Putting restraints on "killer capitalism"

Lawrence Mitchell, a professor at the George Washington University Law School and author of The Speculation Economy: How Finance Triumphed Over Industry, offers a practical suggestion on how the short-term, quarterly pressures on corporate earnings that distort decision-making in a largely-destructive way, can be alleviated in The Tyranny of the Market Business Week 07/30/07 issue.

I should mention in relation to the title of this post, "killer capitalism" is a term that is sometimes used by mainstream European business publications and politicians to describe the prevailing American approach to business regulation.

In many businesses, the pressure on corporate management from the quarterly earnings' effect on their stock has had the serious effect of discouraging critical long-term investments. That's one attraction of outsourcing. Outsourcing can show short-term savings while avoiding the short-term drag on earnings from long-term investments in plant, equipment and information systems. As Mitchell describes:

Ask the 400 CFOs who in a 2005 survey revealed a consensus opinion that they would mutilate their own companies to keep stock prices high. Ask the derivatives traders and hedge fund managers who control the direction of the market by trading in instruments that have nothing to do with financing the production of goods and services and everything to do with stock price movements.

But quarterly earnings pressure is not simply an immutable fact of that legendary Invisible Hand of the market. It comes to bear in a regulatory and tax structure that's created by the government. Mitchell writes:

The only solution is to make short-term behavior costly. And if finance is the driving force of American business, then we have to build the pain into the financial markets.

It's not hard, and in fact we do it now. If you own stock for one year, you receive a deep break in the form of the federal long-term capital-gains tax. Yet though a year may be long-term for stock trading, it's not for industrial production. And since management's horizons (and much of its pay) are determined by stock prices, tax breaks for such a brief holding period don't change managers' short-term focus. (my emphasis)

And he makes a suggestion of how an alternative set of incentives could be structured:

That's why rethinking capital-gains taxation is key. Let's say experts decide that seven years is "long term" for the auto industry. Congress could structure a system imposing punitive taxes if you sell quickly (say, a tax on 90% of gains for trading within a month), then drop the taxes slowly, using a seven-year sliding scale, until you can sell a stock tax-free. Perhaps the right time period is two years in the software industry, or four years in computer hardware. It would only take a little expertise and perhaps some trial and error to get the timing right.

This revamped system would slow finance and allow managers to manage while lessening incentives for options-heavy CEOs to gut companies in order to end the year with a bigger payday. And it would reduce disincentives against spending on worker training, R&D, or better environmental controls.

Tags: lawrence mitchell, stock regulation