Thursday, June 24, 2010

Toward Sustainable Capitalism

In today's (6/24/2010) Wall Street Journal Al Gore says the following:There are several well understood advantages inherent in capitalism that make it superior to any other system for organizing economic activity. It has proven to be far more efficient in the allocation of resources and the matching of supply with demand, far more effective at wealth creation, and far more conducive to high levels of freedom and political self-governance. At the most basic level, however, capitalism has become the world's economic ideology of choice primarily because it demonstrably unlocks a higher fraction of the human potential with ubiquitous organic incentives that reward hard work, ingenuity and innovation.

For these reasons and others, markets lie at the foundation of every successful economy. Yet the recent crisis in global markets (following other significant market dislocations in 1994, 1997, 1998 and in 2000-2001), has shaken the world's confidence in the way modern capitalism is now operating.

Moreover, glaring and worsening systemic failures—such as growing income inequality, high levels of unemployment, public and private indebtedness, chronic under-investment in education and public health, persistent extreme poverty in developing nations and, most importantly, the reckless inattention to the worsening climate crisis—are among the factors that have led many to ask: What type of capitalism will maximize sustainable economic growth? At the very least, the last decade has clearly demonstrated that free and unfettered markets, as they are currently operating, have simply not been delivering optimal long-term results.

The last sentence "At the very least..." telling us that free and unfettered markets do not work or have not been working. This is such a silly statement -- when and where have we seen "free and unfettered markets"? The financial markets are highly regulated and the problems that have arisen there during the past decade all stem from government, not free markets. The oil market is highly regulated. The BP oil disaster is the only such event in hundreds of thousands of wells. Morever, as stated in previous posts, BP was drilling 50 miles out to sea because of government restrictions and a liability cap of $75 million implemented by government.

Gore goes on to define the type of capitalism he supports:

Sustainable capitalism seeks to maximize long-term value creation. It explicitly integrates environmental, social and governance (ESG) factors into strategy, the measurement of outputs, and the assessment of both risks and opportunities. Sustainable capitalism challenges us to generate financial return in a long-term and responsible manner.

He proposes to get to sustainable capitalism by the proper use of incentives.

Incentive structures should also reflect more complete measures of performance. For example, increasingly, best practice companies are explicitly including environmental sustainability, customer satisfaction, employee morale and workplace safety in their incentive schemes. These companies understand that these considerations drive long-term financial performance. We also feel strongly that if asset owners want their asset managers to consider ESG factors in investment decisions, then they should include these factors in evaluating, measuring and rewarding performance.

What Gore is proposing is often called corporate social responsibility or CSR. CSR refers to the idea that firms have a responsibility to anyone affected by the firms’ actions, its stakeholders, rather than just its shareholders. CSR has become such an important political entity that may firms attempt to use their expenditures on the stakeholders as good business strategy. What follows are CSR reports taken from the annual reports of three large U.S. companies.

Starbucks -- Doing Business in a Different Way Contributing positively to our communities and environment is so important to Starbucks that it’s one of the six guiding principles of our mission statement. We work together on a daily basis with partners (employees), suppliers and farmers to help create a more sustainable approach to high-quality coffee production, to help build stronger local communities, to minimize our environmental footprint and to be responsive to our customers’ health and wellness needs.

FedEx -- FedEx cares about the communities in which we live and work. We are dedicated to effective corporate citizenship, leading the way in charitable giving, corporate governance and a commitment to the environment.

Gap -- At Gap Inc., we believe we should go beyond the basics of ethical business practices and embrace our responsibility to people and to the planet. We believe this brings sustained, collective value to our shareholders, our employees, our customers and society

A manager has to make all decisions so as to increase the long run market value of the firm, that is, the sum of the value of all financial claims on the firm, or else the manager will be replaced. If a firm creates an output that consumers value more than they value the inputs that went into creating that output, then society has gained from the output and the company earns profits.

Firms have to respond to whatever issues consumers think are important and are willing to allocate their resources to. It must entice consumers to purchase its goods and services. If a firm is viewed as unethical or a bad citizen, and consumers refuse to do business with the firm as a result, then the firm has to change its ways or go out of business. If consumers think an action deserves to have resources allocated to it and are willing to pay for that allocation, the company responds. A company’s resources have to be managed in such a way as to make them worth more than they would be if managed in any other way or by any other firm. In other words, a firm must maximize the value it adds to resources. If it does not, the resources will be reallocated to other, more valuable uses. A firm has to first and foremost pay attention to its shareholders. If allocating resources to the environment or to income equality or whatever increases the value of the firm then that is where resources should be allocated. But, if such an allocationg reduces the value of the firm, then the firm is being told that the allocation is a cost to society.

In a free market, managers have to respond to all stakeholders in the following way: spend an additional dollar of resources to satisfy the desires of each constituency as long as consumers value the result at more than a dollar. Coercing firms to allocate resources to certain unprofitable activities is a cost to society not a benefit. Sustainable capitalism should be defined as the freest and most unfettered markets possible.

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