How Economists Turned Corporations into Predators

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By Lynn Parramore, Senior Research Analyst at the Institute for New Economic Thinking. Originally published at the Institute for New Economic Thinking website

The Idea That Businesses Exist Solely to Enrich Shareholders Is Harmful Nonsense

In a new INET paper featured in the Financial Times, economist William Lazonick lays out a theory about how corporations can work for everyone – not just a few executives and Wall Streeters. He challenges a set of controversial ideas that became gospel in business schools and the mainstream media starting in the 1980s. He sat down with INET’s Lynn Parramore to discuss.

Lynn Parramore: Since the 1980s, business schools have touted “agency theory,” a controversial set of ideas meant to explain how corporations best operate. Proponents say that you run a business with the goal of channeling money to shareholders instead of, say, creating great products or making any efforts at socially responsible actions such as taking account of climate change. Many now take this view as gospel, even though no less a business titan than Jack Welch, former CEO of GE, called the notion that a company should be run to maximize shareholder value “the dumbest idea in the world.” Why did Welch say that?

William Lazonick: Welch made that statement in a 2009 interview, just ahead of the news that GE had lost its S&P Triple-A rating in the midst of the financial crisis. He explained that, “shareholder value is a result, not a strategy” and that a company’s “main constituencies are your employees, your customers and your products.” During his tenure as GE CEO from 1981 to 2001, Welch had an obsession with increasing the company’s stock price and hitting quarterly earnings-per-share targets, but he also understood that revenues come when your company generates innovative products. He knew that the employees’ skills and efforts enable the company to develop those products and sell them.

If a publicly-listed corporation succeeds in creating innovative goods or services, then shareholders stand to gain from dividend payments if they hold shares or if they sell at a higher price. But where does the company’s value actually come from? It comes from employees who use their collective and cumulative learning to satisfy customers with great products. It follows that these employees are the ones who should be rewarded when the business is a success. We’ve become blinded to this simple, obvious logic.

LP: What have these academic theorists missed about how companies really operate and perform? How have their views impacted our economy and society?

WL: As I show in my new INET paper “Innovative Enterprise Solves the Agency Problem,” agency theorists don’t have a theory of innovative enterprise. That’s strange, since they are talking about how companies succeed.

They believe that to be efficient, business corporations should be run to “maximize shareholder value.” But as I have argued in another recent INET paper, public shareholders at a company like GE are not investors in the company’s productive capabilities.

LP: Wait, as a stockholder I’m not an investor in the company’s capabilities?

WL: When you buy shares of a stock, you are not creating value for the company — you’re just a saver who buys shares outstanding on the stock market for the sake of a yield on your financial portfolio. Public shareholders are value extractors, not value creators.

By touting public shareholders as a corporation’s value creators, agency theorists lay the groundwork for some very harmful activities. They legitimize “hedge fund activists,” for example. These are aggressive corporate predators who buy shares of a company on the stock market and then use the power bestowed upon them by the ill-conceived U.S. proxy voting system, endorsed by the Securities and Exchange Commission (SEC), to demand that the corporation inflate profits by cutting costs. That often means mass layoffs and depressed incomes for anybody who remains. In an industry like pharmaceuticals, the activists also press for extortionate product price increases. The higher profits tend to boost stock prices for the activists and other shareholders if they sell their shares on the market.

LP: So the hedge fund activists are extracting value from a corporation instead of creating it, and yet they are the ones who get enriched.

WL: Right. Agency theory aids and abets this value extraction by advocating, in the name of “maximizing shareholder value,” massive distributions to shareholders in the form of dividends for holding shares as well as stock buybacks that you hear about, which give manipulative boosts to stock prices. Activists get rich when they sell the shares. The people who created the value — the employees — often get poorer.

###p“downsize-and-distribute” —something that corporations have been doing since the 1980s, which has resulted in extreme concentration of income among the richest households and the erosion of middle-class employment opportunities.

LP: You’ve called stock buybacks — what happens when a company buys back its own shares from the marketplace, often to manipulate the stock price upwards— the “legalized looting of the U.S. business corporation.” What’s the problem with this practice?

