Honesty - The Best Growth Policy

My retired grandma used to narrate to me fables on trust and honesty. How does she help the economy grow?

Utopian Objective

A society with high trust and honesty

A world with good economic growth 

We trust that the shop keeper is selling good quality goods and that we can exchange it if that is not the case. We pay taxes because we trust that government will spend it to provide services for us. We trust that these economic players will be honest during the transaction.

It is easy to see how a country where there is little trust suffers economically. Normal economic activities including buying, selling and working can't be done easily. Running a business is a living nightmare! Trust enables people to do business with each other, thus creating wealth and prosperity.

But how much does trust and honesty affect economic growth?

Trust Me From The Bottom Of Your Heart...

According to an article by Forbes in 2006, trust was worth $12.4 trillion dollars ($12,400,000,000,000) in 2006 to the US! That was 99.5% of the GDP. And the US is no exception to this rule. Trust creates a good environment for investment, which is vital for long term growth. It explains the difference between the UK and Somalia, between the developed countries and poor countries.

Market psychologists Richard L Peterson and Frank Murtha once said:

'Trust is the oil in the engine of capitalism, without it, the engine seizes up'

Those of you who think they can't trust any human had better think again. Trust is at the heart of all economic and non-economic activity. Each transaction that takes place involves some degree of trust.

Capitalism can't work without trust

How Can We Increase Societal Trust?

There is no single  solution to increasing trust. Every country has different cultures, different histories, different socio-economic conditions and different education systems. For example, different measures need to be taken in Rwanda, a country which suffered a genocide in 1994 which is facing a trust deficit between the different ethnic groups. Ukraine's trust level has gone down under different reasons, i.e. the civil war that is currently going there.

This makes sense, but are these not extreme examples? It is easy to see why lack of trust is affecting these countries' economic growth. But what is not so obvious is that this problem exists in every country (with some exceptions). And by taking necessary steps, their economies' can function better.

Who Trusts the banker?        

Distrust hampers economic growth. This is a big problem today! Since the 2008 Global Financial Crisis, trust in the financial sector has reduced drastically. In fact, some surveys have shown that it is at a 50 year low. Big problem!

The financial sector depends on trust to function. Without it, why would people deposit their hard earned savings in them? If banks don't have money to lend, businesses can't invest money. This halts long term economic growth. But a trusted financial sector can produce miracles to the economy.

Improving Trust In The Financial Sector

We have learnt many mistakes from the recent crises. But unless we take steps to prevent these in the future, trust levels will not increase.

Many people have suggested that more regulations need to be put in place. I agree that regulations could be one potential solution, but it has a fundamental problem: it tries to improve social trust using politics. And politicians are not very popular when it comes to trust... that doesn't mean there shouldn't be regulations though. But there is another deeper problem, a problem which has for long been dragging down many companies: different incentives.

In my previous blog post, titled 'The Curse Of The Corporation...Aaaaah', I spoke about why the interests of company directors has been generating short term profits. The same logic can be applied to banks. The system has been devised to reward short-termism. This has greatly affected the credibility of the banks.

Following the crisis, the UK itself spent some £500 billion to 'rescue the banks.' Regulations have been introduced, bonuses have been suppressed and executives have been scrutinised....

... but trust in the financial sector has not increased. One of the biggest determinants of trust is government performance. If governments commit to reform the financial sector to make it safe, fair and efficient, trust will slowly but surely increase.

Three Steps Back

A Case For Income Distribution

Many people attack the idea of income redistribution. Milton Friedman once said, "A society that puts equality before freedom will get neither." Many people claim that higher taxes for the rich will only hamper growth since it stops them from investing money. In other words, they claim that if you want growth, you need inequality.

But research suggests that greater equality leads to greater trust, which is especially evident in Scandinavian countries. As we have seen societies with greater trust grows faster. Now I am not suggesting that we suddenly raise taxes for the rich to insane proportions and redistribute money. We need to learn to get the balance right. If government is committed to more equality, it will increase societal trust and this will be reflected in the economy.

Really, by reducing inequality, it means reducing poverty. Poverty means that individuals cannot take part in the economy. It reduces life expectancy, increases crime and reduces trust. These all negatively impact economic growth. Sadly, many governments have neglected the effect and importance of trust. But as we have seen, it is probably the most important social capital to a country. And this justifies efforts to reduce inequality.

