[The High Pay Centre is running a series of events looking at the political power of business in the UK. This is the text of my presentation at a lunch on 10 September 2014]
I want to say a few words about the power of ideas – even mistaken ones, even especially mistaken ones. It’s only by understanding how they arose that we can demystify and debunk them.
I’m going to trace the story of why we’re here, why the High Pay Centre exists and why there’s still an unresolved problem with high pay back to 1970, and more precisely 13 September 1970. That’s the date, according to Dominic Barton, global managing director of McKinsey, that capitalism started veering off track, and it was the day that the New York Times published an essay by Milton Friedman called ‘The Social Responsibility of Business is to Increase its Profits’.
‘In a free-enterprise, private-property system,’ Friedman wrote, ‘a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to their basic rules of the society.’
As it happens, this is actually wrong in almost every particular. In law, managers aren’t employees of shareholders, who don’t own the business. Firms are separate legal entities that own themselves, it’s they that employ directors and executives, and they to whom the latter owe fiduciary duty.
It’s hard to credit, but at the time the idea that the purpose of the firm was to maximise returns to shareholders was novel, even revolutionary. Yet by the turn of the century it had the status of ‘holy writ’, more religion than science, as one writer put it. The purpose of the corporation, it was claimed, had been settled once and for all, and it was only a matter of time before the rest of the world fell in line with the US.
It is a truly remarkable story, even more so since how it happened has nothing to do with whether it was right or not, and all to do with institutional ambition, opportunism and unintended consequences. As Rakesh Khurana wrote in his wonderful book on US business schools, From Higher Aims to Hired Hands, ‘The development of economic institutions… is not simply a function of their efficiency; rather it often results from the outcome of contests in the legal, political, social, and cultural realms’. It’s about the play of different interests, including those of class. It’s political, not technocratic.
Six years after Friedman, another article, another milestone on the road to hegemony, this one called ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, by Michael Jensen and William Meckling, published in 1976 in the Journal of Financial Economics. It’s full of graphs and equations which make it a tough read for non-specialists, but it is the single most cited article in the business literature.
In fact, the graphs and equations are part of the point. Management at that time was desperate to establish academic and scientific legitimacy, and in that context the idea of optimising the firm around a single measurable point, shareholder value, was a heaven-sent opportunity for academics to do just that. Of course what had to be left out of all this was anything to do with the human side of business, notably ethics and intentionality (not to mention things like luck and power) which can’t be mathematically modelled, so what the theory gained in ‘scientific validity’ it lost in common sense, but that’s a whole other, if fascinating, byway of the story.
Jensen and Meckling’s main assertion was that the fundamental problem in corporations was ensuring that self-interested managers focused on maximising value for shareholders rather than attending to their own concerns. It triggered a wave of scholarly theorizing which soon came to dominate the business-school research agenda in the US and UK.
Unlike most management theories, however, shareholder primacy had obvious appeal to other important constituencies as well. Not too surprisingly, the corporate raiders then on the prowl (they’d now be termed ‘activists), loved the idea because it seemed to justify their restructuring activities, which they accordingly redoubled. Institutional investors approved too, and so did the most powerful constituency, company CEOs, who soon discovered, and readily acquiesced to, the warming material benefits of having their interests aligned with those of shareholders by tying their pay to the performance of the share price.
The interlocking pieces were then fixed in place by governments and regulators as they proceeded to reshape governance and company law to give shareholders more influence over company boards and make managers more attentive to the share price.
In this way, an ideologically-based programme, purely abstract and with no empirical backing, has wormed its way into every crevice of management, to the point where it, and its assumptions, are not only unchallenged but have become invisible to the naked eye. Even now it’s rare to pass a week without reading in the FT or hearing on the BBC – for example during the Pfizer-AstraZeneca merger talks – someone starting a response, ‘of course shareholders own companies, so it comes down to them in the end.’
(I’m told that in the last review of UK company law, one or two bolder members of the review panel were firmly told that they could come up with any organising principle so long as it was shareholder value. The answer came out as ‘enlightened shareholder value’, a typically British compromise, which still leaves the UK as the most shareholder-friendly jurisdiction in the world.)
Ironically, the review took came out in 2006, just when the negative consequences of the four-decade-long practical experiment with shareholder value were beginning to emerge, and just two years before all the worst fears in that regard were confirmed by the financial crash.
It’s now clear that shareholder primacy doesn’t work even in its own terms.
Shareholders are suffering their worst returns since the great depression, and Roger Martin has shown that over the whole period since 1970 they have done worse than they did in the post-war years when their interests weren’t put first. The regime doesn’t seem to do companies much good either. The longevity of publicly-quoted companies has tumbled, and their number is dwindling fast. Astonishingly there are now 50 per cent fewer British and US listed companies than there were 15 years ago.
One particular group has consistently benefited from the shareholder primacy regime, however – short-term shareholders comprising activists (hedge funds) and what Thomas Piketty calls the ‘supermanagers’, the corporate elite who since the 1970s (note the date) have come to constitute the largest part of the 1 per cent.
The mechanism that put them there, of course, was shareholder value and agency theory. That was what triggered the ‘revolution in management pay’ that we heard Andrew Smithers describe here a few months ago. Crudely, the revolution consisted in paying them in shares and options to make them think like shareholders, a wheeze that was instantly successful. Shares and options now make up 83 per cent of total top management pay in the US and somewhat less here.
Paying executives like this changed their behaviour, exactly as it was supposed to do. Instead of ‘retaining and reinvesting’ corporate profits, in William Lazonick’s phrase, benefiting all stakeholders, they started to use them primarily to ‘distribute and downsize’, prioritising shareholders. That did indeed push share prices up (and thus their own rewards), but at the cost of R&D and capital investment – with the consequences for corporate health and mortality that I’ve mentioned.
It’s the link with shareholder value, driven by the idea that shareholders own and control companies, that is the hidden mechanism that continues to pull executive pay upward while keeping the pay of everyone else down, irrespective of the effects on the rest of the economy. This is why Smithers said that dismantling the bonus culture that governs managers’ investment decisions is the single most important task facing economic and social policymakers in the world today.
I think he’s right, and that’s why we’re here today. Empirically and intellectually unjustifiable pay is the superstructure and it’s based on shareholder value which in turn rests on the deeply buried foundation of shareholder ownership. We’ve spent four decades vainly trying to make ownership work. It’s time to recognise that it doesn’t, and the alternative moreover is staring us in the face.
The beauty of the corporation is precisely that it isn’t owned, and it’s that which allows it to make the long-term commitments to all its stakeholders that Colin Mayer talks about in his book. Shareholder ownership, the concept launched on the world by Friedman in 1970, is where the demolition work on executive bonuses and shareholder value has to start if serious change is to take place.
In a celebrated passage on the power of ideas, Keynes wrote:
‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back ... Soon or late, it is ideas, not vested interests, which are dangerous for good or evil.’
I suspect that he’d have written ‘ideas and vested interests’ if he were writing today. He added:
‘The real difficulty in changing any enterprise lies not in developing new ideas, but in escaping from the old ones.’