Are CEOs and their golf buddies suppressing innovation and productivity in their effort to maximize shareholder value?

My father was a Wall Street investment banker in the 1950s and 1960s. His industries included steel, aluminum, automotive, and grocery-store chains. He was paid partially on the basis of his investment recommendations, regardless as to whether the investment committee accepted them or not. If his recommendations did well, he did well. He worked hard and often spent evenings and weekends with his long, yellow, legal pads working out mathematical calculations. Computers were not widely available back then. He earned a modest, but comfortable salary, that enabled him to send me in third grade and my sister off to summer camp and boarding school (and later to college and graduate school) when my mother came down with tuberculosis.

I learned to set my limit orders and stop-loss orders as the stock market opened and to expect a reasonable return on my investments. Back then, Wall Street was not a gambling casino. People were rewarded for their creativity, innovation and productivity. Unions represented 35 percent of the labor force. As output per labor hour rose with the introduction of automation, the real wages of employees rose correspondingly. Hard work paid off. The agency of employees as the heart and soul of a business was recognized. Their initiatives in improving product development, production, marketing, sales, and distribution were rewarded. Adam Smith’s invisible hand of competition seemed to be working well in producing better quality products at ever lower prices.

However, starting as early as the mid-1970s, the behavior of many corporations began to change. The “we’re all in this together” attitude coming out of World War II began to dissipate. Some firms began to treat employees as just another factor input like steel or plastic, as if they had no agency. The performance of the exceptions to this rule were striking. The employee-owned construction company Burns & McDonnell in Kansas City grew over the years from a small, local company to a nation-wide and, ultimately, a world-wide construction company. It was entirely employee owned. Its amazing success has been recounted by former B&M CEO Greg Graves in his recent book: “Create Amazing.”

Warren Buffett and others have noted the limited scope of understanding of some corporate boards of the company’s operations. Often board members get most, if not all, of their information about company operations from the CEO. Based on his experience on corporate boards, Steven Clifford has written the book: “The CEO Pay Machine” where he implies that board members are often basically the CEOs golf buddies. CEOs often serve on each other’s corporate boards. They may feel obligated to maximize the CEO’s compensation in return for his vote on their board to maximize theirs. Before 1982, stock buybacks were considered insider trading and were illegal. Starting in 1982 the Securities and Exchange Commission (SEC) began allowing stock buybacks, which are now frequently used to jack up the stock price at the corporate board’s discretion in controlling the amount and timing of such buybacks.

Following President Reagan’s firing of the 11,000 striking air traffic controllers and temporarily replacing them with military air traffic controllers on August 5, 1981 and barring them from ever working again for the federal government under the Taft-Hartley Act of 1947, unions began to lose their clout and have now dropped to less than 10 percent of the overall labor force, including just 6 percent of the private (non-government) labor force. Meanwhile, industries throughout the United States have become increasingly concentrated. Denise Hearn and Jonathan Tepper have carefully documented this rise in industrial concentration in their book: “The Myth of Capitalism,” which perhaps should have been titled: “The Myth of Competition.” Jan Eeckhout followed this with the book: “The Profit Paradox,” which documents the dramatic rise in market power both nationally and internationally. Patents have been extended way beyond the period needed to recoup the costs of investment. Patent trolls create nothing but file patents on some company’s unpatented processes and products to get them to settle out of court to avoid expensive court battles. Government regulations have been subject to regulatory capture where regulators develop close relationships with companies that are then able to twist regulations to block entry to their industry.

The collapse of anti-trust and effective market oversight has been rationalized on the basis on lower prices through economies of scale and network effects. While prices have fallen somewhat, they have not fallen as much as they would have in markets where corporate market power was not so strong. In effect, the benefits of economies of scale and network effects have been countered to a great extent by what might be called Adam Smith’s second invisible hand. Some free market enthusiasts have conveniently forgotten that Adam Smith said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick (sic), or in some contrivance to raise prices.” While Smith’s first invisible hand of competition lowers prices, his second invisible hand of collusion raises prices (or at least limits their fall under economies of scale).

I did not fully understand or appreciate the effect of market power until I read Simcha Barkai’s article “Declining Labor and Capital Shares” in The Journal of Finance (no. 75, issue 5, 2020). Barkai noted that over the period 1984 to 2014, while labor’s share of revenues dropped by 11 percent, the share of real capital dropped by 22 percent. It was only then that I realized that the money flowing to Wall Street was not primarily going into new investments in plant and equipment, but was being retained as profits and used primarily for dividends and share buybacks. Efforts to improve productivity through innovation has largely been replaced with financialization where cutting costs (including a drop in employee compensation in real terms) has taken precedent over efforts to create new and exciting products to grow the company. As a result, gross domestic product (GDP) has typically grown less than 2 percent a year, while the stock market has averaged an annual growth rate of about 10 percent in recent decades. Corporate boards are diverting money away from innovation, employee compensation, and better quality at lower prices for customers, in favor of maximizing shareholder value (as well as maximizing CEO and upper management pay).

Given all this, I should not have been surprised when an investment I had made back in the 1990s gave me a 7,000 percent return. I had forgotten about this investment and did absolutely nothing to help the company, other than loan them a bit of money. I thought that free enterprise was all about rewarding hard work and creativity. Why was so much of the money going to me? Oh, but the risk, the risk!!! Please, give me a break, what was I supposed to do with this extra money, other than invest it? Was the alternative for me to take the money home and hide it in my mattress? Sure, give me a decent return, but stop this insanity. A 7,000 percent return is way over the top. The rise in market power and the maximization of shareholder value is stifling our economy and hurting our country. Much of this money should have gone as incentives for rewarding employees for their creativity and hard work. Some should have allowed for providing customers with better quality products at lower prices as promised under Adam Smith’s first invisible hand.

Proposing solutions for all of these problems is way beyond the scope of this commentary. Clearly, government anti-trust procedures and the role of government regulators needs to be reexamined. However, I recommend a couple of simple solutions in the commentary below.

First of all, Germany has led the way in solving the problem of empowering and incentivizing employees in improving the productivity of their companies. In addition to work councils, Germany requires employee representation on corporate boards. We could greatly improve the performance of our companies while enhancing the compensation of employees and benefiting from their knowledge of company operations by requiring that 40 percent of all corporate board members be elected by rank and file employees. For larger companies, such representation could be distributed throughout the company by areas of operation such as representation from product development, production, sales, marketing, and distribution.

Finally, I recommend that the SEC rules be changed to require that all stock purchased in a company’s stock buybacks be distributed to the company’s employees based on their hard work, productivity, and tenure. This would block the manipulation of the stock’s market price and give employees more of a stake in the company. It would also help transform companies from a simple authoritarian command structure into more of a team of players focused on growing the company over the longer term.

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