Anthony de Jasay

Greed, Need, Risk and Regulation

Anthony de Jasay*
Accusations of every kind of devilry are raining down on capitalism as never before—not that it has ever been much in popular esteem. Now it is condemned as immoral, selfish, greedy, imprudent and unstable. Its crazed pursuit of profit rides roughshod over decency, civic spirit and social justice. It produces in response to the lure of dollars, not to satisfy real needs. It generates glaring inequalities and provokes bitterness and class hatred. Last but not least, it is unable to correct its own inherent excesses.

The heat of these charges makes it urgent to understand at long last that what goes by the name of capitalism in ordinary language is a hybrid system crossbred from liberalism and social democracy, where the freedom of contract is allowed to work in some respects but is stymied in others and where perverse incentives springing from taxation and regulation are mixed with the profit motive that drives competitive markets. It is the performance of this hybrid that draws every man's hostility. But even if it were fully realised that the economy we live by is a brew of freedom and regulatory constraint, market and government, who can really tell whether it tastes bitter by too much market or too much government?

I think that much needless strife could be avoided by identifying the irreducible core content of capitalism, stripped of comic book images of the cigar-smoking moneybag with half-clad bunny girls sitting on each knee and the half-starved labourer staggering under a cruel load. Every economic system puts some labour and some capital in double harness. What distinguishes capitalism from pre-capitalist and putatively socialist systems is that in capitalism the two factors labour and capital are furnished by separate sets of persons who are linked contractually in a node together by firms. The latter are personified by entrepreneurs who may own some of the capital and bear more of the risk, or boards of managers who own little of the capital, bear little of the risk and are the agents of the owners. Some theorists consider that entrepreneurs and managers furnish a third factor of production beside labour and capital, namely organisation of the cooperation of the two other factors.

In a first rough approximation, the share of each factor in the jointly added value is the result of a bargain between each factor and the firm. An indefinite number of bargaining solutions are conceivable. However, only one equilibrium solution is plausible. Under it, the firm pays workers the marginal value-product of their labour and capital the marginal return on investment. If workers were paid less, the firm would gain by hiring more and if they were paid more, it would gain by shedding some labour. The firm is similarly incited to attract more capital if its yield exceeds its cost and to repay debt or buy back its own shares in the contrary case.

This plain yet superbly adapted balancing mechanism, driven by what its enemies are pleased to call "greed", is absent, or present only in embryonic form, in pre-capitalist systems. In idealised socialism, where all labour and all capital is owned by one single entity, "the people", the mechanism is a shadow of that under real capitalism just as prices are the shadows of real prices struck in real bargains between opposing interests of buyers and sellers.

Bearing all this in mind, I will review some of the evergreen and also some of the merely fashionable criticisms of capitalism, such as:

  1. capitalism is socially irresponsible
  2. capitalism panders to greed instead of meeting need
  3. capitalism is unstable and so the strong hand of the state must hold it on course
  4. capitalism fosters reckless risk-taking
  5. capitalism needs re-regulation to survive

My object will be to see how well the core concept itself, rather than its passing warts and blotches, stands up to the barrage of passionate attacks of our day.

1. Capitalism is socially irresponsible.

Several charges fall under this claim. One is that acting solely in response to the profit motive, the firm ignores the multitude of interested parties who are one way or another affected by its actions. They include its customers, its suppliers, the home town and all who are harmed by any externalities by which the firm spoils the environment, aesthetic and cultural values and the social climate of its community. In the language of political correctness, this is summed up in the phrase that the firm must consider its "stakeholders" and not just its shareholders.

In an owner-operated firm, a relative rarity in modern capitalism, the owner has the freedom to decide how much profit, if any, he will devote to the well being of his customers, to easing the problems of his suppliers, to community development, good works, and any other altruistic purpose beside reinvestment and his own consumption. Some of these uses of his profit may actually enhance his future profit by generating goodwill, some may flatter his vanity and some may satisfy his sense of charity. Little of this concerns the nature of capitalism. Most are moral questions which men face whether they are "capitalists" or not.

The case of the modern corporation, owned by shareholders and managed by paid managers, is totally different. The management may justify spending some of the profit, or indeed to forgo the making of some, to benefit "stakeholders" if doing so enhances future profit. But it must not do so otherwise. Doing so in order to look good or to satisfy the managers' own altruism is stealing the shareholders money and betraying their mandate. Such breaking of elementary rules of what belongs to whom is wrong even if we ignore the damage that deviation from the objective of profit maximisation will do to economic efficiency. This is a detail that the "stakeholder" argument grandly overlooks.

