Putting Capitalism in Order

By Paul Collier - 19 November 2012
Putting Capitalism in Order

Forty years ago a British Conservative Prime Minister coined the phrase ‘the unacceptable face of capitalism’ to describe the practices of some companies. This month David Cameron, the current British Conservative Prime Minister, honourably returned to the same theme.

Like any Conservative, Cameron recognizes that good companies are essential for mass prosperity. Their core attribute is to be effective organizations, able to make ordinary people productive: government must not frustrate this process by burdensome regulation. But good companies can be menaced by bad companies as well as by bad governments. Bad companies are those with bad governance. If governments could protect good companies from this menace, they would provide a solution rather than constitute a problem. Bad corporate governance takes three salient forms.

The first type of bad governance is where the management breaches proper ethical standards of stewardship of corporate assets. In the process managers plunder their own shareholders. The global financial crisis demonstrated that such behaviour was not confined to Enron: some banks were run not just by their management but for their management, and were not effectively disciplined by their shareholders. This undermines all companies, good as well as bad, by weakening confidence in share ownership. Since the great corporate scandals of the past five years, for the first time in half-a-century the portfolios of pension funds have drastically reduced their holdings of equities to below their holdings of bonds. If this is maintained, new risk capital for good companies will dry up.

The second type of bad governance is where management wins contracts through bribery. In both the natural resource sector and the construction sector honestly-governed companies lose out to the ethically challenged. The current courageous review by the Government of Guinea of the doubtful resource contracts inherited from illegitimate times is an example of the costs bequeathed by such behaviour.

Although bribery is originated by dishonest managements, it is aided by a host of facilitators – the lawyers and bankers who assist money laundering through setting up shell companies, and opening bank accounts, for which the beneficial owner cannot be traced. These facilitators are usually not based in countries like Guinea; they are based in countries like Britain. In breaching ethical standards they undermine the reputation of their professions.

More fundamentally, corruption in contracts gives rise to a variant of Gresham’s Law: bad companies drive out good. Resource extraction is typically a long-term process. Since not all decisions can be anticipated in contracts, for these processes to be successful requires a relationship of mutual trust between government and company, such as developed over the years between the Government of Botswana and DeBeers. A fortiori, this requires ethically decent companies. The top resource extraction companies are now among the most transparent companies in the world. But the scrutiny to which they have become subject must now be extended to their smaller competitors. The European Parliament currently has the opportunity to do precisely this by passing the European equivalent of the American Cardin-Lugar Amendment.

The third type of bad governance is where the true structure of taxable profits is concealed by transfer pricing. If Starbucks sources the coffee it sells in Britain from a wholly-owned company in Lichtenstein, this is an ethical abuse of management responsibility to pay tax on profits, irrespective of whether it is technically legal. It clearly disadvantages decent, tax-paying competitors such as Costa Coffee. Transfer pricing has only recently become a major problem for OECD countries, but the poorest countries have had to suffer it for many years. As the tax authority of one small African country disarmingly put it to me ‘all the good accountants in the country work for the international companies’. The job of these technically good but ethically challenged accountants is, of course, to minimize taxable profits through transfer pricing.

In recent years these abuses of corporate governance have clearly become more pronounced. Bad companies now pose a significant threat to good companies: the flight of portfolios from equities; the diminished reputation of the private sector; the retreat of top resource-extraction companies from competition with the bad. We need good companies more than ever: their investments will be our principle escape route from stagnation. And so it is time for governments to act. No government, not even the American, can act alone. The Cardin-Lugar Amendment is currently being challenged by top American companies because they are fearful of being held to higher standards than others. Governments have to learn to cooperate: it is not ‘ours’ versus ‘theirs’, it is good versus bad.


This post first appeared at Social Europe Journal.

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