EVER INCREASING PROFITS

A post in naked capitalism: "Why Did Bankers Behave So Badly?" offer up the following:

The real question is why did management fail to do a better job of reining in the aggression of traders? The nature of traders has not changed since, say, the early 1980s; what changed is the willingness of management to rein them in. That fell due the the fact that the industry went from private partnerships with unlimited liability to public corporations. As long as what the traders did appeared †o be profitable, management benefited too, since larger trading desk profits also meant larger bonuses for the MDs overseeing them.

To chalk this up to simple "bad incentives" puts a Wizard of Oz-type veil over the problem The leadership of good firms did not take on risk and drive themselves into what would have been bankruptcy en mass (would even Goldman have made it without the Fed's various interventions, including all the special facilities and the interest rate cuts at critical moments? Doubtful). The "bad incentives" turn of phrase, while narrowly correct, does not put blame where blame was due. The industry's leadership designed the compensation schemes; they were not visited upon them by a mysterious outside force.

I think the most important part of the first paragraph is that part about industry moving from private partnerships to public corporations. In fact, this change, and the huge increases in the the number of people owning stocks through mutual funds, may be a major cause of most of the finance related problems we are now facing.

In the bygone past, say 30 years ago, the decision makers had large stakes in the companies they owned, brought years of experience to the table and understood that there are up times and down times and decisions had to be made to account for both. Now, while the decision makers may hold large stakes in the form of stocks and stock options, and while they may have lots of experience, they are subject to the unbelievably huge weight of the stockholder's will. Why unbelievably huge? Because the advent of the mutual fund and similar groupings and resales of financial instruments has created tens of millions of new and inexperienced stockholders. It has also created layer upon layer of brokers and fund managers and firms, all of whom are looking for not just a profit but a profit the gets bigger each year.

So how did this change in ownership contribute to our current financial mess? The decision makers stopped doing what was right for the company and started doing what was right for the stockholders. I know, that sounds like nonsense. Aren't both interests the same? Well no, they aren't.

The new and greatly expanded population of stockholders, as stated above, want their ever increasing profits from a mass of companies. They may, and do, own only fractional shares of actual companies. And those companies are constantly changing as the fund managers seek to maximize the funds profits. The best interests of each individual company may not always be maximum profit in this quarter or the next. Maybe a slowing of growth is needed to allow supply chains to catch up to sales is the best thing to do. But, since the company decision makers measure their success by how well the stock is doing on a day to day basis, they start to make decisions that are both short term and short sighted. They don't slow down to allow the catch up. They don't want Wall Street to start having doubts. They zig when maybe they should zag, all the time driven by the stock ticker. They begin to take greater and ever greater risks. The result, price bubbles and the eventual bursting of those bubbles.

As I see it, this problem is systemic. It is a part of our basic economy now and effects most industries to a greater or lesser degree. Look at drug companies, for example. They put their R & D money into developing high profit drugs that can be sold to the largest number of people. They spend millions on directly advertising those drugs to the end users, even though those end users can't buy the product without a prescription. One result is the Bush era Prescription Drug benefit, which by itself, could lead to the country going broke in the next 15 or 20 years. The drug companies aren't going to make much money in that future, but hey, the stockholders will do great in the short term.

Or take a national franchise like McDonalds. The decision makers will send down to the franchisees a new sandwich that has a high cost to make, in either labor, raw materials or both, because Wall Street will look kindly upon MCD stock and the stock price will go up. Never mind that franchisees will suffer loses that could result in restaurants being closed and thus lower the number of units sending money up to the company in the long run. The stockholders (that is the fund managers and brokers) don't look at the long term.

What's the bottom line, then? I don't know if the mutual fund/mass ownership genie can be stuffed back in the bottle. I do know that the bailouts already done, in process, and yet to come seem to address the problem from the top down, thus continuing to feed the appetite for more and bigger profits at the expense of long term corporate health. But what do I know. I'm just a curmudgeon with a blog.