by Paul Collier
If a firm fails, many people suffer; the risk-bearing extends well beyond people who have put in capital. The people who probably lose most are the long-term workers in the company, as they will have accumulated skills and reputation that are only valuable in that company. In addition, if the company is an important employer in the town, everyone who owns a house there will take a significant capital loss.
Customers will also suffer. At the trivial end, when Monarch Airlines went bankrupt in 2017, 100,000 people were stranded. At the more serious end, modern supply chains create interdependencies between firms through which a bankruptcy is transmitted like a virus around the global economy. That is why the bankruptcy of a medium-size investment bank like Lehman Brothers caused such devastation in the financial crisis.
Those who have provided the firm with capital in the form of loans will suffer losses, alongside those who have bought shares, but only the shareholders will have the power conferred by ownership. In contrast, the shareholders may not suffer at all. As a professor, I am entitled to a pension from a fund that covers all universities. The fund is financed by its shareholdings in companies, so if a company fails does my pension suffer? Thankfully not, because the responsibility passes collectively to the entire university system; according to the contract, even if some universities were themselves to fail, the liability would pass to whichever ones remained. How would the universities meet a shortfall? In the end, the liability for my pension is likely to pass to generations of students. To students reading this I assure you of my profound gratitude. But in return for bearing this risk how much control do you have over the management of the companies held by my pension fund?
The company has to be accountable to someone motivated to care about the long-term performance of the company, and sufficiently knowledgeable to spot management mistakes. If share ownership is highly fragmented, there is a free-rider problem: nobody has much incentive to understand whether the long-term strategy of the management is smart. In Germany, the banks play this oversight role, holding shares on behalf of their owners and getting actively involved in company management. In America, and much of the world, it is played by the families that founded successful companies and which retain a blocking shareholding. Only one country has implemented the full Friedman vision. Its companies are tied to profit by millions of shareholders, and they hold companies to account by selling their shares on the market unless profits keep rising. Britain has been the guinea-pig for an economic ideology. Britain’s banks have steered well clear of involvement in company management. Founding families have shed their shares because of the design of taxation. Legal control of companies is exclusively in the hands of the shareholders, of whom 80 per cent are pension funds and insurance companies. They, in turn, adopt the mantra, ‘If you don’t like the company, sell the shares.’ Their decisions are now based primarily on algorithms within computers, making sophisticated inferences from recent movements in stock prices: around 60 per cent of the stock-market trades are automated. The superstars are the finest mathematical brains in society, devising algorithms of genius to detect patterns of price momentum. What is missing is any direct knowledge of the company, its management, its workforce, and its prospects such as can only be acquired through long involvement with the company.
Why should the management of a company care whether a pension fund sells its shares? In Britain, the ultimate threat to management is to be taken over by a rival, and this becomes easier the lower the company’s share price. Two chocolate companies – Hershey in the USA, and Cadbury in Britain – illustrate the contrasting consequences of ownership. The Hershey family has retained a blocking shareholding, whereas the Cadbury family, an exemplar of Quaker philanthropy, sold its holding on the market. When Kraft tried to expand its presence in the chocolate market it targeted Cadbury, and the pension funds duly sold their holdings: Cadbury ceased to exist as a separate entity. So, effective power lies with the board of the company to avoid this fate. Pre-emptively, the board will watch quarterly profits to determine whether to dismiss the CEO. The typical CEO is now in post for only four years.
