David
 James
 Brunner

From Bootle’s recent book The Trouble with Markets, excerpted in a Telegraph article entitled “Greed isn’t good - it’s dangerous“:

Society cannot live by greed alone. Even if it can cope perfectly well if some of its members are motivated in this way, it needs millions of people to be motivated by duty, responsibility, and a sense of public purpose. These are feelings that the triumph of unbridled greed in the financial markets threatens to overwhelm. The market was made for man, not man for the market.

Exactly.  We need to get the financial sector under control and restore the balance between private and public interest in corporate management.

I’m at the Tokyo Foundation office in Toranomon, Tokyo reading this article by Masahiko Aoki and Gregory Jackson entitled “Understanding an emergent diversity of corporate governance and organizational architecture: an essentiality-based analysis”.  Aoki and Jackson propose that the view (currently ascendent in financial economics) of the firm as the private property of the shareholders can be understood as a special case of a more general game-theoretical model of corporate governance.  Moreover, when employees and managers can create value by exerting control over the production process, circumscribing the control rights of shareholders may be desirable.  Aoki and Jackson argue:

An enforceable legal framework for worker participation may be a necessary prerequisite to focus managers and workers on the potential positive-sum gains of cooperation by constraining the potential for short-term gains from non-cooperation that may exist under liberal and purely contractual regimes

As Mary O’Sullivan argues in her book Contests for Corporate Control, insider (manager and employee) control is essential to innovation.  Thus, in a world where competitive advantage increasingly derives from dynamic capabilities, learning, and innovation, it seems reasonable to expect that forms of corporate governance that limit the control rights of shareholders will exhibit better performance.

This work is thus broadly consistent with my research on Public Interest Capitalism, which advocates redesigning capitalist institutions (”rules of the game”) in order to encourage more equitable, sustainable, and innovative economic activity.  Along these lines, I favor a rule requiring employee approval in the case of hostile takeovers, since the possibility of a hostile takeover impedes the creation of implicit contracts between managers and employees, among other stakeholders.

The article also includes an interesting empirical analysis of the institutional clusters emerging in the Japanese economy.

Former health care executive Wendell Potter has been calling attention to how health insurance companies increase shareholder value at the expense of their customers and the broader public interest.  Potter left an executive post at CIGNA to become a senior fellow at the Center for Media and Democracy.  His descriptions of how insurance firms short-change their customers and cynically manipulate the political process to serve there masters on Wall Street are a powerful indictment of the shareholder value maximization ideology.  Potter’s interview with Bill Moyers, below, is well worth watching.

From a Public Interest Capitalism perspective, one of the most interesting characteristics of the interview is that neither Moyers nor Potter ever questions the ideology of shareholder value maximization–Milton Friedman’s doctrine that a company exists only to make as much money as possible for its shareholders.  So we have only two choices: healthcare managed by greedy corporations who will (metaphorically) throw their customers under the bus to boost profits, or healthcare managed by the government.  Although I have nothing against healthcare managed by the government, my research on Public Interest Capitalism suggests another possibility: restructuring capitalism so that corporations seek to balance private profits and the public interest.

The idea of such enlightened corporate management may seem far-fetched, and it is far-fetched when economic institutions create overwhelming incentives for management to increase shareholder value regardless at any social cost.  But these incentives can be changed.  We could start by prohibiting compensation linked to share price (stock options and stock grants) in publicly traded companies.  Capping executive compensation at a multiple of the compensation of the lowest-paid employee–perhaps forty times–would probably help, too, by limiting the ability of senior executives to profit personally from abusive tactics.  Then limit dividends and voting rights to shareholders who have owned shares for at least five years, thereby reducing the influence of activist investors and hedge funds while protecting the legitimate interests of long-term shareholders.  Requiring that insurance companies disclose, in a standard and easy-to-understand format, performance metrics related to patient satisfaction, recision rates, and so forth would help the public identify abusive firms.

In light of our shareholder-oriented corporate governance institutions, it’s easy to understand why health insurance companies behave the way they do.  Institutions determine whether we can cooperate productively, or whether we slip into wasteful and socially injurious redistributive conflicts, as in the case of the American health insurance industry.  But just because we have developed pathological institutions doesn’t mean that managers necessarily want to behave this way–Potter obviously did not–or that we have to stand idly by as these institutions wreak havoc on our healthcare system and our government.  As Nobel-prize-winning economist Douglass North points out in his book Institutions, Institutional Change, and Economic Performance, institutions are “humanly devised constraints that shape human interaction”.  Humans devised them, and humans can change them.