WL: If you buy shares in Apple, for example, you can get a dividend for holding shares and, possibly, a capital gain when you sell the shares. Since 2012, when Apple made its first dividend payment since 1996, the company has shelled out $57.4 billion as dividends, equivalent to over 22 percent of net income. That’s fine. But the company has also spent $157.9 billion on stock buybacks, equal to 62 percent of net income.

Yet the only time in its history that Apple ever raised funds on the public stock market was in 1980, when it collected $97 million in its initial public offering.  How can a corporation return capital to parties that never supplied it with capital? It’s a very misleading concept.

The vast majority of people who hold Apple’s publicly-listed shares have simply bought outstanding shares on the stock market. They have contributed nothing to Apple’s value-creating capabilities. That includes veteran corporate raider Carl Icahn, who raked in $2 billion by holding $3.6 billion in Apple shares for about 32 months, while using his influence to encourage Apple to do $80.3 billion in buybacks in 2014-2015, the largest repurchases ever. Over this period, Apple, the most cash-rich company in history, increased its debt by $47.6 billion to do buybacks so that it would not have to repatriate its offshore profits, sheltered from U.S. corporate taxes.

There are many ways in which the company could have returned its profits to employees and taxpayers — the real value creators — that are consistent with an innovative business model. Instead, in doing massive buybacks, Apple’s board (which includes former Vice President Al Gore) has endorsed legalized looting. The SEC bears a lot of blame. It’s supposed to protect investors and make sure financial markets are free of manipulation. But back in 1982, the SEC bought into agency theory under Reagan and came up with a rule that gives corporate executives a “safe harbor” against charges of stock-price manipulation when they do billions of dollars of buybacks for the sole purpose of manipulating their company’s stock price.

LP: But don’t shareholders deserve some of the profits as part owners of the corporation? 

WL: Let’s say you buy stock in General Motors. You are just buying a share that is outstanding on the market. You are contributing nothing to the company. And you will only buy the shares because the stock market is highly liquid, enabling you to easily sell some or all of the shares at any moment that you so choose.

In contrast, people who work for General Motors supply skill and effort to generate the company’s innovative products. They are making productive contributions with expectations that, if the innovative strategy is successful, they will share in the gains — a bigger paycheck, employment security, a promotion. In providing their labor services, these employees are the real value creators whose economic futures are at risk.

LP: This is really different from what a lot of us have been taught to believe. An employee gets a paycheck for showing up at work — there’s your reward. When we take a job, we probably don’t expect management to see us as risk-takers entitled to share in the profits unless we’re pretty high up.

WL: If you work for a company, even if its innovative strategy is a big success, you run a big risk because under the current regime of “maximizing shareholder value” a group of hedge fund activists can suck the value that you’ve created right out, driving your company down and making you worse off and the company financially fragile. And they are not the only predators you have to deal with. Incentivized with huge amounts of stock-based pay, senior corporate executives will, and often do, extract value from the company for their own personal gain — at your expense. As Professor Jang-Sup Shin and I argue in a forthcoming book, senior executives often become value-extracting insiders. And they open the corporate coffers to hedge fund activists, the value-extracting outsiders. Large institutional investors can use their proxy votes to support corporate raids, acting as value-extracting enablers.

You put in your ideas, knowledge, time, and effort to make the company a huge success, and still you may get laid off or find your paycheck shrinking. The losers are not only the mass of corporate employees — if you’re a taxpayer, your money provides the business corporation with physical infrastructure, like roads and bridges, and human knowledge, like scientific discoveries, that it needs to innovate and profit. Senior corporate executives are constantly complaining that they need lower corporate taxes in order to compete, when what they really want is more cash to distribute to shareholders and boost stock prices. In that system, they win but the rest of us lose.

LP: Some academics say that hedge fund activism is great because it makes a company run better and produce higher profits. Others say, “No, Wall Streeters shouldn’t have more say than executives who know better how to run the company.” You say that both of these camps have got it wrong. How so?

