“The Corporate Fallacy”

In the July Monthly, Noel Pearson zeroes in on one of the key structural issues underlying the recent crisis; why did so many corporations (especially financial ones) act in a manner so disastrously contrary to their own self-interest?

His short answer? “The cause of Greenspan’s bewilderment [this follows an extended quote from Greenspan’s mea culpa testimony last October] is so obvious that he, the most brilliant of rationalists, cannot see it: he had assigned self-interest to corporations, but self-interest can only be held by people.”

Absolutely right, I think, even though the increasingly euphoric mood in the years leading up to the bust had managed to snare plenty of (presumably self-interested) principals as well. The deeper structural distinction is still vital:

The question, therefore, is who gets to determine the interest of the institution. In the modern corporation, it is the management. But the self-interest of managers, who have no significant ownership of the corporation, is  disconnected from the interests of the other parties with a stake in the corporation’s fortune and fate.

He cites Professor Lucien Bebchuk of Harvard Law School who distinguishes between “controlled companies” and “widely held companies”.

In controlled companies, the problem of governance centres on opportunism by the controlling shareholder. In widely held companies, it centres on opportunism by managers, who exercise de facto control. Bebchuk argues that reforms to improve corporate governance and protect investors must take into account the fundamental differences between controlled and widely held companies – that “one size fits both” reforms will not work.

Once again, complex as this issue undoubtedly is, this seems about right.

Before closing, one more quote which nicely juxtaposes the behaviour of JP Morgan (both man and company) during the Panic of 1907 with that of financial institutions more recently.

It was for good reason that collapse was averted following the Panic of 1907 by the actions of the financier JP Morgan, in the absence of any governmental mechanism to rescue the financial system. It was Morgan’s self-interest in his own organisation and the wealth that was tied up in it that drove him to provide a guarantee to the banks – in the form of a $100 million gold loan – in order to avert a general collapse. [ . . . . ] In those days, owner-oligarchs concerned themselves with the long-term survival of their organisations, whereas today the manager-oligarchs’ self-interest is short-term. And so we have a long list of venerable institutions that have fallen over (or should have fallen over, had they not been heavily transfused with the blood of taxpayers) like so many ten-pins.

One thing seems certain; quite apart from the need to (hopefully?) deal with the broader systemic and structural issues, never again should the incentive structures for managers and employees of financial institutions be allowed to so grievously diverge from the long-term interests of their hosts.

Easier said than done, of course.

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Tel_
Tel_
12 years ago

Bit of a straw-man to be knocking down claims that corporations act in their own interest.

The strongest claim that I can think of, is that corporations act in the shareholder’s interest, which will happen in those cases where shareholders take an active interest in their investments. There is usually but not always a parallel interest between shareholder value, CEO career reputation and long term survival of the company. In some cases it may be quite rational to put the company onto a self-destruct course in order to milk the best short term returns in an industry that is changing. Shareholders can always reinvest their profits elsewhere.

As for the balance of power between a CEO and the dispersion of “widely held” shares, I’m all for transparency but when shareholders don’t pay attention, they will get burnt. No decision that government can make will fix that, and if government really think they can do a smarter and better job of investing then they should just take people’s money by force and put it all into some sort of big funds then go invest it themselves and show what a good job they can do. Only when these funds demonstrate how much better return they achieve than individual investors then they can start explaining to us about self-interest. If minority shareholders in a “widely held” situation don’t like the CEO and don’t like where they see that company is headed, they just sell out and buy elsewhere.

Of course, anyone with great ideas for company documents of incorporation and methods of ensuring shareholder value is welcome to publish these ideas and get some investors interested. If it works, no doubt even more people will be interested. Pushing yet more arbitrary compliance systems (that the shareholders never asked for) down from on top is the last thing that will help us recover from recession.

JC
JC(@jc)
12 years ago

Hi Ingolf nice to see you back. You dont do nearly enough blogging

Of course I have to take issue with some of this. Lol

But the self-interest of managers, who have no significant ownership of the corporation, is disconnected from the interests of the other parties with a stake in the corporations fortune and fate.

I would tend to disagree with that premise at least for the two most spectacular failures, which were the two I-Banks, Bear Sterns and Lehman Bros. In both cases the substantial shareholders were the management and the employees holding up to 40% of the firms. In other words the workers and the managements interest were totally connected with the fortunes of the firm. I dont know about the quiet failure, the one that went down the same weekend as Lehman, but I would bet the same ownership culture also applied at Merrills. Granted the Citi fiasco, UBS and British banks fall into the disinterested-management group, however the entire slow motion horror show suggests there probably isnt anything we can use to determine likely failure going forward as there are no markers from this perspective and I dont think ownership is a good enough criteria by itself.

On the other hand I guess we can. As the worker owned I-banks have basically disappeared and were now left only with the second group

One thing seems certain; quite apart from the need to (hopefully?) deal with the broader systemic and structural issues, never again should the incentive structures for managers and employees of financial institutions be allowed to so grievously diverge from the long-term interests of their hosts.

