The nature of American capitalism has become part of the Republican political agenda as candidates argue about the virtues and vices of Bain Capital. This debate is fascinating from the perspective of an economist, but it has not dampened the support of the American people for the “free enterprise” system. However, I think there is a significant gap in understanding the way the world really works.
Part of the problem stems from a failure to distinguish the various phases of capitalism. The mercantilism of the 17th and 18th centuries was different from the slave based capitalism of the 18th and 19th centuries. And the industrial capitalism of the 19th and 20th centuries differs from today’s information and financial capitalism. Unfortunately, when some commentators or political figures talk about capitalism, they are actually referring to the capitalism of a bygone era.
Economic theory and the history of economic thought can improve the quality of the debate on the virtues of capitalism that is certain to continue to be a major theme of 2012. The lighting rod that attracted attention to this issue is Mitt Romney’s work at the private equity firm, Bain Capital. (Bain Capital is actually a neighbor of ours in Boston.) Like other private equity companies, Bain Capital plays an important role in the way markets work today. But let’s start with some basic principles.
The first economic principle that is relevant here is that individuals have an insatiable desire for success and its financial rewards. No matter how much wealth or income people have, they will still want to succeed and earn more. The second principle is that owners of companies seek to maximize their profits. Management has the task of maximizing shareholder value. That shareholder value comes in the form of cash flows generated by profits that increase share prices that can be converted to cash once those shares are sold.
Private equity comes into play by collecting wealth from investors and their own management team. This concentrated wealth is then focused on market opportunities that are created by firms/management that are not performing in a way to maximize shareholder value. Private equity companies offer their investors the opportunity to buy underperforming assets, convert them through better management into higher performing assets and reap the rewards of greater wealth. This usually comes through the sale of the recapitalized company.
The public relations problem that private equity companies like Bain faces usually occurs when this approach does not work, and sometimes even when it works best. In some cases, private equity comes in and reorganizes the company. Often this means cutting employment, eliminating “non-core” divisions or exploring top line growth. Even when private equity is successful, it might mean that companies are downsized, re-engineered, right-sized or otherwise transformed. There is a human cost to these actions.
In the defense of this process, in the absence of the private equity intervention, there might have been an even worse outcome for the employees and original shareholders of the company. What is most troubling from a PR perspective is that regardless of whether the outcome is positive or not, the private equity company is likely to walk away with at least some very high fees.
Economists have a concept called “moral hazard” which occurs when individuals, investors or firms have incentives to do the wrong thing, or to not care about outcomes because there are no consequences. I believe the problem with private equity is the appearance of moral hazard. They would argue that severe consequences of making bad decisions would impair their ability to attract future capital. This is true, but while they are still unlikely to lose money because of the management fees they charge on the front end, that is no substitute for the substantial financial rewards from a successful project.
There is one more economic theory relevant to this debate and that is the concept of “creative destruction.” The German economist Joseph Schumpeter argued that capitalism works because the old structures and industries are destroyed by new structures and industries. Think of how the automobile industry destroyed the horse and buggy industry, or the iPod reduced the need for the retail music store, or how the Bain Capital-financed Staples rendered the corner stationery store obsolete. It is the pursuit of greater wealth, while simultaneously providing benefits to consumers, that motivates these changes. As in all cases of change, there are positives and negatives.
As a believer that capitalism is the best method of allocating resources, these costs have to be weighed against the benefits not only to the investors in private equity, but ultimately to consumers. The great 18th century economist Adam Smith argued in the “Wealth of Nations” that the consumer is king. The question being debated in America today is whether this is still the case. It was Winston Churchill who said, “Democracy is the worst form of government, except for all those other forms that have been tried from time to time.” The same might be said for capitalism in its current form.
Fred McKinney, Ph.D., is the president and CEO of the Greater New England Minority Supplier Development Council.