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The Anglo-Saxon Model of CapitalismThe American Economy: Market Capitalism

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I. Models of Capitalism• The Anglo-Saxon model

– Originated in England in the 18 century and it is patterned after the classical liberal ideas of A. Smith; uses common law, which operates with lay judges, broader legal principles, oral arguments

– Based on the principle that government intervention in the economy should be limited

– Best real-world example-USA

• The European model– Is patterned after the econ principles from the 19 century in France and

Germany that places less faith in the invisible hand and call for more state intervention in econ activity, including more state ownership

– Uses civil (roman) law, which is based on professional judges, legal codes and written records.

– Best real-world examples-France, Germany and Sweden

• The Asian model– Is closer in its institutional arrangements to the European model; it focuses on

high rates of capital formation;– Exists in variety of forms and involves a considerable amount of

experimentation – Best real-world examples-Japan, South Korea, Taiwan, Hong Kong, Sigapore.

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II. The U.S. Economy1. Constitutional Foundations

• The legal foundations of the US economy is the US Constitution:– was ratified in 1787

• the original intent of the US Constitution was to limit the power and scope of the federal government

• the US Constitution specifies three brunches of government-executive, legislative, and judicial, each of which represents a substantial check over the others.

We study the US economy as an example of the Anglo-Saxon model. The US economy is large and wealthy economy that has enjoyed a considerable success. It relies predominantly on markets with less government intervention. It is also the most technologically advanced economy.

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2. The Environment• Large size and rich natural resources—7% of world land area, and

5% of world's population.• Philosophy of Individualism

– Individuals can have significant impact on society; success through individual hard work.

– Encourages higher education; discourages welfare spending.

3. Changes in the Structure of the Economy.

– Agriculture was most important employment sector until 20th century. Industry was dominant 1900-1930.

– The service sector employs 75% of the US labor force. Expansion moved from wholesale and retail trade to public services, and finally the non-profit services, education and health, accounting, finance, insurance, and computer programming. (“Industry output and employment projections to 2014”)

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4. The Private Sector.

• Business Organization

–Forms

•Sole proprietorship– owned by 1 individual who makes all decisions, absorbs profits/losses

– Important in agriculture, retail trade, services

•Partnerships– owned by 2 or more partners who make all decisions, and share

profits/losses

– Finance, insurance, real estate, services

– Advantages

» Relatively simple

» Their profits are taxed only once

– Disadvantages

» The owners are personally liable for the debts of the business

» The ability to raise capital is limited, dependent on the owner’s ability to borrow against personal assets

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•Corporations– owned by its shareholders and act as a legal person. A board of

directors, elected by the stockholders, appoints management to run the corporation

– Advantages:» The owners (stockholders) are not personally liable for the

debts of the corporation (limited liability)

» The management can be changed if necessary

» It has more options for raising capital (sale of bonds and additional stock)

– Disadvantages:» The income is taxed a second time when corporate profits are

distributed to stockholders as dividends.

» Double taxation gives American corporations to reinvest earnings rather than pay out dividends.

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Distribution of US enterprises according to the legal form of business organization. Corporations about 20% of total number, account for 90 % of business revenues.

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• Corporate Governance– Is concerned with the issue of for whose interest a corporation is

operated. In theory, the corporation can be run in the interests of:• Shareholders

– owners• Stakeholders

– those who participate in the corporation as managers, employees, workers, suppliers or buyers, but not as owners.

• The community

– The task of the manager is to maximize shareholder value, the value of the corporation in stock mkts as measured by its mkt capitalization.

• The mkt capitalization of a corporation is the product of the number of shares outstanding and its stock price as determined in the stock mkt where it is listed, such as the NY exchange, etc.

– Large corporations are characterized by separation of ownership and management

• The managers of large corporations own only a small fraction of shares. The bulk of the shares are owned by individuals either directly or indirectly or through private pensions and retirement funds

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– Control in widely held corporations--managers act in their own interest

• The potential problem The principal-agent problems -how to motivate managers to max shareholders value is solved through two approaches:

– The Market for Corporate Control -a market wherein rival management teams have the opportunity to buy control of the corporation from its owners (threat of takeover as disciplining device for management)

• As many citizens began investing in private pension funds; these funds began to inquire and control significant shares of large corporations. E.g the CREF Teacher’s retirement fund currently has more than $100 billion investment in stock.