But to what extent does government actually affect trust?

In Government We Trust

Richer countries generally have higher trust levels than poorer countries. Is this to do with money? Does higher income increase social trust? Income per capita is correlated with higher trust levels. But there is something else that plays a large part here - Quality Of Governance.

Nowadays honest government is considered to be either a joke or fiction. But there are many good examples of good, honest governments including Nordic countries like Norway and Denmark and Singapore.

In 1965, the tiny island country of Singapore gained independence. The country was poor with a GDP per capita of just $516. The country was torn with tensions between the different ethnicities. Trust between different groups was very low. Now however, it is one of the most developed countries in the world with low crime rates and high life expectancy. How was this possible?


Singapore in 1965



Singapore is now a developed country

The Singapore government under Lee Kuan Yek tried to be as efficient as possible. Even now, Singapore is known for its Quality of Governance. A honest, open government can make the difference. It has been shown that good governance can improve trust within society. If it could promote both growth and harmony between people in Singapore, it can happen any where in the world.

Hence, honesty is the best growth policy.

The Curse Of The Corporation...Aaaaah

The corporation brought about a curse on society... can we survive it? 

Utopian objectives

A world where companies focus on long term growth, not short term profit

Stakeholders are not the victims of brutal cost cutting 

The Key To Modern Capitalism

Often, very small and insignificant things have enabled humans to make great progress. For example, technological progress has allowed us to increase the productivity of workers. But another not so obvious example is: limited liability.

That small Ltd, PLC, or LLP symbolises limited liability 

In the past, someone starting a company risked everything, their wealth, property and even personal freedom. This was because owners were personally responsible for the companies debts. Anyone who was unable to pay off their companies debts could end up in a debtors' prison.

Limited liability changed all this; if a limited liability company was sued, then the plaintiffs are suing the company and not the owners or investors. Other than the value of their investment, investors are not personally liable for the companies debts.

An early steel factory - Limited liability made such investments

less risky

This concept was responsible for the industrialisation of countries. With its gradual introduction in the US and Europe over the 19th century, risk became more affordable. This led to increased investment and the emergence of large scale industries like railways, steel, chemicals and factories, all of which were the building stones of modern society. This way, limited liability is the key to modern capitalism.

The 1st Transcontinental Railway - After limited liability was
introduced, many such investments were made possible

 

Manager vs Investor Incentives

You would think that the idea of limited liability, considering its benefits would be embraced immediately. However, for many hundred years, limited liability companies have been viewed suspiciously. In fact, Adam Smith, the father of modern economics criticised the idea. Why?

In the past, company owner often used to run companies and factories on their own. But as limited liability became more widespread, it led to the separation of management and ownership. Many people, including Adam Smith, then asked the question: how can managers be trusted to handle others (investors) money?

As companies grew in size, and it became increasingly difficult for one person to own a substantial part of the company, this question was once again raised. It was argued that company managers would not work for owners but for themselves. Instead of increasing profits, managers would focus to increase sales (and thus their own prestige) and their own perks; managers would focus on large prestige projects which does not add much to the company's profit and value. Finally, in the 1980s, a solution was found.

The Dumbest Idea In The World

 

The solution was called shareholder value maximisation. Since previously manager and investor interests conflicted, the idea aimed to bring them on the same side. Under the new idea, professional managers would be rewarded based on how much money they returned to their shareholders.

This idea was first introduced by Jack Welch. And at first, it seemed to work. The amount of money returned to shareholders by companies increased rapidly.

 Value Maximisation has increased the amount of money returned to shareholders



However, the way this was achieved is a different story. There are two ways to achieve higher profits: one is to cut costs which is a short term solution and the other is to grow profits.

This increase in dividends was achieved by ruthlessly cutting jobs and holding back on investment. Increase in wages were suppressed with the threat of outsourcing and governments were forced to lower tax rates under the threat of companies relocating to other countries.

In fact, shareholder value maximisation often harms a companies long term prospects. In the past, companies spent most of their profits reinvesting and growing the company. Now, most of their profits are spent in share buybacks and dividends. And why don't the shareholders care about their own company. The truth is, even though shareholders are the owners of the company, they are least committed to the long term growth of companies.

