In the latest installment of his series “Breaking Through the Jobless Recovery,” economist William Lazonick challenges the assumption that shareholders are the only ones taking risks in a business — and therefore deserving of rewards.
Want to solve the mystery of the American economy’s current employment and competitiveness problems? Take a close look at the current corporate obsession with “maximizing shareholder value.” It sounds like a sound business principle, but in reality, it’s based on a flawed ideology that leaves something crucial out of the business equation — workers and taxpayers.
Let’s review the decade of 2000-2009. During this time, companies in the S&P 500 index, accounting for about 75% of the market capitalization of publicly listed corporations in the United States, distributed 99% of their profits — almost $4.3 trillion — to shareholders. Cash dividends were 41% of profits, while stock buybacks absorbed 58%. This left companies with precious little left over to invest in innovation and job creation (for more on this, see my paper on Innovation and Financialization).
At the most basic level, the rationale for maximizing shareholder value is that shareholders own the company’s assets, and therefore have exclusive claim on its profits. A more sophisticated argument is that that among all stakeholders in the business corporation, only shareholders bear the risk of getting a positive return from the firm, while all other participants receive guaranteed returns for their productive contributions. If we want risk-bearing, so the argument goes, we need to return value to shareholders.
This argument sounds logical — until you question its fundamental assumption. Especially in a “knowledge economy” that can generate innovation, the productive assets of a business enterprise reside in human capital as well as physical capital. And while shareholders may presume to own physical capital, they can’t claim to own human capital (we no longer permit slavery, which is why we do not show human, or intangible, assets on the firm’s balance sheet). And if you think about it, shareholders are the only participants in the business enterprise who make investments in productive resources without a guaranteed return. In an innovative economy, workers and taxpayers make these risky investments all the time!
When you work for a company, you may contribute your time and effort over and above the levels required by your current remuneration to a collective and cumulative innovation process. By definition, this innovation process can only generate returns in the future (otherwise it would not be innovation), and because the innovation process is uncertain, it may not in fact generate returns. As a member of the firm, therefore, you bear the risk that your extra time and effort won’t yield the gains to innovative enterprise from which you can be rewarded. But if the innovation process does generate profits, then you, as a risk-bearer, have a claim to a share in the forms of higher earnings and benefits.
Taxpayers also invest in the innovation process without a guaranteed return. Through government agencies, taxpayers fund infrastructural investments that, given required levels of financial commitment and inherent uncertainty of economic outcomes, business enterprises would not have made on their own. These state agencies also provide businesses with subsidies that encourage investment in innovation.
In terms of investment in new knowledge with applications to industry, the US has been the world’s foremost developmental state. It is impossible, for example, to explain US dominance in computers, microelectronics, software, and data communications without recognizing the role of government in making investments that developed new knowledge and facilitated its diffusion. As another prime example, the 2010 budget of the US National Institutes of Health (NIH) for life sciences research was $30.9 billion, almost double in real terms the budget of 1993 and triple that of 1985. Since the founding of the first national institute in 1938, NIH spending has totaled $738 billion in 2010 dollars (for further discussion, see my paper on Biopharmaceutical Finance).
More generally, the US government has made investments to boost the productive power of the nation through federal, corporate, and university research labs that have generated new knowledge as well as through educational institutions that have developed the capabilities of the future labor force. Businesses have taken full advantage of this knowledge and capability. In funding these investments, taxpayers have borne the risk that the nation’s business enterprises would further develop and utilize these productive capabilities in ways that would ultimately redound to the benefit of the nation, but with the return to taxpayers in no way contractually guaranteed.
And there’s more: Federal, state, and local governments often provide cash subsidies to businesses, both established and new, to develop new products and processes. The public has funded these subsidies through current taxes, borrowing against the future, or by making consumers pay higher product prices for current goods and services than would have otherwise prevailed. Multitudes of business enterprises have benefited from subsidies without having to enter into contracts with the public bodies that have granted them to remit a guaranteed return from the productive investments that the subsidies help to finance.
So the ideology of maximizing shareholder value provides a flawed rationale for excluding workers and taxpayers from sharing in the gains of innovative enterprise. To turn this idea on its head, ask yourself: What risk-bearing role do public shareholders play in the innovation process? Do they confront uncertainty by strategically allocating resources to innovative investments? No. As portfolio investors, they diversify their financial holdings across the outstanding shares of existing firms to minimize risk. They do so, moreover, with limited liability, which means that they are under no legal obligation to make further investments of “good” money to support previous investments that have gone bad. Even for these previous investments, the existence of a highly liquid stock market enables public shareholders to cut their losses instantaneously by selling their shares — what has long been called the “Wall Street walk”.
The modern corporation has brought about a fundamental transformation in the character of ownership, as Adolf Berle and Gardiner Means recognized almost 80 years ago in “The Modern Corporation and Private Property.” As property owners, public shareholders own tradable shares in a company that has invested in productive assets. In an innovative enterprise, however, the most important productive assets are human. In a free society, human assets can’t be owned by others. Through massive distributions to shareholders, dominated by stock buybacks, the ideology of maximizing shareholder value is robbing taxpayers and workers of returns to the risks that they took — and in the process undermining the innovative capability of the US economy.
William Lazonick is director of the UMass Center for Industrial Competitiveness and president of The Academic-Industry Research Network. His book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute 2009) was awarded the 2010 Schumpeter Prize.