The Third Pillar

by Raghuram Rajan

  The pessimists are more practical, but the idea of Europe, indeed of world citizenship, is as much about idealism as it is about practicality. After all, empathy builds only when people get to know one another—European officials and students, who travel and work much more in other European countries, are far more sympathetic to the idea of Europe than those who travel little. That idealism needs to be more widely shared. Perhaps it is best to take small steps forward to keep the idea of the United States of Europe alive, but to wait till there is more solidarity among the peoples of Europe for large steps. And perhaps it would be wise to ask them this time!

  CONCLUSION

  Dani Rodrik from Harvard University has argued that globalization, democracy, and national sovereignty constitute a trilemma that are impossible to reconcile. Countries can have two but not all three. As with all supposed trilemmas, though, the difficulties of reconciling different objectives simply means that we cannot find doctrinaire or esthetically pleasing solutions. Most policies will have trade-offs, and countries will have to find ways of muddling through.

  Attempts at globalization have gone too far in two ways. We have tried to encourage cross-border flows that are not strictly necessary for all countries to prosper, such as financial flows. Allowing them freely may indeed do damage to some countries. Decisions on whether to allow or disallow cross-border flows should largely be left to countries, with a few exceptions such as trade in goods and services, where the long term benefits for all (with a few narrow caveats) are clear. Here, there is a role for multilateral organizations to nudge countries to continue on the path of reducing tariffs on goods and services and binding them to be low. The benefits of a global competitive market are not just greater efficiency, but stronger and more independent private sectors in each country, and potentially stronger democracies.

  At the same time, we should be less eager to harmonize rules and regulations across countries unless absolutely necessary to avoid high transactions costs. The process of setting these rules at the international level is not transparent and is undemocratic. Furthermore, harmonization reduces variety and competition between jurisdictions. Binding international agreements reduce the sense people have of self-determination, and should be used sparingly—to secure low tariffs but rarely to force harmonization of other rules and regulations. This is one way to reap the benefits of globalization while respecting democracy and national sovereignty.

  Turning to domestic policies, countries should have a free hand except in two regards. First, we should evolve collective agreements or rules on the legitimacy of policies that have sustained adverse effects on other countries. Such policies should be flagged and the country asked to cease and desist, with the full weight of international bodies descending on defaulters. Second, actions such as creating carbon emissions or overfishing that affect the global commons should be subject to globally agreed limits, but through a process that engages the people of the countries in the targets to which they agree.

  Globalization has to be managed. Countries have to regain the tools to manage it, which means steadily delegating back to countries the powers that international agreements have usurped. Even as sovereign powers to act are enhanced, countries have to accept they have international responsibilities. As countries obtain more control over globalization, the push toward self-interested nationalism could well be tempered by a realization that we do have to live together in the only home we have.

  13

  REFORMING MARKETS

  Markets endanger themselves when they stop working for the broader citizenry, because it may rise up to shut them down. Today, some people are disenchanted because they feel large firms are closing opportunities for small firms and individuals. Others are angry because they have suffered painful losses of wealth and incomes and see little support forthcoming from the community or state. Yet others fear their jobs will be displaced by technology or foreign competition. For far too many, the markets have been disappointing. We must take actions to restore public faith in the power of markets to improve well-being.

  Growth in the economic pie, which requires innovation and competition, will help. To enable this, barriers that currently protect dominant incumbents must be brought down so that markets are accessible by all. Everyone’s ideas and products can then compete to generate that growth. Widely accessible markets are also less likely to be seen as only vehicles for the rich to grow richer. Within markets, powerful participants must be trusted to do the right thing by society. The right explicit objectives and monetary incentives for such participants will help, but so will community-provided social rewards for those who behave admirably. In this chapter, I will suggest three steps to help restore faith in markets and make them more reliable vehicles for sustainable inclusive growth.

  First, people need to believe once more that corporations can be trusted to take the right actions for society’s well-being. The mantra of shareholder value maximization worked well to dissuade the government from insisting that private corporations were extensions of government departments. Unfortunately, it has also led important constituencies, especially labor and the general public, to worry that top management is out to rip everyone off in the interests of shareholders. We need a better objective that promotes not just efficiency but also trust.

  Second, a market dominated by a few is unlikely to create opportunities for the many. Competition today in an industry is the best way to guarantee society is benefited, not just today but also in the future. We have to examine and reduce barriers to competition, including new forms of incumbent property rights that have built up in recent years.

  Finally, policies can help jump-start adjustment but both the market and the community will also adjust on their own over time. They should be given the space and time to do so.

