Economic liberalism asserts that entrepreneurial freedom is a condition necessary to economic dynamism. It is efficient and just that those who exercise that freedom suffer the consequences of bad choices. “Competition may well be the ruin of a man, but it is the business of the parties involved to be on their guard,” wrote Scottish philosopher and economist Adam Smith in “The Wealth of Nations” (1776).
Up until the end of the 19th century, companies were small enough that the risk taken by entrepreneurs could be underwritten by their private fortune. The dominant legal form was the partnership, in which the manager is responsible and liable to the extent of his personal fortune in the event of bankruptcy. The risk he took assured the legitimacy of his power as well as the self-limitation of his excesses. In “The Control of Industry” (Nisbet & Co., 1923), English economist Dennis Roberston defined this connection between responsibility/liability and the risks incurred as capitalism’s “golden rule.”
But that golden rule has run up against a second golden rule: capital accumulation is the engine of capitalism. As a result of competition, companies that accumulate more investment capital may eliminate others; consequently, they have a tendency to increase their size. Hence, private fortunes became inadequate to guarantee the growing risks and it was not in families’ interest anymore to concentrate their patrimony into a sole entity, the bankruptcy of which would ruin them. So, beginning around 1900, limited-liability joint stock companies replaced partnerships; they allowed capital to be opened up to shareholders whose liability was limited to their investment – in contradiction, therefore, to the first golden rule.
The more companies became national, then international, then global, the more their financing needs grew, and, in parallel, the more did the personal risk incurred by economic decision-makers – managers and/or shareholders – shrink.
As formerly, families and investors – especially when they are investing household savings – try to limit their risk by diversifying their portfolios. The connection between economic decisions and private risks becomes tenuous.
On top of that, the failure of big companies may lead to such significant consequences that governments have to intervene – as during Washington’s rescue of American banks or General Motors. That’s the too-big-to-fail principle. The very large company ends up transferring the risk of bankruptcy to the taxpayer, which is the last straw for a capitalist society based on decentralization of economic decisions.
So there is a contradiction between the first golden rule (economic decision-makers’ responsibility is based on personal risk) and the second (capital accumulation allows company growth).
Known since the dawn of capitalism, this contradiction has been exacerbated by the fact that the economy has produced gigantic firms in which shareholders and managers incur an ever-more-limited personal risk.
These companies pose a political problem to which we must respond by clarifying who is liable for what, according to what laws, rights and duties, and under penalty of what sanctions. That is the complex and tentative role of corporate governance.
Pierre-Yves Gomez is professor at EM Lyon and director of the Institut français de gouvernement des entreprises [French Institute for Corporate Governance].
Translation: Truthout French Language Editor Leslie Thatcher.