Making firm governance part of the economists’ dialogue
from Robert Locke
In a recent article,”The Milton Friedman Doctrine is Wrong. Here’s How to Rethink the Corporation,” Susan Holmberg and Mark Schmitt intoned: “We won’t fix the problem until we address the nature of the corporation.” at http://economics.com/milton-friedman-doctrine-wrong-heres-rethink-corporation/. Egmont Kakarot-Handtke asserts that sciences of society make no contribution to economics because they are scientifically invalid — to which I replied that his assertion is not true because the neoclassical economists who took over economics in the 20th century excluded history and social studies from the discipline’s purview. History and social studies could make no contribution since they have been ignored. The neoclassical economists’ failure to incorporate firm governance into the economists’ dialogue is a prime example of what I mean.
“The Milton Friedman Doctrine”, H and S explain, is based on “’agency theory’ or ‘shareholder primacy.’ The intellectual godfather of shareholder primacy is Milton Friedman, who wrote in 1970 that ‘a corporate executive is an employee of the owners of the business [i.e., the shareholders]. 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, without breaking the law or cheating people.’ … Michael C. Jensen and William H. Meckling codified Friedman’s argument with their seminal 1976 article, ‘Theory of the Firm.’ The purpose of corporate governance, they argued, is about finding ways to align the incentives of shareholders (whom they referred to as ‘principals’) and executives (‘agents’ of the shareholder-owners). This theory has enraptured economics departments and business and law schools for decades and profoundly shaped how corporate officers, shareholders, taxpayers, policy-makers, and even most Americans think about the roles and responsibilities of corporations.”
[A] bit of heresy did happen at the 2013 annual meeting of the Allied Social Science Associations. … That year, a French financial economist named Jean-Charles Rochet gave the keynote address, in which he skewered the very foundation of pay for performance. Cornell Law School professor Lynn Stout calls it the “shareholder value myth”—the idea that corporations exist for shareholders and no one else. Rochet told the conference: “Everyone knows that corporations are not just cash machines for their shareholders, but that they also provide goods and services for their consumers, as well as jobs and incomes for their employees. Everyone, that is, except most economists, [for whom] shareholder primacy has never been challenged in a serious way.”
H and S argue that the prevalent economic theory prevents economists from “fixing” the problem,” of the growing gap between the incomes of the top 1% and the bottom 99% of Americans, because the doctrine of shareholder value when combined with “the economic theory of marginal productivity— justifies the gap, i.e., the theory holds that ‘any worker is paid based on what he or she adds to the firm’s income’— and inasmuch as executives work for the shareholders — the explanation for the extraordinarily high pay for those at the top has to be performance . As Harvard economist N. Gregory Mankiw phrased it, the value of a good CEO is extraordinarily high ”because of what she/he add to the firm’s income.”
“But,” they continue, “this is the most tautological of economic ideas. The theory requires very strict assumptions that are found nowhere in the real world, and it cannot be put to the test, because it is impossible to measure the performance of a CEO in terms of his or her marginal contribution to a firm, particularly when success is the function of an entire team. And when ‘pay for performance’ is based on the company’s stock price, it is really ‘pay for luck,’ because more of the share price performance that CEOs are paid for is driven by broader macroeconomic factors, particularly economic upswings, than anything the executives did.”
In any event H and S, with reference to the argument of Lucian Bebchuk and Jesse Fried, in their 2004 book Pay Without Performance, went on to observe that executive pay cannot even be said to be based on a subjective appreciation by stockholder-owners of executive performance. They (Bebchuk and Fried) “wrote that skyrocketing executive pay is the blatant result of CEOs’ power over decisions within U.S. firms, including compensation. (Also see, S Bainbridge’s 2006 article. “Director Primacy and Shareholder Disempowerment,” Harvard Law Review, Vol. 119 and UCLA School of Law – Research Paper No. 05-25.) Salaries at the top rose rapidly under director primacy governance, because those at the top had the power to rig the system to their advantage.
Stakeholder primacy as an alternative form of firm governance.
“Simply put,” H and S point out, “a stakeholder is any group or individual who can affect, or is affected by, the achievement of a corporation’s purpose. Stakeholders include employees, customers, suppliers, stockholders, banks, environmentalists, government, and other groups who can help or hurt the corporation. The stakeholder concept provides a new way of thinking about strategic management—that is, how a corporation can and should set and implement direction. By paying attention to strategic management, executives can begin to put their corporations back on the road to success.”
They further specify: “the term stakeholder has been in circulation since the 1960s to characterize the key groups of people that support an organization. R. Edward Freeman brought it into the management world in 1984, when he published Strategic Management. The book proposed that effective management consists of balancing the interests of all the corporation’s stakeholders, including employees, customers, and communities.”
