Tag Archives: economic institutions

Applying Public Interest Capitalism to the health insurance industry

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.

Wendell Potter interview with Bill Moyers from YouTube

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.

The case for restricting stock buybacks

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?

The limits of self interest

When I visit Tokyo, I teach an ad hoc, voluntary seminar to Japanese university students.  Each time, we meet for three hours and discuss an assigned text.  The students read the text in Japanese, I read it in English, and we discuss in Japanese.  Last year, we met three times and worked our way through John Kenneth Galbraith’s Affluent Society.  This year, we have been reading Douglass North’s excellent book Institutions, Institutional Change and Economic Performance.  We had our second meeting of the year this afternoon.

During our discussion today, I was particularly struck by North’s conclusions regarding third-party enforcement of contracts and property rights.  He posits capacity for effective third-party enforcement to be a necessary condition for a sophisticated market economy.  This turns out to be problematic:

Third-party enforcement means the development of the state as a coercive force able to monitor property rights and enforce contracts effectively, but no one at this stage in our knowledge knows how to create such an entity.  Indeed, with a strictly wealth-maximizing behavioral assumption it is hard even to create such a model abstractly.  Put simply, if the state has coercive force, then those who run the state will use that force in their own interest at the expense of the rest of the society.  (North, 1990: 59)

North identifies an important limitation of neoclassical economic theory.  In a sophisticated market economy, competition by self-interested agents yields efficient outcomes only given effective third-party enforcement.  Conveniently, the theory assumes both self-interested agents and effective third-party enforcement.  However, North argues that self interest undermines effective third-party enforcement.  If so, then the assumptions of neoclassical theory are mutually contradictory.

To explain the economies of the advanced nations, North suggests that the theory must take into account non-wealth-maximizing human motivations including values and ideologies.  Such internal restraints on self interest appear to be an essential ingredient in the even-handed third-party enforcement that makes possible sophisticated market economies.  With respect to the successful development of third-party enforcement in England during the seventeenth century, North says:

although that story describes a successful outcome, it does not give a definitive answer to the question of how it was achieved.  It was surely a mixture of formal and informal constraints.  Both respect of the law and the honesty and integrity of judges are an important part of this success story.  They are self-enforcing standards of conduct, and I believe that they are important. (North, 1990: 60)

Though the importance of non-wealth-maximizing motivations may seem obvious, they are ignored by most of mainstream economics.  (Sometimes the utility function is said to incorporate non-wealth-maximizing motivations, but this is disingenuous: they are implicitly excluded by the structure of most mainstream models.)

These passages are deeply disconcerting, because they indicate how poorly we understand the foundations of our prosperity.   Moreover, by teaching models that legitimate the pursuit of self interest without regard for social consequences, mainstream neoclassical economics may be weakening those foundations.

Varieties of capitalism on Hime Island

The New York Times offers an example of a Japanese island that has developed a communitarian form of capitalism.  Residents share government jobs, watch free cable television, enjoy immaculate parks and public toilets, and limit displays of wealth to prevent jealousy from undermining community solidarity.

Under Hime’s system, village employees earn about a third less pay than public servants elsewhere in Japan, though they work the same hours. This has allowed the village to create more jobs: it now directly or indirectly employs a fifth of all working islanders. Most of the rest are engaged in fishing, also government-subsidized. In fact, village officials say, there are few fully private-sector jobs on the island.

This is an interesting case study, because it shows how a community can engineer capitalism to their own liking.  Creating such communitarian economic institutions probably requires a certain amount of social closure, so being an island may help.  (Just to be clear: Hime Island’s economy is certainly capitalist; individuals living there have considerable freedom to deploy their human and financial capital as they please, and the entrepreneurially-minded open restaurants or small hotels for tourists.)  The whole world cannot be Hime Island any more than Hime Island can be Silicon Valley, but the example suggests that communities may have more control over their destinies than neoclassical economics would predict.  My friend David Grewal explains why such freedom requires collective action in his book Network Power.

The financial crisis provides an opportunity to revisit the assumptions of capitalism and recognize many possible varieties of capitalism, many of which have yet to emerge.