Guardians and Private Profit

Classical economics defends profit on a variety of grounds: some logical, some intuitive. Most arguments, however, are based on wishful thinking about how people should behave in a world of imperfect markets and passive worker-consumers.

Traditionally, profit implies economy. You can’t have a surplus of anything, including money, until what comes in exceeds what goes out. This is a polite way of saying that profit only occurs when the buyer pays “too much” for a service or commodity: the price exceeds the sum of all costs that went into providing it, including the cost of capital. If profit is “normal”–that is, if it is not so high that it drives buyers away but is still high enough to keep producers in that business–the economy “gets by” in that particular market. It lurches from one state of equilibrium to another, as prices asked and quantities demanded fluctuate–depending on changing tastes, the cost and availability of labor and raw materials, contributions from new technology, the number of new firms entering the market, and so on. What doesn’t change (or changes by only a small amount) is the seller’s markup: typically, a modest percentage of total cost. This markup, or profit, allows the company to reward certain stakeholders whose compensation is not a usual or necessary element of total cost, such as dividends to shareholders.

Unfortunately, mature markets tend eventually toward oligopoly or monopoly. In these real-world markets, “normal” profit is too low because it forces firms to concentrate on minimizing costs, which is hard to do when workers demand higher wages, managers want bigger salaries and bonuses, suppliers increase their prices, taxes and regulatory expenses rise, and investors and lenders seek higher returns. It’s much easier–and more rewarding to all concerned–for private guardians to create market conditions that support higher-than-normal profits.

One way to do this is to minimize competition with the help of regulatory guardians, who can raise legal barriers to market entry, creating an environment that favors established firms. Another is with the cooperation of financial guardians, such as institutional investors and big lenders, who can grant favorable terms to established firms (the larger, the better) and make the economic cost of entry so high that it discourages new competitors. While steps like these may enhance the firm’s bottom-line, they tend to drive up prices and limit consumer choices–not what free markets are supposed to be about.

Even worse, greater-than-normal profits take money out of the hands of buyers, who may have better uses for it (including savings, investment, or spending in other areas) and concentrates it in the hands of guardians who, insulated from competitive forces, have fewer incentives to manage it wisely. Even sellers in this supposedly advantageous position eventually find their options limited, since they are hesitant to risk their current, predictable high return by investing in new products–another traditional use for profits. As resources continue to be misallocated to these less-competitive, bloated firms, new products and new markets fail to materialize, and the whole economy gradually becomes worse off. In short, what begins as a dream come true for one firm or industry becomes a nightmare for everybody. If the common good, in this case, is more, better, and less expensive products for more people, it is unlikely that the production, pricing, and political decisions that led to an oligopolized or monopolized market would have been made by the community at large.

A second argument for private profit is that economic surplus is the engine that drives social progress. After all, society is better off when unprofitable firms fail, reallocating resources to firms that will use them more efficiently and please more customers. And public sector guardians can always use the extra income provided by taxes, which usually depend on profit. While the first part may be true in the early stages of market development, mature markets tend to stifle, not promote, competition. Profits rise not because of increased demand, better products, or more efficient use of resources, but because pricing has become inelastic. In other words, prices go up simply because they can go up without penalizing sales–at least to a point beyond which they would trigger consumer revolt and regulatory backlash. Money to pay for this extra profit must come from somewhere, and it is siphoned away from other uses to which the community might have put it. Again, it’s hard to imagine that the firm’s broadest base of stakeholders–its lenders, investors, employees, customers, suppliers, regulators, community neighbors, and so on, acting together on a consensual basis–would make the same pricing and production decisions as a handful of well-insulated corporate guardians.

