The question that emerges from proposals to elevate a corporation’s “purpose,”[1] the call for co-determination in Senator Warren’s Accountable Capitalism Act and now the Business Roundtable’s purported elevation of stakeholder interests, is whether corporate governance is capable of playing the important role in addressing social problems that some have posited. Such an approach seems to suggest that the social challenges we face can be dealt with at the level of the firm – that is, by specific corporations and their boards. This assumption seems to animate the argument for firm-specific tailoring of corporate governance in light of distinct corporate missions.
The alternative perspective is that the fundamental issues are more clearly viewed as the economic and social effects of a dynamic and global market economy in which companies operate and are forced to compete. And so rather than focusing on the firm as the unit of greatest concern, and assuming that companies themselves are responsible for, say, retraining workers whose skills have become obsolete, whose human capital has depreciated, I think the real issue is one of social insurance, of ensuring that we have the right form of government match to ensure the preservation and, where possible, the reinvigoration, of human potential over the lifetime of employees. Designing and implementing this kind of insurance is critically important in a dynamic economy like ours – an economy in which no single firm is able to offer thick enough insurance, including income preservation insurance, to compensate workers, especially aging workers, for the shrinking job security associated with technological change and obsolescence.[2]
So, to me the big question here is: What is the right form of government match for the economy we have?
As I see it, the current malaise consists of three elements: inequality, economic insecurity, and slow economic growth. Corporate governance has to do with the way power is exercised within the firm. Although the legal framework of corporate governance has remained stable for a very long time, the implications – or the actual workings and effectiveness – of that framework have varied greatly during the decades that I’ve been in law teaching. The observed changes in corporate governance are at bottom the result of major changes in corporate ownership. The dispersed ownership of the Berle-Means corporation of yesteryear gave managers effective control. In those days, collective action problems muted shareholder voice. Today, the re-concentration of ownership into the hands of institutional investors means that shareholder activism can effectively challenge managerial prerogative. So, it’s the interaction between the legal framework and ownership that creates the corporate governance environment.
My focus will be on economic insecurity. Presumably, there is a strong corporate governance feature to the risk of downsizing and layoffs. By contrast, although inequality is also a serious problem, I think that corporate governance plays a secondary role in its creation and persistence. Although Thomas Piketty’s research identified executive compensation as a major source of inequality, I think the more fundamental sources of inequality are quite different. They relate, first, to the structural changes in the nature of work and the different ways that some firms succeed and others do not; and second, the wealth effects associated with the rise of the private economy.
David Autor’s work, for example, on the “superstar firm” shows large inequality across companies in the compensation of people with the same jobs.[3] Successful firms, “superstars,” pay more. The secretaries at Google, for example, would be extremely well paid. More generally, the high compensation that tech firms pay their armies of software engineers has exacerbated the sense of inequality throughout the Bay Area. And along with Autor, I would argue that the compensation consequences of disparate levels of economic success across firms and industries is a more profound driver of inequality than high levels of CEO compensation or rewarding corporate efforts to increase profits by controlling labor costs. And so, from this perspective, addressing inequality is not fundamentally a corporate governance issue.
Perhaps an even more important source of inequality is the growing shift of economic activity from public to private firms, in which income and wealth are increasingly concentrated in the hands of modern day capitalists.[4] This trend, documented by public finance economists using U.S. tax data, is not obviously connected to corporate governance of the large public corporation. Tax policy that favors pass-through entities accelerates this trend.
In a YouTube video that went viral, Dutch historian Rutger Bregman told a Davos audience that the way to address inequality is “taxes” – particularly, estate taxes – and all the rest is beside the point. Tax policy is the first-best way to address inequality, not a focus on firm level decision-making.