A somewhat different but related charge accuses the capitalist firm of social irresponsibility because profit-maximisation serves the interests of capital only but would, if it could, squeeze labour to the point of inhumanity. The apparent bias against labour is mostly an optical illusion due to the fact that adversarial bargaining over wages and conditions is highly visible, while no such adversarial bargaining surfaces in the firm's recourse to its shareholders or to the capital market. However, in reality the profit-maximising firm is unbiased toward either labour or capital. Towards either, its attitude must be one of striving to equate marginal value product to factor price, whichever of the factors it may prefer.

What does it really mean to abandon this rule of profit maximisation in favour of the sort of ostensible "social responsibility" in the shape of an employment policy that makes managers popular? Here, of course, we must deal with a pro-labour policy that goes beyond enlightened self-interest and beyond what makes workers more productive by enhancing loyalty, stability and health.

It is obvious enough that the firm makes a mistake when it underpays its employees relative to their marginal product. But what if it overpays them?—which it is supposed to do, at least occasionally if not permanently, in the name of social responsibility. It would be making a mistake as the decline and fall of General Motors testifies (though the latter overpaid and over-committed itself to future benefits not because it wanted to be socially responsible, but because its management was soft rather than greedy).

Since value added would not be increased by paying labour over the odds, the immediate effect would be its redistribution from capital to labour and a signal to the firm to reduce the labour force and also to decrease the capital it employs. The ultimate effect is difficult to predict and would depend, among many other things, on whether the firm obeyed the signal and reduced sail or not. However, the gift made to the overpaid workers would have to be paid for one way or another by the rest of society, a kind of hidden taxation its members may not recognise but may not agree to if they did. If there must be redistribution, let it be done overtly and frankly by legislation and not by falsifying the function of capitalism as a mechanism of efficient resource allocation.

2. Capitalism panders to greed instead of meeting need

In any type of organisation, the top dogs are greedy and can exploit for personal gain any latitude they can get away with. This is likely to be as true of feudal lords and party Central Committee members as of entrepreneurs and corporate executives. The blame lies not with capitalism, but with the wide range of human characters.

In reality, the grievance is that the capitalist firm responds to wants expressed by dollar bills laid on counters. The well-to-do have more dollar bills than the needy. Hence capitalism accommodates inequality.

How otherwise could need express itself? People might make periodic declarations listing their needs. The political authority could add up the lists, charging designated enterprises with producing the required quantities by using resources in labour, capital and materials provided by "society" as a whole in some fashion. Socialism that gives "to each according to his needs" must be imagined along such lines.

The sin of capitalism, then, is not so much that it panders to greed and ignores need, but that it is not socialism. If socialism were ever realised, its hopeless inefficiency at meeting needs and its unresponsiveness to wants would no doubt be blamed on its not being capitalism. Any system is liable to be censured for not being another. This is perhaps no great matter and we can live with it. The real mischief is done by asking a system to be both itself and another.

3. Capitalism is unstable and so the strong hand of the state must hold it on course

The world economy has of course never moved along on a ruler-straight course. Nothing permits us to say that its changes of direction and rhythm, some of it relatively severe and painful, have been due to its capitalist type of organisation, the less so as it exhibited some such lurches in pre-capitalist times as well. One could with equal likelihood assert that far from needing more government for running straight, the economic system is unstable precisely because it is, and has always been, a hybrid rendered unstable by incompatibilities between its contractual and its regulatory components.

Only the settled judgment of economic history can provide a plausible answer to this question, and economic historians as a whole have not yet reached a settled judgment. However, even a single economic valuable can move so as to raise strong suspicion about government interventions as a stabiliser.

Consider thrift. One factor in the vulnerability of the economy to the shock it received in the latter part of 2008 was high indebtedness. It is fair to say that its major cause was government policy. Debt interest is, but the cost of equity is not, deductible from company tax in most countries, which depresses corporate saving below what it would otherwise be. Compulsory "social" insurance and state provision for health care and old age pension weakens the precautionary motive for saving by households. Democratic politics, where the electorate likes to vote for more spending and fewer taxes raises government dissaving. Highly developed low-saving welfare states are a "soft touch" for the strongly export-oriented emerging economies, notably China and the result is a very lopsided international balance of payments and indebtedness.