Umm, this is going to upset you but since Gold Sack has paid back the TARP Lloyd Blankfein, GSs CEO has announced that the firms profits are at record levels so far this year and bonus accrual will be at record levels if the same pace continues. Theres probably no reason to think that the pace wont, as the competition has basically gone AWAL for a time at least. They seem to be the only ones who decided to maintain the same model regarding risk taking (Morgan Stanley to a lesser extent) and these are great trading markets.

Theres a school of thought that suggests one of the reasons everyone suffered the same malaise was because the entire global banking world suffers from Goldman Sachs envy. This is an interesting proposition, as it lends itself to the idea that a large number of participants simply are ill-equipped to be able to handle risking and do so only because Gold Sack does .. as in they make a lot of money out of it and the shareholders will want to know why you cant.

So the process is about to, or rather may be about start again. Gold Sack has a great year causing deep envy and were off to the races again. hahahahaha

I actually think Wall Street compensation practices were reasonably well thought out. And let me suggest that theres only one subject that never bores anyone on the street and that is compensation, so theres probably nothing new that hasnt been discussed 1 billion times over the past 100 years or so

The reason why I think its great is that people are paid a low base salary, which allows firms the luxury of reducing fixed costs and therefore aligns comp with the vagaries of the market gods by variablizing costs, which is really what you want think the opposite and think airlines and how much they would love the luxury of being able to convert a greater proportion of fixed into variable costs.

Perhaps longer-term comp arrangements will find their way back and for this reason it will be interesting to see what Gold Sack does in December.

Heres my humble idea if you want to slow down silly risk taking by the street. Offer, or at least patent or license (or whatever you want to call it) any new products that come out and dont allow any other firm to originate them for a period of time like say 5 years. This allows for innovation and doesnt infect the rest of the street with a bad financial product. It also allows the innovator a chance to reap in the money and not feel burdened by having to move fast and foot loose.

Imagine the money say a Bankers Trust could have made id they were the only ones to have been trading interest swaps in the 80s. I think it was their innovation although Im not sure.

Heres the thing that I seem to always come back to. We can assume that banks will remain leveraged at 13:1 as deleveraging hasnt really been discussed as an option to any serious degree. That leverage ratio basically means that a bank has to lose 7.5% of its asset value to be out of business and in reallity far less than that before tangible equity takes then down. As most businesses suffer losses of that magnitude we can be pretty much rest assured that at some stage in their life nearly all banks will fail (thats really called recapping in this modern age). The older shareholders get wiped out and a brand-new load comes in ready to ride the wave up. Nothing really changes, hey? Lol.

Tel_
Tel_
12 years ago

Heres the thing that I seem to always come back to. We can assume that banks will remain leveraged at 13:1 as deleveraging hasnt really been discussed as an option to any serious degree. That leverage ratio basically means that a bank has to lose 7.5% of its asset value to be out of business and in reallity far less than that before tangible equity takes then down. As most businesses suffer losses of that magnitude we can be pretty much rest assured that at some stage in their life nearly all banks will fail (thats really called recapping in this modern age).

If you compare the basic model of http://www.lendingclub.com with current Australian banking models, I see the microloan design as more stable and more sustainable. The “lending club” stands off slightly to one side, like a broker or a stock exchange, rather than standing squarely in the middle. Then the investors have to evaluate the risk on a case by case basis and (to me at least) that is the correct design of how a marketplace should operate. In many ways the “lending club” design is a step backwards away from aggregated banking towards man-to-man handshake banking, no “slice n dice”, no man behind the curtain. Seems like a step in the right direction. Aggregated investment funds with opaque management that isolate investors from investments are the fundamental problem IMHO.

Not that I know any details about these particular guys, they may be good or bad, but no doubt some competitors will pop up offering the same model with minor variations on a theme, so sooner or later it will get settled down into something workable.

Patrick
Patrick(@patrick)
12 years ago

Tax law already recognises several differences between closely and widely held companies. Off the top of my head every one is detrimental to the closely held company!

Implicit in that is a model in which managers in widely held companies cannot appropriate the company as if they were owners, ie just such a model as you are arguing is false.

I wonder if anyone will have any luck arguing that to Treasury in this context?

Patrick
Patrick(@patrick)
12 years ago

i meant more vice-versa! But the Treasury’s view in this area is based mainly on principal-agent theory as well..

Tel_
Tel_
12 years ago

The cause of Greenspans bewilderment is so obvious that he, the most brilliant of rationalists, cannot see it: he had assigned self-interest to corporations, but self-interest can only be held by people.

Seems clear to me that Pearson is making a distinction between self-interested people (e.g. shareholders) and self interested constructs (e.g. any large corporation). Without such distinction the above quote would become meaningless.

It may well be that Greenspan never really made the confusion of assigning self-interest to corporations, and merely used a shorthand expression to imply the stakeholders (that would be my reading of Greenspan), but I’m commenting on Pearson’s reading of Greenspan.

