The court of public opinion has arraigned many villains for the parts they played in our current predicament. But one has so far escaped censure. This is the joint stock limited liability company. In its modern form of a legal personality, which issues shares to investors whose liability to loss is limited to the sum they invest, the company is a Victorian invention. As it happens, this year marks the 150th anniversary of the Companies Act passed by the British Parliament, which finally conferred on joint stock companies the legal privilege of limited liability without let or hindrance. In retrospect, the debate that preceded its passage is rich in presentiments. Limited liability was advanced by its advocates as a means by which the aspirant could challenge the entrenched, labor reconciled to capital and savings mobilized on a scale commensurate to the opportunities spawned by an industrial economy. Its opponents warned that limited liability would stimulate speculation and foster irresponsible delegation, by which investors would transfer capital to others without the restraint of full liability for the obligations they might incur. Some even warned of the damaging moral consequences of permitting investors exposure to business practices and the attendant possibilities of loss and failure, which would have outraged their consciences as individuals and imposed a stain on their reputations if undertaken directly.
A century and a half later, with $9 out of every $10 spent or received in the developed economies passing through the bank accounts of joint stock companies, it is the opponents of limited liability who seem the more prescient. The world economy is mired in a crisis preceded by a speculative frenzy driven by bankers, brokers, fund managers, private equity managers and investors who cannot in any meaningful sense be said to have acted like owners (as opposed to traders) of the corporate assets and liabilities they have exchanged or financed. Coupled with the rapid growth and enormous size of the financial services industries, particularly in the United States and the United Kingdom, it is not necessary to be a socialist or a mercantilist to ask whether financialized economies represent a genuine advance in wealth and knowledge, as merely the hosting of a gaming parlor in which the players exchange paper claims on the corporate economy. Before the crisis, it was possible to believe that the financialization of economic life was leading to the more efficient allocation of capital to companies; that more liquid markets were improving price discovery in equity markets; that securitization was diversifying the risks incurred by companies; and that derivatives were enabling companies to mitigate the risks they run. As the crisis that erupted in the summer of 2007 enters a sixth year without resolution, different questions are being asked. Chief among them is the suspicion that, after 20 years of searching for the perfect systems of corporate governance and executive remuneration, it might be better to cure the disease than treat the symptoms.
The disease is the current pattern of corporate ownership and control. The case for limited liability joint stock corporations of the kind that now dominate economic life is that they are an essential piece of legal technology for any ambitious economy. They marshal large pools of capital by spreading the risk across multiple investors. They impose effective management on large bodies of people. Most importantly of all, companies minimize the transaction costs of coordinating multifarious activities. If it were necessary to negotiate afresh every input of goods and labor that go into the manufacture and marketing of a product, it would become prohibitively expensive by comparison with putting the people at every stage of the process on the company payroll. Companies, in other words, are bundles of contracts and capabilities that exist primarily to cut the costs of coordination. Whether this is as true as it was when Ronald Coase first pointed this out in 1937 is questionable. In the age of outsourcing and offshoringdriven in large part, ironically enough, by stock market pressure to fatten marginsit is not obvious that large corporations do in fact minimize transaction costs by insourcing as many functions as possible. Even large manufacturing businesses, in industries as various motorcars and computers, are better understood as confederations of independent specialists tied together as much by digital technology as old-fashioned contracts. Even in banking, some companies have outsourced entire processes to third-party providers. It is no longer universally true that the costs of maintaining a corporate bureaucracy are lower than the transaction costs of sourcing every requirement in the marketplace.
Certainly, hierarchical companies of the old-fashioned kind areas everyone who works for one knows, and everyone who buys from one eventually finds outastonishingly inefficient. Waste is intrinsic to capitalism, but limited liability increases waste by lowering the risks of wasteful behavior and blunting the incentives to avoid it. Companies can afford to be political (promotion does not hinge on adding efficiency), hierarchical (senior managers benefit from the accumulation of layers of management), careless (the company stationery cupboard is not the only freebie employees enjoy) and circumscriptive (initiative, particularly at the lowest levels, is seen as a source of inefficiency rather than efficiency). Being large, they are unavoidably inept at gathering, processing, interpreting and acting on dispersed information. In fact, the only technology capable of doing thisthe allocation of resources according to price signals delivered through the marketis deliberately excluded from corporate life. Inside companies, the allocation of monies to purchases or investment in products, services and people is decided not by prices but by managers. This is, absurdly, the raison dtre of the company. Alfred Chandler famously said that companies came into being as soon as the visible hand of management proved to be more efficient than the invisible hand of market forces. The understandable propensity of managers to proceed on the basis of this fallacy is a major source of inefficiency in the corporate economy. But it is not the most important one. That honor belongs to the fact that the group with the largest interest in efficiency (the shareholders) is too fragmented to impose its will on the group with the largest interest in inefficiency (the management).