• Corporate riders—individuals as Warren Buffet or investment banks targeted corporations that were not realizing their potential and developed a business plan, showing that with new management the corporation could earn higher profits. The corporate raiders then would offer a price above the current stock price to shareholders to replace the current management with a better management team.

• The US mkt for corporate control became quite complex and effective in 1980’s and 1990’s, using instruments such as the purchase of one company with shares of another

– AOL’s purchase of Time Warner, largely with AOL shares 2001

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– Corporate Incentives -US executives receive a fixed salary and a bonus based on the performance of the corporation. In the 1990’s corporations began introducing more direct incentives to ensure that corporate executives are motivated to max shareholder’s value

• Stock option– Executives are granted the right to buy a designated number of shares of the

company at specified price– Stock option would direct executives to think about the company's long term

performance• To match any employee contribution to their 401K retirement accounts that were

invested in the corporation’s own stock– The management to accumulate shares in their own corporation and they will

have a personal interest to see the price of shares increase.• Golden parachute

– The provision for a limited number of executives to receive generous severance bonuses if their company is taken over by a new management team

– The purpose is to prevent existing management resisting corporate takeovers

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• Preoccupation with shareholder’s value is a hallmark of the Anglo-Saxon model

• Criticism of the Anglo-Saxon model– It neglects the interests of stakeholders (managers, employees), who may

have worked for the company for decades

• Max of shareholder’s value will periodically engage in cost cutting and downsizing; hence loss of jobs

– Max shareholder value can create distortions in stock markets that require accurate info to operate efficiently

• Top executives will withhold negative info to prevent the decline in the share price, as in 2001-2002 scandals involving Enron, Arthur Anderson.

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5. Capital Markets

• The market in which businesses raise investment finance trough the issue of stocks, bonds and bank borrowing.

• Brings together users and suppliers of credit

• Well organized and efficient (new information is very quickly reflected in share prices)

– stock markets

– bond markets

• A capital market could be:

– Primary• The corporation sells (issue) new shares of stocks or bonds to buyers, called

Initial Public Offering (IPO).

• Investment financing is created in the primary mkt

– Secondary• Secondhand mkt in which shares of stock or bonds that have already been

issued are traded by one owner to another.

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• The American capital mkt is one in which new shares are sold to private investors by underwriters who organize the initial sale of shares. The stock exchanges are private organizations that have established operating rules and have the power to punish underwriters, brokers or companies that violate their rules.– Insider trading laws—stock exchanges and security commissions have more

strict laws against insider trading; all insider transactions must be reported to the security and exchange commission for publication. Insider trading occurs, but if it discovered, is punishable.

– Strict accounting standards that require transparency

• Features:– The operating principle of major US stock exchange is full financial

disclosure—the potential buyers of new stocks need to have a full info about the company

– In US more investment is financed by the issue of stock and bonds than through bank financing. The financing of investments through stock mkt is characteristic feature of the Anglo-Saxon model

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– Separation of those who finance from those who manage. In the European and Asian models, which rely heavily on bank financing, the bank is closely associated with the corporation and would be reluctant to withhold financing from closely related company. The separation of financing from management has the advantage that a generally impartial decision will be made whether a company deserves additional financing.

– In the US capital mkt promotes dynamic change over relatively short period, by its willingness to move capital quickly from one sector to another and from one corporation to another. If one sector develops a new technology and another sector’s technology lag, the capital mkt will automatically direct capital to develop the new technology. If consumer taste change, new capital will flow to the sector with rising consumer demand

• Table 8.2 shows the dramatic changes in ranking over relatively short period of time

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2009 RankCompany Revenues ($ millions) Profits ($ millions)

1.Exxon Mobil 442,851 45,2202.Wal-Mart Stores 405,607 13,4003.Chevron 263,159 23,9314.ConocoPhillips 230,764 -16,9985.General Electric 183,207 17,4106.General Motors 148,979 -30,8607.Ford Motor 146,277 -14,6728.At&T 124,028 12,8679. Hewlett-Packard 118,364 8,32910.Valero Energy 118,298 -1,131

Source: Fortune 500http://money.cnn.com/magazines/fortune/fortune500/2009/full_list/index.html

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•The opponents of the Anglo-Saxon model of investment finance argue that stock mkts are too volatile and are dominated by emotion. They believe it is better to have knowledgeable bankers deciding who should get investment financing. A disadvantage of the bank financing is that tends to get too closely linked to the corporation to make impartial investment decisions. The US capital mkt punishes corporations that fail in their business plan.

