Adam Smith, the 18th century Scottish economist, was a renowned critic of multinational companies whose directors not only enjoyed limited liability, but also profited by taking advantage of state monopolies, or quasi-monopolies.
The East India Company was a particular target for his criticism as a result of the way the UK government tried to boost its tax revenues by backing its expansion in Bengal.
The EIC was founded in the year 1600 by a group of 218 merchants, who were granted a monopoly over trade to the east of the Cape of Good Hope by Elizabeth I. She gave its directors limited liability to encourage them to sponsor trade with the east, secure in the knowledge they would not go bankrupt if ships were lost at sea or wiped out by marauders. The EIC called on the protection of the English armed forces. It repaid the assistance by providing the government with tariffs, taxes and access to prosperous markets.
At first, this mercantilist model worked rather well. As time went on, however, its managers and shareholders demanded higher and higher returns. In 1757, Sir Robert Clive delivered Bengal to his associates at EIC to govern. The EIC extracted high taxes from the luckless colony, with the help of a standing army coordinated by Clive.
Adam Smith denounced the EIC as a bloodstained monopoly. The directors paid themselves generously and were broadly seen as corrupt. But when famine wiped out a third of Bengal’s tax revenue, the EIC could not make its own ends meet.
The directors had to go cap in hand to the government to avoid bankruptcy. Clive committed suicide in 1774. After a century of tight state regulation, the EIC was finally put out of its misery in 1874.
Long before, Adam Smith had warned that monopolies “encouraged waste, fraud and abuse”. He talked of “the invisible hand” which guides self-interest into taking advantage of the wealth of nations.
He added: “The interest of the dealers in any branch of trade or manufacturers is always in some respects different from and opposite that of the public. They have generally an interest to deceive and even to oppress.”
Ring any bells?
During the credit boom, the largest of the world’s banks straddled the capital markets, spending immense sums to trade every scrap of information they could find.
They put together loans for companies, but they were more partial to racking up proprietary trading profits on the other side of the deal. Derivatives were forged into products to sell to investors and used as trading tool.
Like the EIC, the banks supplied governments with valuable tax revenue. By way of support, the governments gave the banks free rein, seeing no problem with trading divisions working alongside their commercial operations. The banks were an oligopoly rather than a monopoly, but they were individually, and collectively, too big to fail.
The latest allegations about the way banks manipulated the Libor debt interest charge benchmark illustrates how powerful the banks were feeling at the top of the credit boom.
In the 1990s, Federal Reserve chairman Alan Greenspan was their biggest friend, willingly pumping liquidity into the system following every crisis. The introduction of mark-to-market accounting fuelled their ability to extract real, or paper, trading profits and boost their bonuses.
As was the case with the EIC, directors were protected by their limited liability status in contrast to private banks forcing directors to take unlimited liability, which came out of the credit crisis in good shape.
By 2008, global banking balance sheets had become badly exposed to borrowers whose ability to repay debts was no better than the chances of famine-hit Bengalis to pay taxes on time to the East India Company.
They have already been forced to seek direct, or indirect, support from governments. None of them dare to write down their debts to a practical level and their ability to trade their way out of trouble is being regulated away.
Writing in Financial News, commentator Harold James reckons governments need to draw lessons from the teachings of Adam Smith in dealing with the banks.
And one thing is already certain – the next steps are likely to be protracted and painful.
Let’s just hope it doesn’t go on for another century.