Maximizing Shareholder Value Hurts the Free Market

When teaching economics, or almost any subject, we try to portray the material we are presenting as simple, logical, and straightforward. “Introductory Economics” is supposed to be just that => a clear and compelling presentation that makes sense. If we call it “Principles of Economics,” we want to present the ideas as truths that will hold in virtually every context and hold up over time. Students should not be surprised that beginning economics is presented as reflecting rational, independent decisions of self-interested individuals with foresight and reasonable and rational expectations. We want students to believe in the “laws” of economics that move us efficiently and effectively to an equilibrium solution where supply and demand meet at the equilibrium price and quantity.

But is this the real world? Is there just one price for gasoline that clears the market or is there a wide array of prices throughout the city? Are the interest rates for certificates of deposit of the same tenure the same for all of the banks in your area? Are we leading our students astray when we present such a nice, neat package of ideas portraying economics as driven by irrefutable forces that clear the market? What about contagion effects that drive irrational exuberance in the stock market driving stock prices higher and higher until reaching such unrealistic price-earnings ratios that they finally collapse in a “Minsky moment”? Do fear and uncertainty cause investors to sell their stock shares in a rush to the exits just as stock prices bottom out in a bear market? When housing prices collapse, do we try to blame all those NIJA (no income, no job, no assets) loans on the government or face the reality of short-term profit seeking overcoming longer-term rational judgement? What about the role of securitization? Don’t mortgage-backed securities encourage the transfer of risk from the banks that knowingly make risky loans because they know that they can quickly offload them to distant investors who are clueless?

After all, in 1994 two Nobel prize winning economists (Myron Scholes and Robert Merton) help found a hedge fund called Long Term Capital Management (LTCM) which ended in bankruptcy in 1998, because they assumed that markets that were out of equilibrium would return to equilibrium before too long. Too long turned out to be longer than they thought. Their leveraged position was so large and so untenable that it put the entire financial system into jeopardy. Ultimately LTCM had to be bailed out with the help of the government.

The idea that our economic system is all about rationality and about individuals fine tuning their optimal strategies to maximize their individual well-being can be very misleading and far from the real world. Perhaps we would be better served by the story of disequilibrium economics where our economy operates in a very precarious and unstable state with anti-equilibrium forces constantly fighting against and often overcoming equilibrium forces. Instead of economic paradigms that see an efficiently operating free market economy with only occasional disruptions requiring government intervention (Keynesian paradigm) or not (Austrian paradigm), we need to adopt the more realistic money flow paradigm that sees government with all its rules, regulations, taxes, and expenditures as the heart of the free market. Pretending that government is not needed (neoclassical paradigm) or should totally dominate every major economic decision (Marxian paradigm) does not provide us with a true path to the efficient allocation of resources, which, after all, is what economics is all about.

The money flow paradigm reveals the most disruptive and destructive force that is currently undermining the economic incentive structure and the efficient and effective allocation of resources in our economy. It is the short-term, narrowly focused excuse for suppressing the entrepreneurial spirit, denigrating product quality, and undermining employee incentives called “maximizing shareholder value.”

The great success of Apple, Inc. was not due to a short-term focus on maximizing shareholder value but instead due to the determination of the entrepreneur Steve Jobs to change the world by providing new and exciting products affordable for the average consumer. After starting Apple Computer with great success but eventually being talked into hiring a professional manager, Jobs was set aside for his failure to focus on maximizing shareholder value. He then set out on his own to create Pixar Animation. However, Apple did poorly under the maximizing shareholder value mandate, and Steve Jobs was brought back in to restore the mission of producing amazing products to change the world.

Another case that reveals the destructive nature of using financialization in a short-term effort to maximize shareholder value is the case of Saluto Pizza. The pizzas produced by the pizza business, Saluto Pizza, in Saint Joseph, Michigan, became so popular that the owner began freezing the pizzas for people to reheat and eat at home. Local supermarkets soon agreed to sell the Saluto pizzas. Saluto pizzas became widely available in the Midwest. In fact, they were so popular that Saluto Pizza opened a production plant in Montgomery, Alabama to serve the grocery stores in the South. Again, the pizza was very popular and sales were brisk. But then a large food conglomerate stepped in and bought up Saluto Pizza. In an effort to maximize shareholder value using the financialization strategy of cutting costs to maximize short-term profits, the crust, marinara sauce, and other ingredients were cheapened until sales of the pizza dropped precipitously and the production of the pizza was discontinued.