  CHANGING FROM PROFIT MAXIMIZATION TO VALUE MAXIMIZATION

  We have seen that along with the search for more productive efficiency, shareholder value maximization also encourages aberrant behavior, such as violating implicit contracts with employees. Can corporations not do better? If the private sector is to be trusted by the community, and if it is to be a reliable check on the state, it does not just have to be well behaved, it has to be seen to be well behaved. At the same time, though, the private sector cannot give up its hard-nosed focus on productive efficiency, for that is an important contribution markets make to society. How can these varied goals be reconciled?

  MAXIMIZING THE VALUE OF THE FIRM

  Shareholders are only one set of claimholders on the firm. One possible alternative is to ask top management to maximize the value of stakeholders in the firm, as is sometimes suggested to corporate bosses in Continental Europe. Yet this prescription needs, at the very least, to be fleshed out. Who exactly is a stakeholder? If a customer is one, is not one way of maximizing her value to give her everything she wants free? If so, how will the firm survive?

  Here is a better alternative.1 It may seem a small tweak, but it would alter firm behavior significantly in some situations. Not only would it increase firm value, but it would increase public understanding and support for the public corporation. Specifically, let the objective set for firm management be to maximize the value of the firm, but define firm value to be more than just the value of the financial investments in the firm. Let it also include the value of specific investments made in the firm by those who have a long-term attachment to it. So, for example, the investment made by an employee in learning a hotel’s culture of hospitality is a specific investment. It is specific in that it has little value in another hotel with a different culture, and it is an investment because it takes time and effort for the employee to learn it. The value of that specific investment is the stream of additional profits the hotel will generate from the great customer experience provided by its long-term employees specialized in that culture. Others who make specific investments include long-term suppliers who have built a relationship with the hotel and have
specialized personnel and equipment catering to it. In contrast, one-off suppliers who are protected by contract or price-conscious customers who flip-flop between hotels would not be deemed to have made specific investments in the hotel.

  By taking as its objective the maximization of the value of financial and specific investments, management inspires greater trust in key constituents, offers a more socially acceptable picture of the corporation and, in fact, maximizes the economic value of the firm.

  Why is this last statement true? Think of it this way. When management is bringing together the people and entities that make up the firm, it has no need to worry about those who have a passing relationship with the firm, or who are protected by contract. In Milton Friedman’s framework, everyone but the equity holders were protected by contract. Hence, he postulated that management would maximize economic value by maximizing the value of equity. If the only unprotected entities in the firm were equity holders, our proposal would be consistent with that dictum. In practice, though, debt holders are unprotected when the hotel gets near financial default. Worse, those who have specific investments in the firm are rarely protected by contract, even in good times.

  In many situations, our objective of firm value maximization would elicit similar behavior from management as when the objective is shareholder value maximization. Consider a couple of situations where it produces a better outcome. When the hotel is highly levered, management has an incentive to invest in riskier but high-yielding projects, which may even destroy value on net. The reason is that if the projects succeed, equity holders benefit from the substantial upside, while if they fail and the hotel goes into bankruptcy, highly levered equity has little to lose, and the losses are borne by the debtholders and the long-term employees. If hotel management were governed by our proposal, they would incorporate the loss from bankruptcy to creditors and employees in their assessments, and be more cautious in their investment.

  Consider now an investment in training long-term employees in the specifics of the hotel’s business and culture that generates more revenue for the hotel than the training costs. Assume that trained long-term employees can bargain for higher wages (because they now are better trained), and the increase in revenues is not enough to cover both the training costs and the increase in wages. The shareholder value maximizing management would not undertake the training because it negatively impacts profits. The firm value maximizing management would train, because it would see the higher wages going to long-term employees not as a cost, but merely a transfer from one set of firm investors (shareholders) to another (long-term employees). It would see the positive increase in revenue net of training costs as the total benefit to the firm.

  The shift to firm value maximization is not just good for society (in that a value-enhancing investment takes place, regardless of how the fruits are shared), it is good for employees (since their wages go up), and it is even good for shareholders. This may seem strange since shareholders suffer a direct loss in profits from training the employees. This is where the words “specific investment” and “long-term” come in. If employees are expected to make substantial specific investments in the hotel’s culture over time, they know they are tied to it because they would be reluctant to leave the hotel’s employment and lose the additional wages that come from their specialization. Conversely, hotel management knows these are long-term employees.

