Saturday, May 11, 2013

Mitt Romney and the capitalism of Bain Capital

(This was written during the run for the 2012 US Presidency between Mitt Romney and Barack Obama)

As the race for the US Presidency heats up, it is clear that Mitt Romney’s role at the private equity firm Bain Capital is going to be a major focus. Barack Obama’s campaign has been running advertisements that accuse Bain Capital and by implication Mr Romney of predatory practices such as buying companies and then stripping their assets as well as job destruction and out-sourcing of jobs overseas. The current debate centres around when most of these practices occurred and whether Mr Romney was still in charge or not. Mr Romney claims that he left before many of these adverse events occurred while a report in the Boston Globe last week suggests otherwise. This week Mr Romney is embarking on a sustained media campaign and will be giving interviews to all the major television channels talking about Bain Capital and his tenure there.

The Obama campaign’s attack on Romney’s role at Bain Capital has attracted a lot of attention and come under fire from defenders of capitalism including many prominent Democrats and supporters of Mr. Obama. Criticism of Bain Capital is being viewed as criticising the capitalist system as a whole. Nothing can be further from the truth. Debate on this issue has implications for the rest of the world not only because who becomes the next US President matters for all of us but also because success in the corporate world is often touted – elsewhere and in New Zealand - as a pre-requisite for success as a country’s leader.

It is true that the forces of competition as espoused by Adam Smith are fundamental to the success of our market system. Under this view competition leads to better decision making and greater efficiency; the firms that excel, prosper; the rest perish. But as any serious economist can tell you markets do not always deliver optimal outcomes and at times the cause of market failure is rooted in the very nature of the competition that characterizes much of contemporary economic transactions. As the Cornell University economist Robert Frank points out, a large part of modern-day competition resembles the Darwinian struggle of the animal world, where mutations that confer individual benefits can be detrimental to the group as a whole.

Frank points out the example of elephant seals. Bulls of the species often weigh as much as six thousand pounds, more than five times as much as the average female. During the mating season pairs of mature bulls engage in ferocious and bloody battles for access to females. Being larger than rivals makes it easier to prevail in battles and consequently have much larger harems with greater reproductive success. But at the same time such large bulk is a serious drawback for the bulls as a group because this makes it more difficult to escape from predators like sharks. If it was possible to reduce the size of each bull by half, everyone would be better off since it is relative and not absolute size that matters in gaining access to females and it would also make it easier to escape from predators. Similar evolutionary forces lie behind the long and colourful tails of peacocks and the large antlers on stags. They make the possessor more attractive to females but more vulnerable to predators. The quest for reproductive success becomes an escalating “arms race” which leaves everyone worse off.

How is this relevant to the work of private equity firms like Bain?  Many of the decisions that eventually led to the current global financial crisis can also be traced back to this type of Darwinian competition and the consequent jockeying for higher rank within the social hierarchy. Consider the incentives in the financial industry which was instrumental in causing the current crisis. For money managers, the larger component of their pay is bonuses rather than salary. Your bonus depends on whether your fund has a higher rate of return relative to others or whether your company’s stocks made greater gains. This provides strong incentives to invest in highly leveraged risky assets, which yield higher average returns or engage in strategies that provide a short-term boost to your company’s stock prices. But as recent events have shown such strategies designed to create short-term gains generate considerable systemic risk.

The point is that even if you are successful at making money for your shareholders, it says nothing about your ability to run a country because success as a CEO says nothing about success as a President. In fact such success says nothing about your ability to successfully handle even the economy, forget foreign affairs and the like.

In running these advertisements Obama and his team are really not asking whether Mitt Romney created jobs at Bain Capital or destroyed them as the advertisements seem to imply. That is somewhat beside the point. What they are doing is to raise questions about what Mitt Romney’s work at Bain says about Mitt Romney and his vision for the economy. Even now as we absorb JPMorgan’s loss of US $2 billion (or maybe US $6 billion!) and everything else that has gone wrong with the world financial system, Mitt Romney opposes the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), legislation that would lead to greater governmental oversight of the financial services industry, an industry known for its lack of transparency and lobbying clout.  

The issue here is what kind of capitalism does Mitt Romney and his supporters believe in? Is it the kind envisioned by Adam Smith that leads to creative destruction and the triumph of good ideas or the Darwinian one where individual success comes at the expense of the greater good? Many people – both in the US and outside – fear that Mitt Romney embodies the latter view. But the fundamental question at the heart of this debate should have as much resonance in this country as in the United States.

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