One of the most important issues in the ongoing economic controversy is whether the crisis is due to a “failure of capitalism”. What both sides of this argument often overlook, however, is that there is not just one but three different and not equally desirable kinds of capitalism. The failure to appreciate this point has been the source of much confusion.

The issues that distinguish between them are: ownership, control and the role of the state.

The first of these is individual shareholder capitalism: a form of capitalism in which firms are primarily controlled – as well as owned – by individual large shareholders, and with little state involvement. These large shareholders have extensive personal liability – they bear the downside as well as the upside of their decisions – and typically operate under unlimited liability in which all their wealth is “at risk” from the decisions they make: if the company fails, the big shareholders can lose everything they have. This gives them a strong incentive to exercise effective control: they hold the management accountable and the typical manager knows his place and is moderately remunerated.

At the risk of some oversimplification, this is “classic” early-19th-century capitalism, the capitalism of the industrial revolution. Ownership and control go together, leading to strong corporate governance and a long-term outlook, and there is little state intervention. This is capitalism at its best and most effective.

The second and more modern form of capitalism is managerial capitalism: the shareholders still own the company, but the management is much more powerful. There is now a major disconnect between ownership and control – the “separation between ownership and control” identified by Berle and Means in 1932 – and corporate governance is much weaker.

This second form of capitalism is associated with the limited liability corporate form, in which shareholders’ liability is limited to the value of their shareholder investment. Adam Smith had identified this problem in the Wealth of Nations in 1776: in a prescient passage, Smith deplored the “negligence and profusion” that “must always prevail” in such a company, because its directors would never look after its money as carefully as their own. The dominant shareholders are no longer the old powerful founding families but modern institutional shareholders, who don’t have the same long-term stake in “their” company: their behaviour is determined by middle-level asset managers who have the instincts of sheep, unable and unwilling and lacking the incentive to tackle powerful directors.

Not surprisingly, management remuneration increases sharply, and the focus shifts to the short run: long-term industrial logic gives way to short-term “pop” and, in the (all too common) worst cases, to senior management’s unconstrained Napoleonic fantasies. This management feather-bedding is often disguised by convenient ideologies, such as the nonsense of “shareholder value” theory and much of Modern Finance. The ideology of free markets also provides another convenient fig-leaf for managerial self-aggrandisement, thus tarnishing the image of free-market capitalism. However, these are no longer truly free markets.

Managerial capitalism represents a major deterioration from the older form of capitalism. This is made possible by the availability of limited liability – itself a major form of state intervention, which creates corrosive moral hazards and incentives towards excessive risk-taking – and by tax regimes that erode the old family fortunes and penalise shareholding in favour of the issue of debt. Thus, the move towards managerial capitalism is largely due to an increasingly interventionist state.

Then there is the third and least desirable but most modern form of capitalism: crony capitalism. Management is now largely out of control and its remuneration skyrockets. This is especially so in the so-called financial “services” sector. This sector encapsulates the excesses of “capitalism” at its worst: stratospheric remuneration for practitioners, a disregard for both shareholders and customers, and an obsession on short run “grab and run” profits with no concern about the longer run. It is also characterised by massive risk-taking with practitioners safe in the knowledge that the taxpayer will bail them out if they get into difficulties: profits are privatised, but losses are socialised, i.e, the social contract is “heads I win, tails you lose”.

In this form of capitalism, the financial sector is dominant: it is the biggest sector in the economy – thus, trading stocks and similar activities (such as shuffling paper) becomes more important than say, making things or providing useful services such as health or education.

Worst of all, the financial sector is now so powerful that is able to take over the state itself: its financial resources enable it to buy political influence and subvert the state apparatus for its own ends. Financial regulation becomes a tool for the “regulated” to control the markets in which they operate and, when the crisis hits, they are able to blackmail the politicians into bailing them out: we need a bailout – fast – otherwise the world will end. Of course, their world would end, but that is not a bad thing for the rest of us and we don’t get a say in the matter. There is, in short, a financial coup d’etat.

At this point, the financiers have the politicians in their pocket. No wonder they are openly bragging that happy days are here again (whilst adding insult to injury by telling us that this is God’s work!), even as banks are still on life support, courtesy of the taxpayers who are being robbed blind; meanwhile, the politicians they elect to represent their interests do not so much as stand idly by but actively collude in the robbery.

So what do we do about this?

Let’s begin by being clear about which form of capitalism we support – and there can, I believe, be only one answer. As for those who advocate further state intervention, we need to get the message across that it is state intervention that is the problem.