If the words stakeholder primacy became common phraseology then, the concept and practice has been around much longer, especially if frames of reference are extended outside America. In Germany the Law for the Protection of Labor granted the workers joint consultation right on social matters in firm governance during the Second Empire (1871-1918); members of the Constituent Assembly wrote co-determination into the Weimar Constitution (Article 165) in 1919; Hitler, who personified the Führerprinzip, countermanded worker participation in firm governance during the 12 years of the 3rd Reich, but, on the founding of the Federal Republic of Germany(1949), the Bundestag passed with a vengeance a Co-Determination Law for the Iron and Steel Industry (1951) and then in 1952 a Works Constitution Act.
It is important to stress the historical origins of the stakeholder concept of the corporation for two reasons. First the development of a participatory form of firm governance takes time. The Germans have worked on integrating the various components of their system for over sixty years (see “The Emergence of the German Management Alternative,” pp. 80-103, in The Collapse of the American Mystique). Second, American Management’s preoccupation with stakeholder forms of corporate governance began much earlier than the publication of Freeman’s book on Strategic Management in 1984.
In fact, the American preoccupation with employee participatory management began in Germany immediately after the war. General Lucius Clay, who headed the US Zone of occupation, stymied German efforts to introduce co-determination modes of management in German firms when Germans assumed increasing control over their civil government in the late 1940s. American private business openly opposed the German legislation, i.e., the National Association of Manufacturers sending a delegation to Europe to speak against it, a representative of NAM writing an open letter to the German Council in New York, published in the New York Times, which warned that Americans would not invest in German industry if the co-determination bill passed. (Locke, 1996, 64-67). When the Social Democrats-Liberal coalition legislation in the mid-1970s strengthened employee participation in firm governance, Henry Ford III, visiting his company’s factories in Cologne at the time of the debate, deplored the new legislation’s infringement on the prerogatives of management. (Reported in New York Times, 17 Oct. 1975). The Americans warned the Germans that workers participation in firm governance would result in bad management.
As long as American and Germans firms thrived the issue was muted, but around 1980 the rise of a revitalized Japanese industrial-managerial challenge to industries in both countries squarely posed the question: to what extent did forms of firm government shape the response in each country to the Japanese challenge to their industries? The answer: director primacy-stockholder-value forms of governance hampered American firms as they adapted to the Japanese management challenge and German co-determination governance did not .
On the contrary, one manager at Opel (Rüsselsheim) observed that because of the institutions of co-determination, Opel plants could implement shop floor reforms better than GM plants in the US. [W. Streeck (1984). Industrial Relations in West Germany: A Case Study of the Car Industry. p. 84.)] Another, Professor Horst Wildemann, a leading figures involved in the transformation of German firms along Japanese lines, reported after four years of reform at Volkswagen that the contributions of works councilors and shop stewards to change are uniformly positive; indeed, employee representatives often led rather than followed management. (Locke Interview, 19 July 1994).
For Germany if a sustainability yardstick is used to evaluate corporations, their performance is remarkable. Among the Fortune magazine global 500 corporations in 2007 (23 July issue), 37 German firms are listed; among them 30 trace their origins to the German postwar recovery and among the 30 at least 13 had been successful firms in the 19th century. In the 20 top German corporations listed by revenues in 2013, ten were manufacturing firms, half of which were German automobile companies, with Mercedes and Volkswagen (rated number one on the list of 20) included.
Evidence about the fate of established US firms, caught in the manufacturing crisis supports an opposite conclusion. In the tire industry, United States Rubber and Royal went under and rising Japanese Bridgestone bought declining Firestone; in the steel industry once mighty US Steel fell to 479th on the 2007 Fortune Global 500 list; previously renowned US manufacturers of machine tools (for example, Burgmaster), and manufacturers of electronic products (Philco, Zenith, RCA, and others) were replaced by Sony, Matsushita, Sanyo, and others, and Japanese automobile manufacturers crowded out or replaced American firms at the top of the 500. Once mighty General Motors and Chrysler declined into receivership.
Comparisons of the manufacturing sectors in both countries during the crisis period (1980-2000) show that the German stakeholder firms outperform the Americans. In all advanced economies in the West, the manufacturing sector shrank between 1990 and 2012, but the numbers employed in manufacturing in Germany declined the least (ten percent) compared to America’s 28 percent (in the UK it was over 50 percent). (Bureau of Labor Statistics, 2013, Table 2-4). Between 2002 and 2012, the employment in manufacturing increased in both countries, but the percentage of the increase was higher in Germany (20 percent) compared to 12 percent in America. Inasmuch as the manufacturing employment numbers included people working in the new information technology firms, in which the US was the acknowledged leader, the percentage of Germans working in the older manufacturing firms, where work process reform had been concentrated, was even more weighted in their favor.
