GENERAL INTRODUCTION Financialization, coupon ...

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GENERAL INTRODUCTION Financialization, coupon pool and conjuncture 䊏

Ismail Erturk, Julie Froud, Sukhdev Johal, Adam Leaver and Karel Williams

the social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual private object of most skilled investment today is . . . to outwit the crowd. J. M. Keynes, The General Theory of Employment, Interest and Money (1936) the need for security is fundamental and almost the gravest indictment of our civilization is that the mass of mankind are without it. Property is one way of organizing it . . . In fact, however, property is not the only method of assuring the future. R. H. Tawney, The Acquisitive Society (1923) T I S H A R D T O I G N O R E or escape finance.1 As citizens, we received multiple

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(unsolicited) offers of loans through the post or tips for buying company shares by email. The movement of financial markets is increasingly seen as a barometer of the state of the economy and the quality of economic management, while news of corporate performance, takeover bids, demerger decisions and executive pay frequently makes newspaper front pages as well as filling whole sections of quality broadsheet newspapers. If finance is everywhere, does this mean that we have, in some sense, become financialized? In the 1980s and 1990s, journalists, academics, business and politicians used globalization to connote a meaningful change in the way that we as citizens, consumers and employees connect to the rest of the world. Commentators and analysts did not always mean the same thing when they used the word globalization and, even more so, if there have been deeply divided views about winner and losers in the process; but the idea has been powerful because many believe it captures something about how our world is changing. In the 1990s and 2000s, academics have begun to explore the idea of financialization and the ways that finance seems to have become more important. As the new term passes into general use in academia, politics, and business, it is a good time to explore not only what is new about finance, but also what is old. How do we understand the significance of finance for households

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general introduction

and businesses and how do the motives and operations of finance in its various forms create problems and opportunities? Finance rather confusingly connects with long-term issues and medium-term outcomes as well as rapid conjunctural changes and multiple discrepancies in presentday capitalism. The opening quotations from Keynes and Tawney remind us that the influence of finance in our own time raises issues which have been actively debated by the centre-left for nearly a hundred years. Do financial markets serve or frustrate the social purpose of physical investment in appropriate technologies?; and is ‘property’ (or what we now call long-term saving through the financial markets) a credible way of achieving security for the mass of the population? But the story is not all deja vu because finance in the present day is also associated with different medium-term outcomes in the form of new inequalities. In the advanced countries, long-term trends towards greater income equality have ended since the early 1980s while the trend has been reversed in countries like the US and UK which are returning to pre-1918 levels of income inequality with a new group of the working rich occupying the place of the Edwardian rentier class. Finance is implicated in this outcome of the period since the 1980s because financial intermediaries like bankers and fund managers are the leading element in the new group of the working rich. A different kind of excitement is bound up with the leading role of finance in rapid conjunctural change every five or seven years. These transitions are now supported by grand narratives and performances that are just as quickly discredited and discarded in present-day capitalism. Consider, for example, the decade from the mid1990s to the around 2005. This begins with the successful initial public offering (IPO) of Netscape in 1995 when US investors bought into a company without a profit history. The decade ends with the Northern Rock bank run in 2007, when UK savers panicked about a bank which had been borrowing short in the money markets to finance long-term mortgage lending. Exuberant rhetoric about the New Economy as a new economic paradigm based on the internet and falling costs of information fuelled a boom in new issues and tech stock prices until the 2000 crash. The US policy response to that crash then inflated a credit bubble which was legitimized through a new rhetoric about the marketization of risk, where banks which sold loans on were supposedly dispersing risk and strengthening the system; at least that was so until confidence failed amidst paralysing uncertainty about which banks held bad loans from the US sub prime mortgage market. Equally striking and puzzling are the multiplying inconsistencies and discrepancies around the requirements of finance within and between successive conjunctures. Consider ‘shareholder value’ or the demand that giant public companies deliver value for shareholders through increased profits and higher share prices. Shareholder value has survived as a motif since the early 1990s because its meaning is inconsistent and mutable. Thus, in the second half of the 1990s, established old-economy giant companies were pressured for higher profits, and specifically to deliver a return on capital over and above its imputed cost; meanwhile, new economy companies like Amazon sustained high share prices without current profits or even business models for cost recovery. Shareholder value has also been effectively redefined over time as the conjuncture changes. The early 1990s emphasis on a stream of value creation from