•Financial crisis started at the end of 2007•The new innovations had allowed the banks to hide much of their bad lending to move it off their balance sheets, to increase their effective leverage. The new instruments (credit default swaps) allegedly for managing risk but in reality as much design for deceiving regulators, were so complex that they amplify risk.•The mortgages had high transaction costs and variable interest rates with payments that suddenly could spike, but with no protection against the risk of job loss. The designers of these mortgages focus on maximizing their revenues and their efforts produced a whole range of complicated mortgages that made them a lot of money in the short run and led to temporary increase in homeownership, but at a great cost to society as a whole

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6. Competition in the product market

• Resource-allocation arrangements depend on the degree of mkt power in different product mkts. There is no accurate measure of mkt power but the most frequently used measure is the CR

a) Concentration ratios (CR)• percent of total domestic output of largest 2, 4, 8,…, n firms

– e.g. 4-firm concentration ratio of 85% means that the 4 largest firms account for 85% of the industry sales

– Low CR – competitive industry

– High CR—”oligopoly”

b) Increased competition from global market• consider auto industry

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7. Regulation

• Another important part of the institutional infrastructure that supports a mkt economy.

• The constitution of the US was designed to protect private property from the government regulation. – The federal government can make decisions affecting businesses through the legislature,

in which a bill is passed by congress and signed by the president, or by executive order or regulation.

• Regulation of the private business evolved for the purposes of protecting the public interest, as evidence by almost 30 different regulatory bodies. – Environmental Protection Agency has control over what substances business can release

into air or water.

– Food and drug administration approves new drugs.

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•Regulation has been exercised by a wide variety of local, state and federal agencies. Government regulation can be classified as:

Social-regulation of health, safety, and environment (consumer product safety rules; environmental protection etc.) is used to protect public safety and health EPA, FDA.Economic-gov’t involvement in mkts, such as setting prices, restricting corporate decision-making, and controlling competition (utility rates, the setting of local taxi rates)

•Both econ and social regulation impose costs and creates benefits--Costs

One of the costs is compliance cost, the associated paper work, etc2002 the cost of business regulation was approx. $1 trillion or 9% GDP (large costs)The Fed register, which publishes all federal regulations has reached 100,000 pages per year

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– Benefits• Substantial progress in cleaning air, water and land

• Reducing automobile emissions

• Improvements in automobile safety

• A regulation is economically and socially beneficial if it yields benefits in excess of its costs.– Complications in evaluating the costs of regulation:

• Capture only the direct costs of federal regulations. Indirect costs, called unfunded mandate, is a regulation such as handicap-assess regulations, that the private business must pay for out its pocket without government assistance

• Absence of counterfactual info-it is presumed that improvements in car safety, gas mileage are due to government regulation. But this ignores the fact that private businesses might have been motivated by profit-max to produce the same results without regulation.

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8. Deregulation• In the 1960’s and 1970’s the high cost and percieved inefficiencies of

regulation prompted a movement to deregulation• The reduced incidence of gov’t regulation of business and the return

of decision-making to the private business themselves• The deregulation in the American economy began in late 1970s-

airlines, railroad, transport– The Airline Deregulation Act signed in 1978, allowing the airlines rather than

the Civil Aeronautics Board to set fares and routes– Much of the deregulation was motivated by the message of microecon theory—

the development of competitive mkts could provide benefits that would outweigh associated costs.

• Effects from the deregulation (The consumers are the prime beneficiaries of deregulation)– Increased competition– Improves efficiency in an industry– More business uncertainty and volatility, which is characteristic of capitalism– Lower prices for most (but not all consumers)

• Consumers in small mkts characterized by high costs are no longer protected and now have to pay prices closer to costs.

– increased diversity of services offered to consumers (more choices)

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– The most controversial area of expansion in deregulation is the electricity mkt

• Under deregulation, local utilities would serve as common carriers obligated to transmit electricity purchased from various supplies to the national power grid.

• 2001 utility deregulation under intense scrutiny. California passed deregulation legislature that froze the retail price of electricity while allowing the wholesale electricity be purchased in short-term forward mkts, forbidding purchases in long-term forward mkts. As energy prices and electricity prices rose unexpectedly in world mkts, CA electricity retailers found that their retail prices did not cover their wholesale prices and to avoid massive bankruptcies, the state of CA had to cover the price differentials through the state budget, which was thrown in a severe deficit as a consequence.