Companies spend most of their companies on dividends and buybacks

  

Impact On Economy

 

Investment by firms have fallen in many countries

Since companies spend an insane proportion of their profits on share buybacks and dividends, investment and growth rates have fallen.

In fact, S&P 500 companies, the 500 largest companies based on market capitalisation, spent nearly $914 billion ($914,000,000,000) on share buybacks/dividends this year. This is about 95% of their earnings. Instead, this money could have been used to build factories, research new products, employee retraining or other ways that will benefit the company in the long run.

 It is however important to notice that this has happened mostly in the US and UK. Jack Welch, the one who came up with the term 'shareholder value maximisation' later called it 'the dumbest idea in the world'. In short, it has failed to do what it was suppose to help: make money.

 

Alternatives - The Google Way 

 

Many governments outside the Anglo-American companies have tried to reduce the impact of shareholders. But there is one example which really stands out to me: Google.

Before Google went private, it's founders Larry Page and Sergey Brin worried about their company losing focus on innovation and falling into the same trap as other large corporation. So they decided to retain control over their company by issuing three different types of shares: class A for regular investors and carry 1 vote each, class B shares for themselves which carry 10 votes per share and class C shares which do not carry any votes.

Nowadays, we see how Google still manages to maintain it's focus and invests in a wide range of projects, from self driving cars to wearable glasses. The company has been growing. Not only that, its shareholders have also benefited from an increase in their share value.

One of Google's current research involves self driving cars..

Many more, like Groupon, Facebook and other tech companies have also opted for dual class shares because of its benefit.

Google glasses have been called the Best Inventions Of The Year

This is only one way, there are many others like cross-shareholding, Corporate Social Responsibility etc.  But one thing is for sure...we need to replace Shareholder Value Maximisation. It will benefit employees, corporations, the economy and even shareholders. Because there is more to a company than just this: shareholders trading in stocking exchanges trying to make money as soon as possible.

What is important to them is not necessarily important to Microsoft or

it's employees

Shareholders are not interested in company's growth. Shareholder Value Maximisation harms growth, reduces long term potential and hurts stakeholders like employees and suppliers the most.

Is this really what is important for everyone?

What is it all about?

Our world has had many Utopians. Utopia means a perfect state and a utopian is one who aims to create a utopia.

A Utopian Socialist Society created by Robert Owen

We have had Plato advocate for a state run by philosopher-kings; we had the utopian socialists who tried to set up 'perfect societies'.

Plato teaching his disciples

But now, we laugh at  philosophers. Socialism has been tried and distrusted. Capitalism has once again depressed us in the form of The Great Recession and inequality.

Capitalism, Communism, Socialism, Anarchism, Imperialism.......
                                                                                                  but still no Utopia.

Which 'ism' will be next?

Which 'ism' will be next?

There probably will never be 'a perfect world'. But there can always be a better world. Any society where corruption and crime is rare, few people smoke or eat junk food, innovation is encouraged etc. is closer to a Utopian world.

And as you might have guessed, I am not going to side with any 'ism' in this blog. I am only going to be pragmatic and use a powerful tool to identify solutions to problems (big or small)...ECONOMICS.

Economics is often defined as 'the science of scarce resources'. But it is more than that. The common misconception among people is that Economics is only to do with money. But money is only ONE of the things which Economists study. I too was surprised when I learnt this.

 Economics is about human behaviour, individuals and peoples choice, society's wellbeing and a lot more also. In short, where there are humans (or aliens), there is Economics. And because of this, we can apply it to almost anything to do with humans.

About Me

I am currently in grade 10 in school. I am an Autodidact in Economics and whatever I have learnt is from books and the internet. I started this blog for many reasons...

1. It sounded fun to have an Economics blog
2. It will help me apply what I have learnt to the world
3. It will help me improve
4. It will give me a chance to hopefully teach others a little about Economics

Any feedback, comments and criticism will be welcomed. After all, one reason why I started this blog was to learn and improve.

P.S: Some of my posts will have a 'Utopian Objective' stated in the beginning like:

Utopian Objective : A world without corruption

Then, I will use data, common sense and Economics to see how we can achieve that objective realistically.