American workers are more productive than ever, but they take home the same pay they did 40 years ago.  While firms have enjoyed blockbuster profits—and the U.S. gross domestic product has tripled—most American households have not shared in this increasing prosperity. As wages have stagnated, income inequality has skyrocketed. Causes like de-unionization, globalization, immigration, labor market concentration, and technology have been blamed for these trends. But an additional culprit has escaped detection: common ownership—a few powerful institutional investors controlling large stakes in most U.S. corporations. In a new article, we explain how the shift to common ownership has been a significant cause of wage stagnation and income inequality.

Since the 1980s, control of the American stock markets has moved from individual retail investors to an interlocking set of powerful financial institutions who own shares in practically all public corporations. Scholars have dubbed these institutions common owners.  Today, these highly diversified institutional investors own more than 70 percent of American publicly traded equity, up from less than 25 percent in the 1980s. The three largest asset managers—BlackRock, Vanguard, and State Street—collectively constitute the largest shareholder in nine out of 10 S&P 500 firms. The once prevalent dispersed-ownership structure has now been replaced by common ownership. Effectively, common owners have hung an “Under New Management” sign over public corporations. And, at the same time American workers got a new set of bosses, the percentage of workers employed by public corporations shrank, and their wages stopped growing.

Common owners move public corporations en masse toward strong governance—which provides shareholders with greater control over managers—and are praised for doing that, because strong governance supposedly improves corporate efficiency by deterring disloyal managers from overinvesting and wasting resources on pet projects. However, while strong governance improves corporate efficiency by deterring disloyal managers from overinvesting, it also deters loyal managers from investing in value-increasing projects. Managers who are more exposed to shareholder intervention are less likely to pursue bold, long-term, or transformative investments. Such investments are hard to evaluate and might be misperceived by shareholders as inefficient, thereby increasing managers’ risk of being mistakenly fired. Instead of investing, both types of managers, loyal and disloyal, will increase shareholder payouts through dividends and share buybacks. As investment falls, so too will hiring: Companies no longer require the labor force to operate new factories, staff new divisions, or open new locations.  This hiring shortfall artificially depresses wages, allowing firms to enjoy a wage discount and moving wealth from workers to shareholders. Because shareholders tend to be wealthier than wage-earners, this process exacerbates income inequality.

Indeed, scholars have heralded institutional investors as guardians of shareholder rights whose ability to monitor corporations and hold disloyal managers accountable creates a net social benefit, a portion of which accrues to employees through their retirement plans. Unfortunately, in exchange for the marginal increase in their pension’s stock portfolio value, employees are resigning themselves to depressed hiring and stagnant wages, even as their productivity surges to record levels.

Cutting investment is not harmless; rather, it causes corporations to cut back on hiring, depressing the demand for employees and keeping wages below their competitive rate. In other words, it creates a monopsony—a firm (or set of firms) with sufficient market power that it can and does cut back on its purchases of an input (here, labor) to reduce its price and enjoy a discount.  By switching firms en masse to strong governance, common owners create a labor market monopsony without resorting to collusion and, indeed, likely without intending to create one.  This newly identified labor monopsony is driven by the concentration of shareholders’ market power over the management of numerous entities, each separately pursuing its own economic interest. This concentration of ownership results in lower demand, and consequently a lower equilibrium price, for labor, causing wages to stagnate rather than rise with productivity increases.

We present a novel economic model that exposes the mechanism by which common ownership and governance structure leads to stagnant wages. In a competitive market, shareholders will respond to abnormally low wages by switching to weak governance so that managers will be free to invest and take advantage of discounted labor prices. As more firms switch to weak governance and increase their investments, increased hiring will push wages up, making investments less profitable. A symmetric process of firms switching to strong governance kicks in to discourage investments when wages are abnormally high. Wages and governance structure thus form a feedback loop, resulting in a competitive equilibrium where a certain number of strong- and weak-governance corporations coexist and are equally profitable—and, importantly, where wages are determined competitively.

Common ownership breaks this feedback loop. Unlike in the competitive equilibrium, common owners push firms toward strong governance regardless of prevailing labor prices. Fewer firms with weak governance lead to lower investment, reduced demand for labor, and decreased wages.  Those firms that continue to invest (the remaining weak-governance firms) see increased profits due to the labor discount. And because common owners hold the entire portfolio of strong- and weak-governance firms, their portfolio values go up. By preventing firms from switching to weak governance, common owners disable the market mechanism—choice of governance structure—that normally drives wages back up when they are below their competitive rate. As a result, under common ownership, wages will be persistently low without the need for collusion among firms. And because the labor monopsony means greater profits for (typically wealthier) shareholders and lower wages for (typically less wealthy) employees, it exacerbates income inequality.

Importantly, our article shows that common owners exert labor-monopsony power not by exercising control in a certain way (as existing literature argues) but rather by allocating more control to shareholders (pushing toward strong governance), which can then be exercised by other shareholders such as activist hedge funds or hostile acquirers.  That is, institutional investors do not need to engage in any illegal anticompetitive conspiracy—such as coordinating production cutbacks across firms —to enjoy a labor discount. Instead, they only need to adopt a one-size-fits-all policy requiring most firms to adopt strong governance. Thus, this common-ownership-labor-monopsony theory does not share the same drawbacks as other theories alleging anticompetitive effects of common ownership.

Acknowledging the inherent tradeoff of strong governance—reducing management agency costs while creating a labor monopsony—presents a dilemma for policymakers. Should they side with employees or shareholders? If shareholders’ interests are the sole concern, nothing should be done. If the interests of employees are the concern, however, then policymakers should act. To return markets to their previous competitive equilibrium, where labor and capital efficiently and equitably shared corporate value, they must eliminate common owners’ monopsony effect.

To achieve this goal, in the absence of collusive activity that can be directly policed, our article suggests breaking up the large institutional investors by limiting their size, thus removing their structural impacts on governance. Several institutional investors have assets under management in trillions of dollars. Limiting institutional investors to holding no more than a half-trillion dollars would increase the number of institutional investors, encourage competition in the market, and readjust the balance of power between managers and shareholders. These shifts would reignite corporate managers’ incentives to increase corporate investment and labor demand, restoring the labor markets’ competitive equilibrium and leading to higher wages and greater income equality.

This post comes to us from professors Zohar Goshen at Columbia Law School and Doron Levit at the University of Washington’s Foster School of Business. It is based on their recent article, “Common Ownership and the Decline of the American Worker,” available here.