Ciepley

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The Firm, Yet Again

There is a new eBook published by the Stigler Center which is an offshoot of the Booth Business School at the University of Chicago.  The publication contains a number of short essays either attacking or defending the infamous pronouncements by Milton Friedman on the role of the corporation.  This year, you may recall, is the 50th anniversary of the newspaper article in which Friedman described his view that the purpose of the corporation is too maximize shareholder value.  The subsequent decades have seen that view permeate the business and  legal systems such that to argue against it is seen as oddball in the extreme.

Steve Kaplan leads the defense of Friedman with the opening essay and slides almost immediately into a humdrum general defense of capitalism rather than staying on the specific topic of the corporation.  Thus we read this:

“Many observers, including the organizers of the Stigler Center’s Political Economy of Finance Conference, believe that his view has been extremely influential. It has been implemented in the US and globally starting in the 1980s, encouraged by scholars like Michael Jensen (a Booth alum and my thesis advisor).1What has been the result of corporate shareholder value maximization mixed in with globalization? Let me cite Nicholas Kristof, of the New York Times, who wrote at the end of 2019 (and pre-pandemic): “For humanity over all, life just keeps getting better.” People living in extreme poverty fell from 42 percent of the world’s population in 1981 to below 10 percent today. That is 2 billion people who are no longer suffering extreme poverty. Absolute poverty declined substantially in the US, from 13 percent in 1980 to 3 percent today. And this is more or less what Friedman predicted. The pandemic will affect these numbers, but I am hopeful that the effect will be temporary.”

Notice that the reduction in world poverty is, apparently, a consequence of the acceptance that corporations ought to devote themselves exclusively to enriching their shareholders.   This extraordinary over-reach is best left to you to absorb and think over at your leisure.  Just make sure you are sitting down when you do so.

This claim follows a subtle revision of Friedman’s intentions.  In order to immunize against what he clearly thinks is a vulnerability in the Friedman line of thought, Kaplan adjusts Friedman’s use of the word”profits”: the word is narrowed to mean “long term shareholder value” as if the specification of the longer term somehow eliminates the corrosive worry that corporations have become ever more short term in their focus.  Of course they have.  The average share is owned for a paltry four months.  There are fewer long term shareholders than there were in Friedman’s day, and the manic search for that little extra profit is one of the root causes of the much criticized short term nature of most management nowadays.  But, the longer term view is, we are assured, what Friedman “surely meant”.

Then he ought to have said so.  Friedman was never one to avoid saying what he meant.  So I think when he said “profits” he meant exactly that.  Kaplan’s revision is simply an attempt to soften a potential fatal blow against his idol.

It gets better: Kaplan suggests that all those who argue for a return to the older stakeholder focus for management are creating insurmountable difficulties.  Just how, he asks, is management supposed to choose between all those competing ends for whatever their limited resources are?  Worse still, since, he goes on, corporations compete against other value maximizers, any corporation who fails to maximize will likely invest less efficiently and operate worse.  Notice the weasel word “likely”, it sounds as if Kaplan is a little unsure of himself.

And that’s it.  That’s all we need to know.  Without shareholder value as a single point of focus, our managers will dither, dally, and the world will slide into oblivion.  Kaplan’s convinced:

“To conclude, Friedman was and is right. A world in which businesses maximize shareholder value has been immensely productive and successful over the last 50 years. Accordingly, business should continue to maximize shareholder value as long as it stays within the rules of the game. Any other goal incentivizes disorder, disinvestment, government interference, and, ultimately, decline.”

Oh no!  Disorder? Disinvestment? Government interference? Decline?

Enough.  This is old ground.  The fact that the shift towards shareholder value exactly coincides with the stagnation of wages, the helter-skelter dive into globalization, the decline in domestic investment, and the rise of populist politics is just, well, a coincidence.

As ideas go shareholder value has been a failure for most households.  CEOs have done well though, and they probably will continue to direct their generous support to the Stigler Center, and the various academics it houses, in return

It is an irony that I came across the Stigler Center eBook this morning just as I was about to comment on the continuing confusion in economics over the firm.  It is a stunning omission from mainstream economics that there is no well worked through story of how business sits within the economy.  The continued effort to flatten business into the pre-existing, and more easily mathematized, structure of aggressive individualism, distorts reality out of all recognition.  It’s as if physicists theorized the universe only as an assemblage of atoms.  No stars, galaxies, or even planets, just atoms.  Imagine the lack of insight that would result from such an approach.  Yet that its exactly what economics does.  No intermediate structure is tolerated between the individual and the market [whatever that is].

