Elizabeth Warren introduced her Accountable Capitalism Act in the Senate on Wednesday and set forth the logic of her bill in a Wall Street Journal op-ed. The Massachusetts senator described how as recently as the early 1980s, even conservative groups acknowledged publicly that corporations were responsible to employees and communities as well as to shareholders. And as we’ve written, and is implicit in the Warren article, there is no such thing as a legal obligation to “maximize shareholder value.” It’s simply an ideology that has become widely accepted, even as some of its most prominent advocates, such as Harvard’s Michael Jensen, have since renounced it. But this practice has become so deeply embedded and so damaging that it will apparently take a change in rules, or at least a credible and live threat to do so, to change behavior in boardrooms and the C-suite.
We documented in the early 2000s that the cost of shareholder-fixated short-termism was that corporations as a whole were net saving, as in not investing, which was a disturbing departure from long-established norms. Corporate priorities have become even more warped in the post-crisis era as companies borrowed to buy back stock.
Warren highlights how “shareholders come first” doesn’t look to have been very positive for anyone save corporate execs who have asymmetrical pay deals. They get paid handsomely even in the face of so-so to lousy performance, and are paid egregiously if results are good.1 From her article:
In the four decades after World War II, shareholders on net contributed more than $250 billion to US companies. But since 1985 they have extracted almost $7 trillion. That’s trillions of dollars in profits that might otherwise have been reinvested in the workers who helped produce them.
Before “shareholder value maximization” ideology took hold, wages and productivity grew at roughly the same rate. But since the early 1980s, real wages have stagnated even as productivity has continued to rise. Workers aren’t getting what they’ve earned.
Companies also are setting themselves up to fail. Retained earnings were once the foundation for long-term investments. But from 1990 to 2015, nonfinancial US companies invested trillions less than projected, funneling earnings to shareholders instead. This underinvestment handcuffs US enterprise and bestows an advantage on foreign competitors.
To put it another way, the notion that the US stock market is for raising funds so companies can invest has become a hoary old myth. And even back in the stone ages of my youth when companies actually believe in investing, the most important sources of corporate funding were retained earnings and borrowing. New equity offerings were third.
Nevertheless, Warren’s bill is sure to attract opposition from parties that will contend that interfering with the “shareholders come first” doctrine will hurt both investors and growth.
They are wrong. Efforts to pursue shareholder value fail. Companies will do better not just for other constituencies but also for shareholders by pursuing a broader set of interests. We’ve been writing about this issue since 2007. Our first post on this topic quoted a 2004 Financial Times article by John Kay:
If you want to go in one direction, the best route may involve going in the other. Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit-oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity…
Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them…Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph “He maximised shareholder value”. Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved.
I strongly urge you to read the article in full. Kay goes long-form through how ICI and Boeing went into decline after they made an explicit and sharp change in corporate goals from being ambitious leaders with aspirational goals for their products to “maximizing shareholder value.” When he returned to the theme in later articles at the pink paper, and then in his book Obliquity, he cited a study of paired companies in the same industry, one with broad and lofty aims with ones that cared only about share price, and the latter always showed worse investment performance.
Or as reader Ruben said in 2017:
Congrats, you have highlighted a trade secret held by experts in nonlinear optimization. The saying is: you can’t go there from here. So whenever optimization (such as profit maximization) has to happen over an irregular landscape (often multidimensional, not just 3D as Earth landscapes) the process is multi-step (cannot go in straight-line, 2 steps) and so it happens that often times you take steps that move you in the opposite direction (less profit) of your final destination (maximum profit), but that was a necessary step to avoid a salient non-linearity (an obstacle)….
What you describe as the short term behavior of firms to show the rapidest result to shareholders is equivalent to getting stuck in a local maximum for not being able to look at the whole landscape and find the global maximum.
A further complication of certain system such as markets is that the multidimensional landscape is not fixed, it is dynamic so the global maximum moves at a certain speed because the landscape changes its shape as a result of the actions of its agents and other forces.
So even if Warren’s bill merely winds up pressuring corporate executives and fomenting debate on “what are corporations for and whose interest should they serve?” that would be a very salutary development. Limited liability companies generate externalities (defaults, violations of laws and regulations that they are unduly willing to risk because executives and officers are not personally liable) that forcing them to be accountable to the communities in which they live is long overdue. And contrary to what lobbyists will lead you to believe, forcing them out of their tunnel-vision, local maximum focus will be good for investors too.
1 It is actually far worse than that, since there are massively overpaid CEOs at poorly performing companies, plus most CEOs get to profit from mere “market” appreciation. And we’ve also discussed how comp consultants assure that CEO pay will ever and always keep rising by virtue of virtually ever company setting its pay target at 50% or higher of comparable companies. Companies that find themselves below their target must move their pay up. That moves up the average for that group and thus puts some companies below their benchmarks, leading to yet more pay increases. That assures ever-rising CEO pay, as well as ever-busy comp consultants.
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