Similarly, I don’t think that corporate governance has much to say about slow economic growth, though purported corporate governance defects have been blamed. Assertions that stock buybacks produce cutbacks in R&D and prevent significant investments that would promote an economic boom are contradicted by the careful marshalling of evidence by Jesse Fried and Charles Wang in a recent issue of the Harvard Business Review and related work. Their research indicates that buybacks occur predominantly in those economic sectors where the ROI is low, meaning that managers (and companies) are returning money to the shareholders because they don’t have good investments to make on their own.[5]
There are of course other explanations for this slow growth. Robert Gordon, for example, argues that the really big inventions – like electricity – aren’t going to happen again. And alongside something like the invention of automobiles, the Internet just doesn’t really cut it.[6] But from casual conversation, I think many business executives don’t share Gordon’s pessimism.
One plausible argument focuses on the negative effect on growth of erratic government policy, which can make it difficult for companies to contemplate significant investments with long-term payoffs. For example, the fiscal austerity policies that were widely followed after the outbreak of the financial crisis exacerbated and prolonged the Great Recession in the U.S. and Western Europe; during those years companies focused on survival not expansion. Four years ago, we weren’t sure if the Euro was going to survive; what’s the right payoff horizon facing that risk? And the abrupt U.S. turn toward economic nationalism and neo-mercantilism by the Trump administration surely disrupts long-term planning and investment.[7]
It also seems to me that many politicians who attack buybacks are really looking for companies to provide a kind of Keynesian stimulus – that is, a way to drive the economy by spending not government funds, but more shareholder capital, to promote a boom. Whether shareholders get a competitive return on that investment is the least of politicians’ concerns – though it does seem to matter to shareholders. In short, the rate of economic growth turns on factors other than firm-specific levers of corporate governance.
If there’s a big idea here, it’s that the investing environment has produced a profound risk shift. There’s been a risk shift away from the shareholders, who now can and do diversify away all firm-specific and idiosyncratic risks, and toward employees and all the other stakeholders who benefit from and indeed depend on the existence and stability of particular corporations. The result of this dynamic, as mediated through corporate governance, has been to shift risk from shareholders onto the employees, who are far less able to bear that risk and insure against it. Employee payoffs are firm-specific; not so for the diversified shareholder. Companies are subject to strong pressure from product and capital markets; corporate governance, viewed as the way that companies are funded and managed, is the mechanism by which those external market pressures are transmitted to their employees. And this creates the economic insecurity that is not so much about governance but instead, about social insurance. It’s not something that companies can address acting alone.
The resulting policy prescription focuses on the need for a new match between government and enterprise – one that recognizes the role of government, perhaps in collaboration with the private sector, in renewing human potential as a lifetime concern. Innovations in government support for human capital development have, historically, been a mainstay of U.S. growth. For example, the “high school” movement of a century ago, which expanded education support beyond elementary school, and the post-World War II GI bill, which expanded support through college and beyond, have been critical elements of U.S. comparative advantage.[8]
Given that companies today are not able to provide the kind of insurance they once did, the right move is further innovation in government support for human capital development, towards maintaining lifetime human potential. This is not primarily a redistribution of wealth but a more effective allocation of social resources designed to increase social wealth. The economic rationale for layoffs, after all, is that they preserve or increase value by preventing companies from wasting resources – potentially valuable human capital – that might be put to higher-value uses.
That at least is the theory of “constructive” layoffs. But in the modern economy with technological change and obsolescence, layoffs tend to mean a very large, if not complete, loss of firm-specific investments by displaced employees. The aim of the government match I’m envisioning is an ongoing investment in our workforce, a rebuilding of the human capital that has been lost. And the ultimate purpose of this match is to make society as a whole more productive in dealing with some of the demographic issues that the U.S. and other countries are now facing.[9]
Here is one quick final point about the interesting position of the Vanguards and BlackRocks, the indexed asset managers, of the world with respect to such a policy proposal. The product they offer is not a firm-specific investment, but a low-cost diversified portfolio of all companies in the economy. And if that’s your product, the only way that you can improve the outcomes for your investors is by increasing expected returns and lowering systematic risk across the portfolio as a whole—that is, the entire economy.