This is laughable.  But that’s what economics is.

When economics tries to engage with the firm is is almost invariably through the lens of contracts and the cost of transacting.  This is familiar turf for economists, so they attempt to bash the firm into a shape they can deal with using their preferred methods.  They ignore anything that gets in the way of this wholly unscientific approach.

Just too add to the confusion, economists are prone to use the. two words “firm” and “corporation” interchangeably.  This is a monstrous error.  The two are totally different animals.  Confusing them leads to all sorts of subsequent errors.  One of which is the notion of shareholder value.  Friedman might not have expounded as he did had he grasped the difference between a firm, which is an organization created to undertake economic activity, and a corporation, which is a legal person created as a shell within which a firm may, or may not, sit.

The impact of understanding this separation of the two concepts is profound.  One of which is that a corporation is decidedly not owned by shareholders.  The entire Friedman project unravels at this point.  Corporations are not owned by anyone.  They exist at the whim of the state to perform functions that further the ends of the state.  In return for so doing they are given all sorts of legal capabilities such as that of limited liability, the ability to sue and be sued in court, to own and dispose of assets and so on.  Shareholders are peripheral.  They own pieces of paper that give them access to financial rewards as defined by the board of directors.  After the initial influx of capital at the launch of the corporation, shareholders contribute nothing.  They benefit from the upside potential of the stock price, but are immunized against personal losses if the corporation fails or goes bankrupt.  It is rare to hear economists comment on this monumental example of moral hazard.  Which is odd because they like to rabbit on about it elsewhere.

Legal personhood is an extremely valuable asset that the state endows a corporation with.  It is an ancient concept — the Romans had corporations precisely because of the benefits the concept bestows.  It is a privilege to be a corporation.  It allows economic activity to be defined and protected against risks that might preclude that activity otherwise.  Indeed the modern use of the corporate form since industrialization is a recognition of the immense value legal personhood brings into commerce.  It is a vital technology the absence of which would most certainly have hampered modern economic development.  We all benefit from the existence of corporations.  They mitigate risks as they help stave off uncertainty.   Everyone associated with a corporation receives these benefits, not just shareholders.

On the contrary, shareholders rank low within a corporation.  Least of all do they “own” the corporation.  In David Ciepley’s words:

“And all of the rights over the firm’s assets that we normally think of as bundled into the right of ownership – such as rights to exclude, use, lend out, collateralize, sell, or profit from the use or sale of an asset – are held by the legal entity and exercised on its behalf by the board and its hirelings. The stockholders possess none of them, which makes them very odd “owners.”

Odd indeed.

Perhaps Kaplan and his hero Friedman need to revise not just the word profit, but also their entire notion of ownership.

No one owns a corporation.  It is a ward of the state.

 

 

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Who “Owns” a Corporation?

 

I have become quite a fan of David Ciepley this summer.  He, amongst many I am sure, is blazing a trail through the morass of corporate law and providing new insights into the role and status of the animal we know as the “corporation”.

Anyone with an interest in the role business plays in the economy needs to understand what Ciepley is saying.

In one talk he gave, at MacGill University, the introductory remarks by his host were illumination in themselves.  The occasion was a presentation and interdisciplinary discussion about the corporation and its role in shaping the social landscape.  The host rattled off the university departments and working groups involved in the discussion in his welcoming remarks.  There was no mention of economics.  The omission tells us all we need to know.  Economics cannot engage, easily with other disciplines in discussions about the organization of business because it cannot recognize the reality associated with said organization.  This is not to say that somewhere in the great archipelago known as economics there isn’t some little island of thought about institutions — at one time that island was much more significant — but nowadays the need to crush everything into an anti-social market driven explanation makes the odds of communication with such distant shores very difficult if not impossible.

Which is a shame because I think the key to understanding the contemporary economy requires a solid knowledge of modern business theory, that theory is, after all, simply an expression of neoclassical thought.  It is mid-twentieth century economics packaged as organizational technology, and as such, is one of the most powerful innovations and foundations upon which our economy rests.  The arc of wages since the 1970s depends upon the incessant and pervasive uptake of that organizational technology.  As does the subsequent woeful policy reaction, the supine regulatory response, and the invasion of politics by corporate-financed interests.

This technology has one idea at its core which gives it supreme simplicity and ideological power.  That is the idea of shareholder value.

Which gets me back to Ciepley.

