In the early 1980s, a sort of a revolution started in corporate governance. It started in the US, but it spread (often in diluted form, as it bumped against local culture) to other countries as well. This revolution can be described with the term shareholder capitalism. The essence of the theory can be depicted by two simple propositions:
- Companies should be run in order to maximize shareholder value.
- In order to align incentives (and defuse the "agency problem"), an important part of managerial compensation should be tied to stock market performance.
The shareholder approach has been in the ascendancy over other forms, like managerial capitalism (or stakeholder capitalism) because it has sort of a unity of purpose - profit maximization for the benefit of shareholders. There are good reasons for this:
- Increasing competition causes interest to converge around the survival of the firm, returns should cover the cost of capital in the long run.
- Pursuit of other goals is increasingly a luxury, managers who pursue other goals will be replaced in a more active market for corporate control and more active institutional investors.
- For simplicity reasons, strategic decision making can be easier subjected to rational analysis with the assumption of profit maximization most analytical tools are based on profit maximization.
- One could also argue that conflicts of interests between different stakeholders are more apparent than real conflicts - long-term
profitability is difficult to achieve without treating employees well, and this is also easier if the company performs. Long-term success requires companies to be responsive to the needs of consumers, communities and employees.
But this isn't so clear cut as it might seem at first sight. For instance, it's far from clear ex-ante which strategies will lead to profit maximization, even more so if time enters as a factor. The results of this revolution have been a mixed bag. We'll discuss these in the following points.
It took a while for things to show up in the figures (there are, of course, quite a number of other factors influencing corporate profits), but corporate profits started to grow significantly faster than nominal GDP from the mid 1990s, and despite temporal reversals of this trend before and during recessions, the trend seems to have very much re-established itself post 2008/9 financial crisis.
Stock prices took off right from the start of the shareholders revolution:
Although, as the chart does, one could argue the last decades didn't achieve much gains due to markedly increased financial instability.
Increased corporate profits and higher stock prices - so far, so good for shareholder capitalism.
This is going to be a bit more surprising:
Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity. [Money News]
That 12% figure has increased a bit, but it's clear that business investment has been on a downward path since the early 1980s:
What does shareholder capitalism has to do with that? Well, much business investment has uncertain returns that lay far into the future, while costs are born from the start. From the perspective of beating next quarter's earnings, this often isn't the best way.
While already on the decline before the crisis, an important question is why it hasn't recovered in the light of record profits and cash balances of corporations. After all, investments should surge with such a record low cost of capital. We have already analyzed this phenomenon and came up with two main causes:
- A sectoral shift from high capital intensive manufacturing to lower capital intensive services.
- A shift in categorical income distribution from wages to profits.
The latter is intimately connected with the rise in shareholder capitalism, with its emphasis on profit maximization and forms of managerial compensation, as we'll try to show below.
Rising inequality and managerial compensation
Recently, much public debate has been focused on the seemingly inexorable rise in inequality. There are good reasons to believe that the rise of shareholder capitalism is perhaps the main driver of this:
- The rise in inequality is significantly more pronounced in countries which have embraced shareholder capitalism, like the Anglo-Saxon countries, especially the US. It's much less pronounced in countries that have other models of capitalism (the Rheinland model in Germany, or Japanese capitalism).
- Most of the rise in inequality seems to be produced by spectacular gains at the very top, the 0.1% of income distribution, mostly populated by corporate officers and financial tycoons.
- A more singular emphasis on profitability has led to a rise in corporate profits, partly at the expense of wages, which have been lagging.
- The rising importance in income from capital, which is also highly unequally distributed, and ...