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9. The Labor Markets• The US corporations managed to max shareholder value not

stakeholder value. The major stakeholder are managers, workers. Their interests are regarded as less important than those of the shareholders. Therefore, should be less job security in the American labor market than the European where the stakeholder rights are higher.

• Market allocation (wage rate equals supply and demand for labor) with influence from unions, government, and discrimination.

• The impact of unions– In all industrial democracies, union power grew with the rise of large scale

industrial enterprises. We have labor and trade unions—organizations of employees and workers of a company, occupation or branch that come together for the purpose of affecting conditions of work and pay

– less than 15% unionized.• In the US government employees account for the majority of unionized workers.• Most American unions are associated with the American federation of Labor-

Congress of Industrial Organization (80% of the union members)

– weak compared to Europe (European unions politicized)

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Lue

Wue

Wuf

Luf

S S'

Ln1 Ln2

Wn1

Wn2

D D

S

Non-Union Union

$ $

Labor Labor

PerceivedSupply w/union wagefloor

Supply w/o union wage floor

-effects on productivity•Negative (strikes; work rules; distortion on union-nonunion wage)•Positive (training; reduced turnover and higher moral)

-effect on wages•unions increase unionized wages about 15-18%•increased wages cause reduction in quantity of labor demanded in unionized sector•thus supply of labor in non-unionized sector increased•thus non-unionized wages depressed

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• The impact of government– licensing

– In long run it affects the supply of labor through government policies toward public education and job training

– Moreover, anti-discrimination regulations affect employment practicies• hiring quotas

• minimum wages (minimum wages cause unemployment)

The Effect of Minimum Wages

Wm

We

Le LsLm

Excess supply

I II III

Labor

$I -- Better off (working at higher

wage than before)

II -- Worse off (were working, now unemployed)

III -- Frustrated (would like towork at higher wage butcan’t find work -- countedas unemployed)

0

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– much more limited degree of government regulation in American labor markets then European

• The US employers are regulated by several acts:– The Fair Labor Standards Acts of 1938, establishes the standards for min wage,

overtime pay, child labor– The Occupational Safety and Health Act of 1970—sets health and safety standards and

conduct inspections to ensure safe and healthful workplaces. – But these regulations did not dictate hiring and firing procedures

The government intervenes the labor market with ant discriminatory policies

• Discrimination against:– Women– Minorities/ race– Potential effects

• exclusion from certain occupations/channeling into certain occupations• reducing wages of women and minorities

– Most work indicates that discrimination does exist but affect on wages small

• Unemployment rate—US unemployment lower than European since 1982. Although 2009 is 9.5%

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The US economy consists of private and public sectors.

10. The Public Sector• Small relative to other industrialized countries

– Especially small given large defense needs– Government expenditure about 35% of GDP (Germany and France about 50%)

– 24% federal– 11% state

In the pure Anglo-Saxon model the state is not responsible for the income and security of its citizens. But no country can ignore the income and security of its citizens

11. Welfare • In the US, government public assistance has been limited to public

education, some low cost health care for the poor, social security, disability and unemployment.

• FSP, TANF• Limited welfare assistance• promoting self-reliance thru the acquisition of job skills

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12. Income Distribution• Relatively unequal compared to other industrial nations. • Lorentz curve—compares family income by rank with percentage share of

income either before or after taxes

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• The government plays a modest role in the redistribution of income in the US.

• The taxation system has little effect on distribution, but transfer payments have a significant effect. In 2003, taxes and the earned income credit reduced the Gini index by only 4.6%, but transfer payments reduced it by 17%.

13. Providing for Income and Security• Principle of self-reliance• The state is not responsible for the income and security of its citizens• Social security act, 1935, created a social insurance to the retired

workers aged 65 or older.– 1956 Medicare

• Educational system– Public and private educ. In the US education is more a personal rather than

social investment

• Health care system– Medicare, Medicaid, health care costs are increasing

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14. Privatization• the shift of the economy from the public sector to the private• publicly owned facilities, such as airports, roads, water systems• there is substantial amount of private initiative in the provision of local services.

In the US privatization is more likely to consist of government contracting for the private production of traditionally public sector goods and services such as trash collection, local transportation services, etc.