Under the regime of director primacy, US management let employees of the struggling firms shoulder, compared to stockholders, a disproportionate burden, primarily if not exclusively, through the elimination of so-called legacy costs after 1980. There had been 112,000 defined-benefit private pension plans in them in 1983, each guaranteeing fixed levels of income to a company’s retirees. Jack Rasmus, reported in 2004 that “From the passage of the Employee Retirement Income Security Act (ERISA) in 1974 until 2003, more than 160,000 Defined Benefit plans have gone under in the US.” [J. Rasmus (2004) Pension Plans in the Corporate Cross-Hairs. Kyklos Productions. p. 3)] During the same time the number of personal retirement accounts mushroomed. Very few households had such accounts in 1982; by 1995 23 percent of households had a 401K or an equivalent individual retirement account.
Most Americans, except for those located in rust belt manufacturing cities, ignored the comparative American failure. And for good reason, because while staple US industries declined and their workers suffered, a Pentagon induced revolution in information technology transformed the American economy and through it the world economy. Because of this Americans praised their management capabilities as second to none, and they made the very disappearance of the old firms a virtue. R. N. Foster and S. Kaplan 2001 book portrayed the era of industrial decline positively as one of ‘Discontinuity.’ They observed that when Forbes’ list of the 100 largest US corporations in 1987 is compared to Forbes’ first list in 1917, only 18 of the original 100 firms appear among the 100 sixty years later; 61 percent of the firms were gone. Scanning the S&P 500 over the period 1957-1998, they estimated that the pace of turnover at the top was accelerating so rapidly that by 2010 the average life-span of an S&P listed firm would be ten years. By 2020 at that turnover rate, ‘no more than one third of today’s major corporations’ on the S&P list ‘will have survived in an economically important way.’ (Foster and Kaplan, Creative Destruction: Why Companies that are Built to Last Underperform in the Market. chap 1)
It was convenient to praise this discontinuity as an economic positive and to fault continuity in Germany as stagnation, but the high tech start-ups in “Phenomenal Silicon Valley” (see, R Locke & K Schöne, The Entrepreneurial Shift, CUP, 2004, chap. 1) had nothing much to do with management systems in firms, and everything to do with networking in high tech regional clusters. Most discussion of this phenomenon trace its origins to the Triple Helix, the symbiosis among government sponsored scientific research in private and public universities, promoters of private firm start ups, and developing circles of angel and venture capitalism outside traditional financial institutions, the best example of which existed in Silicon Valley networks.
Tradition forms of American firm management did enter the picture when successful IT start-ups went public. The management systems that took over the new high tech public firms mirrored the stockholder primacy-director-controlled model, typical of US corporations. Their management policies as the firms grew followed the model: big emoluments for those at the top, a strategy of low cost, often off shore located production facilities, where workers are treated not as stakeholders in the firm but as a variable cost to be minimized.
The recent transformation of the US economy from managerial to finance capitalism has accelerated the gap between high and low incomes that director primacy governance in public corporations fostered. Managerial capitalists believed that returns on investment are based on the value created by productive enterprise; finance capitalists, whose ideas and actions have superseded theirs, treat “companies … as assets to be bought and sold for maximizing profits through financial strategies.” [R. Ball and E. Appelbaum (2013). “The Impact of Financialization on Management and Employment Outcomes.” Upjohn Institute for Employment Research, Working Paper, pp. 13-19)] Financialization brought new financial institutions (investment banks, hedge funds, private equity firms, etc) and instruments (i.e., derivatives and stock options) concocted and used by Wall Street analysts, finance economists, and managers of public pensions adept at increasing the income of people at the top through financial strategies. Petra Dünhaupt claims that just one financialization instrument, the introduction of stock options into pay packages, is responsible for increasing the share of total incomes of the top 1% from two percent in 2000 to eight percent in 2007 [(P. Dünhaupt (2011). The Impact of Financialization on Income Distribution in the USA and Germany. p. 19)]
H and S believe, as German economists anticipated in the 19th century Verein für Sozialpolitik and German business economists thoroughly discussed in their professional publications in the 1920s that the Milton Friedman’s agency theory and stockholder primacy theory of firm governance promote not just the mal-distribution of incomes but the lack of firm sustainability. [(See, R. Locke (1984, 2006). The End of the Practical Man, pp. 155-62)] They also affirm that in rethinking the corporation the adoption of the German stakeholder form of corporate government is a viable alternative that has proven itself in Rhineland capitalism. In their words:
“Yes, we need to reform corporate boards, but let’s do it by following the successful German model and creating a place for workers at the board table. Employee board-level representation is a core part of Germany’s corporate “dual structure”: a management board for day-to-day functions and a supervisory board for more high-level decisions. …
The stakeholder corporation is not only a brilliant model, as the German economic success, especially in manufacturing, shows—it is also the key to the unresolved problem of CEO pay.”