Your manager lives in a suburb about thirty miles north of Chicago. Over the years, some well known residents built beautiful homes there along Lake Michigan. Less known, but far more plentiful, are the perfectly nice, but much less grand homes which make up most of the town. These homes were historically owned by managers, professionals, and independent business owners.

In 1993, your manager purchased his first home — a four bedroom colonial on a tree lined street near a school. The home was built in the early 1960’s. Next door was a similar one which had been built around the same time. In a discussion with a neighbor one day, I learned that the home next to ours had previously been owned by the president of United Airlines. I found this striking. Thirty years ago, the president of one of Chicago’s leading companies lived in a home which today would sell for under a million dollars.

This is how capitalism used to work. The homes on the lake were owned by people (or their heirs) who took risks with their own capital in order to earn their fortunes. They generally were innovators in technology, marketing, or finance.

They faced the potential for loss as well as gain. When they were successful, they made huge fortunes. When they failed, they often lost everything.

Contrast this with the mind-set of many CEO’s today. The bulk of their compensation generally comes from stock options, so the potential exists for gains but not losses. When options don’t work out, the strike prices can be reset at a lower level. If an executive performs really poorly, there is generally a nice severance package waiting at the door.

How did we get to this point, where the “hired help” was living in mansions along with the entrepreneurs? In the 1970’s, many American businesses were thought to be lazy and under-managed. There are many reasons why companies become less creative and less entrepreneurial: A poor business environment, lack of an activist shareholder base, and an oldboys club approach to competition, to name three. CEO salaries were low by today’s standards, but so were expectations.

This changed in the 1980’s when buyouts began to shake up the establishment. Entrepreneurs and innovative financiers showed companies that if they failed to perform they were subject to losing their jobs. The old system was under attack. Two of the rallying cries of this period were “create shareholder value” and “align the interests of management and shareholders.” This movement was a key aspect in the renaissance in American business which began in the early 1980’s.

Along the way, however, the original idea of aligning shareholders’ interests with management was co-opted through the combined efforts of complacent boards, uninvolved shareholders, and an army of compliant compensation consultants. It would be interesting to study whether or not there has been a correlation over the past 20 years between CEO compensation and profitability. My guess is that there wouldn’t be any, especially given the collapse of the financials in the past year.

The level of entitlement among some executives has reached remarkable levels. In many cases those who worked for failed financial firms have argued that they are entitled to large payouts despite their firms’ collapse on the grounds: 1.) it wasn’t their fault, 2.) their division had a good year, and 3.) they will go work somewhere else otherwise. These claims are in most cases dubious. Imagine a worker at the now bankrupt General Motors who argued for a bonus with similar claims: “my bumper assembly line had a great year, productivity was up, accidents were down, and we controlled costs. I deserve a raise.”

Capitalism has been — and will continue to be — an amazing engine of economic growth, creativity, and entrepreneurial initiative. As Gary Becker points out, it has done more to lift people out of poverty in the past 30 years than anything else. However it is also true that market economies break sometimes (governments break too, of course, probably more often). The response of policy makers cannot be to sit frozen when the failure of market mechanisms is causing substantial harm to the world economy. This doesn’t mean all ideas to fix the system are good, just that they aren’t all bad either.

In Ayn Rand’s classic novel Atlas Shrugged, the story is told of an epic battle between those who move society forward and those who live off the spoils. Ms. Rand is now often cited by so-called free market advocates who are critical of some of the financial market reforms which are being proposed. What these people miss is that the executives who have lived off shareholder largess over the years are like the villains of her novel, not the heroes. With apologies to those who haven’t read the book, John Thain was no John Gault.

William R. Andersen, CFA is the Portfolio Manager of the Wanger Income and Growth Fund