WL: A company has to be run by executive insiders, and in order to produce innovation these executives have got to do three things:

First you need a resource-allocation strategy that, in the face of uncertainty, seeks to generate high-quality, low-cost products. Second, you need to implement that strategy through training, retaining, motivating, and rewarding employees, upon whom the development and utilization of the organization’s productive capabilities depend. Third, you have to mobilize and leverage the company’s cash flow to support the innovative strategy. But under the sway of the “maximizing shareholder value” idea, many senior corporate executives have been unwilling, and often unable, to perform these value-creating functions. Agency theorists have got it so backwards that they actually celebrate the virtues of “the value extracting CEO.” How strange is that?

Massive stock buybacks is where the incentives of corporate executives who extract value align with the interests of hedge fund activists who also want to suck value from a corporation. When they promote this kind of alliance, agency theorists have in effect served as academic agents of activist aggression. Lacking a theory of the value-creating firm, or what I call a “theory of innovative enterprise,” agency theorists cannot imagine what an executive who creates value actually does. They don’t see that it’s crucial to align executives’ interests with the value-creating investment requirements of the organizations over which they exercise strategic control. This intellectual deficit is not unique to agency theorists; it is inherent in their training in neoclassical economics.

LP: So if shareholders and executives are too often just looting companies to enrich themselves – “value extraction,” as you put it – and not caring about long-term success, who is in a better position to decide how to run them, where to allocate resources and so on?

WL: We need to redesign corporate-governance institutions to promote the interests of American households as workers and taxpayers. Because of technological, market, or competitive uncertainties, workers take the risk that the application of their skills and the expenditure of their efforts will be in vain. In financing investments in infrastructure and knowledge, taxpayers make productive capabilities available to business enterprises, but with no guaranteed return on those investments.

These stakeholders need to have representation on corporate boards of directors. Predators, including self-serving corporate executives and greed-driven shareholder activists, should certainly not have representation on corporate boards.

LP: Sounds like we’ve lost sight of what a business needs to do to be successful in the long run, and it’s costing everybody except a handful of senior executives, hedge fund managers, and Wall Street bankers. How would your “innovation theory” help companies run better and make for a healthier economy and society?

WL: Major corporations are key to the operation and performance of the economy. So we need a revolution in corporate governance to get us back on track to stable and equitable economic growth.  Besides changing board representation, I would change the incentives for top executives so that they are rewarded for allocating corporate resources to value creation. Senior executives should gain along with the rest of the organization when the corporation is successful in generating competitive products while sharing the gains with workers and taxpayers.

Innovation theory calls for changing the mindsets and skill sets of senior executives. That means transforming business education, including the replacement of agency theory with innovation theory. That also means changing the career paths through which corporate personnel can rise to positions of strategic control, so that leaders who create value get rewarded and those who extract it are disfavored. At the institutional level, it would be great to see the SEC, as the regulator of financial markets, take a giant step in supporting value creation by banning stock buybacks whose purpose it is to manipulate stock prices.

To get from here to there, we have to replace nonsense with common sense in our understanding of how business enterprises operate and perform.

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32 comments

  1. Enquiring Mind

    Owners come first!
    That was the slogan of our former board chair. He didn’t disclose to the employees that his compensation was influenced mightily by how big the net income was. He did tell the employees that they were well down the hierarchy, after Owners (capital O) and then vendors and then customers. His former employees deserted in droves.

    Reply
    1. RepubAnon

      I’d say that maximizing long-term shareholder value is a great idea… the problem is, as is so often the case these days, short-term thinking.

      Driving away a company’s best employees makes that quarter’s numbers look better, but destroys long-term value. Same thing for so many other short-term, “I’ll be gone, you’ll be gone” strategies.

      One step to fixing things – change the definition of long-term capital gains from the current 1 year to, say, 5 years. This “one simple trick” would fix everything from the carried interest loophole to the abuses inherent in the current Wall Street gambling mentality.

      It won’t happen, of course, but it’d be nice.

      Reply
    2. Tim

      We can talk about what is best in theory, but reality is just that, shareholders come first.

      They control the board and the CEO and the CEO institutes the will of the shareholders down into the business entities, determining the level of reinvestment in the business units and the level of employee compensation. That will continue to be the case until the company goes bankrupt at which point shareholders are entitled to nothing.

      I agree with others that Jack Welch is saying what he is saying after the fact. Way too easy to do.