This is a problem that was identified long before its classic exposition by Adolf Berle and Gardiner Means in The Modern Corporation and Private Property, first published in 1932. The directors of such companies, however, being the managers of other peoples money than of their own, it cannot be well expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own, wrote that herald of modern capitalism, Adam Smith. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. At those investment banks that have exchanged private partnerships for public companies, such as Goldman Sachs and Salomon Brothers, no one would say that the firm was unchanged by the experience. The appetite for risk, and even for less-than-honorable behavior, was bound to increase when the consequences of misjudgments fall on people other than the author. When things go wrong, it is their problem, as John Gutfreund, architect of the sale of Salomon Brothers, once put it. This risk was identified by Victorian critics of the introduction of limited liability, who foresaw that weakening the commitment of shareholders to the long-term success of a business would free its managers to exploit it for short-term gains of their own. As Berle and Means explained 80 years ago, the managers of companies where ownership is divorced from control can serve their own pockets better by profiting at the expense of the company than by making profits for it.
Investment banks have in recent years hosted a series of cameos of this agency problem in practice. Their senior management took egregious risks with shareholders money and pocketed large sums based on illusory profits, leaving the shareholders to deal with a tanking share price or expropriation by taxpayers. But the agency problem is endemic to modern capitalism. Nothing illustrates this better than the rise in executive remuneration. In the United States, the salary of the average CEO rose from 42 times that of the average employee in 1980 to 520 times by 2008. Value, measured by corporate profits, rose at a third of that rate in the same period. It is a more than minor curiosity why the institutional investors who own half or more of the market capitalization of the United States and the United Kingdom have proved so powerless to influence this obvious discrepancy, despite repeated reviews of the state of corporate governance, endless disclosure rules and codes and even the occasional legislative initiative, such as the Sarbanes-Oxley Act passed in the wake of the various corporate scandals that disfigured the dot-com boom. The only sensible conclusion is that the problem is structural, not procedural. The separation of ownership from control in joint stock limited liability companies listed on regulated stock exchanges has transformed investors from owners into rentiers. Where stock is held by a great number, wrote Andrew Carnegie, what is anybodys business is nobodys business. Investors have put their rights of property into commission in exchange for the prospect of capital gain and the promise of liquidity. They are absentee landlords, except in those few cases where it is practically impossible to change the management by selling the stock or orchestrating a corporate takeover, and it becomes necessary to engage in that modern substitute for exercising the rights of property known as shareholder activism.
Such activism is in practice just another investment strategy. It is not a serious attempt to overcome the fundamental structural flaw behind the agency problem. Activism has at least not made the problem worse, unlike some other attempts to repair the breach. Grants to managers of stock and options to buy stock, for example, have merely opened for managements a further axis of personal profit. The ideological insistence that managerial success and failure be judged solely by shareholder value has encouraged managements to borrow money to finance share buy-backs, or to fund takeovers and investments, increasing the risk to investors by making companies more vulnerable to failure in a downturn. Similarly, cuts in operating costs are used to boost short-term profits at the expense of long-term performance. Accounting tricks, such as writing off losses against capital to keep them out of the profit and loss account, are used to inflate the share price. In the banking sector a cottage industry developed whose sole objective was to turn uncertain future cash flows into immediate profits by purchasing protection in the credit default swap market, or by marking assets to market or to model, or by making little or no provision for anticipated losses on grounds the risks were hedged. If none of these measures worked sufficiently well to guarantee the management the rewards they expected from their stock options, they were simply repriced or backdated. The interwar economy described by Berle and Means was one in which the control of property had passed out of the hands of its owners. The listed, limited liability joint stock company of today is often one in which managers do not respect the rights of property at all.
