In the catechism of capitalism, shares represent the part-
ownership of an economic enterprise, usually a firm. The
value of shares is determined by the replacement value of
the assets of the firm, including intangibles such as
goodwill. The price of the share is determined by
transactions among arm's length buyers and sellers in an
efficient and liquid market. The price reflects expectations
regarding the future value of the firm and the stock's
future stream of income - i.e., dividends.
Alas, none of these oft-recited dogmas bears any
resemblance to reality. Shares rarely represent ownership.
The float - the number of shares available to the public - is
frequently marginal. Shareholders meet once a year to
vent and disperse. Boards of directors are appointed by
management - as are auditors. Shareholders are not
represented in any decision making process - small or big.
The dismal truth is that shares reify the expectation to find
future buyers at a higher price and thus incur capital gains.
In the Ponzi scheme known as the stock exchange, this
expectation is proportional to liquidity - new suckers - and
volatility. Thus, the price of any given stock reflects
merely the consensus as to how easy it would be to
offload one's holdings and at what price.
Another myth has to do with the role of managers. They
are supposed to generate higher returns to shareholders by
increasing the value of the firm's assets and, therefore, of
the firm. If they fail to do so, goes the moral tale, they are
booted out mercilessly. This is one manifestation of the
"Principal-Agent Problem". It is defined thus by the
Oxford Dictionary of Economics:
"The problem of how a person A can motivate person B to
act for A's benefit rather than following (his) self-
interest".
The obvious answer is that A can never motivate B not to
follow B's self-interest - never mind what the incentives
are. That economists pretend otherwise - in "optimal
contracting theory" - just serves to demonstrate how
divorced economics is from human psychology and, thus,
from reality.
Managers will always rob blind the companies they run.
They will always manipulate boards to collude in their
shenanigans. They will always bribe auditors to bend the
rules. In other words, they will always act in their self-
interest. In their defense, they can say that the damage
from such actions to each shareholder is minuscule while
the benefits to the manager are enormous. In other words,
this is the rational, self-interested, thing to do.
But why do shareholders cooperate with such corporate
brigandage? In an important Chicago Law Review article
whose preprint was posted to the Web a few weeks ago -
titled "Managerial Power and Rent Extraction in the
Design of Executive Compensation" - the authors
demonstrate how the typical stock option granted to
managers as part of their remuneration rewards mediocrity
rather than encourages excellence.
But everything falls into place if we realize that
shareholders and managers are allied against the firm - not
pitted against each other. The paramount interest of both
shareholders and managers is to increase the value of the
stock - regardless of the true value of the firm. Both are
concerned with the performance of the share - rather than
the performance of the firm. Both are preoccupied with
boosting the share's price - rather than the company's
business.
Hence the inflationary executive pay packets.
Shareholders hire stock manipulators - euphemistically
known as "managers" - to generate expectations regarding
the future prices of their shares. These snake oil salesmen
and snake charmers - the corporate executives - are
allowed by shareholders to loot the company providing
they generate consistent capital gains to their masters by
provoking persistent interest and excitement around the
business. Shareholders, in other words, do not behave as
owners of the firm - they behave as free-riders.
The Principal-Agent Problem arises in other social
interactions and is equally misunderstood there. Consider
taxpayers and their government. Contrary to conservative
lore, the former want the government to tax them
providing they share in the spoils. They tolerate
corruption in high places, cronyism, nepotism, inaptitude
and worse - on condition that the government and the
legislature redistribute the wealth they confiscate. Such
redistribution often comes in the form of pork barrel
projects and benefits to the middle-class.
This is why the tax burden and the government's share of
GDP have been soaring inexorably with the consent of the
citizenry. People adore government spending precisely
because it is inefficient and distorts the proper allocation
of economic resources. The vast majority of people are
rent-seekers. Witness the mass demonstrations that erupt
whenever governments try to slash expenditures,
privatize, and eliminate their gaping deficits. This is one
reason the IMF with its austerity measures is universally
unpopular.
Employers and employees, producers and consumers -
these are all instances of the Principal-Agent Problem.
Economists would do well to discard their models and go
back to basics. They could start by asking:
Why do shareholders acquiesce with executive
malfeasance as long as share prices are rising?
Why do citizens protest against a smaller government -
even though it means lower taxes?
Could it mean that the interests of shareholders and
managers are identical? Does it imply that people prefer
tax-and-spend governments and pork barrel politics to the
Thatcherite alternative?
Nothing happens by accident or by coercion. Shareholders
aided and abetted the current crop of corporate executives
enthusiastically. They knew well what was happening.
They may not have been aware of the exact nature and
extent of the rot - but they witnessed approvingly the
public relations antics, insider trading, stock option
resetting , unwinding, and unloading, share price
manipulation, opaque transactions, and outlandish pay
packages. Investors remained mum throughout the
corruption of corporate America. It is time for the
hangover.