The question is no longer: are dispersed outside shareholders a bad way of organizing firm ownership? That’s clear. Instead, it’s: if publicly quoted firms are in theory so inefficient, why have so many thrived for so long?
This paper (pdf) by Raghuram Rajan and colleagues (via Brad DeLong) gives an answer: it’s because control over chief executives is exercised bottom-up, by key workers, rather than top-down, from shareholders.
Imagine a selfish CEO approaching retirement. He wants to get as much cash out of the firm as he can, and shareholders provide no discipline over him. Sounds like a recipe for catastrophe?
Not necessarily. In order to maximize revenues, and hence his own opportunities for rent extraction, the CEO needs his subordinates to work hard. But they won’t do this if they think the CEO is out only to maximize his own short-term rewards at the expense of the health of the company, because they‘ll believe the firm has no future.
In order to motivate them, he’ll have to invest in growing the firm, to give key employees the hope of big rewards in the future.
In this way, even a selfish, short-termist CEO can be coerced into acting in the long-term interests of the firm.
And efforts to increase shareholders rights - say by paying big dividends or by getting more activist owners - might be counter-productive. Subordinates’ might reduce their effort if they think shareholders are depressing growth prospects. And shareholder control over a CEO might be a poor substitute for de facto workers’ control, as the latter know more about the firm.
They key assumption in all this is the CEO’s opportunities for rent extraction depend upon subordinates’ efforts - that is, that human capital is a key resource. If, however, the key resource is physical assets, and workers’ efforts are less important, bottom-up control might not be so effective.
There is, though, an obvious question here. If quoted firms thrive to the extent that they act a little like co-ops - by giving (some) employees (some) de facto control, why shouldn’t this arrangement be extend and formalized?
This paper (pdf) by Raghuram Rajan and colleagues (via Brad DeLong) gives an answer: it’s because control over chief executives is exercised bottom-up, by key workers, rather than top-down, from shareholders.
Imagine a selfish CEO approaching retirement. He wants to get as much cash out of the firm as he can, and shareholders provide no discipline over him. Sounds like a recipe for catastrophe?
Not necessarily. In order to maximize revenues, and hence his own opportunities for rent extraction, the CEO needs his subordinates to work hard. But they won’t do this if they think the CEO is out only to maximize his own short-term rewards at the expense of the health of the company, because they‘ll believe the firm has no future.
In order to motivate them, he’ll have to invest in growing the firm, to give key employees the hope of big rewards in the future.
In this way, even a selfish, short-termist CEO can be coerced into acting in the long-term interests of the firm.
And efforts to increase shareholders rights - say by paying big dividends or by getting more activist owners - might be counter-productive. Subordinates’ might reduce their effort if they think shareholders are depressing growth prospects. And shareholder control over a CEO might be a poor substitute for de facto workers’ control, as the latter know more about the firm.
They key assumption in all this is the CEO’s opportunities for rent extraction depend upon subordinates’ efforts - that is, that human capital is a key resource. If, however, the key resource is physical assets, and workers’ efforts are less important, bottom-up control might not be so effective.
There is, though, an obvious question here. If quoted firms thrive to the extent that they act a little like co-ops - by giving (some) employees (some) de facto control, why shouldn’t this arrangement be extend and formalized?
In principle, I'm a thoroughly dedicated enthusiast for bottom-up control - except that I suspect it would soon end up with the quality of debate exhibited by most local councils or tenant associations.
Granted that the John Lewis Partnership is a success story of a producer co-operative, we still need to ask why there are so few other examples if co-operatives are so good.
Posted by: Bob B | October 17, 2008 at 11:01 AM
This is why encouraging meaningful staff share stakes is such a good idea. Staff feel likes it's their business, even if, in reality, their shareholdings are trivial. Worked well for the fund management firm I worked for. And that's why (small) partnerships can work well. I'm not so convinced about large partnershiops such as accountancy or law firms. These are too big for staff to feel part of them and anyway, outside the partners, the workers have no stake.
Posted by: tolkein | October 17, 2008 at 02:13 PM
I have a theory that the success of the US is that exploited workers work hard even though they are being royally screwed. Collectively this makes for a productive economy.
Posted by: tom s. | October 17, 2008 at 06:42 PM
To turn the argument around, the reason the kind of "investor capitalism" Michael Jensen championed has been such a disaster from the '80s on is that it weakened bottom-up control of corporate management. Of course shareholder control of management is a myth. But it's a pernicious myth, because it serves to legitimize the independence of corporate management from internal stakeholders. They can expropriate the value created by human capital, gut that human capital, and hollow out productive capability to game their short-term bonuses and stock options--and then say "I have no choice; it's all for the stockholders."
Posted by: Kevin Carson | October 18, 2008 at 08:06 AM
You may find enlightenment in reading 'Decline and Fall of the Roman Empire'. A succession of CEO's had exactly that need (for the support) of their subordinates.
However, what the subordinates most wanted was to be CEO to gain personal control of the cash flow. They had no scruples about making the CEO look bad in order to drum up support for a (boardroom) coup. Only the really evil CEOs survived for long.
The result of all the infighting for the Empire was inexorable decline. It took a long time (over 1000 years) mainly because the external enemies were relatively very weak. But in the end, the co-op model polished off the Roman Empire.
Posted by: David Snell | October 20, 2008 at 10:51 AM
You may find enlightenment in reading 'Decline and Fall of the Roman Empire'. A succession of CEO's had exactly that need (for the support) of their subordinates.
However, what the subordinates most wanted was to be CEO to gain personal control of the cash flow. They had no scruples about making the CEO look bad in order to drum up support for a (boardroom) coup. Only the really evil CEOs survived for long.
The result of all the infighting for the Empire was inexorable decline. It took a long time (over 1000 years) mainly because the external enemies were relatively very weak. But in the end, the co-op model polished off the Roman Empire.
Posted by: David Snell | October 20, 2008 at 10:51 AM
I'm actually thinking seriously about starting up a co-op to fund our several ventures.
Posted by: jameshigham | October 23, 2008 at 07:38 PM