Is shareholder capitalism passe?
The emerging backlash against CSR and the resultant endorsement of shareholder capitalism make sense
The Anglo-american free enterprise system has been based on the classical liberal principles of shareholder capitalism epitomised by the modern corporation. Its sole social responsibility — as Milton Friedman stated in his 1962 classical liberal text Capitalism and Freedom — is “to make as much money for their stockholders as possible”. However, every time there is a financial crisis, there are dirigiste voices demanding that corporations have a “social responsibility” that goes beyond the interest of their stockholders. The dot-com speculative boom and the ensuing financial scandals like Enron bred moral outrage at the behaviour of corporations, with demands for government intervention to improve corporate governance, and some even asking for stakeholder capitalism to replace shareholder capitalism. Many corporations succumbed to these demands for corporate social responsibility (CSR). None with more dire results than Levi Strauss, the creator of denim jeans, whose CEO Robert Haas, embarked on “a failed utopian management experiment” in which he “was intent on showing “that a company driven by social values could outperform a company hostage to profit alone”. The outcome was declining sales, profits and share value. (Nina Munk: “How Levi’s trashed a great American brand”, Fortune, April 1999).
After the financial crisis of 2008, CSR and stakeholder capitalism are again on the agenda, with corporations asked to fix social problems like inequality and environmental concerns like global warming. More than 180 CEOS in the US, including those of Walmart and J P Morgan Chase, have vowed to go beyond Friedman’s simple and clear stated purpose of corporations to incorporate various social responsibilities. The US Business Roundtable, which like its other national associates had upheld the primacy of shareholders interests, has also caved in. This could be a tactical response to the claim by Senator Elizabeth Warren — a Democrat contender for the Presidency — that “being a big company is a privilege not a right”, and should have to apply for charters allowing them “to look after stakeholders, especially local ones. Those who let the side down would have their charters revoked”. (“I’m here from a company, and I’m here to help you”, The Economist August 24, 2019).
Raghuram Rajan and Luigi Zingales had argued in an important book, Saving Capitalism From the Capitalists, that stakeholder (or as they call it “relationship”) capitalism leads to the monopolisation of access to finance by financiers, through implicit or explicit collusion with the state, preventing outsiders to challenge the incumbent insiders, thereby short-circuiting the creative destruction, which — as Schumpeter emphasised — lies at the heart of the dynamic efficiency of a capitalist economy. This is how the rich and well connected have maintained their wealth and power. The nationalised banking systems in both China and India embody this political exclusion of outsiders leading to crony capitalism in which the economic rents (like those from land) are garnered by insiders.
By contrast, in Anglo-american capitalism as it has evolved, the contemporary “search fund” is the ultimate symbol of the most highly developed financial market, where an individual can create wealth through the strength of their ideas rather than through the tyranny of collateral and connections. This enables outsiders without resources to challenge insiders to impart the dynamism of death and rebirth, which is involved in the most efficient deployment of an economy’s resources. But, as Adam Smith knew, insiders will collude or use the political process to keep out outsiders.
With the separation of ownership from management in the current managerial capitalism, managers were prevented from milking shareholders through the threat of hostile takeovers, where shareholders in a company with a falling share price were offered a premium for their shares by the raider, and the existing management was sacked. In 1968 managers succeeded in getting the US Congress to remove the element of surprise in hostile takeovers and later to allow managers to protect themselves with “poison pill” defenses against takeovers. The decline in hostile takeovers meant that shareholders who had got an average premium of 40 per cent over the pre-bid price for their shares in the 1950s and 1960s only got 4 per cent in the 1990s. The managers got the lion’s share and their compensation soared whilst their companies continued to be mismanaged until they collapsed.
This attenuation of the market for corporate control was worsened by the postwar fiscal system in which there was double taxation of dividends, greatly reducing the post-tax return from stocks. Investors came to depend on increases in the share price as the major component of the return on their investment. With stock options for managers being increasingly used to align managerial incentives with those of shareholders, they both had a common interest in a rising share price of the corporation. This led some managers to fraudulently manipulate their share price through irregular accounting practices, as in the Enron scandal.
Thus, the perceived ills of shareholder capitalism are due to the perverse incentives created for managerial “rent-seeking” by regulations preventing hostile takeovers and the unintended effects of fiscal policy through the double taxation of dividends. If these policy induced distortions in the workings of the free market in corporate control can be removed, executive compensation would begin to fall, accountants would feel less pressure to cook their books and the Anglo-American corporation would pursue the innovation, efficiency and profitability, which has been its hallmark.
This leaves the question of CSR. If this is not forced on every corporation, it is of little concern, as shareholder capitalism is compatible with a thousand flowers blooming. With other companies following policies of maximising shareholder value free to compete with those following a CSR agenda, revealed preference will decide which comes out on top. This was recently highlighted in the case of Calpers (the California public servants pension fund) which had on ethical CSR grounds dumped its tobacco stocks in 2001, which thereafter boomed, leading the pension fund to be underfunded. This then led to the state not being able to afford wage increases for its police and other public servants. An incensed police officer, Jason Perez, won a seat on the board of CALPERS seeking to let the fund invest in law abiding, profit-maximising companies purely on the basis of potential returns. Pitted against the fund’s chief CSR guru, Priya Mathur, he won.
Another pet desire of CSR advocates is to stop climate change by divesting in fossil fuel stocks, But, as Bill Gates, the Microsoft founder, has said, “Divestment has reduced zero tonnes of emissions. Those who want to change the world would do better to put their money and energy behind disruptive technologies that slow carbon emissions and help people adapt to a warming world”. (“Gates says fossil fuel divestment campaigners wasting their time”, Financial Times, September 18, 2019). Two cheers then for this emerging backlash against CSR and the resultant endorsement of Friedman’s sole objective for corporations: Maximise shareholder value.