The Battle for the Soul of Capitalism by John C. Bogle (Yale University Press, 260 pages, $25.00)
The stock market collapse of 2000-2001 was the most serious since the crash of 1929. But unlike the earlier Great Crash, the recent one led neither to a general depression nor to a wider indictment of laissez-faire capitalism. Given the continuing commitment of both political parties to largely deregulated financial markets, Congress responded with the most modest of reforms, the Sarbanes-Oxley Act -- and that only thanks to the grotesque self-immolation of Enron.
Today, many of the abuses that led to the stock meltdown are reappearing. Insiders continue to reap fortunes at the expense of small investors. Conflicts of interest pervade financial markets.
One way to view the crash of 2000-2001 is as a failure of what social scientists call the principal-agent relationship. In this case, the principals are shareholders, and the agents include accountants, lawyers, stockbrokers, underwriters, and other fiduciaries, not least of all boards of directors. The responsibility of these agents is codified in the scheme of financial regulation and disclosure created during the New Deal. In a well-functioning market, investors discipline companies by buying and selling their shares at a price that reflects accurate information. Their agents are supposed to supply that information.
In the 1980s and 1990s, however, every element of agency failed. Nominally independent auditors colluded with executives to dress up corporate books. Ostensibly fair-minded securities analysts turned out to be stock touts. Boards of directors that allegedly represented shareholders helped CEOs reap astronomical compensation packages based on manipulation of share prices. Mutual funds, rather than serving as the agents of investors, helped themselves to huge transaction fees and invariably voted their shares with management.
Behind the failure of agency was a broader failure of politics. Neither party in Congress had an appetite for policing abuses. On the contrary, Congress loosened the remaining regulatory strictures against conflicts of interest, such as the Glass-Steagall Act, which had prohibited commercial banks from underwriting or marketing securities. Congress even weakened self-regulation, making it much more difficult for individual shareholders to win lawsuits against corporations or underwriters that deliberately falsified data. Fittingly, a leading architect of that fraud-inviting law, former California Congressman Chris Cox, is now chairman of the Securities and Exchange Commission (SEC). In the 1990s, the relatively public-minded Arthur Levitt headed the SEC. But whenever Chairman Levitt tried to enact tough new regulations to deal with new abuses, a bipartisan consensus in Congress reined him in. This was less about market theory than about the sheer political power of insiders.
Investors, gulled by engineered euphoria, overpriced financial assets by several trillion dollars. When reality finally intruded, a crash was inevitable. A relatively small number of the most spectacular cases, such as Enron, grabbed most of the headlines. But if you read the financial press carefully, it was clear just how pervasive the abuses were, and still are. For instance, a list of the banks and investment banks implicated in the Wall Street scandals includes all 10 of the 10 largest -- Goldman Sachs, Morgan Stanley, Citigroup, Merrill Lynch, J.P. Morgan, and so on. Together, these worthies paid an unprecedented $1.388 billion in fines and disgorgements to settle the litigation brought by New York Attorney General Elliot Spitzer.
My immediate source for that list is John C. Bogle's indispensable The Battle for the Soul of Capitalism. Since 2000, a shelf's worth of valuable studies have appeared on the collapse and its causes. But if you have the time or inclination to read only one, read Bogle.
Not only is his book a lucid summary of all that went wrong. More important, Bogle is uniquely credible as the rare insider who knows just how the game is rigged -- and is disgusted enough to tell what he knows. In 1974, Bogle founded one of the most innovative and successful mutual fund companies, Vanguard. Since then, he has been almost alone as an insider calling for radical reforms.
Bogle is particularly good at exploring the default of the mutual funds and other large institutional investors that supposedly serve the interests of small shareholders. The ongoing scams of the mutual-fund industry -- what one Republican senator called “the world's largest skimming operation” -- have gone almost unnoticed amid the more extreme frauds. And, as usual, the scandal is what's legal.
Astonishingly, Bogle calculates that, in the absence of reforms, “more than three quarters of the cumulative financial wealth produced by stocks over an investment lifetime will be consumed by fund managers,” through fees, commissions, market-timing schemes designed to favor the house over the investor, and other hidden forms of insider compensation. From 1997 to 2002 alone, he writes, “the total revenues paid by investors to investment banking and brokerage firms exceeded $1 trillion, and payments to mutual funds exceeded $275 billion.” The quartile of mutual funds with the highest expenses (3 percent per year), he reports, paid investors a net annual return of 9 percent during the decade that ended in 2005. The lowest cost quartile paid 11.7 percent. The stock market as a whole beat the average managed fund.
