THE BEAR'S LAIR
Back to shareholder capitalism
By Martin Hutchinson
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.
(Republished with permission from PrudentBear.com.
Copyright 2005-2010 David W Tice & Associates.)
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