As Adam Smith knew, corporations are meant to increase the Wealth of Nations. When they increase only the wealth of greedy managers, watch out!
This article was first published on the Stratfor website.
The author, George Friedman, is chairman and CEO of Stratfor, the
world’s leading online publisher of geopolitical intelligence.
Financial panics are an integral part of capitalism. So are economic recessions.
The system generates them and it becomes stronger because of them. Like
forest fires, they are painful when they occur, yet without them, the
forest could not survive. They impose discipline, punishing the
reckless, rewarding the cautious. They do so imperfectly, of course, as
at times the reckless are rewarded and the cautious penalized.
Political crises — as opposed to normal financial panics — emerge when
the reckless appear to be the beneficiaries of the crisis they have
caused, while the rest of society bears the burdens of their
recklessness. At that point, the crisis ceases to be financial or
economic. It becomes political.
The financial and economic systems are subsystems of the broader
political system. More precisely, think of nations as consisting of
three basic systems: political, economic and military. Each of these
systems has elites that manage it. The three systems are constantly
interacting — and in a healthy polity, balancing each other,
compensating for failures in one as well as taking advantage of
success. Every nation has a different configuration within and between
these systems. The relative weight of each system differs, as does the
importance of its elites. But each nation contains these systems, and
no system exists without the other two.
Limited Liability Investing
Consider the capitalist economic system. The concept of the
corporation provides its modern foundation. The corporation is built
around the idea of limited liability for investors, the notion that if
you buy part or all of a company, you yourself are not liable for its
debts or the harm that it might do; your risk is limited to your
investment. In other words, you may own all or part of a company, but
you are not responsible for what it does beyond your investment.
Whereas supply and demand exist in all times and places, the notion of
limited liability investing is unique to modern capitalism and reshapes
the dynamic of supply and demand.
It is also a political invention and not an economic one. The
decision to create corporations that limit liability flows from
political decisions implemented through the legal subsystem of
politics. The corporation dominates even in China; though the rules of
liability and the definition of control vary, the principle that the
state and politics define the structure of corporate risk remains
In a more natural organization of the marketplace, the owners are
entirely responsible for the debts and liabilities of the entity they
own. That, of course, would create excessive risk, suppressing economic
activity. So the political system over time has reallocated risk away
from the owners of companies to the companies’ creditors and customers
by allowing corporations to become bankrupt without pulling in the
The precise distribution of risk within an economic system is a
political matter expressed through the law; it differs from nation to
nation and over time. But contrary to the idea that there is a tension
between the political and economic systems, the modern economic system
is unthinkable except for the eccentric but indispensible
political-legal contrivance of the limited liability corporation. In
the precise and complex allocation of risk and immunity, we find the
origins of the modern market. Among other reasons, this is why
classical economists never spoke of “economics” but always of
The state both invents the principle of the corporation and defines
the conditions in which the corporation is able to arise. The state
defines the structure of risk and liabilities and assures that the laws
are enforced. Emerging out of this complexity — and justifying it — is
a moral regime. Protection from liability comes with a burden: Poor
decisions will be penalized by losses, while wise decisions are
rewarded by greater wealth. Because of this, society as a whole will
benefit. The entire scheme is designed to increase, in Adam Smith’s
words, “The Wealth of Nations” by limiting liability, increasing the
willingness to take risk and imposing penalties for poor judgment and
rewards for wise judgment. But the measure of the system is not whether
individuals benefit, but whether in benefiting they enhance the wealth
of the nation.
The greatest systemic risk, therefore, is not an economic concept but a political one. Systemic risk
emerges when it appears that the political and legal protections given
to economic actors, and particularly to members of the economic elite,
have been used to subvert the intent of the system. In other words, the
crisis occurs when it appears that the economic elite used the law’s
allocation of risk to enrich themselves in ways that undermined the
wealth of the nation. Put another way, the crisis occurs when it
appears that the financial elite used the politico-legal structure to
enrich themselves through systematically imprudent behavior while those
engaged in prudent behavior were harmed, with the political elite
apparently taking no action to protect the victims.