Now, how could institutional investors mitigate systematic risk? If you think that some of the disruption we see at the individual firm level creates political risks to stability – and we’ve seen evidence of that in the political realm – then stability-seeking becomes one way that a diversified investor can reduce the level of systematic risk. So if you think that some system of broader social insurance, particularly this maintenance of human potential over a lifetime, will not only increase expected returns across the portfolio (across the economy) but will also mitigate certain sort of socio-political risk, then the question is, what position should the asset managers play in moving towards this consensus? These so-called “universal investors” hold the shares of all the companies. They have the vision to perceive what’s going on. The question is, how involved will they be in politics, and what does that do to their business model?
The investment diversification point bears emphasis, because it is key to understanding the world in which we live, in particular the “profound risk shift” referred to previously. It was a Nobel Prize-winning idea that investors should aim to maximize their utility by achieving the highest risk-adjusted expected returns, meaning attention to risk as well as returns, “Modern Portfolio Theory,” or MPT. The follow-on investment strategy is portfolio diversification, which minimizes firm-specific idiosyncratic risk.
The implications of MPT begin with how investors should invest but extend to how firms should conduct their business. Investors want companies to be aggressive in taking business risks, while being willing to accept the greater risk that such companies will fail. Diversified investors are risk-neutral with respect to the failure of any particularly firm, not risk-averse, and want firms to operate accordingly.
What are the consequences for other parties to the firm? Creditors of the firm can adjust to such increased risk-taking by, say, charging higher interest rates or insisting on lower leverage. The managers of the firm can also adjust; after all, we pay them in stock-based pay, which encourages them to take these risks. Increasing managers’ upside will thus make them risk-neutral or even risk-seeking. But it’s the employees who are unable to adjust to the extra risk arising from the changed incentives that diversification provides shareholders to encourage more corporate risk-taking.[10]
Think about the way that the organization of companies has changed in the past 50 or 60 years. The conglomerates of the 1950s and 1960s proved to be failures, in significant part because investors who wanted diversification could get it at the portfolio level. Such investors don’t need, and so won’t pay up for, diversification at the firm level; and as had become clear by the end of the 1970s, firm-level diversification introduces new expenses and other inefficiencies. It requires managers to oversee a broad range of businesses, many of them with no operating synergies. And it’s “managerialist” in the sense that the size and scope achieved by this kind of empire-building, which has the effect of reducing efficiency and value, actually benefits managers because it buffers performance variation across the firm’s diverse businesses.
Who else ends up being protected through the diversification of a conglomerate? It’s really the employees, because the resulting diversification of the profits and operating cash flow means that the conglomerate will be less likely than a focused-business firm to lay off employees of a unit that’s in trouble. Cash flows in a conglomerate can be reallocated to protect a failing unit; employees can be shifted to more profitable divisions within the firm.
But starting in the early 1980s, the decades-long process of dismantling the conglomerate structure by corporate raiders and LBO firms helped bring about this major shift of risk from the shareholders to employees – a change that is partly attributable to investors’ growing reliance on low-cost diversification methods. With the rise of hostile takeovers in the 1980s – and running more or less continuously to today’s shareholder activists – we have seen the unfolding of a high-powered governance system whose main goal is to eliminate corporate “slack,” or inefficiency, as seen from a shareholder point of view.
The big difference between today and the 1970s and even the 1980s is that the amount of slack, or value left on the table that it would take to trigger corrective action is much less today. The dispersion of share ownership once meant that collective action problems could be overcome only through the expensive mechanism of a hostile takeover bid, in which a buyer faced all the risk of a misjudged opportunity. Today’s reconcentration of ownership has invigorated the proxy battle, which can be pursued at much lower cost than a hostile bid and for which a shareholder activist bears only the risk of its toehold stake, not 100 percent ownership. The consequence is that companies have much less margin for what is perceived as strategic or operational shortfalls.
Investors’ diversification has made profound changes in not only how parties invest, but in what shareholders want from firms, and how firms are structured and operate – all in pursuit of the highest risk-adjusted returns. As a consequence, we now have a system that is extremely efficient in the utilization of resources. But one regrettable, though inevitable, effect of such efficiency is the shifting of risk from shareholders to employees. And, again, I don’t see any way for companies to insure employees against this kind of risk. Hence my call for a government solution. If we’re going to have this high-powered governance system, then I think we also need government to play a bigger role in helping retrain employees. And this is not a problem that neo-mercantilism can solve. With domestic companies like Walmart, Amazon, and Netflix completely disrupting the way business is done, a disproportionate share of the risk of change is being borne by employees.