      Reply
      1. False Solace

        In theory maybe. In the real world it’s CEOs who have the most influence over the board. It’s exceedingly rare for shareholders to ever vote against a sitting director, which is why 94% of board members receive over 90% approval in election after election. The theory that shareholders exercise meaningful oversight over the board is a farce.

        Note these are similar figures to reelection rates for Congress, which probably says something about the amount of actual democracy involved in both arenas.

        Reply
        1. Todde

          Proxy votes and executive share pay packages are corporate gerrymandering.

          Shareholders rarely try to take over a corporation’s BOD, they will just sell the stock.

          Reply
  2. a different chris

    >Welch had an obsession with increasing the company’s stock price and hitting quarterly earnings-per-share targets, but he also understood

    Yeah so he talks a good game but when he had the reins – one of the most powerful men in the world meekly (ok, that’s a hilarious adjective when applied to Jack Welsh) followed the herd. Or more accurately, found out where the herd was heading and got out in front of it. The true sign of modern “leadership”.

    Reply
    1. RepubAnon

      Folks at GE back in the day nicknamed him “Neutron Jack” – if he visited a site, all the employees disappeared, leaving only the buildings standing…

      Reply
    2. digi_owl

      Or more accurately, found out where the herd was heading and got out in front of it. The true sign of modern “leadership”.

      Reminds me of something i have read, supposedly a quite from some politician or other, going to the tune of “i need to find out where the mob is going, so i can lead them there”.

      Reply
    3. Left in Wisconsin

      Welch’s primary business strategy at GE was to exit every product market in which GE’s market share was not in the top two in the industry (selling them off or closing them down) and reallocate resources to industries where GE was market dominant, often buying up the competition rather than truly investing in innovation. A truly awful human being.

      Reply
  3. Synoia

    As I personally have always believed, Employees have more invested in their employers than shareholders. Shareholders can sell quickly and have no loyalty.

    Employees do not enjoy such a liquid “jobs market.”

    There also seems to be a turning point in companies, where they change the perception of the customers form a group to be treasured, to a group who are to b exploited – change the relationship so the customers become “marks.”

    I also believe there should be an almost automatic “break -up” provision for companies who reach a certain market share.

    Finally there should be one definition of income, and it should include Wages, Dividends, and Capital Gains.

    Reply
    1. Vatch

      there should be an almost automatic “break -up” provision for companies who reach a certain market share.

      Yes, anti-trust enforcement would be nice. Hypothetical President Sanders might actually do that. Real and hypothetical Presidents Bush, Obama, Romney, B. Clinton, H. Clinton, and Trump have other priorities.

      Reply
      1. readerOfTeaLeaves

        Sen Bernie Sanders sees right through the neoclassical fetters, blinders, and bullshit.
        He recognizes how intellectually and economically stagnant and dangerous it is.
        He has the most powerful conceptual, articulate grasp of economics that I’ve seen the past 40 years.
        He also, IIRC, had MMTer Stephanie Kelton as an advisor, and had her advise the Senate Finance Committee.
        Also notable: Sen Elizabeth Warren.

        The other political operators that you mention are still in thrall to neoclassical assumptions. They mistake ‘takers’ for ‘makers’ and are economically bamboozled. And it has worked out well for all of them, on a personal basis, so it is not surprising that they don’t see the problems.

        Anyone actually trying to build an innovative business, OTOH, has to see through the bamboozlement or else you’re out of business pronto.

        Reply
  4. JTMcPhee

    Chicken and egg question:

    The class of humans that by inclination and opportunity become C-Suite and VC looters and “owners:” did they precede the imprimatur of “economists” with their notions of price, value, and crossing of curves, or did the “economists” do a Martin Luther, nail up a bunch of theses, and preach fire and brimstone to turn the greedheads loose?

    And was/is any other outcome for the species and the planet even possible?

    Reply
    1. Left in Wisconsin

      Neil Fligstein wrote a good book awhile back called The Transformation of Corporate Control that shows how most large manufacturing companies were initially run by engineers, then sales people, then finance people (as corporations came to be seen as bundles of assets as opposed to businesses). I think this transformation paralleled the rise of neoclassical economics. So, not so much “chicken-and-egg” as “class war.” In Germany, at least until recently, I believe CEO’s of manufacturing firms were still disproportionately engineers.

