Tarnished Ideas: Free-Trade and Shareholder Wealth Maximization

American voters are expressing a lack of confidence in free trade and question whether the purpose of a corporation is to maximize shareholder wealth. These two ideas have guided U.S. economic policies for decades. Why are they tarnished in the minds of voters across the political spectrum?

Three developments help explain this question: the end of the Cold War, outsourcing, and computer technologies. Each benefited consumers and businesses globally. But by making it easier to use cheaper labor, each development eroded job and wage security for U.S. workers.

The end of the Cold War led countries such as China and India to adopt export-oriented policies. At first, their workers provided competition for low-skill jobs in the U.S. but eventually they competed for high-skill work as well.
Companies outsourced activities beginning with computer services then migrated to payroll, customer support, and even manufacturing. Out-sourcing begat off-shoring; once a function was contracted out, it was less of a leap to secure it from abroad.
Computer technologies digitized knowledge and communications which made it easy to spread know-how and relocate where work was performed.

Put another way, these developments increased the return on capital and weakened the return on labor.

Free Trade

Free trade brings lower prices and innovation because it makes it easier for foreign producers to sell in the U.S. Trade costs are borne by those who own or work for domestic suppliers that are not efficient or innovative enough to compete locally.

Economists argue that free trade results in more efficient use of resources because it encourages nations to produce the products and services they have competitive advantage in and to import what others produce more efficiently. Economic natural selection results when products are made by the most efficient producers which then lowers prices. Arguably, it provides the greatest good for the greatest number of people.

With free trade, there is supposedly less corruption on both sides as there are no gatekeepers to pay for market access. It can improve the standard of living of disadvantaged people. Trade promotes peace as interdependent nations are less likely to engage in aggression. Yet, free trade can be a difficult pill for countries to swallow because it may threaten domestic producers and make it harder for policy makers to achieve economic goals and maintain political stability.

Once free trade is adopted, it is difficult to put the genie back in the bottle as it has many benefits. That said, it is easy to be theoretical about the dynamics until you or someone you know is a casualty.

Shareholder Wealth Maximization as Corporate Purpose

What is the purpose of business? There was a time when corporate purpose was tied to customers, employees, and the communities in which they operated, as well as benefit to their owners. This appears to be a quaint notion to some. Drug companies implement colossal price increases simply because they can. Multi-national corporations structure transactions to keep income in a low tax country. So-called tax inversions are mergers that achieve the same purpose. Such behavior undermines socio-economic confidence.

In a compelling article called How the Cult of Shareholder Value Wrecked American Business (http://wapo.st/18Kr1yY ), Washington Post columnist Steven Pearlstein writes:

In the history of management ideas, few have had a more profound — or pernicious — effect than the one that says corporations should be run in a manner that ‘maximizes shareholder value.’ Indeed, you could argue that much of what Americans perceive to be wrong with the economy these days — the slow growth and rising inequality; the recurring scandals; the wild swings from boom to bust; the inadequate investment in R&D, worker training and public goods — has its roots in this ideology.

The funny thing is that this imperative to ‘maximize’ a company’s share price has no foundation in history or in law. Nor is there any evidence that it makes the economy or the society better off. What began in the 1970s and ’80s as a corrective to managerial mediocrity has become a corrupting, self-interested dogma peddled by finance professors, money managers and over-compensated corporate executives.

Signs of rebellion to this dogma are developing. Since 2010, nearly thirty states have authorized a form of corporate charter known as a benefit corporation or B Corp for short. It can protect boards of directors from shareholder lawsuits for considering social matters in a decision. Another development is increased interest in social entrepreneurship. Also, an increasing number of investors express a desire to support companies that strive to make positive contributions to society.

Pearlstein points out that maximizing shareholder wealth promotes short-term thinking; stock is increasingly held for months, not years; CEO tenures average less than four years and there is less willingness to make long-term investments. He adds:

The real irony surrounding this focus on maximizing shareholder value is that it hasn’t, in fact, done much for shareholders. One thing we know is that less and less of the wealth generated by the corporate sector was going to frontline workers. Another is that more of it was going to top executives. Almost all of that increase came from stock-based compensation.

Viewed through the lens of the relative returns of capital and labor, that last point provides insight into a source of voter restiveness.

For decades, the Middle Class largely participated in the return on capital via home ownership. As home values shrank, more people became more reliant on the diminishing return on labor for their well-being. The intersection of corporate purpose and manufacturing job loss provides a perspective on voter concerns that are fueling this election.