Professor Kevin Dowd is the co-author, with Martin Hutchinson, of Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System.

10 thoughts on “A tale of three capitalisms”

  1. Posted 18/10/2010 at 13:46 | Permalink

    Some thoughts arising from this very important piece.
    1) It needn’t necessarily be FS – automotive manufacturers have often wielded similar influence e.g. – and cronies can often be organisations like the TUC or CBI (1970s corporatism). As I see it, the contemporary prominence of FS is the product of government manipulation of money which is probably the most interfered with market that there is.
    2) ‘Classical capitalism’ is indeed the ‘best and effective’ for the whole but not for the few who seek to adapt it into their own special interests, often by co-opting large blocs of voters and/or politicians. The question is, whether the shift from one form to another is an inescapable result..

  2. Posted 18/10/2010 at 13:51 | Permalink

    … of democratic constitutions or not, as all democracies have to a varying extent gone down this path? Of course, that’s not an argument against democracy as other systems usually do worse, but it does seem to beg the question of whether democracy can really support something close to classical capitalism, especially given the huge system of vested interests we now see.

  3. Posted 18/10/2010 at 15:10 | Permalink

    […] A tale of three capitalisms By Andy Duncan, on 18 October 10 Professor Kevin Dowd has penned an excellent article for the Institute of Economic […]

  4. Posted 18/10/2010 at 15:15 | Permalink

    I would also think it is important to add that the short termism of the second form may be, in part, down to the listing and thus liquidity of the shareholdings, and the volatility that can accompany it.

    If shares are illiquid or not listed, but still held by the same players, the motivation to get stuck in and kick out bad management will be stronger.

    If management is also remunerated/targeted by share price, then what do you expect – management is acting “rationally”.

  5. Posted 18/10/2010 at 16:42 | Permalink

    I appreciate the agency problems caused by limited liability. But if liability were unlimited for companies (as with partnerships) would it not be almost impossible to find very-high-risk capital for new ventures?

    At present that may sometimes be forthcoming from wealthy individuals, who may be prepared to risk what to them is a small amount. But if their liability were unlimited, surely they would be unwilling to put any money in?

    It would be interesting to know how much of the equity capital of large companies today has come from money invested by shareholders and how much from retained profits. The calculation would be tricky, because of the need to allow for inflation.

  6. Posted 19/10/2010 at 03:15 | Permalink

    I am with DRM on the unfortunate necessity of limited liability, but I took Kevin’s point to be that the exposure to risk and reward of shareholders under individual shareholder capitalism, even if their liability is limited to the loss of their business, is so much greater than under dispersed and intermediated forms of shareholding, that their incentives to take care and control, and to invest for the long-term are significantly greater. I thought the article was bang on.

  7. Posted 20/10/2010 at 09:53 | Permalink

    I believe that DRM is wrong to worry about where “venture capital” for risky new ventures would come from under unlimited liability; the price charged for such funds would merely reflect such risk – and with modern information-discovery processes, it would not be as much as it was when people were financing East India company spice ships… At present we have a system that has evolved to deter such investment, because of the way risk is embraced, without penalty for failure. That safety net needs to be removed at once, and then the true value of an investment can become clear.

  8. Posted 23/10/2010 at 06:50 | Permalink

    1 Make all Directors and above of corporations fully liable and vested, as in Capitalism #1. They are owners by proxy. In bankruptcy cases, make the judge’s personal wealth hang in the balance if he shows preference regarding management owners’ attempts to hide or transfer their assets.

    2 PE has repaired at least some of what regulation and governments have botched.

    3 The 17th Amendment must be abandoned if there is any hope of devolution of federal power. The people can not do it alone.

    4 Bank leverage and counterfeit money is bankrupting the country. The practicality of fixing that is beyond me.

    Saving the banks may have irreparably damaged the country given ensuing wealth transfer.

  9. Posted 31/10/2010 at 20:13 | Permalink

    […] I think the benefits of limited liability exceed the costs. […]

  10. Posted 05/11/2010 at 17:57 | Permalink

    Yes, managers (agents) feather their nests rather than run shareholders’ companies properly. Worse, shareholders are now often agents too, eg fund managers, and/or don’t have big enough stakes. The current crisis is different but connected? It is another credit bust, caused by bad public policy – allowing fractional reserve banking, central bank money creation, fiat money and deposit insurance. Bad monetary systems create inflation as well as crashes. Inflation makes bonds unsound compared to shares, creating widespread retail investment in shares. And over-taxation of directly held investments hands these shareholdings to state privileged ‘City’ agents – pension or other fund managers.

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