15. Macroeconomic Planning is limited to:• use of indirect tools of monetary and fiscal policy• The FED established in 1913, the Federal Reserve system consists of 12 federal

reserve district banks coordinated by the Board of Governors in DC.– The functions of regulating the money supply through open market, setting reserve

requirements. The FED is in charge of formulating monetary policy. – Authority over fiscal policy is diffused among the various executives and legislative

bodies in charge of government spending and taxation. • National budget is prepared and proposed by the executive branch; examined,

amended, and approved by the Congress; and signed into law by the President.• No formal use of indicative planning or industrial policy. • On the whole, the distinctive feature of econ planning in the US is its absence.

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16. The current financial crisis 2007-2009

has forced us to rethink our common ideas about capitalism. It was long thought that the “invisible hand” of the markets would keep everything in check—full employment, a growing economy, and minimum governmental regulation. But watching people lose their homes, the stock market plummeting further everyday, retirement savings shrinking, and massive unemployment numbers, it seems the “invisible hand” has been amputated. Greedy mortgage brokers, blind faith in rising home prices, panic selling, poor consumer confidence—or what Keynes called “animal spirits”—move economies in irrational ways. These powerful psychological forces are imperiling the wealth of nations today.

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•The term "animal spirits," popularized by John Keynes in his 1936 book "The General Theory of Employment, Interest and Money:""Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.“

•is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. Then, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.

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“Animal spirits: How Human Psychology Drives the Economy” 2009

• George Akerloff and Robert Shiller challenge the econ wisdom that got us into this mess, and put forward a new vision that will transform economics and restore prosperity.

• The authors reassert the necessity of an active government role in econ policymaking by recovering the idea of animal spirits, a term Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery.

• Like Keynes, Akerloff and Shiller know that managing these animal spirits requires the steady hand of government –simply allowing markets to work won’t do it. They detailed the most pervasive effects of animal spirits in contemporary economic life—such as confidence, fear, bad faith, corruption, a concern for fairness.

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Fiscal policy adjustments are what almost all the econ policy advisers have in mind when they say now is the time to pursue Keynesian policies. Especially now, when conventional monetary policy is ineffective, since short-term interest rates on safe assets are close to zero, Keynesian theory would argue that the government should have a fiscal target. If spending would otherwise be less than full employment GDP, the government should put more money into people's pockets.

A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people's somewhat rash, impulsive decision-making is not discovered.

Unfortunately, the recent period showed that confidence was blind. It was not based on rational evidence. The trust in the mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits.

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Furthermore, while animal spirits have been high over a very long period of time, a whole new system for the granting of credit had been generated. Some 30 or 40 years ago there was much less intermediation in financial markets. But then along came financial innovation and a new financial system, not just in mortgages and housing but throughout the credit system, with complicated strategies of securitization and use of derivatives. The more complex the transaction the more trust is needed to sustain the transaction.

Then too, over the past several decades a vast "shadow" banking sector developed that engaged in the purchase and sale of such securities. To a great extent these traders borrowed short term at low interest rates against collateral of asset-backed securities, of which residential mortgage-backed securities would be just one example. What enabled them to do that? It was the animal spirits. Those who loaned short to the shadow banking sector were confident. They thought they would be repaid. (They also thought they could insure against loss by the purchase of derivatives). They were trusting. But as soon as these lenders lost their confidence they were no longer trusting. It was like a classic bank run, but this time not on the formal banking sector but on those who borrowed short, and loaned long -- on the shadow banking sector. Lenders to the shadow banking sector wanted to be the first not to renew their loans.

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The trust in the innovative lending practices was excessive; now that trust is replaced by deep mistrust.

So what to do to revive our animal spirits and economic growth? – Need programs to solve the current financial and economic crisis are large

enough, and targeted broadly enough, to impact public confidence.• need a fiscal stimulus

• government action is also needed to take the place of the credit markets that seemingly worked so well when animal spirits were high.

• The Treasury and the Federal Reserve not only need a fiscal target, they also need a credit target (how the credit markets should behave). The goal should be that those who would normally receive credit in times of full employment can once again find it easy to do so, at rates with realistic risk premiums.

• to meet the credit target, the expansion of special loan facilities, recapitalization of banks, and use of government institutions to grant credit where it has dried up must be on a scale great enough to overwhelm further doubts about the economy.

The role of the government is not to harness animal spirits but really to set them free, to allow them to be maximally creative.