  When management commits to fair treatment of its investors, including employees, the expectation of fair treatment is then priced into the dealings they have. When employees join the firm initially, they have alternative choices. If they join a firm where management maximizes shareholder value only, employees know that when forced to choose between investing in employees and enhancing shareholder value, the firm will choose the latter if there is a conflict. Rationally, employees will know they will not see the increment to their wages if that firm had to make the training decision. They will therefore require additional compensation, equal to the prospective foregone increase in wages, to join a firm that does not invest in training relative to one that does. Consequently, the shareholder value maximizing firm saves nothing in wages over time. However, because it foregoes the additional net revenue from the investment in training, it is worse off economically. Put differently, the firm value maximizing firm will be valued higher, both by the stock market and by long-term employees, because it makes decisions that benefit both rather than playing one off against the other.

  The law in some countries already urges management to behave in this way. In the United Kingdom, for example, the Companies Act requires the consideration of interests other than shareholders, including employees, customers, and suppliers provided it ultimately “promotes the success of the company.”2 Nevertheless, uncertainty over what exactly management will do in various situations can prevent the firm from benefiting fully from a clearly articulated objective. If the proposed objective is mandated in board policy and filters into managerial compensation structures, stock market investors will be able to predict management actions. They will bid up firm value appropriately. Equally, such commitment will enhance the legitimacy of corporate activity in the eyes of the public.

  The firm value maximizing management will continue to take hard decisions, a necessity if the firm is to stay competitive and survive. If, for example, employees are overpaid, management has an incentive to negotiate employee salaries down. So long as the rationale is carefully explained and employee morale is not depressed significantly, not only will this benefit shareholders, it will benefit other key stakeholders, including employees, by ensuring the survival of the firm. The corporation also has no incentive to hold prices down to help the government, one of the fears that prompted Milton Friedman’s article. Firm value maximization will ensure a continued separation between the corporate sector and the government. Tough decisions will continue to enhance productive efficiency, a key contribution of private corporations.

  Will the firm desist from political lobbying? Lobbying is sometimes needed to correct truly misguided legislation, or to ensure that legislators have the full picture while framing legislation. These legitimate rationales for lobbying can undoubtedly serve as cover for more self-interested lobbying that benefits the corporation at the expense of society. A ban on lobbying would be near impossible to enforce, though. Far better, then, to follow Madison’s cure for the problem of political interests—have enough corporations lobbying that no interest dominates and they compete to keep each other honest. This is one more reason to not have any industry or country dominated by a few large firms, a matter we will return to shortly.

  Finally, what about corporate social responsibility? Firms should focus on business in normal times, maximizing the value of the firm while obeying the law. Broader social responsibility should be left to the state and the community, enriched by the value the firm creates and the taxes it pays—the only exception is if the firm operates in a society where both the state and the community are totally dysfunctional. This is not to discourage actions firms take to attract a certain kind of employee or to improve their public image. For example, some firms will allow their employees to devote some of their time to voluntary social work. To the extent that this enables them to induct the right kind of employee, or allows employees to stay motivated by seeing a larger purpose in their jobs, and to the extent it allows the firm to be more acceptable to the community, it actually increases firm value. However, movements that want corporations to have a “social conscience” beyond this will risk undermining their hard-nosed focus on productivity, and thus their key contribution to the economy—producing a useful product at the least cost and sold cheaply, thus benefiting consumers and creating jobs. Overburdening the corporation with what truly should be done by the community and the state ensures it will do none of these tasks well.

  Even in a functional society, though, the corporation must act in extraordinary times. When fundamental principles of societ
y such as rule of law, fundamental rights, and democracy are being threatened, a corporation cannot stick to business and free-ride on the political activities of others. If every corporation does that, an enormous source of power is neutered, and society’s underpinnings are more likely to crumble. At such times, corporations that do not use their power are much like those who keep earth-moving equipment under lock and key as society copes with an earthquake. In extraordinary circumstances—and it is a difficult judgment call for corporate boards and management to decide when such a situation prevails—corporations should act even if they do not enhance firm value directly, simply because of the power society has entrusted them with. In doing so, they maximize societal value, not just economic value.

  ENHANCING COMPETITION TO BUILD TRUST IN MARKETS

  A second aspect of markets that needs attention is the degree of competition in them, and the increasing dominance of large firms in each sector. Let us start first with competition.

  INDUSTRY DOMINANCE AND MARKET POWER

  The benign view of an industry dominated by a few large firms has much to do with the Austrian economist Joseph Schumpeter. He believed that competitive discipline did not come from existing competitors in the market at a point in time, but from the disruptive innovator who would strike “not at the margins of the profits and their outputs of the existing firms but at their foundations and their very lives.”3 Schumpeter’s view was that a monopoly firm’s paranoia about possible future threats to its monopoly profits would be the spur to innovation, and the reason it would give its customers a good deal. The continuation of its monopoly would be its reward.