At the very least, then, this is a call for a rethinking of social insurance, a call for a kind of lifetime human potential insurance. Now, this is not a codetermination strategy or an argument against shareholder primacy. Those won’t solve the problem. And we can view this not as an issue of fairness or redistribution or part of the safety net – although those are all legitimate framings of the problem – but rather as an economic question of the optimal kind and amount of investment in retraining workers, in reinvesting in workers whose skills have been made obsolete, whose prior human capital investment has been dissipated. It’s the way the world has turned that’s created the problem, and the solution requires a different sort of match between government and enterprise.
ENDNOTES
[1] Colin Mayer, Prosperity (2019).
[2] For elaboration of this perspective, see Jeffrey Gordon, “Is Corporate Governance a First Order Cause of the Current Malaise?”, 6 J. British Academy (Supp, Iss. 1) (“Reforming Business for the 21st Century” ) (Dec. 2018).
[3] David Autor, David Dorn, Lawrence F. Katz, Christina Patterson, and John Van Reenen. 2017. “The Fall of the Labor Share and the Rise of Superstar Firms.” http://economics.mit.edu/faculty/dautor/policy.
[4] See, e.g., Mathew Smith, Own Zidar, Eric Zwick, “Top Wealth in the United States: New Estimates and Implications for Taxing the Rich,” WP July 2019, available at https://scholar.princeton.edu/zidar/publications/top-wealth-united-states-new-estimates-and-implications-taxing-rich; Mathew Smith, Danny Yagan, Owen Zidar, and Eric Zwick, “Capitalists in the Twenty-First Century” (forthcoming 2020 QJE); Michael Cooper et al, “Business in the United States: Who Owns It, and How Much Tax Do They Pay?” 30(1) Tax Policy and the Economy 91 (2016).
[5] Jesse Fried & Charles Wang, “Are Buybacks Really Shortchanging Investment,” Harvard Business Review (March-April 2018), 88-95.
[6] Robert J. Gordon, The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections (NBER 2014), http://www.nber.org/papers/w19895.
[7] See, e.g., Neil Irwin, “Is a New Recession Imminent? Here’s How One Could Happen,” NY Times, A.1, cols 5-6 (Aug. 18, 2019).
[8] E.g., Claudia Goldin, “America’s Graduation from High School: The Evolution and Spread of Secondary Schooling in the Twentieth Century”, 58 Journal of Economic History 345 (1998).
[9] The U.S. experience with retraining program programs, mostly pilots and experiments, has not been positive. Yet the U.S. spend the 2d lowest amount of OECD countries on “active labor market programs” as a share of GDP, one tenth the amount spent by Denmark, for example. Such U.S. expenditures are also almost entirely front-loaded. Council of Economic Advisers, Addressing America’s Reskilling Challenge (July 2018), at 8 (fig. 3), 10 (fig. 4). It seems fair to say that the U.S. has not made a serious investment in over-coming the barriers to retraining and lifetime human capital re-investment.
[10] While there is some evidence of wage differentials in jobs that present foreseeable safety or health risks, I am unaware of comparable evidence of compensating risk differentials for jobs/industries because of unexpected layoffs and job loss. In start-ups and other businesses where the failure rate is high, compensation in form (stock options) and amount sometimes anticipates the expected risk, but in many industries the business shock is not readily foreseeable and thus not ex ante compensable. Additionally, limited bargaining power and general labor market conditions may limit risk-based compensation. Indeed, an uncertain business environment may be a factor in holding down wages, a kind of reverse “efficiency wage,” in which employees attempt to mitigate layoff risk by accepting wages below marginal labor product, a highly imperfect form of self-insurance.
This post comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia Law School. It is based on his talk at the Columbia Law School Symposium on Corporate Governance, “Counter-Narratives,” and responds in part to the book, Prosperity, by Professor Colin Mayer.