the world.

Since the early 1980’s, leading corporations have shared four principal characteristics: One, an obsessive focus on shareholder value at the expense of other stakeholders, such as workers, suppliers, regulators, and society at large; two, complex global supply chains; three, just-in-time inventory; and four, reliance on market-based debt finance and de-equitization.

The model was great for shareholders, executives, and boards. Excess cash funded share buybacks, balance sheets were run as lean as possible, leverage was employed liberally, and job security was sacrificed to efficiency. Profits were optimized at the expense of resiliency.

Think Jack Welch and the GE of old. A workhorse industrial, financially engineered into a leveraged play on Wall Street, where “six sigma” became a twisted metaphor to justify morale-sapping layoffs, all in the pursuit of short-term share-price performance. Following the financial crisis, the company became a shadow of itself. Today, the Covid-19 crisis has revealed that GE’s symptoms are shared across the economy. It’s not just one company in trouble: The American business model’s vulnerabilities are being exposed.

First, a reminder of how we got here. Then, how American capitalism will change.

For over a century after the Civil War, breakthroughs in energy, medicine, telecommunications, and transportation reshaped America. The average human lifespan almost doubled and economic productivity rose dramatically. After economic growth slowed in the 1970s, voters ushered in Ronald Reagan and in subsequent partnership with Alan Greenspan’s Federal Reserve, taxes were cut, interest rates slashed and America was transformed from a country of savers to borrowers.

Financial leverage supercharged demand. Although the U.S. enjoyed a brief productivity spurt from 1995 until the early 2000’s, in truth the supply-side fantasies of Reagan (and Margaret Thatcher) were, well, fantasies. Productivity, as measured by output per hour worked, languished, despite deregulation, lower taxes, and even whiz-bang technological advances. Spending rose faster than output, with imports making up the difference.

Americans went ever deeper into debt to buy foreign-made goods. Countries exporting to the U.S., in turn, offered vendor finance by purchasing trillions of dollars of U.S. government debt. It was a Faustian bargain, because in doing so U.S. interest rates remained well below where they ought to have been, fueling even more domestic borrowing and spending.

It couldn’t last.

Though many Americans felt prosperous, the real economy—as measured by productivity growth—grew sluggishly and median wages stagnated. Meanwhile, finance went from the tail that wagged the dog to being, pretty much, the dog itself. By the eve of the financial crisis, the stock of financial assets, disproportionately owned by the wealthy, had ballooned to nearly three times the size of the real economy.

The financial crisis should have been the proverbial reset, putting the economy back on a sustainable path. But governments and policymakers could not face the political consequences of what would have been required. Bailouts had little or no conditionality; the Fed’s printing press helped to temporarily push debt burdens from the private to the public sector; and a combination of historically low interest rates and high returns on capital fueled the longest bull market in U.S. history.

The reprieve allowed the shareholder-capitalism model to reign triumphant for another decade. Meanwhile, working Americans saw limited wage growth and continued job insecurity, while the gilded age embodied by Silicon Valley and Wall Street billionaires fostered the cruel illusion that fortunes were meritocratic. Little wonder that, as the decade drew to a close, nearly half of Americans did not have enough savings to cope with an unplanned $400 expense, and were burdened by health care costs rising twice as fast as their wages.

Then came Covid-19. Our ill-prepared country’s primary response has been social isolation, with devastating economic consequences that hit working families hardest. In the last four weeks, 22 million Americans have filed for unemployment. The pillars of America’s economy are made of sand.

And, once again, large-scale government assistance is on the way. The hope is that massive fiscal transfers to support lost income and prevent widespread household and business failures will buy enough time for science to rid us of a modern-day plague.

Eventually the fog of the pandemic will dissipate. When it does, we must rebuild in a fundamentally different way — because the nation deserves better and because the old model simply does not function any more.

We have identified 10 ways that that the crisis will reshape economies, upend business models, and alter society to deliver more sustainable outcomes.

First, rescues require conditions. Business executives and corporate boards are in the midst of pleading with their stakeholders for survival, above all to the body politic. Saving jobs is essential, but workers also deserve to come back to an economy that can support them for the long haul. Bailed-out airlines must fly, even to unprofitable destinations, to ensure that essential supplies and key personal get to where they are needed. Governments that make emergency loans or grants to businesses must receive equity stakes or at least greater say in how company revenues are allocated among all stakeholders. In socializing losses, society must expect that the subsequent returns on investment accrue not only to the owners of capital.

Nor can those decisions be deferred. Executives, boards, and shareholders have the right to know, at least in broad terms, the price of society’s commitment to them, should they decide to opt for a bailout. And if policymakers do not establish conditionality when they hold the cards, a rerun of what happened a decade ago with the banks will ensue. Executives and boards will shirk social responsibility once they are back on their feet and able to recapture regulators with political and financial favors.

Second, firms will have to rethink their reliance on long supply chains. Populist backlashes against globalization and misguided acts of protectionism were already putting pressure on this strategy. The Covid-19 pandemic showed that firms reliant on far-flung suppliers are taking larger risks than they understood. Business leaders, suppliers, and workers need to engage together to bolster resilience to future pandemics, which are all-but inevitable.