However, to some extent social constructs do have self-interest in the Darwinian sense. Thus, if you take a random survey of large corporations, you will find a larger than random proportion of them are also relatively old, for the simple reason that all the short-lived corporations drop out of the sample space. If you take a survey of the constitutional structures of large corporations you find that although a large number of plausible structures exist, a much narrower selection turn up in the survey (for example, there are relatively few large cooperatives running, and almost no instances where employees are given Democratic powers). This is because the most successful corporate structures tend to be the ones that are copied, and a process of elimination removes those structures that are poorly designed for long term self preservation.

Getting back to Greenspan and Pearson, we would expect that the typical decision making system of a large corporation be substantially slanted toward the long term self preservation of that corporation, even when it may be at the expense of shareholders and other stakeholders (because that’s what Darwin predicted would happen). Doubly so when the shareholders don’t bother taking any active oversight.

Suppose we consider the modern corporation as merely one instance of a much broader class of social constructs, the really long lived institutions (e.g. the churches) tend to be remarkably similar to each other in their fundamental design (ignoring the details of what they believe in, since it is irrelevant to their function). They tend to be hierarchical, and require their leadership to take the slow path through the ranks, and put great emphasis on lifetime loyalty of their members. They make decisions primarily on the basis of precedent and extreme resistance to change.

The purpose of Pearsons article, as I read it, was just to draw attention to a structural problem in a reasonably engaging fashion, not to propose solutions. I cant quite see how you concluded that anyone was suggesting governments take over investment decisions.

I was being a bit oblique, hoping to trigger the realisation that our government already decreed a substantial proportion of GDP was to be channelled into tightly regulated, centrally managed funds that were (and still are) strongly isolated from individual investor scrutiny (i.e. falling into a fairly extreme example of the “widely held” stakeholder category). These funds did not prove any more clairvoyant than anyone else, nor did their layers of regulation do a better job of aligning the managers interests with the owners. If we are to fairly and even-handedly apply Noel Pearson’s reading of Greenspan to the general discussion of social constructs, we would have to include the big unions and the superannuation funds, and various self-justifying government initiatives in the category of “widely held” — they all suffer from the same isolation of the decision makers from the stakeholders, brought on by a concentration of power and a diffusion of ownership. No doubt Pearson would not be particularly interested in such a broad interpretation of his work.

Tel_
Tel_
12 years ago

Churches run on a pretty simple business model: extract a tithe from your followers and smite anyone who is not a follower. Their smiting capabilities have been a bit hamstrung lately but they find avenues wherever they get half an opportunity. Simple business models tend to stand the test of time, some aspects of the world don’t change real fast. Coca-Cola keep bringing out new products, primarily so they can extract a bit of publicity and then abandon the new product and go back to good sales of the good old product. Kenwood make mixers, your mum bought one for no other reason than that her mum bought one. No one knows which housewife bought the first Kenwood mixer or why, that secret has been lost in the mists of time. Kenwood make almost precisely the same mixer that they did when home electricity seemed an new and interesting idea.

I’ll agree that other business models are not as simple, and maybe some financial services fall into that category, but after that historic big breakthrough with double-entry bookkeeping most of the rest has been streamlining and centralising what we already knew how to do. I guess a bit of repackaging has happened, and we all got plenty of computers. A lot of procedures have become more complex, that’s for sure… then we need specialists to explain these complex procedures, and the endless tax flowcharts and record keeping requirements.

Have we gained any progress from that complexity? Hmmm, mostly we’ve gained opacity, and a feeling of intense activity that somehow must be significant, of something.

As for whether Pearson would be interested in broader considerations of this kind, Id have thought he would. Hasnt much of his work over the years in effect been devoted to precisely these issues?

Hmmm, I don’t want to wander too far off topic but Pearson is pretty enthusiastic to invoke the power of central authority when it comes to enforcing a “zero tolerance” for the breaking of social norms (presumably Pearson and the central authority get to decide what these norms are, or maybe there’s a special committee for it). Somehow I can’t see the ritual extraction of a million dollar cheque from a mining company and the handing of this cheque to some headman or chieftan as seriously representing Aboriginal engagement with the mainstream economy. But regardless of whether I agree with the man, the best people to solve problems are the people themselves who live with those problems. Pearson at least deserves credit for being part of that process. Let them have their zero tolerance, see where it gets them.

derrida derider
derrida derider
12 years ago

“Separation of ownership and control” has been a concern for economists since the invention of the joint-stock company, and certainly an absolute obsession of organisational economists for the last 60 years. Noel Pearson is not exactly the first to notice that, among other things, it leads to uncontrolled systemic risk.

Having lived through a few business cycles I find it really interesting to see how its vagaries change public perceptions of economics. The main change is the air time that different economists get. During booms, the let-the-free-market-rip finance economists ones get all the fame, inventing ingenious “reasons” for random movements in stocks or exchange rates. During busts, it’s the social democrat labour economists purveying doom and gloom. But the balance of them within the profession doesn’t change much – just who gets their faces on the TV news.