Of course, this still begs the question of whether less-profitable firms deserve to fail simply because other firms, for whatever reason (including collusion with politicians and exploitation of employees and customers), manage to create a bigger surplus. Should the same rule apply to individuals, households, and families? After all, the provident often suffer along with the impecunious when a big employer downsizes or goes bankrupt. Should these bystanders (really, stakeholders) be punished because a particular firm chose not to charge its customers “too much”? Even more to the point, why should one form of inefficiency–inelastic pricing, for example–be permitted (or even facilitated by political guardians) while other kinds of inefficiency are punished, especially when the social cost of the preferred inefficiency is borne by society as a whole while its benefits are enjoyed by a few? Again, these questions are less economic than moral and social; but they’re all related to the high price we ultimately pay for guardianism.
A third rationale for private (and especially for higher-than-normal) profit is that return is, or should be, proportional to risk. An entrepreneur or property owner should be rewarded for inventing new technology, constructing new facilities, and gambling on satisfying consumer wants. Sources of capital–big lenders and institutional investors, including venture capitalists–use the same argument: that the “bets” they lose on many unsuccessful ventures must be compensated for by higher-than-normal returns on the relative handful that succeed.

On closer inspection, though, neither of these rationales holds water. Entrepreneurs do indeed take a risk when they start a new enterprise, but so do their employees, their suppliers (at least those who extend them credit), their customers (who depend on product safety and quality, availability of parts, warrantees, and customer service), and so on. Few of these people participate in the strategic decisions that guide the firm or share the super-normal profits that may result. Nonetheless they certainly are asked to share in losses should the firm become insolvent and seek court protection from its creditors–as has become a standard contingency in many modern business plans, with no stigma or shame attached.29

As to the justification of extra-normal profit for the providers of capital: the dirty little secret here is that financial backers don’t reward risk at all, they reward market advantage, which (although some risk may be associated with it initially) is something completely different, and which can be achieved in a variety of ways that have nothing to do with thrift, improving the land, or inventing a better mousetrap. For example, realizing a profit from investment in a firm that promises to make a faster computer chip involves three main contingencies: (a) that the company will actually deliver the chip; (b) that the chip will be superior to, and more price competitive than its competitors; and (c ) that computer makers will demand it in sufficient quantities to make production profitable. These outcomes are uncertain, it’s true, but the probability of any particular one occurring–and therefore the particular level of profit or loss that will go with it–can be analyzed, and investors can hedge their “bet” appropriately. What’s truly risky is trying to satisfy needs for which market probabilities are unknown–like providing health care to the poor or fielding a practical alternative to the internal combustion engine. Because the market performance of these risky ventures is unclear, capitalists generally avoid funding them, regardless of the potential social or economic benefit–factors that might be more important to a broader base of stakeholders making similar allocation decisions.

Finally, it is not the occasional, successful entrepreneur who rewards financiers and makes them whole from previous “bad bets,” it is the community–principally the firm’s customers–who pay that excess profit. Entrepreneurs are important players, to be sure, but they are not the only ones. Their privileged status–the ability to allocate resources arbitrarily and profit disproportionately from a venture’s success–comes mainly from traditional guardian rights in property, and not from anything inherent in the production process.

Again, these are primarily moral and social questions whose economic component, while important, has been given inordinate weight in a value system set up primarily to serve the interests of guardians, not their stakeholders. There is no reason to think that a more broadly based, consensual method of allocating capital to new ventures and determining (and distributing) the profit therefrom would be notably less efficient that the guardian-based system, and there are many reasons to suppose it would be a great deal fairer.

A fourth argument for extra-normal profit is that hefty surpluses permit the formation of extra capital, both human and material. That is, the more money economic guardians make (as profit, not just a return of principal) the more money they can return to the community in the form of new lending and investment, corporate charity, and improved worker benefits. While corporate altruism is not unknown and modern companies are much more aware of their social responsibilities today than in the past, there is no compelling reason why such surpluses–if buyers are otherwise willing to provide them–should be filtered first through guardian coffers. Why should corporate executives decide how that portion of market surplus earmarked as “social profit” be spent?–especially since those guardians will be tempted to use some or all of it as contributions to political guardians, as dividends to shareholders, or simply to award higher salaries, bonuses, or stock options to themselves.30 Referring to the Enron scandal of 2001, in which top executives used their guardian positions and inside information to profit from inflated stock values while many shareholders and employees lost their life saving, the Washington Post’s E.J. Dionne Jr. notes, “For a very long time, we’ve assumed that the fundamental conflict in capitalism is between owners and the workers. Enron proves that the real conflict is between insiders and outsiders. The losers in the Enron case are both stockholders and workers. This suggests a new form of politics both inside corporations and in the country as a whole.”31