Gradually, CEO pay has become increasingly tied to indicators of short-term performance. The problem is most acute in Britain and the USA, the countries in which financial markets are most ‘developed’ and where CEOs have the shortest tenure. Gradually, this has come to infect the way in which the CEOs of non-financial companies are rewarded. Reflecting the heightened risks, the pay of CEOs has accelerated far beyond the average pay in their companies. In Britain over the past thirty years, it has risen from 30 times that of their workers to 150 times; as such, they are a model of restraint compared with their American counterparts, whose pay has risen from 20 times that of their workers to 231 times. Yet during this period, judged by objective measures, there has been no overall improvement in company performance. The higher pay is evidently not for enhanced performance; nor is it just compensation for extra risk. The people on the compensation committees of major companies constitute yet another networked group. As with all such groups, narratives gradually build a belief system. Over time, as I set out in the previous chapter, our societies have fractured from national to skill-based identities. A microcosm of this vast process is that the peer group of a CEO has shifted from being the fellow-workers in his company to his fellow-CEOs in other companies. In consequence, the norms of the group on the compensation committee as to what might be ‘fair’ have crept upwards. An executive relates hearing the comment, ‘He gets $5 million and I only get $4 million: it isn’t fair.’ At the heart of this is not even greed, many of these CEOs are not hedonists but driven workaholics. It is the changed source of peer esteem arising from redefined identities. The $4-million CEO may not have been thinking of what he could have bought with the missing million dollars, but of the condescending sympathy of his $5-million colleague when they next met at Davos.
The financial sector has practised what it preached. If short-term performance in companies should be incentivized by highly geared pay, they themselves should adopt the same model. Nor have they been coy about it. They have led the way in the upward march of CEO pay relative to that of their workforce; in banks, it has now reached 500:1, undented by the financial crisis. This changed the ethical composition of the people who clawed their way to the top. Deutsche Bank got Edson Mitchell as its CEO, who transformed the bank’s culture from German staidness to one of wild excess: he ‘hired mercenaries . . . they didn’t care about ethics’.3 There was an ethical vacuum: on Friday evenings, the trading teams would decamp to leer at pole dancers; prostitutes were hired to entertain the senior staff at Christmas parties; and Mitchell was openly contemptuous of obligations to family. What rapidly inflated to become the world’s largest bank was being run by people whose ethics were more suited to the management of a brothel. Mitchell died in a plane crash; his bank has met an equivalent fate.
Lower down the food chain, fund managers are judged by the quarterly valuation of the shares in the portfolio for which they are responsible. Asset management appears to lend itself to such an approach precisely because performance is so readily measured using a single metric. But it is very difficult to design incentives to reward what is really desired. Asset managers are well rewarded for short-term performance, as a result of which they judge the firms in which they invest on the same criteria.
THE CONSEQUENCES OF VESTING CONTROL WITH OWNERS
Is this ultimately a wise strategy for a pension fund? Being in charge of a company has become a desperate struggle to keep quarterly profits rising until the stock options kick in and the CEO can leave with a golden parachute. So, what is the smart strategy for a CEO? Obviously, it is to make changes that drive up quarterly profits as much as possible, as soon as possible. Here is the assessment of Carolyn Fairbairn, Director-General of the Confederation of British Industries. She worries that ‘there is a fixation on shareholder value at the expense of purpose’.4 The CBI is the lobby group for Britain’s major firms: it
s director-general is hardly a dreamy radical.
