Proventus’ view the world in light of recent developments

December 30, 2008

Since the summer of 2007 problematic developments have materialised in the financial markets, first in the sub-prime crisis, and over time in a general credit crisis. The risk that we foresaw in our annual report 2007, that we will see a situation where major financial institutions cannot obtain funding, and that that would lead to a major credibility crisis for the entire financial system, is now a fact.

In order to manage change in companies we have to understand what is happening in the world at large. It has become increasingly important with a long-term perspective due to the dual challenges facing European industry: the severe structural problems and the lack of innovation. We believe that a well thought through view of the world around us, which also comprises political and cultural conditions, makes us better investors. For this reason Proventus has taken the initiative of establishing Glasshouse Forum, a European network organization which critically illuminates our rapidly changing world, with an emphasis on Europe. We do this out of an enlightened self-interest, in order to understand how business affects the rest of society, but also to stimulate debate on these important issues. For the foreseeable future there will be a need for long-term investment and an adaptation on the part of European industry. As capitalists, our aim is naturally for our businesses to make a profit, but we have to understand the problems and tensions to which capitalism gives rise and which in the more distant future may affect the prospects of the market economy.

The profits from a long-term perspective

Criticism of the market economy cannot be left to those who want to abolish it, and wish to exploit existing problems to drive anti-democratic and protectionist agendas. Since the fall of the Berlin Wall there has been no rival to capitalism corresponding to communism, and this has made many advocates of the liberal market economy self-confident, not to say complacent. But as concerned capitalists we have always to consider how our actions affect the society which we operate in and those people we work with, as well as the environment.

Capitalism’s enormous wealth creation results primarily from innovations that are efficiently commercialised. Creating and maintaining an innovative climate is therefore an overall priority. It is far from obvious that aiming for short-term profit favours long-term development. The model which focuses narrowly on shareholder value has won inroads in Europe in recent years and underlies many of the manifestations we call short-termism. Developments are driven by changes in ownership structure, distinguished by large institutional owners who demand rapid returns, but also by technological developments which allow and therefore tempt owners into constant assessments. It is far from self-evident that this favours competitiveness; short-termism contains an in-built temptation to underinvest in innovations, research and other long-term developments.

As yet we know rather little about what consequence this high rate of change has for human capital, which of course is by far the most important renewal factor. Are people worn down by the unpredictability, or does it spur them on to greater productivity? Perhaps both. But it is important to take a step back and consider what in contemporary company strategies might be herd behaviour and the vagaries of fashion. How many companies outsource production because everyone else does it? We believe that there can be advantages with a global division of labour and Proventus has over the last 20 years located or outsourced production to Eastern Europe and South-East Asia. A current example is BRIO with a large part of its production being located in China. But we must take the social and ecological costs into account to a much greater extent than is generally done today.

A bursting consumption bubble

It is not merely within production that short-termism is making inroads; it is also characterizing a great deal of consumption. But can we continue to consume in the same way as we are today? Since the summer of 2007 problematic developments have materialised in the financial markets, first in the sub-prime crisis, and over time in a general credit crisis. Spreads have increased; in many markets the pricing mechanisms are not working and the inter-bank market is experiencing a severe drought of liquidity. The big question has been whether this will have a substantial effect on the real economy – in short whether the main problem is really insolvency or illiquidity. That we are entering a recession is now increasingly accepted. The last few years have made large banks on the one hand increasingly dependent on offloading asset-backed securities from their business and on the other hand increasingly dependent on short-term funding. The risk that we foresaw in our annual report 2007, that we will see a situation where major financial institutions cannot obtain funding, and that that would lead to a major credibility crisis for the entire financial system, is now a fact.

We must also remember that in terms of the development of the Western economies, we do not merely have to deal with the reversal of the business cycle. At some point we will have to deal with a structural change in the savings/consumption balance. Over the last couple of decades the Western economies have become increasingly asset-dependent. This has been most visible in the US, where net national savings has averaged a mere 1.4 per cent of national income over the last five years, lower than it has been since the 1930’s. The US consumer has been convinced for a long time, by irrational asset appreciation coupled with an abundance of cheap credit, that there is no need to save in the old-fashioned way, from income. And thus, despite median earnings having decreased by 2.5 per cent since 2000, private consumption soared to a record 70.5 per cent of real GDP in 2007 . While income-based measures of savings changed to a negative in 2007, household debt hit a record level of 133 per cent of disposable income. In fact, if we exclude the proceeds and effects of mortgage refinancing in the US economy over the last five years, the average growth rate was – not as stated officially 2.7 per cent – but a mere 0.5 per cent.

So while we are focusing on the bubbles in the financial markets – sub-prime, asset-backed securities and others – the largest bubble in terms of long-term impact is the consumption bubble. At some point, the Western world will come into a period of considerably lower consumption levels. This is a structural change that will obviously have a dramatic impact on retail and consumer goods companies as well as on advertising, media and ultimately on our standard of living. The argument that over time the US consumer will be replaced by the consumers of China, Russia and India needs a very long-term perspective to hold true. These economies are far too small.

Either we can successfully build a new industrial base in the Western world which leads to greater competitiveness and ultimately to job creation guaranteeing widespread prosperity or we will be faced with a considerably lower standard of living over time. In order for the benign scenario to happen we will need to abstain from maximising our short-term opportunities for exploiting global markets to the full and instead choose a more sustainable route.

As consumers we have been tremendously favoured by developments in recent decades. We buy better and cheaper goods. Imagination and farsightedness is required on the part of the individual in order to realize that this is bound up with things that we often regard as negative consequences, such as cutbacks and the movement of work abroad. Actions which make these cheap goods possible.