The point is that while consensual decisions about the way surplus is used may result in the same distribution, a broader base of stakeholders would likely have wiser and fairer ideas about what to do with it.

Finally, guardians argue that big profits allow firms to grow faster than the growth permitted by normal profit. When it flows liberally, it nourishes all the firm’s stakeholders, from new hires and suppliers to consumers who enjoy new products as well as the government that depends on corporate and employee incomes for taxes. What guardians don’t mention is that surplus usually runs much deeper in real corporations than the number that shows up on the bottom line. In addition to huge salaries and other executive perks–from company cars and company condos to housing subsidies for CEO mansions–top executives regularly take large bonuses and stock options, all of which are accounted as corporate expenses, not as profit participation. And these are only a few of the ways the law treats these corporate queen bees differently from the drones who make the honey. Unlike individuals, who must borrow or save before they can invest, the fictitious corporate “person” can issue new equity–essentially, make the pie bigger by widening it with a rolling pin–an option just not available to real, flesh-and-blood people.

Further, guardians controlling corporate assets often create surpluses by cutting costs that do not affect them personally, sometimes increasing their own compensation as a reward for  clever “fat trimming.” In a 1997 study of executive compensation in recently downsized firms, two nonpartisan research groups discovered that “layoff leaders” experienced an average increase in total compensation that was 13 percent higher than executives of firms that found other ways to reduce expenses, cut losses, or increase their profits.32 This percentage rose even higher in the year 2000, when a deepening recession caused even more big firms to “cut fat” by cutting employment. According to a Business Week survey, CEOs of the 52 major companies laying off at least 1,000 workers paid themselves on average a whopping 80 percent more than CEOs of big corporations who dealt with the downturn in other, more humane ways.33

Even when employment is not affected, well-insulated corporate guardians can use their position to prosper in the worst of times. According to U.C. Berkeley professor (and former management compensation consultant) Graef Crystal, between the mid-1970s and mid-1990s, compensation for a typical American CEO rose from 35 times to 120 times the pay of the average manufacturing worker–and this differential only increased when the comparison was extended to other industries.34 On average, a CEO in the United States can count on making 160 times what his average employee earns. Even worse, in a similar study conducted by Crystal for the United Shareholders Association, in which objective criteria were applied to normalize pay differences due to company size and performance, 521 of the 920 executives surveyed (over 56 percent) were found to be overpaid. While company size accounted for about 30 percent of this variation, performance accounted for no more than 4 percent, leaving, in Crystal’s words, “about 66 percent of the differences in CEO pay not explainable by the two things that ought to explain virtually all of the differences.”35

What does explain this discrepancy? One obvious reason is the tendency of any well-entrenched power hierarchy to serve itself first. Guardians of any kind quickly form their own society which is separate and above the demos that anoints and tolerates them. This by itself may not make profit undemocratic, but it certainly suggests that stakeholders rather than guardians would make better custodians of so potent a resource.

The advent of an integrated guardian hierarchy created another big barrier to the further merging of individual rights with property rights, and to the development of fairer, more consensual methods for allocating resources, including profits.

As capitalism matured and became more institutionalized, political choice began to resemble consumer choice, and political activity took on the color of market action. Citizen-workers weren’t expected to exert direct influence on their government. They were expected merely to “shop with their ballots” among competing candidates, who marketed themselves aggressively both to voters and to the economic guardians who became their biggest campaign contributors.