If a CEO has to drive up quarterly profits, how can it be done? Consider three options. Option 1 is to build a company like Johnson & Johnson, with good, trusting relationships between the firm and its workers, its suppliers and its customers. This pays off handsomely in the end, but the snag is that it takes a long time. Option 2 is to cut all expenditures that are not essential for production. This sounds as if it drives the company into efficiencies that are valuable for society, even if they are painful for the company itself. But since past CEOs will have already cut the fat, the largest remaining category of expenditure that can be cut most easily without rapidly affecting production is investment. Naturally, in due course, cutting investment will hit output, but ‘in due course’ the CEO may be out of a job anyway. Option 3 is not to waste time on any real decisions about production or investment, but to rearrange the company’s accounts. Those of us who are not accountants imagine that the profession has established clear rules as to how accounts are drawn up, but in practice there are many grey areas that enable profits to be increased, decreased, or shifted from one subsidiary to another.5
Which of these would you choose were you a CEO? We can see the consequences of Option 2 playing out in corporate America and Britain. Despite high profitability, companies are choosing not to invest. Striking evidence for this behaviour comes from the contrasting investment rates of companies whose shares are traded on stock exchanges and those whose shares are held privately and cannot be sold on markets. The investment rate of the companies whose shares are traded is 2.7 per cent; that of those whose shares are privately held is 9 per cent. In Britain, which has the largest financial sector relative to its economy of any major country, corporate investment in research and development is far below the average for advanced economies.6
Unsurprisingly, the quarterly profit-chasing companies have worse long-term records of performance – even on the yardstick of profitability – than companies that are able to take a longer-term perspective. But if the previous CEO has already cut investment to the bone, perhaps you would be driven to Option 3. By its nature, this is hard to detect except in those instances in which the scam has been pushed so far that it gets uncovered. Periodically, this happens. In the USA, the legendary case is that of Enron. Enron’s British equivalents are Robert Maxwell, CEO of Mirror Group Newspapers, who had once been investigated by public officials and found to be ‘unfit to run a public company’, and Philip Green, CEO of BHS, who was actually knighted. Each of them stripped their company of its pension fund, leaving thousands of employees impoverished. Maxwell stepped off the back of his mega-yacht as the scam was about to be discovered; Green still has his mega-yacht, aptly renamed by his critics The BHS Destroyer. Perhaps mega-yachts should be considered leading indicators for ‘creative’ accounting?
Options 2 and 3 each have consequences that are seriously damaging for society. Major companies are run without adequate attention to the longer term; and the reported accounts of companies become untrustworthy.
It gets worse: so far, we have seen that CEOs are increasingly diverting their energies from the long-term process of building a great firm to short-term tricks. But the widening of pay differentials has made it harder even for those CEOs and boards who want to take that long-term approach. As the Johnson & Johnson, ICI, Volkswagen and Toyota stories demonstrate, a key part of a long-term strategy is to persuade workers to identify with the firm. Narratives can only do their magic if they are not contradicted by actions. Telling workers ‘we are all in this together’ while paying yourself five hundred times more than your typical employee is likely to be met with a degree of cynicism. A worker on the production line may come to think, ‘Since you are using your power to loot the company, I’m going to pull that Andon cord next time I want a break.’ Do as I say, but not as I do, seldom works.
So is the current strategy of pension funds wise? Quite evidently, it isn’t. They have a clear obligation to be able to pay decent pensions to their members as they come due. Whether they are able to meet these obligations depends upon one thing only – the long-term return on their assets. This depends upon the long-term performance of the pool of companies whose shares they hold. In aggregate, pension funds cannot outperform the market, and so their ability to meet their obligations depends upon the l ong-term performance of the firms in the economy. By diverting managements from this task, pension funds have reduced their own ability to meet their obligations.
WHAT WE CAN DO ABOUT IT
It is time to turn from this depressing litany of failings to practical solutions. Fortunately, these problems are not inevitable features of capitalism but the results of fixable mistakes of public policy. Public policy has gone wrong because of the trivialization generated by the strident rivalry of antiquated ideologies. The ideology of the right asserts faith in ‘the market’ and denigrates all policy intervention. Its solution is ‘get the government off the back of business: deregulate!’ The ideology of the left denigrates capitalism and condemns the managers of firms and funds as greedy. Its solution is state control of companies, and state ownership of the commanding heights of the economy. Both these fundamentalist ideologies are ill-founded, but between them they have set the terms of public discussion, impeding productive thought.
The starting point for a new approach is to recognize that the role of the large corporation in society has never properly been thought through. The boards that run large companies are taking decisions of overarching importance for society. Yet their present structure is the result of individual, unco-ordinated decisions, each of which happened to lead to some further decision that had not been anticipated. The system of corporate governance has lacked any process remotely equivalent to the intense and shrewd public discussion, embodied by the Federalist papers, that produced the American Constitution and its system of national governance. Public policies towards business have been incremental, and so have never properly addressed the fundamental issue of control. Any viable solution must begin with rebalancing the interests in which the power of control is legally vested.