Some illustrations of the above:
One table that's been making the rounds on Facebook is a comparison between CEO and worker salary. For example, in Japan the ratio is 11 to one, in Germany it's 12 to one, but in the US it's 475 to one. (Daron Acemoglu)
The exact number varies by source considered, but what's not in doubt is that this ratio is much higher in countries that have embraced shareholder capitalism, as is inequality in general:
It also has increased spectacularly in the US:
The ratio of CEO-to-worker pay has increased 1,000 percent since 1950, according to data from Bloomberg. Today Fortune 500 CEOs make 204 times regular workers on average, Bloomberg found. The ratio is up from 120-to-1 in 2000, 42-to-1 in 1980 and 20-to-1 in 1950. (Huffington Post)
Much of the gains since shareholder capitalism (the early 1980s) have gone to the top 0.1%:
The top gets much of their income from capital, and this has been increasing rather a lot:
And the concentration of capital at the top has been relentless.
As you can see, just as with income gains, the concentration of capital is mainly an 0.1% phenomenon, even the next strata (0.1%-1%) hasn't seen much gains:
Many wages have been stagnant for quite some time.
Again, this isn't entirely or even mainly due to the rise of shareholder capitalism, but wages have a tendency to be treated mostly as a cost to be minimized. Witness the invariable jump in share price when companies announce big layoffs and restructurings. Cutting labor costs, high managerial compensation and a rise in the share price often go hand in hand, especially where there are few institutional protections to firing workers.
Former Heinz chief executive William Johnson received $110.5m (£66.1m) for the final eight months of 2013, the food firm disclosed in a filing to US regulators. Current boss Bernardo Hees, who joined the firm in June, received $9.2m. Mr Hees has cut more than 3,400 positions and closed factories in an effort to boost profits. (BBC)
Now, we're not arguing that this is all bad, in fact, most of it is good. In times of fast change, resources need to be rapidly deployed, although the evidence on labor is mixed.
But you can have too much of a good thing. The focus on cost cutting and the bias against investments with a longer-term, more uncertain return but direct cost can become a bit of a self-reinforcing mechanism.
For instance, in the last five years, stocks have rallied in a distinctly mediocre economy and with stagnant or falling wages. Much of the earnings per share growth has been the result of cost cutting and share buybacks, rather than growing revenues. This isn't a coincidence.
With stagnant or even declining wages, it is ever more difficult to increase revenue growth, at least at home. This reinforces the emphasis on cost cutting and/or share buybacks and companies reluctant to invest in new capacity, despite all the profits, cash and low cost of capital. All this is consistent with the facts:
- A secular decline in business investment
- A secular increase in corporate profits
- An enormous rise in executive pay
- A secular shift in income from wages to profits
- Stagnant median wages
- Companies focusing mostly on the bottom rather than the top line
The secular decline in investment matters a great deal, for various reasons:
- Investment builds productive capacity and incorporates the latest technology. Less investment leads to long-term deterioration of the capital stock, both in quantity and in quality.
- Investment is part of aggregate demand, less investment can easily lead to less demand. And this will be demand for goods and services of industries (capital goods, software, ICT, etc.) at the forefront of the technological and knowledge frontier,
so less demand could lead to slower progress here.
That is, less productive capacity gets built and productivity grows at a slower pace than it would otherwise do, leading to a secular decline in economic growth.
So we have a secular decline in investment and in wages, and a secular rise in profits, share prices and managerial compensation. Sure, not all of this can be ascribed to the rise of shareholder capitalism, but for those worried about secular stagnation, it's food for thought.
The distinct danger is a low growth equilibrium where business investment is low because demand for end product growth is low, caused by stagnating wages. This forces companies, under pressure from shareholders, to focus on cost cutting which tends to reinforce these tendencies. There are some further negative sides to shareholder capitalism.
A rather unintended but toxic consequence of aligning the interests of managers and owners has been for managers to game the system, that is, to artificially, or even illegally inflate the metrics on which their compensation packages depend. A decade ago a raft of outsized corporate scandals (WorldCom, etc.) emerged that illustrated this.
It's also widely recognized that in the financial sector traders face significant asymmetrical risks and often have little to lose, while much to win by taking on risky bets.