This development did nothing to increase citizen control over, or the accountability of, political guardians; but it went a long way toward commodifying the electoral process–turning campaigns into exercises in image-making, candidate-packaging, and advertising. The legislative process, too, became a marketplace where lobbyists and interest/identity groups invested in the careers of individual politicians in expectation of a promised return. It also cast the cold shadow of covert governance over the entire political economy. It assumed that political guardians were somehow as entitled to privacy in making their deals as economic guardians were in making theirs.

Gradually, this linkage became the rationale for holding government officials responsible for the overall economic health of the nation. Political guardians asked voters to evaluate their performance based on their ability to coerce or cajole big business into generating an adequate surplus. These public guardians, who had largely replaced family and church as the principal arbiters of moral standards, were now seen as the agents of prosperity as well. Grass-roots democratic input was confined mostly to special-interest lobbying and the usual tactics of the marginalized and voiceless: demonstrations, protests, strikes, and boycotts. Political micro-management, such as wage and price controls in certain industries and policing the working conditions in others, meant that big questions such as deciding just who should participate in making these decisions were ignored. As a result, guardians and their preferred groups became better off while out-of-favor groups gradually became worse off. The seamless fusion of state power with the power of property came to be seen not as an exception to long-term historical trends (such as those that produced the joint-stock company and citizen initiatives and referenda), but as the rule that made them happen.

In reality, capitalism (which always bore the faint stain of elitism) and free enterprise (which has strong, if unjustified, democratic connotations) are really two different things. Firms like competition only when they are trying to enter a new market; after that, they prefer oligopoly or monopoly–a decidedly non-competitive and unfree market situation. Investors, after all, are not motivated by risk, but the expectation of gain. Lenders, in particular, worship at the shrine of low-risk returns, using their power to ration capital to keep its “price”–interest rates and a growing variety of fees–a bit higher than necessary.

In all of this, political guardians act mainly to protect the interests of existing holders of capital, as in the infamous 1998 government-orchestrated bailout of trendy but over-extended Long-Term Capital Management by a consortium of financiers who had personal, as well as institutional, interests in the company.36 When the government finally does intervene in a monopolized market–almost always at the last possible moment and after considerable public outcry–it does not act to restore a low-friction, competitive market (a condition of more perfect competition); it relieves the current owners of property and the current suppliers of capital from any serious risk of true loss, especially the loss of their ability to command future surpluses. Typically, showcase price or operating controls are temporarily imposed, followed by the application of antitrust litigation that is so protracted that it invariably allows the offending private guardians to quietly reallocate their holdings, over time, from one area of economic concentration to another–and the cycle begins again.

If you doubt that this happens in real life, compare the breakup of AT&T in the 1980s with the post-divestiture telecommunications market ten or fifteen years later. A few big companies still provide most of the same services, and a few have added related new services, like cable television, which only increases their market power–and even the so-called Baby Bells have started to recombine. Similarly, airline deregulation of that same era did not create better, cheaper airline service for all, but resulted in a few highly competitive routes embedded within a structure of more expensive and restrictive service to everywhere else–not to mention fewer airlines and skies filled with aircraft that are demonstrably less safe, plus Draconian cuts to passenger amenities.37 In testimony to a Senate oversight committee, a Department of Transportation official confessed that after 20-years of airline deregulation, consumers generally faced higher fares and fewer choices in most areas. He attributed this to the way large airlines dominate key hub cities and hamper new carriers (aided and abetted by airport authorities) through takeoff and landing time restrictions, excessive gate leasing fees, and limiting access to certain cities from hub airports. Where price competition exists, it is used to drive smaller carriers out of business, after which fares are restored to higher levels. Look also at California’s very expensive experiment with public utility “deregulation.” Instead of unleashing market power to bring more and cheaper energy to an expanding population, it actually caused blackouts and astronomical price increases to those consumers and businesses not included on the guardian hierarchy’s list of favored companies, such as Southern California Edison, which was bailed out at taxpayers’ expense, and Pacific Gas & Electric, which consigned those assets not previously transferred to its parent holding company to the protection of bankruptcy court.38 This very avoidable crisis was caused when a consortium of energy-gobbling private guardians–steel, mining, and cement producers, as well as numerous high-tech companies, to name only a few–wanted access to the cheaper electricity available from independent producers. Using their clout with the state legislature, they forced big utilities to go out of the power production business and buy power at the independents’ prices. Inevitably, those independent producers (the notorious Enron Corporation included) used their new market power to withhold supplies and bid prices up to obscene new levels, which eventually affected ordinary citizens. Since public guardians could not let the lights go out in California, they used taxpayer money to pick up the tab–to subsidize wholesale energy purchases and, in some cases, go into the utilities business themselves.