CHANGING POWER IN THE FIRM
Currently, in the Anglo-Saxon economies, the law requires directors of companies to run the company in the interest of its owners. This, for example, is how the wording of Britain’s Companies Act is usually interpreted, even though it would permit wider considerations.* In turn, the owners are exclusively those who hold shares in the company. This system is not intrinsic to capitalism: it arose because, in the early stages of firm growth during the eighteenth century, the binding constraint was raising enough finance for risky investments that needed a minimum scale. That world has been superseded. The risk of financial loss is now routinely addressed by diversification, information and checks on corporate governance. There is plenty of capital willing to finance risky investments (as evidenced by the dot. com boom, followed by the securitized mortgage boom). People are now willing to buy non-voting shares: they take the same risks as other shareholders but without the power of control. The largest undiversified risks are now probably those of long-serving employees, who have invested their human capital in a single company, and customers who have locked themselves into long-term structures of supply, yet who are usually unrepresented on the board. It is entirely possible to give either of these groups representation on a board and sometimes it happens; such companies are called ‘mutuals’.
The most respected company in Britain is no longer ICI; it is the John Lewis Partnership. This enduring and hugely successful firm has a highly unusual power structure. It is owned by a trust run in the interests of its workforce. Reflecting this, workers receive a substantial share of profits as an annual bonus. Moreover, what is sauce for the CEO goose is seen to be sauce for the shop assistant: the same percentage is paid to a shop-floor worker as to the CEO. All workers have a say in how the company is run through a series of local, regional and national councils, electing 80 per cent of the company’s gove
rning council. John Lewis is an example of a mutual company, owned collectively by people with a direct interest in it, such as workers or customers, as opposed to shareholders. As new workers are hired, or the firm acquires new customers, they gradually accumulate entitlements, replacing those who had left. By design, ownership and control are vested in those who participate in the company and so have a direct interest in its performance.
Many companies used to have such a structure, but it is subject to one fatal temptation. Those in whom ownership and control is currently vested are legally entitled to convert the company from its mutual status to a one whose owners have shares that can be sold on financial markets. By doing so, the current vintage of ‘owners’ acquire the entire capital value of the firm at the expense of all subsequent generations of participants. In Britain, the scope for demutualization was created by a change in the law in 1986; underpinning the previous law had been social norms that recognized such a move as unethical. But the new financial culture of the 1980s weakened norms of obligation. Sometimes, temptation proved too great.
In the USA, one vintage of partners in Goldman Sachs, a group of people more renowned for their exceptional acumen than for their exceptional decency, seized the opportunity provided by the new ethics. This enabled them to escape the grinding poverty experienced by all previous vintages of partners. In Britain, most building societies (savings and loan associations, in American parlance) demutualized. The largest, the Halifax Building Society, had been a huge and enduring company, built over the course of 150 years from humble beginnings in a small town in the north of England to a financial giant that efficiently provided millions of people with mortgages, and millions more small savers with security. The change in ownership structure freed the management of this magnificent company from the deadweight amateur control of its users, handing what had grown to be the largest bank in Britain to the professional scrutiny of fund managers watching quarterly profits. John Kay was on the board and observed the results.7 The liberated management decided that quarterly profits could be increased by broadening the business from the boring process of taking in the deposits of small savers and lending them on to people buying homes. The big money was in playing the market in financial derivatives. Kay pointed out that gambling on these markets could only make money if other players lost it, and asked why the Halifax thought that it was going to be among the winners. The CEO explained that the bank had recruited a particularly smart team of players. Kay’s laconic comment on this brag was that he found it somewhat less credible once he had met the team. But despite his doubts, Halifax’s profits surged on the back of this new strategy, and the CEO appeared vindicated. Then they tanked. The Halifax had to be rescued by another bank and massive losses gradually came to light. The professional fund managers had presided over rampant management folly that within one generation had bankrupted a company that as a mutual had grown over the course of 150 years from tiny beginnings to a world-class business. But, personally, I cannot complain. Long ago, my mother had opened a Halifax Building Society savings account for my pocket money, and I had never got around to closing it: so, I received a little windfall as my interest was converted into shares which I sold in time.