Return on Capital exceeds the Return on Labor

In his book Capital in the 21st Century, economist Thomas Piketty’s presents data that measures the return on capital and economic growth rate for two thousand years. His work led him to conclude that the 20th century rise in the Middle Class was an anomaly and that rising income inequality represents a return to historic normalcy.

He found that the return on capital (i.e., rents, interest, capital gains) had been about five percentage points higher than the rate of economic growth for two thousand years. The exception is the 20th century, when two world wars and an economic depression destroyed massive quantities of assets. As a result, the return on capital fell as low as to where the economic growth rate was. As the world recovered, both rates rose in tandem until the late 20th century when the return on capital continued to climb but economic growth slowed.

Piketty expressed his findings in the formula R>G where R is the return on capital and G is the economic growth rate.

Since growth is associated with job creation and rising wages, it can be a proxy for the return on labor. Thus, his formula can be recast as R>L where L is the return on labor. That is, Piketty provides substantial evidence that the return on capital has long exceeded the return on labor, except for a portion of the 20th century associated with the growth of a Middle Class.

This leads one to ponder the nature of the aberration. Popular explanations for the economic malaise include free trade, immigration, corporate greed, bad tax policies, and the regulatory environment. But what if the economy is simply returning to the historically observed relationship between capital and labor? How might that affect policy prescriptions?

The Way Forward

A debate about the net benefits of free trade seems called for. It’s a complicated issue, but if the benefits outweigh the costs, as seems likely, we need fresh thinking on how to help those hurt by it. This discussion will raise awareness that most of the jobs created in the decades ahead will come from companies that are small now or have yet to be formed. In his book, Rebooting Work, Maynard Webb, a notable Silicon Valley executive, observes that:

The speed at which companies come and go, succeed and fail, is different from even a short while ago. The half-life of a company is diminishing incredibly quickly. One-third of the companies listed in the 1970 Fortune 500 were gone by 1983. (They were acquired, merged, or split apart.) The average life expectancy of a company in the S&P 500 has dropped from seventy-five years (in 1937) to fifteen years today.

The good news is that America’s entrepreneurial spirit is vibrant and its capital markets inspire more confidence than any other in the world. From a free trade angle, the U.S. has a competitive advantage in its ability to match ideas, talent and capital; these are the per-conditions for a vibrant economy.

What polices might advance this process? Economists Robert E. Litan and Carl J. Schramm propose the following four ideas in their book, Better Capitalism. [Note: Video http://bit.ly/1Y74dOA.]

With respect to the recommendation to improve access to capital, I have two ideas to help young companies raise capital and help those who rely on the return on labor to participate in the return on capital.

Require companies to disclose their valuation in their offering documents. This would help data aggregators collect and analyze private and public company valuation data. Greater price competition for capital would result. In real estate, it is easy to discover a seller’s price per square foot and compare it to the property’s history and to other homes. In a public offering, valuation disclosure should result in better deals for buyers, like free trade does.
Risky companies should adopt the Fairshare Model when they raise capital in a public offering. It is an idea for a performance-based capital structure that balances and aligns the interests of investors and employees. A company that adopts the Fairshare Model has two classes of stock — one that trades, one that does not: both vote. Investors get the tradable stock and employees get the non-tradable stock. Based on performance milestones, the non-tradable stock converts to the tradable stock. The Fairshare Model helps employees who create a return on capital to have a share of it.

A Thought Experiment: General Motors and The Fairshare Model

Think about the challenges General Motors faced as the era of rising fuel prices began in the mid 1970s — low mileage products, non-competitive costs and poor quality. Now, imagine its response if it’s capital structure had been based on the Fairshare Model.

Had the interests of capital and labor been better balanced and aligned, the quality of communications, the sense of urgency and commitment throughout GM would have been more effective. The labor union would have been more interested in enhancing worker training and involvement in process improvement than in increasing wages and benefits. All employees would have focused more on the long-term health of the company. They would have valued knowledge-based authority over hierarchical-based authority and been more inclined to take product risks.

Simply put, had GM used the Fairshare Model, it is unlikely that it would have followed a path to bankruptcy. Even with free trade, it would have been a more dynamic, vibrant organization, one that benefited investors, employees and the communities in which it operated.

Conclusion

The growing gap between the return on capital and return on labor is at the heart of the political discontent that defines this election cycle. It is expressed in opposition to free trade, in questions about corporate purpose, and even in concern about immigration — all of which create negative energy. It is time thought leaders shifted the discussion in a positive, forward-looking direction, and formulated ways to nurture an entrepreneurial economy that benefits both capital and labor.

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