Part of these problems can be ameliorated by regulation (indeed, Sarbanes-Oxely, Dodd-Frank, etc.). It has to be recognized that there will always be ways to circumvent new regulations at least in part and the fact that setting up any kind of system (that is, making pay partly dependent on performance measures) invites gaming. A better idea is perhaps to alter the incentives themselves, for instance, by tying compensation to longer term firm performance.
One should not judge overly harsh here. Alternative forms of capitalism generate their own forms of fraud problems and we're not aware of studies that arrive at clear-cut conclusions about which form is more fraud prone. Before shareholder activism reasserted itself in the 1980s, while compensation was much lower, managers often had lavish perks.
The secular decline in business investment not only produced a secular decline in economic growth, but also made the economy more unstable and prone to financial crisis. Why? Well, with low investment demand, the interest rate equating savings and investment demand is low, perhaps even negative and there isn't much of a threat from inflation taking off.
In the absence of inflationary pressures, the Fed will keep interest rates low. While failing to stimulate business investment even at very low rates, these low rates could be conducive to the formation of speculative asset bubbles. Normally, the buildup of these will lead to an overheating economy and inflationary pressures building up, prompting the Fed to hike rates to stave off inflation.
I'm sure most readers recognize this situation. However, it has been worse. Even in the credit frenzy of the first decade of this century, the economy stubbornly refused to overheat and inflation didn't take off. Before the crisis, the secular stagnation was kept in check, first by longer working hours and women moving en-mass to the labor market, and then by a borrowing frenzy.
There isn't anything likely to replace even these. The main candidate is demand from overseas, but growth in many emerging markets is slowing, and these countries collectively produce a savings glut. So secular stagnation basically runs unchecked. This is the new normal.
Capital thrives, so do shareholders, but profit margins cannot rise forever, nor can companies buy back their own shares in an unlimited fashion. And with regulation of financial markets usually one (or several) steps behind financial activity, asset bubbles are likely to emerge sooner rather than later, if they haven't already.
What to do?
There isn't much (if any) evidence that shows that the extraordinary explosion in managerial compensation has had any impact on performance:
- Pay is often unrelated to performance
- It is rank order that counts, not pay as such
- Are managers who are primarily motivated by money really the best motivated?
A new book by French economist Piketty has created considerable waves. It argues that in normal times (outside war, catastrophes), the return on capital is considerably higher than economic growth. Over time, this leads to an enormous concentration of wealth and in the last couple of decades, this concentration has been accelerated by the explosion in managerial compensation.
If capital grows considerably faster than the economy, and wages lag productivity growth, rather than combat the resulting low growth equilibrium by demand stimulating policies, one could make many more people "capitalist," that is, give employees a bigger stake in companies. There is considerable evidence that this can increase involvement and motivation, thereby increasing productivity, especially when those stakes are linked to concrete performance goals ("gain-sharing").
This isn't a panacea, just one avenue on which to address a multifaceted problem. It is very much in accordance with the founding fathers of the US to give most people a stake.
George Washington, nine months before his inauguration as the first president, predicted that America "will be the most favorable country of any kind in the world for persons of industry and frugality, possessed of moderate capital, to inhabit." And, he continued, "it will not be less advantageous to the happiness of the lowest class of people, because of the equal distribution of property." The second president, John Adams, feared "monopolies of land" would destroy the nation and that a business aristocracy born of inequality would manipulate voters, creating "a system of subordination to all..."
We think it is plausible that the emphasis on shareholder capitalism has been a considerable (but far from the only) factor in rising profits, and exploding managerial compensation, but also in rising inequality, stagnating wages and investment. The danger is that this has contributed significantly to the risks of an economy stuck in a low growth equilibrium (secular stagnation) and plagued by higher financial volatility.
But shareholder capitalism also has considerable benefits - it produces a unity and clarity of purpose, keeps pressure on management to perform and keeps an active market for corporate control. We think that these features can be preserved and the negative sides ameliorated by giving more people a chance to gain a share in the wealth it creates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.