      Reply
      1. Carla

        “most large manufacturing companies were initially run by engineers, then sales people, then finance people”

        The Lincoln Electric Company, which became famous for its “Incentive Management” program of compensating employees, was a client of mine. Over three decades I saw it progress through precisely those stages, and gradually lose every characteristic that had made the company unique.

        Reply
      2. Eclair

        Kind of like Douglas Adams’ theory of intergalactic civilizations’ history. Every civilization goes through three stages: how can we eat (survival), why do we eat (inquiry) and, finally, where shall we have lunch. Where lunch is the company itself. Or us.

        Reply
      3. John Wright

        To give a small idea of how involved some engineer-owners of corporations were with their products, here is one example of Bill Hewlett of HP.

        Hewlett was known to carry a golf ball in his pocket during visits to the measurement instrument side of HP.

        During the demonstration of new instruments, Hewlett would drop his golf ball on the case or frame to see if the displayed measurement result was disturbed by the vibrations (the instrument exhibited microphonic behavior).

        I worked for HP when “Bill and Dave” were still active in the pre-Carly era, and the employee respect for these two billionaires was widespread.

        Reply
  5. readerOfTeaLeaves

    This post was a genuine pleasure to read. Especially:

    If you work for a company, even if its innovative strategy is a big success, you run a big risk because under the current regime of “maximizing shareholder value” a group of hedge fund activists can suck the value that you’ve created right out, driving your company down and making you worse off and the company financially fragile.

    And we’ve had a government by and for hedge fund managers for about the same amount of time that we’ve had economic woes. One problem is that hedge funders like Romney, who actually don’t think about consumer product development, actually don’t have to test and deploy products, bring their bean-counter assumptions to business and make a hash of things. I mention Romney specifically, because he presents himself to the world as a paragon of economic wisdom.

    Romney has a prestigious business school background. Which makes me want to highlight this:

    Innovation theory calls for changing the mindsets and skill sets of senior executives. That means transforming business education, including the replacement of agency theory with innovation theory.

    Reply
    1. JTMcPhee

      Just a thought: “innovation theory,” like MMT, is maybe just a tool set? “Innovation” includes “autonomous combat devices,” and CRSP-R, and nuclear weapons, and the F-35, and fracking, and derivatives, and plastics, and charter schools, stuff and ideas that for some of us constitute “value”… are corporations as the category has grown to be, any more likely to “innovate” in the areas of social improvements and possibilities, or stewardship of the planet, or close down the toll stations and all the other rent collection scams and extortions they have “innovated” to date? Or release their chokehold on “policy?”

      Says the proponent: “Major corporations are key to the operation and performance of the economy. So we need a revolution in corporate governance to get us back on track to stable and equitable economic growth. Besides changing board representation, I would change the incentives for top executives so they are rewarded for allocating corporate resources to value creation. Senior executives should gain along with the rest of the organization when the corporation is successful in generating competitive products while sharing the gains with workers and taxpayers.” There seems to be so much wrong and just more Biz-babble about this, one hardly knows where to start unpacking. “Major corporations are key?” Really? Monsanto? GM? Bechtel? The Big Banks? And “back on track”: When has the political economy, writ small or large, ever been “on track to stability and equitable growth,” said “growth’ itself seemingly one of the pathologies that’s killing us? And who’s going to write the entries for the corporate senior executives’ dance cards that will measure their “success,” in those feel-good categories?

      But it’s a good conversation piece, and maybe an opening into Something Better, however us inherently mostly self-interested, self-pleasing omnivorous predators might define “better…”

      Reply
  6. Disturbed Voter

    Badly run companies, naturally extinguish themselves. Unfortunately they take down their customers, owners, vendors and employees in the process. But the government can step in and either save a company that otherwise would die, or act as a crony corruption partner on behalf of a well connected company. Same as it always was. But since gigantism is the norm, rather than family run farms in a mostly agrarian economy … such failures are catastrophic. The linkage between these elephants tends to create systemic risk. Previously, failure was small and isolated.

