Back to shareholder capitalism


By Martin Hutchinson
Asia Times
Jan 13, 2010


Warren Buffett, whose Berkshire Hathaway owns 9% of Kraft, last week threw the US food company's takeover of the British chocolate company Cadbury into more doubt when he said he would vote Berkshire's shares against a rights issue that Kraft was proposing to consummate the Cadbury deal.

His action was regarded as surprising, because the majority of institutional shareholders generally back management, except in extreme cases or where some fashionable political or environmental cause is involved. The market's surprise is itself disquieting; isn't Buffett's action an example of how capitalism is supposed to work?

Economic theory is pretty clear on the advantages of shareholder capitalism, in which there is no separation between the ownership of businesses and its decision-making. The benefits of the price mechanism, in which economic actors compete with each other for advantage, have been with us since Adam Smith famously wrote, "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages." Thus selfish people acting in their own interest and controlling their own capital produce benefits for society as a whole.

However, Smith recognized that when managers were separated from capital, a very different picture emerged. "The directors of such companies ... being the managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance ... Negligence and profusion must always prevail, more or less, in the management of such a company"

Thus, the defects of managerial capitalism were recognized by Smith 234 years ago - and it has to be said that "negligence and profusion" accurately captures the failings of modern management, both on Wall Street and in much of the corporate sector as a whole. ("Negligence" is a particularly apt description of Wall Street's attitude to risk management in the bubble years, don't you think?) So how the hell did the United States economy get in the mess it occupies today?

It wasn't there 50 years ago. Institutional shareholdings represented only about 15% of quoted share capital in the 1950s, with about half held by individuals and the remainder held by bank trust departments and the like, investing on behalf of single individuals rather than deploying the capital of an amorphous mass. The estate tax, instituted in its modern form in 1916, had risen above 20% only in the infamous Herbert Hoover Great Depression-worsening tax increase of 1932. Thus in the 1950s, there were still many individual fortunes that had not been subjected to the tax, and hence held substantial percentage shareholdings in major corporations. Furthermore, even the less-wealthy middle class retired to live on the dividends from their share portfolios; funded pensions were still fairly uncommon.

The result was a capitalism in which management was only modestly paid - maybe 40 times the remuneration of production-line workers. Because of the substantial individual shareholdings remaining, there was no great enthusiasm for large stock option grants either, which would have diluted the power of the major individual shareholders. Hence, even chief executive officers were hired hands, seeking to maximize the wealth of shareholders through growing the companies, but paying out most of the company's earnings in dividends, on which many of the individual shareholders relied to maintain their living standards.

Thus when AT&T undertook a stock split and dividend increase from its traditional US$9 per share in 1959, there was considerable resistance from shareholders. The company had maintained its $9 dividend (established in 1927) right through the Great Depression and World War II, paying it out of surplus in the worst years but providing the most stable source of income for many elderly middle class widows and pensioners. Thus the 1959 increase caused concern that the new larger dividend might not be sustainable in a prolonged downturn. Needless to say, in the long term, the concern proved correct; technological change, government meddling, inflation and managerial capitalism made AT&T a much less satisfactory investment in 1959-2009 than it had been in 1909-59.

In a series of increases after 1932, the top estate tax rate by the 1950s had been increased in stages to as high as 77%. Thus the 1950s' shareholder structure was intrinsically unstable because the individual fortunes were disappearing, either to the taxman or to various "charitable" trusts that were no longer controlled by their beneficiaries.

As the working and middle classes became entitled to pensions, or later 401(k) accounts, and the mutual fund industry took off, the percentage of funds managed on an individual basis shrank, so that by 1980 institutional shareholders owned more than 50% of publicly quoted shares, a percentage that has trended gently upwards since. Thus, by 1980, the era of individual capitalism was over.

It was not immediately obvious that the era of shareholder capitalism had also passed. The general assumption in the 1970s was that the new institutional shareholders would wield their immense power in a suitably shareholder-value-maximizing way, chastising management when it got out of hand and ensuring that the interests of all shareholders were adequately protected.

It didn't happen, for reasons very well understood by public-choice economists. The money managers at institutions were not titans of finance, moving markets at the slightest whim - those guys were on the "sell side" on Wall Street. They were instead middle-level bureaucrats, well paid by the standards of the outside world but wholly reliant on the career structure within the investment management profession. They were mostly unable to become independently powerful "stars" if only because the tenets of modern financial theory declared that superior investment management performance was impossible.

With money managers needing to preserve their jobs through providing satisfactory investment performance quarter by quarter, they certainly weren't likely to endanger their positions through sticking their neck out in opposition to a powerful corporate management. Naturally, if the issue in question was something fashionable - maybe environmentalism or divestment from South Africa - money managers could be assured of support from like-minded souls in other institutions, thus keeping them comfortably within their comfort zone of conformity. But separating themselves from the herd and confronting corporate big shots, when in any case they spoke for only perhaps 5% of the company's stock - that went entirely against the instincts of people whose closest equivalent in nature was the sheep.

Thus when institutions own majority shareholdings in most companies, and individuals (except for the occasional Buffett) are no longer significant, the structure of capitalism breaks down. Since the managers of institutional money are not motivated to behave like the powerful shareholders they represent, they don't do so. As a result, management has a free rein to indulge in the "negligence and profusion" that Smith deplored. Not only can it overpay itself, dilute the shareholders by excessive stock option grants, and pull the wool over shareholders' eyes by dodgy accounting, but it can also indulge in whatever Napoleonic expansion fantasies it pleases, whatever the damage to shareholders' interests - unless the company's results become so appallingly bad that even the institutional sheep turn feral.

The solution is relatively straightforward, but it will take a long time. No amount of "better corporate governance" initiatives will change the incentives for the managers of institutional money sufficiently to turn them from sheep into watchdogs. Thus any such efforts are essentially doomed, although if they can instill a little interim fear into corporate management, and reduce its depredations, they will be helpful.

Instead, we have to recreate the world in which the majority of shares were held by individuals. To do this, two taxation changes are necessary. First, the estate duty must be reduced, to a level no higher than 15% to 20%, in order to preserve family fortunes in their original form and prevent their dissipation in wasteful charitable trusts. Second, the income tax deductions for home-mortgage interest and for charitable donations must be removed, in order that the incomes of the moderately wealthy, even before their death, are diverted away from overpriced real estate and wasteful charity and towards productive investment.

Restoration of shareholder capitalism by this means will take time. Only over a few decades will individual shareholdings rebuild to the point where corporate management has to take seriously the 82-year-old dowager owning 0.7% of their company who demands higher dividends, lower stock options and an end to wasteful corporate aggrandizement schemes. But over time, the dowagers will once again take over from the bureaucrats, and American capitalism will once again function properly.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.

http://www.atimes.com/atimes/Global_Eco ... 3Dj01.html