Nor, unfortunately, do investors. Owners of equity capital have shown little respect for the responsibilities of ownership, because they prize liquidity more. Yet liquidity defeats even its limited objective. As Jack Bogle has never tired of pointing out, in stock markets the rewards of investment vastly exceed those from speculation. It must be so, for something would be seriously awry in any system in which the returns from buying stocks expected to increase in value, and selling stocks expected to decline in value, could in the long run outperform increases in profits and the steady compounding of the payment of dividends out of those profits. In the short run, of course it is possible to profit from arbitrage trades. But it is equally obvious that the average investor cannot hope to beat the market, because the average investor is the market. This is simply a matter of arithmetic. Yet there is in existence a large and highly profitable industry made up of fund managers and broker-dealers that promise to do exactly that. The overheads they represent, and the performance-sapping transaction costs they incur in product design, management and performance fees, commissions, bid-offer spreads, tax wrappers, turnover taxes, valuation charges, subscription, switching and redemption fees and clearing, settlement and custody imposts, suggests there is a large constituency for speculation as opposed to investment.
This appetite for trading on momentum (in pursuit of capital gain) rather than investing on fundamentals (for income growth) is starkly evident in the shrinkage of holding periods and the rise in transactional activity. The average holding period for equities in the United Kingdom fell from seven years in the 1950s to seven months in 2007. In the same period, the average holding period for American equities fell from 16 years to just four, and at mutual funds alone from six years to one. Stock exchanges that turned over three million shares on a good day in the 1950s now turn over three billion on an average day in the United States. Even after excluding extremes, institutional as well as mutual fund managers now churn equity portfolios anywhere between 50% and 150% a year. A new class of intermediariesthe high-frequency tradershas arisen to drive this activity and to take advantage of it. Few fund managers are interested in the fundamentals of the businesses they buy and sell. Nothing demonstrates this better than the superficiality of contemporary equity research. It reflects the fact that there is no point in fully understanding a company whose stock will be held for so short a period. Indeed, the pressure on analysts runs entirely the other way: It is to misrepresent the company in the hope of selling the stock to an even less well-informed investor. That, in modern equity markets, is what liquidity means.
Yet what makes liquidity available is rarely a genuine surplus set aside from productive economic activity. Savings ratios collapsed in both the United Kingdom and the United States in the years prior to the onset of the crisis in 2007. The chief source of liquidity was the propensity of central banks to increase the supply of money faster than output. This they have done consistently since they were freed from the constraints of the Bretton Woods system in the early 1970s. In fact, no further explanation of the public, private and individual credit binges is necessary than the persistent determination of the monetary authorities to make borrowing as cheap and easy to obtain as possible. In the financial markets, that cheap and plentiful supply of money expressed itself in rising stock market prices, underpinned by the so-called Greenspan put; investment banks leveraged more than 30 times; the manufacture of structured credit instruments; outlandish returns for private equity and hedge funds with ready access to leverage in the so-called shadow banking industry; the growth of complexity and size in financial instruments, and especially in OTC derivatives, to more than $600 trillion in notional value and $20 trillion in gross market value; and incessant rises in equity market turnover at ever-decreasing ticket sizes, driven by a new breed of high-frequency and algorithmic traders interacting with digital exchanges. It is by these various means that financial markets have translated central bank money into the liquidity craved by investors that neither have nor seek effective rights of property in the assets and liabilities they trade.
True, liquidity in financial markets needs issuers as well as investors, and banks and brokers and fund managers have found ready borrowers in the major corporations. Those CEOs and CFOs that rose to positions of authority in business in the late 20th and early 21st centuries had mostly attended business school in the 1960s and 1970s, where they were armed with the Modigliani-Miller theorem of 1958. This taught them that the capital structure of a company is irrelevant to its value. In limited liability companies in particular, the theory demonstrated that an increase in the amount of debt relative to the amount of equity did not increase the total amount of risk the company incurred, but merely redistributed it from creditors to owners. If the balance between equity and debt was a matter of indifference in theory, it helped that it was not a matter of indifference in the real world, where interest payments are tax-deductible but equity dividends are not. Modigliani-Miller provided corporations with the perfect justification for increasing leverage and cutting dividends, and it worked brilliantly in an era of cheap money, when spending is high and the risk of failing to meet an interest payment or maintain an interest cover ratio is low. Corporate CEOs (and private equity managers) were quick to understand that it made sense to issue junk bonds and use the proceeds to reduce the proportion of equity in the company. In the short term, this did what leverage always does (raise the rate of return on equity) while justifying cuts in dividends (which are a drain on equity value, especially for those holding stock options).