In the modern public corporation, shareholders — the corporation’s
owners — rarely control management. A board of directors technically
oversees management on behalf of the shareholders. In the crisis of
2008, we saw behavior that devastated shareholder value while appearing
to enrich the management — the corporation’s employees. In this case,
the protections given to shareholders of corporations were turned
against them when they were forced to pay for the imprudence of their
employees — the managers, whose interests did not align with those of
the shareholders. The managers in many cases profited personally
through their compensation system for actions inimical to shareholder
interests. We now have a political, not an economic, crisis for two
reasons. First, the crisis qualitatively has moved beyond the
boundaries of a cyclical event. Second, the crisis is rooted in the
political-legal definitions of the distribution of corporate risk and
the legally defined relations between management and shareholder. In
leaving the shareholder liable for actions by management, but without
giving shareholders controls to limit managerial risk taking, the
problem lies not with the market but with the political system that
invented and presides over the limited liability corporation.
Financial panics that appear natural and harm the financial elite do
not necessarily create political crises. Financial panics that appear
to be the result of deliberate manipulation of the allocation of risk
under the law, and from which the financial elite as a whole appears to
have profited even while shareholders and the public were harmed,
inevitably create political crises. In the case of 2008 and the events
that followed, we have a paradox. The 2008 crisis was not
unprecedented, nor was the federal bailout. We saw similar things in
the municipal bond crisis of the 1970s, and the Third World Debt Crisis
and Savings and Loan Crisis in the 1980s. Nor was the recession that
followed anomalous. It came seven years after the previous one, and
compared to the 1970s and early 1980s, when unemployment stood at more
than 10 percent and inflation and mortgages were at more than 20
percent, the new one was painful but well within the bounds of expected
The crisis was rooted in the appearance that it was triggered by the
behavior not of small town banks or third world countries, but of the
global financial elite, who took advantage of the complexities of law
to enrich themselves instead of the shareholders and clients to whom it
was thought they had prior fiduciary responsibility.
This is a political crisis then, not an economic one. The political
elite is responsible for the corporate elite in a unique fashion: The
corporation was a political invention, so by definition, its behavior
depends on the political system. But in a deeper sense, the crisis is
one of both political and corporate elites, and the perception that by
omission or commission they acted together — knowingly engineering the
outcome. In a sense, it does not matter whether this is what happened.
That it is widely believed that this is what happened alone is the
origin of the crisis. This generates a political crisis that in turn is
translated into an attack on the economic system.
The public, which is cynical about such things, expects elites to
work to benefit themselves. But at the same time, there are limits to
the behavior the public will tolerate. That limit might be defined,
with Adam Smith in mind, as the point when the wealth of the nation
itself is endangered, i.e., when the system is generating outcomes that
harm the nation. In extreme form, these crises can delegitimize
regimes. In the most extreme form — and we are nowhere near this point
— the military elite typically steps in to take control of the system.
This is not something that is confined to the United States by any
means, although part of this analysis is designed to explain why the
Obama administration must go after Goldman Sachs, Lehman Brothers and
others. The symbol of Goldman Sachs profiting from actions that
devastate national wealth, or of the management of Lehman wiping out
shareholder value while they themselves did well, creates a crisis of
confidence in the political and financial systems. With the crisis of
legitimacy still not settling down after nearly two years, the reaction
of the political system is predictable. It will both anoint symbolic
miscreants, and redefine the structure of risk and liability in
financial corporations. The goal is not so much to achieve something as
to create the impression that it is achieving something, in other
words, to demonstrate that the political system is prepared to control
the entities it created.
The Crisis in Europe
We see a similar crisis in Europe. The financial institutions in
Europe were fully complicit in the global financial crisis. They bought
and sold derivatives whose value they knew to be other than stated, the
same as Americans. Though the European financial institutions have
asserted they were the hapless victims of unscrupulous American firms,
the Europeans were as sophisticated as their American counterparts.
Their elites knew what they were doing.
Complicating the European position was the creation of the economic
union and the euro by the economic and political elite. There has
always been a great deal of ambiguity concerning the powers and
authority of the European Union, but its intentions were always clear:
to harmonize Europe and to create European-wide solutions to economic
problems. This goal always created unease in Europe. There were those
who were concerned that a united Europe would exist to benefit the
elites, rather than the broader public. There were also those who
believed it was designed to benefit the Franco-German core of Europe
rather than Europe as a whole. Overall, this reflected minority
sentiment, but it was a substantial minority.