Looking at other important economic variables closely enough would relieve perverse effects of government presence that may be only a little less malignant than the effect on debt. Accounting rules are one case of moot point, job-protecting regulations are another.


The Oxford English Dictionary defines "Rhenish" in the following terms:

of the Rhine and regions adjoining it. From a medieval Latin alteration of Latin "Rhenanus"... from "Rhenus" (Rhine). From an article by Stefan Vogenauer, "An Empire of Light? Learning and Lawmaking in the History of German Law" - "John Austin, having spent the winter term of 1827/28 in the idyllic and peaceful Rhenanian university town of Bonn, far away from the bustle of London and the irritating failures he had suffered at the chancery bar, was unrivalled in his admiration for the modern version of Roman law as it had been interpreted, refined and further developed by the German scholars of his time."

It is strongly asserted, particularly in Germany and France, that "Anglo-Saxon" capitalism is more unstable and socially destructive than the "Rhenanian" type prevalent in Continental Europe. The latter is less harsh, more consensual and collegial, gives management more autonomy from shareholders, and unions more influence on both management and government. Above all, it is more stable (or Krisenfest) and less vulnerable to business downturns.

Two reasons are cited. One is that European capitalism is not as "financial" or "speculative" as the American one (Great Britain counts as an honorary non-European). This reason appeals to the economically illiterate, but is mostly false, for speculation is parasitic on volatility and if at all successful, eats up some of the instability that would otherwise prevail.

The other reason for crediting "Rhenanian" economies with greater resistance to fluctuations is that they are welfare states, with public expenditure pre-empting one half or more of GDP. When private demand collapses, public demand is upheld or increased, and only less than half of GDP suffers a downturn. High-tax, high-deficit and high-spending welfare states grow more slowly in normal times, but offer stability and protection on bumpy stretches of the road.

This argument has some force, but not enough. The latest (June 2009) forecast of the OECD projects a fall of 2.8 per cent for the United States and 4.8 per cent for the eurozone in 2009. In 2010, the United States should have growth of 0.9 per cent and the Eurozone none. Unemployment figures show no less unfavourable comparisons for "Rhenanian", ungreedy, etatist capitalism.

It is not unfair to add that where state involvement in the economy has been intense, national debt as a share of GDP tends to become uncomfortably high. In such economies—France, Italy, Belgium and Greece spring to mind—the government finds its hands tied when a sharp downturn would call for strong fiscal stimulus and open-handed spending.

4. Capitalism fosters reckless risk-taking

It is not hard to fathom that the more developed is an economy, the more instruments it has that both facilitate the taking of risks and the transfer of these risks to those more willing to bear them than those who had previously taken them. Securitisation that makes debts marketable, futures trading of commodities and securities that permits both risk-taking and hedging, and derivatives that do both in turbo-charged forms, advance the technology of risk-taking as well as its least-cost distribution among potential risk-bearers. Their economic function is valuable. But is the risk-taking they facilitate really reckless, and if so, why?

Because of the recognition that owners are not necessarily the best managers and may be wise to entrust their assets to others who show expertise in the art and science of making the assets work, the principal-agent problem increasingly penetrates the capitalist economy. The problem is serious and has no ideal solution, for as the agent and the principal are typically motivated by a different set of incentives, the actions of the former will only imperfectly serve the interests of the latter. The intrinsic conflict of interest can at best be attenuated.

The main way capitalist practice found to do this is to pay corporate executives in leaving the firm bonuses and stock options that are contingent on results achieved by the executive, his team or department, or the whole corporation.

In the last couple of decades, the scale of these bonuses and options has expanded to reach levels that in many cases, particularly in banking and the law, but also in mass manufacturing and high technology, have come to be regarded by public opinion as unjustifiably excessive and indeed obscene.

This is undeniably a case of market failure. Overpayment of apparent or real executive talent and reputation is thought to exist for a variety of reasons, one of which being that the "product" is not standardised and that those who buy it, namely other corporate executives and board members, are engaged in reciprocal back-scratching. If they overpay others, others will return the favour and overpay them. The game, fuelled by both greed and vanity, leads to an absurd level of bonuses and options. Even in structurally very imperfect markets, absurdities in due course produce their own remedies. One could, for example, hazard the guess that some compensation consultants, instead of playing the game of the boards that retain them for advice, will find it more profitable to serve shareholder groups and even to ally themselves with proxy solicitors to help form such groups.