In my research on Public Interest Capitalism, I argue that markets and self interest do not necessarily serve the public interest.  This research draws on theoretical work by the respected economist Douglass North, who argues that institutions (i.e., values, social norms, and regulations) determine whether economic actors engage in wasteful redistributive activities, or productive value-creating activities.  When resources are squandered on redistributive activities, societies decline.  Recently, similar concerns have been echoed by Yukio Hatoyama, Japan’s prime minister to be.  Today, the Telegraph reports on a remarkable speech by Stephen Green, the chairman of HSBC.  The following are quotes from his speech, as reported by the Telegraph.

At their worst, financial markets can be engines of destructive excess. In recent years, banks have chased short-term profits by introducing complex products of no real use to humanity.

capitalism generally, and banking specifically, needs to reaffirm its commitment to contributing to social and economic development

There is no question that the markets – in the form of investors and traders – have often put pressure on boards to pursue short-term strategies and profits.

The results of that pressure are now plain to see in the broken businesses and weakened economies around the world. This was the basic failure of corporate governance.

Legislation is not and can not be sufficient without a culture of values in our industry

If this crisis leads to a genuine reassessment of the role of business and banking in market economies, it may come to rank as one of the great turning points in history of the modern world.

These points closely parallel the arguments that my colleagues and I make in our research on Public Interest Capitalism, so it’s encouraging to see these views articulated by a senior bank executive.  North would surely applaud Green, too, for recognizing that values are an essential complement to legislation (see also my discussion of Why Greed is Bad).  Finally, I think that Green could be right about the potential historical significance of reassessing the role of business in society: if businesses seek to profit through contributing to the general welfare, instead of seeking to profit at its expense, we may enjoy more equitable, sustainable, satisfying, and rapid economic growth.

I doubt that Green or any of his close associates will stumble across this blog, but I invite anyone at HSBC to contact me to discuss Public Interest Capitalism.

William Lazonick makes the case against stock buybacks in the latest issue of BusinessWeek.  In his article “The Buyback Boondoggle“, He argues that companies spend huge sums of money on buybacks that they could have invested in innovation and employment.  From the article:

The amount of money spent on buybacks is staggering. From 1997 through last year, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on them. In 2007, as profits soared, the average buyback bill for each was about $1.2 billion—a record amount. And faced with a dramatic drop in their combined net income in 2008, these companies trimmed buyback spending, but not proportionately: The buyback-to-profit ratio, which was already unprecedented in 2007, more than tripled in 2008, from 0.90 to 2.80.

He further observes that buybacks helped weaken major American firms to the point that they required government bailouts when the economy deteriorated:

If bailed-out General Motors (GM) had banked the $20.4 billion distributed to shareholders as buybacks from 1986 through 2002 (with a 2.5% aftertax annual return), it would have had $35 billion in 2009 to stave off bankruptcy and respond to global competition.

And the bailed-out banks? Eight of the biggest spent a total of $182 billion on buybacks from 2000 to 2007. That reduced their ability to cover their bets on derivatives, exacerbating the crisis they created in the first place.

At the heart of the issue is the conflict of interest between shareholders and management, on one hand, and other corporate stakeholders such as employees, customers, suppliers, local communities, and nations, on the other.  Shareholders have limited liability, so they can profit by extracting as much money from companies as possible during good times, even to the point of taking on debt to pay dividends–a common private equity practice.  If the companies subsequently go bankrupt, the shareholders have already pocketed their profits.  The greater the likelihood of bankruptcy, the greater the incentive for shareholders to take money out.

A more subtle problem is that shareholders have difficulty quantifying and verifying the value of long-term investments, so they prefer short-term investments or cash distributions.  Thus managing for shareholder value becomes managing for the short term, leading to underinvestment in innovation, human capital, and organizational capital.

As Lazonick points out, executive compensation in the form of stock shares and options create incentives for senior managers to buy back shares, since buybacks both distribute cash to shareholders and increase demand for shares.