China awakes, Europe must wake up

A strong contributing factor to this development is, of course, the massive association of China and India with the world economy. It must presumably be considered to be one of the ironies of history that a communist state which is reforming itself displays many of the characteristics of raw capitalism. It is not merely a question of the often appalling conditions for labour, and the lack of regard for the environment and social safety nets. The fact that the enormous Chinese workforce has so rapidly and to such an extent been introduced into the world economy leads to a decreasing price of labour globally. It is nowadays not merely work in manufacturing which has been exposed to competition; since the beginning of the new millennium what has happened is that the ability to digitalize services and put them out into the global labour market has grown dramatically. The economist Alan Blinder has calculated that between 20 and 30 per cent of jobs may disappear in the USA, or at any case are movable. What we are witnessing is an equalization between countries, at the same time as the gaps within countries appear to be growing.

There also appears to be a shift in public opinion in the West. According to surveys approximately half of the population in the USA and Europe wish to retain trade barriers. There are signs that protectionism may become an important issue in the American presidential election. Many American voters are fully aware that the American economy as a whole benefits from free trade, but at the same time have a very direct experience from their own circumstances deteriorating. According to studies, more than 90 per cent of Americans have reason to regard themselves as losers over the last decade. Acquiring an education is no longer a guarantee for doing well on the labour market. The real winners, measured in increases in income, are no more than 1 per cent of the population of the USA.

Who capitalises?

Capitalism has proved to be unequalled in creating material prosperity, but it does not work as well when it is a question of distributing it. In the USA, income differences are now back at the same levels as they were in the 1920s, and it is primarily the uppermost wage tier which is pulling away from the rest. Linked to this is the fact that mobility in American society is beginning to decline, even if they are still much better at integrating immigrants than we are in Europe. The same trend towards growing income gaps is to be found in several countries in Europe, most clearly in Great Britain, but in other places it is being counteracted by national traditions of equality. Nevertheless, large groups regard liberalization as a threat to their own prosperity.

It would be disastrous to underestimate the political consequences of this. It may seem unlikely that the world’s openness could be rolled back, but it is worth remembering that the world actually has been globalised before and subsequently withdrew from this – with devastating consequences. From the middle of the 19th century up to the First World War the world was in many ways just as open as at present, or even more so – for example, migration was considerably more extensive then. With the gold standard there was in principle a global currency, and capital and goods could move surprisingly freely. For governments during that period it was more important to keep their credibility internationally than to take into account domestic public opinion, and wages and prices were allowed to fluctuate freely.

The prerequisite for this was that the domestic majority did not have much influence. All of this changed after the First World War, and the reactions in many cases had terrifying consequences. Totalitarian regimes such as those in the Soviet Union and Nazi Germany became autarchies, and brought in terrible new orders in their respective spheres.

The return of authoritarian capitalism

One lesson one can draw from this is that we have to take care of the losers of globalisation if we wish to avoid a backlash. In modern society there is a limit to how great the differences can become without being regarded as illegitimate. If they are allowed to exceed this there is a risk of reactions in the form of authoritarian attempts at homogenisation. Nor should one take internal European openness for granted. The nation state has remained the most important framework for political action, and the EU will in the foreseeable future continue to be a union of nation states. Inequality and the fear of the consequences of globalisation may very well exacerbate trends towards what might be called national socialisms, a striving for equalization within the framework of the nation. They may be associated with strivings for ethnic homogenisation, but do not need to be so.

Another lesson to be learned from the first globalisation is that authoritarian states in some ways find it easier to adapt to an internationalized economy, as they do not need to take account of domestic public opinion in the same way. The conviction that, for example, China would have to be democratized in order to secure continued economic development is based on wishful thinking and rickety historical parallels. It might, on the other hand, be the case that we are witnessing the return of the authoritarian capitalist great powers to the global arena. Russia will be important for Europe because it is so close geographically, but it is primarily the Chinese giant which can achieve not merely an economic shift in the continental shelf but also a political shift. An authoritarian China becoming a superpower will of course leave its mark on the overarching political climate in the world, and in that case the liberal political culture which historically has its roots in Europe will become marginalized.

Liberal Europe challenged

Contributing to the weakening of these liberal values is, of course, the fact that Europe risks being weakened in a number of different ways. As regards foreign policy the continent is not able to harmonize its policy and therefore has little weight. Europe is in the process of becoming a greying continent, and an ageing population threatens both economic growth and social security systems. In order to counteract this Europe needs to open itself up to immigration on a large scale, but this presupposes that we can integrate these new Europeans. If, on the other hand, enclaves arise which are marked by alienation, this may easily lead to a mutually accelerating enmity between minority and majority populations.

Both the policy of assimilation and the multicultural policy of encouraging differences have shown their limitations. What Europe needs on the one hand is a fundamental endorsement of its basic liberal principles on the part of all of the ethnic groups, on the other hand the opportunity for everyone to belong both to the majority and a minority at the same time.

One thing is certain: a society in economic crisis is not a tolerant society. If Europe is not able to retain its industrial base, then nor can it retain its middle class, and wealth is not distributed. A Europe going downhill into insignificance will not be a tolerant society either. The continent is no longer sufficiently significant to set the world on fire as it did before; it is without doubt capable of burning itself out radically. But a Europe that dares to stare its problems in the face and to think innovatively is quite capable of meeting these challenges. It can hold in trust and develop further what has for a long time been its strength – secular humanism with its ability to integrate a diversity of perspectives and experiences.

 

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