Column: When capitalism only rewards shareholders, it’s time for reform

Editor’s Note: On both sides of the Atlantic, populist resentments are stewing. In the United Kingdom, this was epitomized by the vote for Brexit — the British exit from the European Union. And as the number of people in the middle class falls in the United States, wide discontent with economic prospects grows, as does support for candidates such as Donald Trump and Bernie Sanders. But what is at the root of stagnating incomes and increasing inequality? Harvard Business School professor Bruce Scott thinks economists are missing a key cause: “shareholder capitalism.” Below, he lays out a compelling case for the need to reform shareholder capitalism.

Kristen Doerer, Making Sen$e Editor

Former Treasury Secretary Lawrence Summers recently warned of populist opposition to the international integration of markets in continental Europe, but his notion that globalization has caused the stagnation of incomes and diminution of opportunities for the bulk of the population is only part of the issue. Part of the problem lies within the firms themselves. British firms, like their U.S. counterparts, shifted from stakeholder capitalism to shareholder capitalism back in the 1970s and 1980s.

Today’s Anglo-American version of capitalism largely ignores the fact that corporations owe their powers to society, their employees, their customers, suppliers, taxpayers and other stakeholders, and not just to shareholders and executives. The shareholder model focuses corporations on maximizing stock price (as opposed to optimizing the value provided to the company’s stakeholders) and pays excessive compensation to top executives. The disparity in incomes between the highest paid executives and the lowest paid employees is grossly excessive.

According to a Sept. 23, 2014 Harvard Business Review article by Gretchen Gavett, the actual CEO-to-employee compensation ratio in the UK is 84 to 1, and in the U.S., it is 354 to 1, or more than four times greater than in the UK. Thus, the U.S. faces even greater income disparity problems than those facing Britain’s new prime minister, and the resentment in the United States is arguably even stronger.

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Until Prime Minister Theresa May’s proposals to add employee and consumer representation to the board and to limit executive pay and incentive compensation, neither Britain nor the United States government nor either of the leading candidates for the presidency had thus far shown any sign of recognizing the role of stakeholders — as opposed to shareholders — in the way capitalism functions in British or U.S. society.

Shareholder capitalism has become a means of extracting value from companies, not adding value to companies. High rates of executive pay and, even more so, the use of aggressive stock buybacks do not create value for a firm’s stakeholders. Instead, they provide a rationale or intellectual cover to allow a limited number of people to extract value to the disadvantage of everyone else.

Economist William Lazonick has written a prize winning analysis in the September 2014 Harvard Business Review on these circumstances, which he titles “Profits Without Prosperity.” It shows how skillful business leaders can capture the regulatory system as a way to plunder their neighbors while criticizing the misfortunes of “excessive business regulation.”

In the July 12 edition of Financial Times, Martin Wolf quotes the work of Robert Gordon, a distinguished economist from Northwestern University, to the effect that in the U.S., growth has slowed dramatically since the period between 1920 and 1970 and still more since 2004 and that “the distribution of the gains has shifted away from those below the top 10 percent of the income distribution. This helps explain the increasingly fraught politics of the U.S. and other high-income countries,” like England. At the same time that growth is slowing, the growth rate for the bottom two-thirds of the populations has essentially fallen close to zero. It should be no wonder that there is frustration with the political system.

Both Britain and the U.S. need to get back into the game of establishing and enforcing realistic and appropriate rules for how our societies want capitalism to operate. They need to reaffirm that the charter for a firm comes from society and not just from shareholders.

As an example of the egregious way the supposedly level playing field has become imbalanced, in 1982, the U.S. Securities and Exchange Commission altered its regulations to allow firms to repurchase their own shares in a framework that invited abuse. Roughly 10 years ago, those purchases began to equal $300 billion to $400 billion per year; over a period of 30 years, the amount of stock taken out of circulation is approaching $10 trillion. Much of this should have been plowed back into new product development, research or employee training.

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Anglo-American capitalism is failing to generate additional income for any but the top 1 percent of the population, and capitalists are enriching themselves as in the 1920s. These issues need to be addressed directly through reforms in and to our capitalist systems and not just through more “responsible nationalism.”

It is a shame that there has been virtually no debate on how our capitalist systems are functioning with respect to societal welfare on either side of the Atlantic, and we should welcome the notion of a new British prime minister who thinks they might be important. It is a shame that there is so little evidence of real reflection on what might be needed to improve the U.S. system. Instead, both U.S. authorities and higher education seem narrowly focused on the need for more attention to English, math and science, while U.S. business schools focus on shareholder capitalism. U.S. academic leaders do not seem willing to recognize and take into consideration that there are other overarching factors at work, like democracy and capitalism and how they interact with each other.

In government, higher education and business, we badly need a renewal of ideas on how capitalism and democracy transform each other and what might be done to get them back on the track again. Capitalism is not a self-regulating system and never has been. It is a socially constructed system that needs regular attention by people who recognize that there is a critical role for government in modern societies to balance the playing field and to provide appropriate and competent regulation where it is needed. Indeed, there can be no capitalism at all without the involvement of government to shape appropriate market frameworks by, for example, abolishing the repurchase of stock in all but exceptional and infrequent circumstances.