In the article, Lazonick proposes banning share buybacks, but this won’t solve the problem of short-termist incentives embedded in executive compensation linked to stock price.  So how about limiting the value of stock grants and options to 5% of base salary for employees of publicly traded companies?

Over the last several decades, maximizing shareholder value has become widely accepted as the duty and legitimate purpose of business managers.  Many scholars propounded this ideology, and probably none more forcefully than Milton Friedman.  In a well-known article in the New York Times Magazine in 1970, he argued that “The Social Responsibility of Business is to Increase its Profits“.  In his book From Higher Aims to Hired Hands, Harvard Business School professor Rakesh Khurana describes how this view replaced a conception of the business manager as a steward of the public interest responsible for skillfully balancing the interests of corporate stakeholders to sustain the enterprise and create value for society.  William Lazonick and Mary O’Sullivan provide a complementary perspective.

Unfortunately, while maximizing shareholder value squares nicely with neoclassical economic theory, it can cause serious problems in practice.  In my research project on Public Interest Capitalism, we link shareholder value maximization to inequity, short-termism and underinvestment, and deterioration of social capital.  In a nutshell, there are three fundamental problems with relying on shareholder value maximization as the criterion for corporate management.  First, market incentives (hence profit) may correlate only slightly or even negatively with social welfare (on this point, see David Grewal’s book Network Power).  Second, markets can impede innovation (Mary O’Sullivan provides the details in Contests for Corporate Control).  Third, by reducing the purpose of the company to generating as much profit as possible for a diffuse external constituency, shareholder value maximization decrease the identification of employees to organizational goals, thereby hindering learning and efficient operation.  For a different but complementary perspective, see Simons, Mintzberg and Basu’s ”Memo to: CEOs“.

Fortunately, it appears that the shareholder value maximization movement may have run its course–albeit after bringing the global economy to the brink of collapse.  A group of MBA students at Harvard Business School, concerned about business ethics and inspired by Rakesh’s work, have started MBA Oath, a movement to professionalize management.  The New York Times has the story: “A Promise to Be Ethical in an Era of Immorality“.  This is a very encouraging development.

The Los Angeles Times is reporting “China relaxes business regulations“.  The article describe government efforts to prevent laws and regulations from hampering business:

The Industry and Commerce Administration of Zhejiang province … earlier this year released what local media called the “three noes” policy. Two of the noes have to do with minor licensing and registration issues. The third one, though, states that there should be no punishment for businesspeople who make “common violations that don’t directly cause harmful consequences.” Instead they should be given suggestions and admonitions to correct their errant behavior, officials said.  …

In China’s southeast industrial hub of Guangdong province … the government cautioned investigators about detaining or taking other action against entrepreneurs or key company managers that could disrupt business. Even if authorities have gathered all the evidence, action may be delayed until the manager has finished conducting business.

On the environmental front, there is evidence of regulatory capture:

In China’s southeast, Jiangxi Copper Corp. is expected to begin work next month on a $730-million lead-zinc smelting operation along the Yangtze River.  … Jiangxi province’s environmental protection bureau boasted that it had finished the environmental-impact review in just three days

According to the article,  favorable treatment for capitalists is nothing new:

Even during ordinary economic times, giving privileged policies to businesspeople in China is common.  Some smaller locales have offered investors immunity for traffic violations and other misdemeanors.

It’s easy to see how these policies could boost economic growth in the short term by removing constraints on business activity.  Whether these policies serve the broader public interest, however, seems questionable.

A Public Interest Capitalism perspective raises three questions.

1. Are these policies sustainable?  Even leaving aside concerns about environmental destruction, economic theory gives us compelling reasons to believe that the rule of law is essential to advanced economic development.
2. Are these policies equitable?  Perhaps investors and entrepreneurs merit special privileges.  I tend to think not, but the US tax system gives preferential treatment to capital gains.  Policies that relax regulatory enforcement are particularly problematic from an equity standpoint, however, because they benefit most those who are profiting from illegal, socially destructive activity.
3. Will these policies promote innovation?  To the extent that these policies protect incumbent businesses, they create obstacles for creative destruction.  This may not be too much of a problem when the economy is growing rapidly and generating entrepreneurial opportunities, but it could hinder readjustment when growth slows.