What’s Lost When Shareholders Rule

The form of capitalism that has emerged in Britain is the textbook description of how to organize capital markets and corporate sectors. It features dispersed shareholders with powers to elect directors and remove them with or without cause, large stock markets, active markets for corporate control, a good legal system, strong investor protection, a rigorous anti-trust authority — the list goes on.

It is what many countries around the world aspire to, what economists recommend, and what international agencies such as the IMF and World Bank encourage developing and emerging economies around the world to adopt. Even in the U.S., which is by global standards pretty close to the textbook, would-be reformers often cite the British example (on shareholder input into executive pay, for example, or the ease of hostile takeovers) as something to strive toward.

Against this background it is surprising to observe how mediocre the performance of the British economy has been, and how dissatisfied much of its population is with its economic and social conditions. Its large scale manufacturing firms have been decimated, it has endured decades of underinvestment and a banking system that does not fund its small and medium sized enterprises properly, and it is heavily dependent on a financial sector that displayed some of the worst failures of any country during the financial crisis.

It is as if the most ardent followers of lifestyle, nutrition, and well-being prescriptions suffer the most chronic symptoms of ill health and depression. And it is as if, in response, we encourage them to follow those recommendations even more closely and not allow them for one moment to question the infallible judgment of the experts. They should, in other words, flog themselves until they feel better.

What exactly is wrong with the progressively greater control that banks, private equity investors, stock markets, and takeovers have exerted over the British corporate sector? They are perfectly within their rights to penalize, remove, and dismiss at a moment's notice anyone who does not perform to the highest standards. Indeed if they do not do this they are abdicating their responsibilities as financiers, property owners, and guardians of corporate assets to ensure that their money, property, and assets are deployed in the very best way. Controlling corporations is their job.

The downside, though, is that exemplary as a form of control the British financial system might be, it systematically extinguishes any sense of commitment — of investors to companies, of executives to employees, of employees to firms, of firms to their investors, of firms to communities, or of this generation to any subsequent or past one. It is a transactional island in which you are as good as your last deal, as farsighted as the next deal, admired for what you can get away with, and condemned for what you confess.

While incentives and control are center-stage in conventional economics, commitment is not. Enhancing choice, competition, and liquidity is the economist's prescription for improving social welfare, and legal contracts, competition policy, and regulation are the toolkit for achieving it. Eliminate restrictions on consumers' freedom to choose, firms' ability to compete, and financial markets' provision of liquidity and we can all move closer to economic nirvana.

What economics does not recognize is the fundamental role of commitment in all aspects of our commercial as well as social lives, and the way in which institutions contribute to the creation and preservation of commitment. It does not appreciate the full manner in which choice, competition, and liquidity undermine commitment or the fact that institutions are not simply mechanisms for reducing costs of transactions, but on the contrary means to establish and enhance commitment at the expense of choice, competition, and liquidity. Commitment is the subject of soft sentimental sociologists, not of realistic rational economists.

Where economics errs is in failing to recognize our dependence on others to assist us, and the dependence of their willingness to do so on our commitment to them. It is not that contracts could not be written or terms of our mutual assistance agreed, it is simply that if we are not committed to abide by them, they are of no significance. My trust in you derives not from the piece of paper that I hold in my hand but from the sacrifice that I see you making on my behalf. What will you forgo if you deceive me; what will I endure from abusing your confidence? What is the capital that we have both invested to secure the relationship and without which no price, contract, incentive, or punishment is of any significance? How durable is your commitment in the face of adversity — is it resilient in difficult times or vulnerable to alternative temptations? Commitment has substance. I can measure the volume of it from the depth of capital committed, the length of time for which it is committed, and the breadth of activities to which it applies. A large amount of capital that can be withdrawn instantaneously is of little value.

Corporations are, as the economists depict them, instruments of control. But they are also commitment devices. In the form of corporate capitalism that has evolved in the UK — and, to a lesser extent, the U.S. — shareholder power makes true commitment extremely difficult. Corporations, and economic well-being, have suffered as a result.

This is adapted from Firm Commitment: Why the Corporation is Failing Us and How to Restore Trust in It (Oxford University Press, 2013).

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