The financial crisis came at Europe in three phases. The first was
part of the American subprime crisis. The second wave was a uniquely
European crisis. European banks had taken massive positions in the
Eastern European banking systems. For example, the Czech system was
almost entirely foreign (Austrian and Italian) owned. These banks began
lending to Eastern European homebuyers, with mortgages denominated in
euros, Swiss francs or yen rather than in the currencies of the
countries involved (none yet included in the eurozone). Doing this
allowed banks to reduce interest rates, as the risk of currency
fluctuation was pushed over to the borrower. But when the zlotys and
forints began to plunge, these monthly mortgage payments began to soar,
as did defaults. The European core, led by Germany, refused a European
bailout of the borrowers or lenders even though the lenders who created
this crisis were based in eurozone countries. Instead, the
International Monetary Fund (IMF) was called in to use funds that
included American and Chinese, as well as European, money to solve the
problem. This raised the political question in Eastern Europe as to
what it meant to be part of the European Union.
The third wave is represented by crisis in sovereign debt in
countries that are part of the eurozone but not in the core of Europe —
Greece, of course, but also Portugal and possibly Spain. In the Greek
case, the Germans in particular hesitated to intervene until it could
draw the IMF — and non-European money and guarantees — into the mix.
This obviously raised questions in the periphery about what membership
in the eurozone meant, just as it created questions in Eastern Europe
about what EU membership meant.
But a much deeper crisis of legitimacy arose. In Germany, elite
sentiment accepted that some sort of intervention in Greece was
inevitable. Public sentiment overwhelmingly opposed intervention,
however. The political elite moved into tension with the financial
elite under public pressure. In Greece, a similar crisis emerged
between an elite that accepted that foreign discipline would have to be
introduced and a public that saw this discipline as a betrayal of its
interests and national sovereignty.
Europe thus has a double crisis. As in the United States, there is a
crisis between the financial and political systems. This crisis is not
as intense as in the United States because of a deeper tradition of
integration between the two systems in Europe. But the tension between
masses and elites is every bit as intense. The second part of the
crisis is the crisis of the European Union and growing sense that the
European Union is the problem and not the solution. As in the United
States, there is a growing movement to distrust not only national
arrangements but also multinational arrangements.
The United States and Europe are far from the only areas of the
world facing crises of legitimacy. In China, for example, the growing
suppression of all dissent derives from serious questions as to whom
the financial expansion of the past 30 years benefits, and who will pay
for the downturns. It is also interesting to note that Russia is
suffering much less from this crisis, having lived through its own
crisis before. The global crisis of legitimacy has many aspects worth
considering at some point.
But for now, the important thing is to understand that both Europe
and the United States are facing fundamental challenges to the
legitimacy of, if not the regime, then at least the manner in which the
regime has handled itself. The geopolitical significance of this crisis
is obvious. If the Americans and Europeans both enter a period in which
managing the internal balance becomes more pressing than managing the
global balance, then other powers will have enhanced windows of
opportunities to redefine their regional balances.
In the United States, we see a predictable process.
With the unease over elites intensifying, the political elite is trying
to stabilize the situation by attacking the financial elite. It is
doing this to both demonstrate that the political elite is distinct
from the financial elite and to impose the consequences on the
financial elite that the impersonal system was unable to do. There is
precedent for this, and it will likely achieve its desired end: greater
control over the financial system by the state and an acceptable moral
tale for the public.
The European process is much less clear. The lack of clarity comes from the fact that this is a test for the European Union.
This is not simply a crisis within national elites, but within the
multinational elite that created the European Union. If this leads to
the de-legitimization of the EU, then we are really in uncharted
But the most important point is that almost two years since a normal
financial panic, the polity has still not managed to absorb the
consequences of that event. The politically contrived corporation, and
particularly the financial corporations, stands accused of undermining
the wealth of nations. As Adam Smith understood, markets are not
natural entities but the result of political decisions, as is the
political system that creates the allocation of risk that allows
markets to function. When that system appears to fail, the consequences
go far beyond the particular financials of that event. They have
political consequences and, in due course, geopolitical consequences.