The same sad pattern appeared in the deregulation of cable television and banks. A 2002 Consumers Union study concluded that deregulation had resulted in decreased services and increased prices in both industries. In banking, predatory lending and hidden fees drove up consumer costs well above those experienced in the regulated 1980s. In cable television, increases in monthly fees have continually exceeded the rate of inflation and viewer satisfaction, says James Guest, the organization’s president, is “bottom of the barrel.”39

  1. 29. One egregious example of this was the highly publicized bankruptcy of Pacific Gas & Electric Corporation, which gave its top executives huge raises just hours before its bankruptcy filing in 2001, triggered by the firm’s biggest loss in a hundred years. Not surprisingly, company officials defended their actions by saying such raises were “comparable to those given to executives running similar businesses.” (Lazarus, David. “PG&E Posts Worst Loss In Firm’s History,” San Francisco Chronicle, April 17, 2001.)
  2. 30. The sudden bankruptcy of Enron Corporation in December 2001 provides an egregious example of self-serving executives. These guardians made heavy donations to their political counterparts while enriching themselves at the expense of shareholders and employees–many of which lost their retirement savings–when excessive profits from the year’s energy crisis, inflated through creative accounting, allowed guardians controlling Enron’s pension fund to prevent employees from cashing out, as the executives did, before a national scandal erupted. (Coile, Zachary and Berthelsen, Christian. “Criminal investigation of Enron: Justice Dept. wants to know if energy giant fleeced investors, workers,” San Francisco Chronicle, January 10, 2002; and Yardley, Jim, Barboza, David, and Van Natta, Don. “Lay’s political savvy backfires: Insider status now under scrutiny,” New York Times (San Francisco Chronicle), February 3, 2002.)
  3. 31. Dionne, E.J. Jr. “New class politics is good for capitalism,” San Francisco Chronicle, February 22, 2002.
  4. 32. McLeod, Ramon G., “CEOs Being Rewarded for Dropping the Ax,” San Francisco Chronicle, May 1, 1997.
  5. 33. Gordon, Marcy. Associated Press. “Job-cutting CEOs had highest pay: Layoff leaders earned 80% more, study finds,” San Francisco Chronicle, September 2, 2001.
  6. 34. San Jose Mercury News, “Consultant Targets CEO Salaries,” Marin Independent Journal, December 30, 1991.
  7. 35. Gruley, Bryan Gannet News Service. “Executive Pay and Performance: It Doesn’t Add Up,” Marin Independent Journal, November 16, 1991.
  8. 36. Fraser, Andrew. Associated Press. “Firms Act as Investor, Lender: Critics say hedge fund bailout smacks of conflict of interest,” San Francisco Chronicle, October 7, 1998.
  9. 37. Dobbyn, Tim. (Reuters). “Airline Competition Has Declined, Panel Told.” San Francisco Chronicle. March 6, 1998.
  10. 38. Berthelsen, Christian. “Genesis of State’s Energy Fiasco,” San Francisco Chronicle, December 11, 2000.
  11. 39. Geewax, Marilyn. Cox News. “Deregulation not working, Consumers Union says” San Francisco Chronicle, June 11, 2002.

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