However, even if the average level of bonuses and options were eventually deflated, the bias the system imparts to recklessness would remain. It is a system of "heads I win, tails I do not lose". If results are poor, bonuses, albeit reduced, are still paid and if options do not rise in value, at least they can never fall to a negative level. It is worth taking large risks even at long odds, because the expected value of the bet will always be positive.

The obvious remedy is to stop granting options that are in fact "long" calls (that either work or expire valueless), and grant combinations of "long" calls and "short" puts (which are exercised against the holder if the outcome is negative, e.g. if his company's shares fall below the option level when it expires). The call and the put have to be accepted or rejected together. To make the option attractive while still retaining its deterrent effect against reckless risk-taking, the put may be smaller than the call and any loss it yields could be chargeable against profits on the calls but not otherwise payable. These details may be left to bargaining as long as the principle of "heads I win, tails I lose" is preserved.

5. Capitalism needs re-regulation to survive

Industry and commerce deal with property in tangible assets and the matching liabilities. Finance deals with intangible rights in property and the derivatives of such rights. The difference lies among others in the fact that tangibles cannot, but intangibles can, be created at the stroke of a pen at the will of two consenting parties. In other words, the quantity of financial assets and liabilities is in theory infinitely elastic, and is limited by one or both of two things: confidence and regulation. This is no doubt why financial regulation is treated as different in kind from any other, and why, after each crisis of confidence, it is felt to be inadequate and in urgent need of radical reform.

Let it never be forgotten, though, that the latest crisis was triggered off in August 2007 by the sudden recognition that with US real estate prices on the decline, "subprime" mortgages of about $600 billion were no longer worth their nominal values. This was a paltry sum for a major banking system. It should have been shrugged off with a pained grimace and a reasonable fraction of it written off. Instead, voices of highly placed authorities, including the head of the IMF and Britain's Chancellor of the Exchequer, cried "Fire", a self-fulfilling prophecy by those who should have known better. A stampede started for the exit, lashed on by the media that responded naturally to the perverse incentive that panic-mongering sells more newspapers. The end result was a very nasty world recession that need not have happened.

It is tempting to think that more and cleverer regulation would have prevented this outcome. But if the Basel II solvency rules had been twice as severe as they were, many banks would still have carried liabilities of ten or more times their own capital. In an earthquake of confidence, being leveraged ten times is just as bad as twenty or thirty. The most draconian regulation cannot remove risk from leverage, and removing leverage altogether would be to put the economy back in the Dark Ages.

Financial innovation can produce quirks that make the desire for more regulation excusable enough. Credit default swaps (CDS) are very clever insurance instruments. However, they permit any number of parties to insure the same credit against default. A loan or bond of $10 million may well be insured a hundred times for a total of $1 billion. Grave conflicts of interest could arise. Sooner or later, the free market would have developed remedies by organising an exchange that imposed collateral to limit counterparty risk and would have provided information on "open interest". But it is understandable that a nervous public wants regulation at once.

Regulation can at best be imperfect and cannot help being a drag on the economy's growth potential even if it were capable of protecting it from shocks. Its great vice is that it is a fount of illusions, making people believe that if a thing is regulated, one need not handle it with care.

Thus in conclusion, the above review of common criticisms of capitalism—that it is socially irresponsible, that it panders to greed not need, that it is inherently unstable and needs to be regulated by government, that it fosters reckless risk-taking, and that it needs to be re-regulated by government to survive—must be viewed in the present-day context that what goes by the name of capitalism in ordinary language is a hybrid system crossbred from liberalism and social democracy. It is not therefore surprising that the performance of this hybrid draws criticism from every direction. But even if it were better realised by commentators and regulators alike, that the economy we live in is a potent brew of freedom and regulatory constraint, market and government, who can really tell whether it tastes bitter because of too much market or too much government?

* Anthony de Jasay is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State (Oxford, 1985), Social Contract, Free Ride (Oxford 1989) and Against Politics (London,1997). His latest book, Justice and Its Surroundings, was published by Liberty Fund in the summer of 2002.

The State is also available online on this website.

For more articles by Anthony de Jasay, see the Archive.
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