Tuesday, 18 May 2010

Thought for the Week - The Global Crisis of Legitimacy

Financial panics are an important part of capitalism as are economic recessions. The system creates them and it becomes stronger because of them. Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless and rewarding the cautious. Political crises - as opposed to normal financial panics - emerge when the reckless appear to be the ones who benefit from the crisis they have caused, while the rest of society feels the repercussions. At that point, the crisis stops being financial or economic. It becomes political. The financial and economic systems are subsystems of the broader political system.

The State both invents the principle of the corporation and defines the conditions in which the corporation is able to act. The State defines the structure of risk and liabilities and assures that the laws are enforced. Emerging out of this complexity - and justifying it - is a moral regime. Poor decisions will be penalized by losses, while wise decisions are rewarded by greater wealth. Because of this, society as a whole will benefit. The entire scheme is designed to increase the general wealth of the nation.

The greatest systemic risk, therefore, is not an economic concept but a political one. The crisis occurs when it appears that the economic elite use the law to enrich themselves in ways that undermined the wealth of the nation. Put another way, the crisis occurs when it appears that the financial elite used the politico-legal structure to benefit themselves through systematically imprudent behavior while those engaged in prudent behavior were harmed, with the political elite apparently taking no action to protect the victims.

In the crisis of 2008, we saw behavior that devastated shareholder value while appearing to enrich the management - the corporation's employees. In this case, the protections given to shareholders of corporations were turned against them when they were forced to pay for the recklessness of their employees - the managers, whose interests were not aligned with shareholders. The managers in many cases profited personally through their compensation system.

Therefore, we now have a political, and economic crisis for two reasons. First, the crisis has moved beyond the boundaries of a normal economic cycle.. Second, the crisis is rooted in the political legal definitions of the distribution of corporate risk and the legally defined relations between management and shareholder. In leaving the shareholder liable for actions by management, but without giving shareholders controls to limit managerial risk taking, the problem lies not with the market but with the political system that invented and presides over corporations and allowed the debacle to occur.

This is a political crisis in that through change of law (think removal of Glass Steagal and other bank lobbyingl) the political elite allowed it to happen without thinking things through. There is even a sense with the public that the political elite together with the financial elite acted together to enable this to happen. It doesn't matter whether they did actually conspire - the impression within the public that they did is enough to undermine public confidence in the political system which in turn undermines the economic system.

The public expects elites to work to benefit themselves. But at the same time, there are limits to the behavior the public will tolerate. That limit might be defined, as the point when the wealth of the nation itself is endangered, i.e., when the system is generating outcomes that harm the nation. In extreme cases these crises can delegitimize regimes. This is not something that is confined to the United States by any means, although part of this analysis is designed to explain why the Obama administration must go after Goldman Sachs, Lehman Brothers and others both on a corporate basis and individual basis. The symbol of Goldman Sachs (and it's managers) profiting from actions that wrecked national wealth creates a crisis of confidence in the political and financial systems.

With the crisis of legitimacy still not settling down after nearly two years, the reaction of the political system is predictable. The political goal is not so much to achieve something as to create the impression that it is achieving something. Using words like 'we must never allow this to happen again' when history demonstrates that it has happened before and probably will happen again, and trooping out that other old chestnut 'Restoring Confidence'. In other words, to demonstrate that the political system is prepared to control the entities it created.