In this concatenation, which is cause and which is effect no longer matters. Cause and effect have fused. Liquidity is possible because joint stock companies are empowered to issue tradable shares to any number of investors, and those investors have limited their risk to the sums they subscribe. On the other hand, joint stock companies are designed to mobilize multiple pockets of capital by the promise of liquidity as well as the limit of liability. But it is worth recalling that the causa causans of the problems spawned by the trading of claims on the assets and liabilities issued by companies does not lie in the markets. The joint stock company with limited liability is not the spontaneous creation of the marketplace but a creature of politics and the law. It is why even todayindeed, especially todaycompanies have a natural affinity with the state that afforded them their original privileges and which continues to afford them more. This is the most sinister development in Anglo-Saxon business today, posing a threat to genuine free market capitalism of a kind not encountered since the corrupt and cartelizing money trusts of the early 20th century, when an American president warned of government of corporations, by corporations and for corporations. Today, the closeness of the ties between Big Business and Big State are once again putting the legitimacy of the free market at risk. Unmistakably, a mutant corporatism is taking root in the United States and the United Kingdom, in which ownerless corporations trade favors with constituency-less politicians and unelected public officials.
Laws and taxes and regulations, which companies claim to find so onerous, are in reality what large corporations exchange for contracts, subsidies and protection from competition. The state is a source of costly taxation and regulation, yet it controls such a lavish proportion of the national income that government is a bountiful source of material benefits. Companies collect taxes on behalf of governments, and deliver social benefits in cash or kind, including legal job security, minimum wages and specified working weeks, even as their lobbyists emasculate other taxes, and modify laws and regulations, transform foreign aid into corporate contracts and capture diplomats as salesmen. There is a constant traffic between the private sector and the public, with regulators becoming corporate executives and corporate executives becoming regulators. Companies purchase politicians through donations to the party funds and by purchasing the rights to plaster their brands all over purely political projects. The London Olympic Gamesrun by and for a nomenklatura of politicians, civil servants, company executives, corrupt but stateless sports administrators and people who simply happen to be rich, right down to the provision of ZiL lanes throughout the cityare a recent but not especially egregious example of this system in practice. In short, modern Anglo-Saxon capitalism is different in form but not in kind from the crony capitalism of Italy, or the illiberal capitalisms of Germany and Japan, where corporations were from the outset perverted to the questionable ends of the state.
No group of business leaders will be more familiar with the distorted form of capitalism that has come into being than bankers. They ran organizations that were allowed to consolidate to the point of oligopoly and then inflate to unsustainable size through excessively loose monetary policies, before being rescued by taxpayers from their understandable errors of optimism. No wonder they have become living metaphors of the corrupting closeness of private and public interests. Bankers cannot of course be expected to see what has happened in quite the same way, for the inhabitants of any industry will tend to regard the interests of their business as synonymous with those of the public. There is nothing new about that. In 1953, half a century before the company had to be rescued by American taxpayers, a president of General Motors was asked if he saw a conflict of interest in becoming Secretary of Defense. I cannot conceive of one, because for years I thought what was good for our country was good for General Motors, and vice versa, replied Charles Wilson. The difference did not exist. Our company is too big. What is new is that it was not just a motor manufacturer that was rescued with TARP money in 2009, but its finance arm, which is the key to how it sells cars. Half a century on, the economy of the United States, like the economy of the United Kingdom, has all the substantiality of an inverted pyramid of credit. Such capitalism is not a real capitalism at all. It is an abstracted, financialized succedaneum, played by professional intermediaries, using money other people have lent to banks, which they in turn have borrowed from the central banks that printed it, and in which only the croupier gets rich.