Systems of production and distribution will require redundancy. Back-up plans can’t be optional. The extra investment required will not increase output, only costs. It is akin to post-9/11 security expenditures, which entailed lots of spending, almost none of which lifted productivity. As a result, running global business will arguably be less profitable—but much of the profits earned under the old model were an illusion, sustained only by an absence of risk recognition. Responsible global firms must ensure that the costs of appropriate risk management are equitably distributed among owners, workers, and suppliers. Risk management should be duly reported and captured in indices of environmental, social, and governance investing.

Third, the just-in-time inventory approach will have to change. Big banks are required to have reserve (and empty) trading floors just in case their primary locations are rendered unusable by acts of terrorism or war. Similar solutions will now be needed across the economy. Technology may eventually offer better solutions, but for now firms need to build for resiliency, not only profits.

Fourth, central banks will have to reroute their arteries of emergency lending. When the lockdowns started, firms drew on bank lines of credit and banks were marshaled into action to deliver small business loans, which in many cases will morph into outright grants. Central banks, in their role as lenders-of-last-resort, still prefer to work through institutions, where they can exert quiet but effective pressure, rather than via markets, where they can only buy assets or, in extremis, close markets. Capital markets may (or may not) distribute risk better than banks, but they generally offer cheaper and more flexible financing in normal times. In abnormal times, however, they can freeze up. Central banks and finance ministers need to rethinktheir strategy of offloading risk from the balance sheets of banks and investment banks to markets, which was the approach they took following the financial crisis. The pandemic will force financial regulators to re-examine where they prefer to see risk housed before the next crisis inevitably arrives.

Fifth, the amount of U.S. public and private sector debt will now start to matter. Once government debt exceeds the size of the economy, as is now happening in the U.S., long-term growth is typically impaired, making debt service even more challenging and future shocks more dangerous. On its current trajectory, the stock of U.S. federal government debt as a percent of GDP will likely surpass levels last seen in World War II. For the foreseeable future, negligible interest rates mean the government can service the debt. The Federal Reserve is already monetizing debt and can do so for as long as necessary, provided inflation remains subdued.

But easy money cannot be more than a temporary fix. Modern monetary theory has not invented a free lunch. At some point, debt obligations must be serviced out of rising real output. Either the economic pie grows larger, ensuring sustainable debt service and eventual debt reduction, or a larger share of the pie must be devoted to paying off debt. Repudiation of national debt is theoretically possible, but it is not practical given the costs it imposes on the holders of debt (foreign and domestic), the global financial and payments systems, and on future generations via default premiums.

Growing the pie is, by far, the best outcome. But it requires big changes in public and private sector behavior to ensure that long-term productivity is boosted in ways compatible with financial, social and environmental sustainability.

Sixth, CEOs should make less money. Profits will be down, buyback activity curtailed, and investor returns lower. Managers will have to make do with less. In 1965 the ratio of CEO to average employee pay for companies in the S&P 500 was 20 to 1. Today it is 278 to 1. That gross absurdity was already under public pressure before the Covid-19 pandemic arrived. Going forward, bailed-out public company boards will have to reset executive compensation, an action that will ripple broadly through the private sector.

Seventh, activist investing will need to change. The typical activist playbook is to buy stock in a target company, attack its leadership, support share buybacks and special dividends by borrowing, and slash employment, all in an effort to reward the activist. In the best of times that strategy was dubious, today it is anachronistic and counterproductive. Future activists ought to promote stakeholder value by pushing for ESG principles. Large institutional investors and asset managers have belatedly begun to move in this direction. More prodding is needed to accelerate the process.

Eighth, private equity bubbles must deflate. PE has been the last holdout of excessive investment fees relative to performance. The PE business model relies on cheap debt, value-destructive mergers and acquisitions, and self-serving public auctions, all in service of PE returns rather than sustainable business planning. Hidden from public view, the portfolios of most PE firms have not yet been marked down to reflect the vast Covid-19 damage. When that happens, returns to limited partners will plunge. Governments should reject the PE industry’s requests for a bailout. There is little reason to believe society will be worse off.

Ninth, big tech will get bigger and, consequently, will attract more scrutiny. The pandemic has accelerated the brick-and-mortar retail industry’s challenges and offered a massive opportunity for market-share gains to online competitors, above all Amazon and its distribution partners. While online retailers’ ability to serve immediate needs of communities under lockdown cannot be underestimated, our gratitude must not blind us to the potential such behemoths will enjoy to exploit their market power. Antitrust powers should be revisited, and reinforced as needed.

Finally, for all the talk to the contrary, the U.S. dollar’s reserve currency status won’t be challenged, barring major policy gaffes. More than 60% of all foreign bank reserves and about 40% of the world’s debt are in U.S. dollars. As much as China might like to dent the reserve status of the dollar, the pandemic has underscored the unique position of the greenback, which has soared as investors seek its safe haven status. The value to the U.S. and the world of a stable reserve currency can hardly be overstated, which is why future U.S. administrations should restore faith abroad that the U.S. takes seriously its responsibility for sustainable global economic and financial outcomes.

Legions of Americans are doing everything they can to fight the virus. Once the immediate public-health crisis has passed, there will be tremendous temptation to go back to the old ways.  This must be rejected categorically. Healing the broken American business model will require just as much effort as we are now spending on science and public health. CEOs, economists, and central bankers won’t be celebrated like doctors or virologists, but their work will be critical, too. It’s past time to push the nation toward a more sustainable capitalism.