My Comments: Wealth inequality has become an existential threat to the future of American society. The chaos in Washington, indeed the election of trump to ‘drain the swamp’, is an evolving extension of this problem.
If the problem has a solution, it’s going to take many years, perhaps generations, to see us return to the societal norms that brought us a growing middle class with a richer economic potential, and a measure of equality, from 1935 to 1985. Since then, it’s been mostly downhill for too many of us.
All I can do as my life drifts away is to try and share my thoughts with those who will perhaps agree with me, who are younger than I, and who realize they have a vested interest in helping develop a solution.
It’s either that or consign ourselves to the devolution of our democracy and the acceptance of something much darker.
by Steve Denning \ May 6, 2019
A recent study by the Federal Reserve reveals the shocking extent of accelerating wealth inequality in America. Out of America’s total assets of $114 trillion owned by Americans in 2018, the wealthiest 10% of Americans owned 70% (up from 61% in 1989), while the bottom 50% of American households had virtually no net worth at all—down from 4% in 1989 to 1% in 2018.
What is even more shocking than these grim economic statistics is the seeming inability of smart macro-economists to figure out why this inequality has arisen, let alone what to do about it. According to Robert J. Samuelson writing in the Washington Post,
The truth is that we still don’t fully understand the surge in economic inequality of the past three decades. The populist temptation is to blame greed, but this is not a satisfactory explanation because greed is hardly new.”
Like many macro-economists, Samuelson seems unaware that this massive surge in wealth inequality has been driven by the notion that the purpose of a corporation is to maximize shareholder value as reflected in the current stock price.
This idea, which got going in the 1980s and 1990s with the intellectual leadership of Milton Friedman and Michael Jensen, has led to a gargantuan extraction of wealth from public corporations for shareholders at the expense of investment and innovation. The negative impact of the idea, which even Jack Welch has called “the dumbest idea in the world,” has further been aggravated by the massive resort to share buybacks, fueled by the 2018 corporate tax cuts.
The Origins Of Worsening Wealth Inequality
Milton Friedman won the Nobel Prize for Economics in 1976 but his article in the New York Times on September 13, 1970, was not particularly scholarly. It was instead a ferocious tirade in defense of the idea that the purpose of a firm is to make money for itself. Any business executives who pursued a goal other than making money for their firm were, Friedman said, “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.” And on the rant went.
Not everyone agreed. Joseph L. Bower, then a young associate professor at Harvard Business School, told a National Public Radio at the time that maximizing shareholder value as the sole goal of business was “pernicious nonsense.”
But the “pernicious nonsense” spread. In 1976, in one of the most-cited, but least-read, business articles of all time, finance professors William Meckling and Michael Jensen offered a quantitative economic rationale for maximizing shareholder value, along with generous stock-based compensation to executives who followed the theory.
In 1990, an article in HBR by Michael Jensen and Kevin Murphy gave shareholder value thinking a new push. The article, “CEO Incentives—It’s Not How Much You Pay, But How” suggested that CEOs were being paid like bureaucrats. Instead, they should be paid with significant amounts of stock so that their interests would be aligned with stockholders. Thereafter, the use of the phrase ‘maximize shareholder value’ exploded and CEOs became very entrepreneurial — but in their own cause, not necessarily their firm ’s cause.
By 2017, shareholder value thinking was pervasive. Joseph Bower and Lynn S. Paine reported in Harvard Business Review that shareholder value thinking “is now pervasive in the financial community and much of the business world.” It had led to a set of behaviors by many actors on a wide range of topics, “from performance measurement and executive compensation to shareholder rights, the role of directors, and corporate responsibility.”
In fact, shareholder value is now no longer just an idea, but an entire “thought system.” It has been embraced by hedge fund activists, institutional investors, boards, managers, lawyers, academics, and even some regulators and lawmakers.
The Downside Of Shareholder Value
Shareholder value thinking is everywhere but, even setting aside the impact on wealth inequality, the results haven’t been good. As Bower and Paine wrote in 2017, it has been “weakening companies” and “damaging to the broader economy,” with negative effects on “corporate strategy and resource allocation.” As a result, managers are under increasing pressure to deliver ever faster and more predictable returns and to curtail riskier investments aimed at meeting future needs.
Rather than creating fresh value and new customers through innovation, executives are busy extracting value for shareholders. As a result, it is “raining share-buybacks on Wall Street.” The Economist has called share buybacks “an addiction to corporate cocaine.” Reuters has called them “self-cannibalization.” The Financial Times has called them “an overwhelming conflict of interest.” In an article that won the HBR McKinsey Award for the best article of the year, Harvard Business Review called them “in effect, stock price manipulation.”
Some CEOs, like Jack Welch, also have spoken out. Vinci Group Chairman and CEO Xavier Huillard have called it “totally idiotic.” Former Alibaba CEO Jack Ma has said that “customers are number one; employees are number two and shareholders are number three.” Paul Polman, the former CEO of Unilever, has denounced shareholder value thinking as “a cult.” Marc Benioff, Chairman, and CEO of Salesforce has declared it to be “wrong.”
Moreover, it has become steadily more apparent that companies that were run in a traditional fashion of profit maximization and controlism, are having trouble and missing shifts in the marketplace. “Market-leading companies,” as analyst Alan Murray has written in the Wall Street Journal, “have missed game-changing transformations in industry after industry—computers (mainframes to PCs), telephony (landline to mobile), photography (film to digital), stock markets (floor to online)—not because of ‘bad’ management, but because they followed the dictates of ‘good’ management.”