    Reply
    1. JTMcPhee

      Welcome to our wonderful new world of infinite mutual vulnerability! Risk On! Nuclear weapons, Equifax, Googleamazon, NSApanopticon, FIRE, hacking, crapification… The Soviet Union vanished as an entity, many starved, but the mopes there at least still knew how to raise up edible crops and live on “less” and maybe do better collective response to that sharp peak on the entropy curve. Wonder how things might play out exceptionally, here in the Empire?

      Reply
      1. Disturbed Voter

        Force decoupling (anti-zaibatsu), rabidly promote anti-trust, eliminate Citizens United. Otherwise it will be a bad day when all the giant dominoes fall down.

        Reply
  7. allan

    It should be noted that Michael Jensen of HBS, one of the originators of the `maximize shareholder value’ of corporate governance, is on some short lists for this year’s not-exactly-the-Nobel Prize in Economics.

    Reply
  8. SeanL

    there is also another pervasive belief of economics & MBA graduates – that only the brightest person matters & everyone else is replaceable. That is, you only need a few very bright people (them) to make an economy work – essentially slaver capitalism. And yet history has shown that this belief always fails – not from revolution but from other countries/systems being more successful. e.g. the more innovative North eventually beating the initially economically strong South.

    Reply
  9. JCC

    Good article, unfortunately very old news and so to me it’s a little frustrating. I’ve been preaching to friends of mine all this ever since I read Marjorie Kelly’s book “The Divine Right of Capital” which explained all of this, and more, 16 years ago. I even went so far as buying a few extra copies to give away to a few college business professors of mine as well as a few friends of mine that taught business courses (still in print, by the way).

    Too bad more weren’t aware of, and read, her book back then. Maybe the public would have started clamping down before Corporate America got as powerful as it is today in solidifying their ownership of our entire Federal Govt and the American Commonwealth.

    This story cannot be told enough. Too bad no one seems to do anything about it.

    Reply
    1. JCC

      I really need to learn to stop shooting from the hip, which on occasion puts me in the embarrassing position of having to reply to my own posts.

      Of course there are many that are trying to something about how large businesses operate in this country, besides the many readers and writers here at NakedCap.

      Out of curiosity, after writing the above, I looked up Marjorie Kelly on the ‘net to see what she was doing and writing today and came across a group that she is part of, The Democracy Collaborative.

      Now if we can just figure out how to eliminate The Agency Problem.

      Reply
  10. Procopius

    This was one of Milton Friedman’s fondest beliefs, maximizing “shareholder value.” It’s probably the most pernicious idea ever popularized. Jamie Galbraith dissects it at length in his “The Predator State.” Of course it’s something I understand the New Democrats believe in, too. Along with deregulation and privatization.

    Reply
  11. Scott

    I appreciate the fine thoughtful comments about how corporations are aimed, what their goals are, and how those goals are facilitated. We have long now understood that stock buy backs to inflate stock prices is not working out.
    I had no idea that corporations had been so feared by founders of the nation that they weren’t supposed to even be chartered if they didn’t serve the public.
    There is no corporate personhood. It is a big lie. It is a failure of the Supreme Court to act as if there was ever a case that firmly established corporate personhood.
    The history of the Rail Roads is where I find the evolution of the corporations most explanatory.

    Reply
  12. wmd

    Apple has arguably used stock to raise human capital via RSU grants to employees (and not C-level employees, rank and file employees, as C-level still typically gets options). It doesn’t rise to the level of stock buybacks, but the employee stock ownership is using stock to raise money.

    Reply
  13. Sound of the Suburbs

    Investor’s interests and companies interests are not aligned.

    World beating companies like Amazon, Microsoft and Apple grew so fast as they constantly re-invested
    profits, and didn’t pay out dividends to the investor’s dismay.

    Investor’s main concern is not investing in the system, but on how much they can get out of the system.

    Activist share holders take this to its ultimate conclusion, and engage in debt leveraged buyouts to strip everything out of the company they can, and leave it loaded up with debt.

    Looking after share holders interests doesn’t make for a successful capitalist system.

    Reply

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