Many more stories of this sort as well as turnaround success stories when companies moved away from the narrow, short-sighted emphasis on maximizing shareholder value are told by Harvard Professor Rebecca Henderson (2020) in her book: “Reimaging Capitalism in a World on Fire.”

But the emphasis on maximizing shareholder value in adding to the inefficient allocation of resources and aiding the anti-equilibrium forces in our economy manifests itself in undermining employee incentives. Before the time of John Locke (1632-1704) the natural resources of the world were viewed as the property of God or, in the case of native Americans, the spirit world. But then Kings claimed to have been given dominion over the natural resources by God. You could not take fish from the stream or deer from the forest without permission from the King. But Locke introduced the idea of private property. Locke argued that people owned their own labor and that by imbuing their labor into natural resources they established their ownership of capital such as a wooden plow or a iron tool. Initially that worked well with craftsmen and craftswomen making their own capital equipment in the form of simple tools. In other words, capital was acquired by what we would call today “sweat equity.” Hard work paid off in establishing the ownership of capital.

However, eventually the needed capital equipment became bigger and more complicated such as a water wheel or a lathe, which then had to be provided under the auspices of the nobility. This intervention by the nobility separated the ownership of capital from the labor that used that capital. Today the incentive to work hard to acquire the right to capital ownership has been undercut by shifting financial rewards away from company employees in favor of maximizing shareholder value. You can drive a truck for a trucking company for thirty years and gain no ownership rights over that truck or in that company. You can work hard in a factory for many years with no corresponding acquisition of ownership rights through sweat equity.

There are exceptions. The construction company Burns & McDonnell in Kansas City has grown enormously by maintaining employee ownership where only the current employees own the company. Efforts to work together to produce better quality results for a wider array of customers worldwide has paid off big time for B&M. See the book by former B&M CEO Greg Graves (2021) called “Create Amazing.”

Other exceptions to the emphasis on maximizing shareholder value for distant, otherwise unassociated investors have provided further evidence of the benefits of rewarding employees. Treating employees as just factor inputs like steel or plastic does not recognize the agency of employees in determining the success or failure of the business. With over 80 percent of the stock market owned by the wealthiest 10 percent of Americans, the argument that investors need extraordinary profits to continue to invest is ludicrous. In reality, the richest Americans have so much money they have no idea what to do with it other than invest it. After all, you can only wear one pair of shoes at a time, or drive one car at a time, or go out to so many fancy restaurants in a given day. At some point, arguing that a wealthy investor is taking a big risk in investing a paltry $100,000 or so in a business is laughable. To the wealthiest investors losing or gaining $100,000 here and there is no big deal. It has no effect on their lifestyle in that their marginal propensity to consume out of each additional dollar earned is extremely low.

The most obvious and damaging effect of maximizing shareholder value is to divert the money flow in our economy away from the people actually producing and consuming products in the real economy to the increasingly separate financial economy. Sending so much money to Wall Street has left very little for the people on Main Street. Lots of money pouring into the New York financial markets drives down interest rates and drives up stock market prices. Instead of money, the people on Main Street are given an ever increasing number and array of credit cards. This just makes rich people richer and drives the people on Main Street deeper and deeper into debt. But even that private debt is not enough to enable employees to be able to buy back the value of what they are capable of producing at full employment. Consequently, to avoid recession the government steps in with deficit spending as carried out by both Republicans with unpaid for tax cuts and Democrats running up unpaid for expenditures to subsidize the people on Main Street.

What then is the solution to move us away from the maximization of shareholder value and CEO pay maximization? One answer used by Germany and some other countries is to require employee representatives on corporate boards. Replace some of the CEO’s golf buddies with representatives from and elected by the rank-and-file employees to make sure that employee ideas and compensation are given careful consideration at corporate board meetings. Perhaps as much as 40 percent of corporate boards should be elected by the company’s employees. This could be structured to distribute the employee representation around the different departments with a balance between representatives from engineering, operations, marketing, et cetera. Each division or aspect of the company would be represented by the rank-and-file employees who are on the front lines of carrying out that division’s mission.

Pretending that the free market can and should operate on its own is a total deception. The government is and should play a major role in appropriately guiding the free market. Government should be accepted as the heart of the free market. The question is not whether the government should be at the center of things, but how the government’s role should be adjusted to keep the free market working for everyone in efficiently allocating our nation’s resources.

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