Toward Sustainable Capitalism
There are several well understood advantages inherent in capitalism that make it superior to any other system for organizing economic activity. It has proven to be far more efficient in the allocation of resources and the matching of supply with demand, far more effective at wealth creation, and far more conducive to high levels of freedom and political self-governance. At the most basic level, however, capitalism has become the world's economic ideology of choice primarily because it demonstrably unlocks a higher fraction of the human potential with ubiquitous organic incentives that reward hard work, ingenuity and innovation.
For these reasons and others, markets lie at the foundation of every successful economy. Yet the recent crisis in global markets (following other significant market dislocations in 1994, 1997, 1998 and in 2000-2001), has shaken the world's confidence in the way modern capitalism is now operating.
Moreover, glaring and worsening systemic failures—such as growing income inequality, high levels of unemployment, public and private indebtedness, chronic under-investment in education and public health, persistent extreme poverty in developing nations and, most importantly, the reckless inattention to the worsening climate crisis—are among the factors that have led many to ask: What type of capitalism will maximize sustainable economic growth? At the very least, the last decade has clearly demonstrated that free and unfettered markets, as they are currently operating, have simply not been delivering optimal long-term results.
Before the crisis and since, we (and others) have called for a more long-term and responsible form of capitalism—what we call "sustainable capitalism." Sustainable capitalism seeks to maximize long-term value creation. It explicitly integrates environmental, social and governance (ESG) factors into strategy, the measurement of outputs, and the assessment of both risks and opportunities. Sustainable capitalism challenges us to generate financial return in a long-term and responsible manner.
Precisely because the energy unlocked by incentives is the true source of capitalism's strength, we believe that the building of sustainable capitalism should start with careful attention to the nature and design of the incentives that businesses use and public policies encourage.
In his book, "The Big Short," Michael Lewis identified the real cause of the subprime mortgage debacle (which triggered the Great Recession) as one factor above all else: "Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed."
So how do we best motivate business leaders to manage for the long- term and compensate them for creating sustainable wealth? To begin with, compensation should be aligned with long-term objectives, and financial rewards should be linked to the period over which results are realized.
For example, in the asset-management industry, we are strong proponents of multiyear rolling performance fees in order to incent investors to manage assets with a long-term perspective. By contrast, if asset owners continue to review and reward their asset managers on a quarterly or annual basis, they should not be surprised to find their investment managers attempting to optimize returns within this time frame—frequently at the expense of long-term value. Unfortunately, this is all too common a practice for asset owners—even for pension funds, whose trustees are obligated to match the long-term performance of their assets to the long-term maturation of their liabilities.
In "Common Sense," Thomas Paine wrote, "A long habit of not thinking a thing is wrong, gives it a superficial appearance of being right." This is certainly true for compensation strategies in both business and finance. Our excessive focus on the short-term represents a primary obstacle to the development of sustainable capitalism.
Incentive structures should also reflect more complete measures of performance. For example, increasingly, best practice companies are explicitly including environmental sustainability, customer satisfaction, employee morale and workplace safety in their incentive schemes. These companies understand that these considerations drive long-term financial performance. We also feel strongly that if asset owners want their asset managers to consider ESG factors in investment decisions, then they should include these factors in evaluating, measuring and rewarding performance.
Ralph Waldo Emerson said, "The reward of a thing well done is to have done it." Countless doctors, nurses, teachers, firemen and policemen work tirelessly not only for the money, but for the satisfaction of doing their job well. In contrast, an overreliance on monetary incentives, often called the "bonus culture," for finance and senior corporate leaders has come at the expense of sustainable competitive strategies like team work, ethics, firm culture and long-term client relationships.
There is no question monetary incentives are important—indeed critical—but it is important also to consider other meaningful ways to motivate and engage work forces. In a recent book by George Akerlof and Rachel Kranton, "Identity Economics," the authors document how people in exceptional organizations work well because they identify with the values and the culture, not simply the financial rewards. Further, a recent survey by consulting firm McKinsey & Co. showed that nonfinancial motivators are more effective at building long-term employee engagement. Yet, somehow over the last decade we have let the "bonus culture" dominate our discourse and thinking on incentives. We can all see the results are not good.
Moreover, the rising inequality in our society is clearly unacceptable. It poses fundamental questions of fairness and whether these levels of income disparity are sustainable within the context of the long-term health and civility of our communities.
Business leaders, as well as compensation committees of boards, need to exert better leadership and shareholders must become more engaged in improving incentive structures. We strongly support "Say on Pay," whereby shareholders vote on the remuneration of executives, and other provisions championed by many institutional investors. We do not support government-mandated compensation caps or other prescribed compensation policies. However, if the business and investment communities do not act, governments may.
All of us in business and finance need to urgently rethink how we design and implement remuneration strategies. We need to get incentives right. They must be aligned with long-term objectives, reflect more complete measures of performance, include important nonfinancial motivators, and be equitable. This, coupled with a renewed commitment to long-term responsible business strategies that include environmental, social and governmental concerns, will be significant steps toward building sustainable capitalism.
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