Most theories of the firm within economics pick up the narrative with the existence of the corporation as a given.  They then bend over backwards to retro-fit this highly centralized pseudo economy into the larger free market narrative preferred in all major textbooks.  In so doing they blithely ignore Alfred Chandler’s famous explanation for the rise of modern business organization, which he argued became possible “only when the hand of management proved be  more efficient than the invisible hand of market forces”. 

Chandler, being a historian rather than an economist, was more interested in reality than in hypotheticals.  He understood and tried to explain the actual landscape of large-scale business.  I have always wondered what would have happened to economics had it absorbed the true gist of the challenge issued by Coase in 1937.  The impudence of that challenge has never been fully understood.  Coase asked simply: “why do firms exist?”.  After all if market forces are as supreme as the textbooks tell us, there is no room for business organization at all.  We ought be able to accomplish all our transacting through a web of contracts in the open marketplace.

Indeed the most common response of economists to the challenge represented by business organization is to argue that a business organization is simply such a web of contracts.  In this view we can continue to ignore any oddities of business organization since it is indistinguishable from the market.  In this view the firm exists at a “nexus of contracts” and has no special attributes that cannot be negotiated and contracted for in the marketplace.

Except this is not true.

The corporation, as Ciepley and his ilk tell us, is a unique vessel.  It has capacities and attributes unavailable in the marketplace.  And it precisely these attributes that make it so convenient for the execution of large-scale business.

The concept of the corporation pre-dates the modern economy and industrialization by centuries. It has its roots way back in the Roman era.  It was adopted along the way by all sorts of organizations needing the advantages it brings.  Those advantages include being able to act as a “legal person” for the purposes of property ownership, being able to enter into contracts in its own name, and having legal standing for the purposes of being sued or suing on its own behalf.

And right there, if we ponder for a while, sits a conundrum for the purveyors of shareholder value.

If we pull on the string hard enough we discover that shareholders do not own corporations.  They are simply one group, amongst many, that have varying degrees of financial claims against the corporation.  They do not own the corporation’s assets.  The corporation does.  The myth of shareholder ownership exists only because of subsequent laziness on the part of analysts, and on the ideological preference of neoclassically oriented legal and business scholars: The Chicago School take a bow!

The reality is more complex.

The corporate form as we know it is an adaptation of its medieval precursor.  It came down to us via the colonial experience where it proved very useful as a vehicle for assembling capital to take on large-scale trading ventures, exploration, and, eventually, colonization.  Those same virtues linger on in its modern business form.  Perhaps least recognized is that the corporate form of organization is that of a mini-state.  It has the same ability to regulate itself as any modern constitutional state with the exception that its internal statutes must not contradict those of the state where it obtained its original charter.  Our separation of the economy into two domains, public and private, needs an addition: the quasi-state of the corporation.

As long as its internal rules are not “repugnant” to the laws of the state the corporation can establish any internal rules it likes.  And since no one actually “owns” the corporation, its existence depends only on an originating charter, which is a delegation or power by the state.  The corporation truly is a state within a state.

Be logical about the establishment of a new corporation: a charter grants it legal existence; that existence allows the appointment of a Board with fiduciary responsibility to uphold the charter; and then the Board seeks financing to bring the hitherto legal-only corporation into physical reality.  So the existence of shareholders, if they are a source of that funding, is secondary to the existence of the corporation.  That most corporate charters are sought by people who subsequently provide the funding should not allow us to miss this crucial sequence.  Their existence as shareholders is not the same thing as the existence of the corporation.  The latter is its own entity, with its own, and prior, legal standing.

Shareholder value thus sits on a false premiss — a rotten one at that.

And the rest, as they say, is history.

Anyway, go read Ciepley.  He can explain all this much better than I do.

 

Addendum:

For those of you carrying the torch for New Institutional Economics, I recognize the effort.  The problem, as I see it, is that NIE still tries to force the square peg of organizational reality into the round hole of equilibrium-oriented market-based analysis.  Transactions cost minimization is a valuable idea only if we recognize that, ultimately, that it implies the secondary nature of the marketplace in the organization of complex business activities.  So textbooks need to be re-written.  We ought to start with an explanation of the economy through the prism of business organization.  We then could talk about the exceptions, one of which is the marketplace.  The other of which is government.  

Such a narrative seems to recognize reality.  NIE seems still to be bending over backwards to allow the market to retain a supremacy, which if it ever had, has long since disappeared.  Markets and hierarchies may be substitutes for one another in theory, but in practice the pragmatic choice is always the hierarchy.