It turns out that maximizing shareholder value as reflected in the current stock price was not only bad morally and socially: it was also bad economically and financially. It doesn’t work, even on its own terms.
The Origin Of The Problem
Why have so many of the biggest and most respected companies in America gotten involved in wealth extraction on such a massive scale? Why is it still tolerated by regulators?
It’s simple, as finance professor Bill Lazonick explains. Once firms began in the 1980s to focus on maximizing shareholder value as reflected in the current share price, the actual capacity of these firms to generate real value for shareholders began to decline, as cost-cutting, dispirited staff and limited capacity to innovate took their toll. Thus, the C-suite faced a dilemma. They had promised increasing shareholder value, and yet their actions were systematically destroying the capacity to create that value. What to do?
They hit upon a magic shortcut: why bother to create new value for shareholders? Why not simply extract value that the organization had already accumulated and transfer it directly to shareholders (including themselves) by way of buying back their own shares? By reducing the number of shares, firms could, as a result of simple mathematics, boost their earnings per share. The result was usually a bump in the stock price—and short-term shareholder value.
Of course, by diverting important resources to boost the stock price, the tactic ran the risk of further hindering the firm’s capacity to innovate and generate fresh value for customers in the future. But why worry about that? With luck, by the time it became apparent that the firm had undermined its long-term capacity to add real value to customers, the executives responsible for the decisions would be safely retired, with bonuses already paid. The loss of capacity to create value would be someone else’s problem.
Rule 10b-18 Of The Securities Exchange Act
There was just one snag. Jacking up the share price with large-scale share buybacks would constitute stock price manipulation and hence would be illegal. But not to worry! In 1982, the Reagan administration was happy to remove the impediment and the SEC instituted Rule 10b-18 of the Securities Exchange Act.
Naturally, the SEC didn’t announce that it was legalizing stock-price manipulation. That would have created a political outcry. Instead, they passed a very complicated rule that made it seem that stock price manipulation was still illegal but provided protection to firms so that it would be hard to detect and almost invulnerable to legal challenge.
The complex rule that the S.E.C. came up with is deliberately hard to understand. It effectively gives firms a green light to buy back their own shares with virtually no regulatory limits. Even better: since the share purchases are happening in the background, the public can’t see what is going on.
The Floodgates Open
And so the floodgates opened. The resulting scale of share buybacks is mind-boggling and accelerating. Over the years 2006-2015, Lazonick’s research shows that the 459 companies in the S&P 500 Index that were publicly listed over the ten-year period expended $3.9 trillion on share buybacks, representing 54% of net income, in addition to another 37% of net income on dividends. Much of the remaining 10% of profits are held abroad, sheltered from U.S. taxes. The total of share buybacks for all US, Canadian, and European firms, for the decade 2004-2013 was $6.9 trillion. The total share buybacks for all public companies in just the U.S. for that decade was around $5 trillion.
Theoretically, the SEC could launch investigations and intervene to prevent what is obviously share-price manipulation. But the SEC has been inactive. “The SEC,” says Lazonick, “has only rarely launched proceedings against a company for using them to manipulate its stock price.”
In fact, even in the Obama era, the SEC declared itself powerless to do anything about the problem. Thus, in July 2015, when Tammy Baldwin, the Democratic Senator from Wisconsin, asked the SEC head appointed by the Obama administration, Mary Jo White, to look into the issue of stock price manipulation resulting from share buybacks, White replied that the SEC could not consider the issue because of the protection offered by Rule 10b-18. The prospects of changing that ruling in the current investor-friendly administration seem even more remote. Democrats have sponsored legislation to this effect in the Senate, but passage seems unlikely in that Republican-controlled body.
A Massive Social And Political Problem
The result? Successful corporations no longer create broad economic prosperity in the United States. Prior to the 1980s, workers’ wages increased in tandem with their productivity. Yet since the 1980s, they have become delinked, which has led to decades of middle-class wage stagnation and grotesque wealth inequality, despite rising corporate profits.
The systematic extraction of value from corporations on a macroeconomic scale isn’t an issue of a few misguided individual CEOs or occasional aberrations from the norm. It’s one of fundamental institutional failure.
CEOs are extracting value from their firms and helping other CEOs do the same thing. Boards are giving the C-Suite incentives to do it. Business schools are teaching them how to do it. Institutional shareholders have been complicit in what the CEOs are doing. Regulators search for individual wrongdoers, usually those below the C-suite while remaining blind to systemic failure. Central bankers indirectly fund the operation and close their eyes to the economic consequences. And macro-economists often seem unaware of the issue.
Solutions Are Staring Us In The Face
Macro-economists must do their part. “It seems virtually certain that, sooner or later, taxes on the well-to-do and wealthy will go up,” writes Samuelson in the Washington Post. “But can we do this in a way that doesn’t weaken incentives for risk-taking and investment?”
This is to miss the point. Raising taxes on the wealthy is merely dealing with a symptom, not the underlying disease. We must abandon “the world’s dumbest idea’ and instead accept Peter Drucker’s fundamental insight of 1954: “There is only one valid purpose of a corporation: to create a customer.” Only one. Making money is the result, not the goal of a corporation.