As political players, the big funds are guardians of rules that favor insider enrichment, not defenders of the small investor. No mutual fund, pension fund manager, bank, or insurance company, Bogle points out, “has ever sponsored a proxy resolution that was opposed by the board of directors or management.” Nor has a single institutional investor testified on the abuse of stock options given to executives. Talk about a failure of agency.
Currently, 66 percent of all shares of stock are held by institutions and just 100 financial institutions hold more than half, so if shareholder democracy is ever going to arrive, institutions must begin serving as agents of the investors who ultimately own the assets. But don't expect that to happen any time soon. Even after the scandals and the market collapse that took trillions from their individual clients, nearly all mutual funds behave just like other financial-industry insiders. The only major exceptions are union pension funds and some large, activist public-employee funds like the California Public Employees' Retirement System.
Bogle deplores stock-option compensation as a fundamentally flawed method for aligning executive and shareholder interests and blames the big funds for tolerating it. Bonuses in the form of restricted stock, he writes, would be a good alternative. “But such sensible programs were almost never used,” he notes, “because those alternative schemes would have required corporations to count the cost as an expense.” He adds that institutional investors should “move away from their present obsession with short-term earnings of dubious validity, and toward a new obsession focused on the creation of intrinsic value over the long term.”
Bogle is appalled that the mega-rich are pulling away from everyone else. Between 1980 and 2004, he calculates, average CEO pay increased 614 percent adjusted for inflation; average worker pay rose just 7 percent. “Yet,” he writes, “the nation's stockholders still did not awaken.”
But, come to think of it, why should shareholders care about the income distribution? “Owners of the World, Unite,” is Bogle's stated credo. But, if there is one flaw in Bogle's otherwise superbly illuminating book, it is the exaggerated faith placed in shareholder democracy as a general remedy.
Just as there was much more to the excesses of the 1920s than a failure of accountability to small investors, the corruption of the 1980s and 1990s went far deeper than the disempowerment of the shareholder. Indeed, many of the worst abuses were perpetrated in the name of “maximizing shareholder value.” The deeper problem was a political failure to hold financial markets and corporations accountable to society as a whole, not just to investors.
The remedies of the New Deal era likewise went far beyond the SEC schema of greater transparency. And a reform of contemporary capitalism would entail much more than a revolt of investors. In the 1930s, Congress gave us not just disclosure, but a far broader strategy to limit the political power of concentrated wealth, to rein in financial conflicts of interest, to appropriate social outlay to complement and constrain private capital, and to assist the fledgling labor movement. The need was to create multiple political and economic counterweights against the abuses of laissez faire and concentrated financial power, not just to liberate shareholders. It is hardly accidental that the only public-minded pension funds are those representing those same countervailing institutions -- namely unions and public employees.
In our own era, there has been a broad political failure to connect these several dots. The deregulation of financial markets, which in turn invited the Wall Street scandals, is of a piece with the weakening of the public sector and the labor movement. At bottom, this is a political failure reflecting corporate inroads deep into the Democratic Party. As a consequence, few liberal leaders cogently tell this broader story; reform is partial and feeble; and there are too few countervailing institutions to offset the concentrated political power of the financial industry.
“The market needs a place,” wrote the moderately liberal economist Arthur Okun, “and the market needs to be kept in its place.” This is not the same as calling for shareholder democracy, which is, in the end, a call for more perfect markets. Keeping markets in general and financial markets in particular in their places requires a political movement, one whose center-left party does not take its economic policies from Democratic investment bankers whose self-interests scarcely differ from Republican ones.
Even as Bogle places his hopes on expanded shareholder power, he well appreciates the necessary role of public regulation. His manifesto includes several regulatory reforms to limit stock-option compensation, give more power to non-management directors, impose tighter regulation on mutual-fund governance, and prohibit a broad range of conflicts of interest. He favors far stronger federal or state regulation of corporations and is even sympathetic to the principles of the Glass-Steagall Act.
Just as the Global Sullivan Principles of the 1980s used consumer and investor leverage, prodding U.S. corporations to push South Africa to end apartheid, we need a set of Bogle Principles. Big fiduciary institutions that signed the principles would become instruments of reform, not agents of insider enrichment. Smart investors would patronize only mutual funds that subscribed to these principles and that used their own behavior and lobbying muscle to carry them out.
Bogle, needless to say, is about as welcome in today's mutual-fund industry as Spitzer. And one has to wonder, why is he so alone? American capitalism was rescued in the 1930s not just by ordinary citizens on the march but also by a generation of splendid class traitors, people of means who recognized the larger stakes. Today, reformist patricians are almost totally AWOL. Bogle reminds us what they could do.