Capitalism is broken suggested Jack Bogle, founder of U.S. mutual fund giant The Vanguard Group, in the keynote address today to the 2004 AIMR Annual Conference in Denver.

Bogle said — borrowing a phrase from another author — that the capitalist system has undergone a “pathological mutation” from ownership capitalism to managers’ capitalism. In the past, Bogle said, capitalism worked, virtuous cycles of growth, prosperity and social improvement were fostered because trust was a necessary element of good business.

The shift from companies that seek shareholders’ interests to companies that serve managers’ interests has led to a corruption of capitalism; at least the capitalism envisioned by Adam Smith, and his “invisible hand” metaphor. Bogle suggested that the “rise of the imperial CEO”, and the diffusion of corporate ownership, has removed accountability from the system.

Regulators and legislators made it worse with their interventions, he insisted, auditors and directors forgot their obligations, the industry failed, investors became focused on short-term returns, and the media helped cheerlead this systematic disintegration, he said.

The stock market bubble, and the subsequent bust, had “1,000 fathers”, Bogle said, but, the chief culprit was spiraling executive compensation. Huge rewards were heaped on “managers who were rarely leaders, bureaurcrats who were rarely creators”, he noted. Instead, companies allowed a huge transfer of wealth from their owners to their managers. An insanity that Bogle says was perpetrated by weak governance structures that allowed managers to be rewarded, not for their actual performance, but in comparison to others, at a time when strong economic growth made all managers look good.

The solution is to return corporations to their owners, he argued. Bogle called for more shareholder democracy. He said that powerful institutional investors should take more responsibility for the actions of companies in their portfolio. And, he called for greater corporate democracy generally — that shareholders should have more power to nominate directors, more power to make shareholder proposals and that more fundamental issues should be put before investors.

Bogle dismissed the idea that disgruntled shareholders can just sell companies that don’t behave as they’d like, saying that’s “not an enlightened approach to public policy”. And, as a proselytizing passive investor, Bogle noted that selling isn’t an option for index funds.

Bogle also suggested that all parts of the capitalist system should be dreaming up ways to help fix its troubles – possibly taxing short-term traders, paying higher dividends to long-term shareholders, making it a fiduciary duty for fund directors to run their funds solely on behalf of unitholders. We should be doing “everything imaginable to to give the true owners the upper hand”, he suggested.