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operations had become much less important a decade later when activist investors and hedge fund managers were operating with a point concept of value crystallization, where value is delivered by the movement in share price that follows the next strategic move. Against this background, if the aim is to construct a concept and analysis of financialization, we find ourselves like medical doctors trying to make sense of presented symptoms and episodes which are bewilderingly diverse and beyond the expertise of any one specialism. Certainly, the relevant discursive specialisms are all challenged by the role of finance. Thus we need historical analysis which focuses on something between the history of the long run and the history of events; while recognizing that, in a finance-led economy, the duration of the conjuncture is much shorter than the several decades, which Braudel (1982, p. 27) assumed. Equally, we need political economy or non-mainstream economics to analyze the quantities, relations, and structures which establish the difference of present day capitalism, while recognizing that none of this meets the Regulation Theory expectations about the restoration of coherence around one dominant logic. Finally, we would also need cultural economy to help us understand how discourse formats the economy, which is itself partly a performance, while also recognizing the limited formatting power of discourse in a half-understood world. How then can we find a pattern or process which justifies the use of a new term ‘financialization’? We start from the position that no one discourse could or should exclude the others. Hence, the idea of a reader which combines key texts from different problematics with extended commentary from our own distinct position. Within this reader, our introduction aims to address two questions: the formal analytic question ‘what is financialization?’ and the more descriptive question ‘how does finance matter in present-day capitalism?’ The second half of this general introduction is analytic partly because it proposes our own conjunctural definition of financialization in a coupon pool frame. Just as important, the second half of this general introduction explains how the reader is divided into four discursive sections drawing on historical texts, mainstream finance, political economy, and cultural economy, which all operate with different working definitions of financialization deployed in the fifth section which covers the debate on financialized management. The first half of this introduction offers a more descriptive account of how finance matters in present day capitalism. We do not presume that description is in some way innocent because all description rests on preconception (even if it avoids the formal a priori of theory). But, description is both more accessible and supplies an incentive to persevere with the more difficult conceptual material which follows.

How does finance matter? Descriptive frame and some prehistory from the 1960s and 1970s How does finance matter? The descriptive answer depends on period and historical context as much as on our preconceptions. Since the 1970s, finance matters because

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the experience of individual subjects and the trajectory of the macro-economy are both increasingly mediated by new relations with financial markets. At least this is so if we focus on describing financial innovation. As section 3 outlines, innovation figures as one of the two main political economy perspectives on financialization, but description is different because it can start by bracketing big theoretical questions about the nature and role of innovation in a putative financialization process. Our descriptive account uses empirics mainly on the USA and UK but also adds relevant empirics on continental European countries so as to make the point that many of the broader changes described below are relevant to countries which are typically not classified under the rubrics of stock market or pension fund capitalism. We do not discuss Japan, which represents a different trajectory because the collapse of share and property prices at the end of the Hesei boom in 1991 was followed by chronic depression for much of the rest of the decade. If what happened everywhere after the 1970s was new and different, these changes did not come out of nothing because they had a euphoric Anglo-Saxon prehistory in the 1950s and 1960s, when finance (within the post-war settlement) delivered on its promise of long-term security and capital gains for increasing numbers. The basis for a new connection between finance and the financialized masses was established in two ways during the long boom of the 1950s and 1960s in the UK and USA: first, by the growth of company pensions increasingly invested in ordinary shares by intermediary fund managers; and second, via the growth of home ownership. Between 1953 and 1967, the number of UK employees covered by occupational pensions more than doubled from 3.1 to 8.1 million workers (Government Actuary’s Department 2006, p. 33). While in the US occupational pension schemes expanded rapidly after the establishment of the 1935 Old Age Insurance system, so that by the 1980s 45 per cent of all US workers were covered by some form of private pension (Arza and Johnson 2004, p. 22).2 Increasingly, these UK and US institutional investment funds were invested in equities or the ordinary shares of public companies and initially in the shares of domestic companies (not bonds) and this pattern continued into the 1990s. By the end of the 1990s, 52 per cent of all UK pension fund assets were held in domestic equities (Davis and Steil 2001) and, by 2005, 54.6 per cent of US institutional investment fund assets were in shares and other equity (OECD Institutional Investor Assets Dataset). Equally striking was the growth of home ownership during the long boom of the 1950s and 1960s so that the US and UK ended up with owner occupancy rates of nearly 70 per cent. These developments established new international differences about the forms of long-term household saving and asset holding because home ownership was generally somewhat lower outside the Anglo-American countries and funded pension saving was quite negligible in many European countries. The accumulated value of pension funds by the 2000s is almost as much as GDP in the US and around two-thirds of GDP in the UK but only 5 per cent or less in France, Italy, and Germany (OECD Global Pensions Statistics). We should not, however, make too much of this point because, as we will note later, there was a general tendency in mainland Europe in the 1980s and 1990s for household savers to switch from bank deposits and government

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bonds into riskier assets whose value could go up or down. As Figure 1 shows, if we compare, not pension assets to GDP, but the ratio of all investment fund assets (i.e. pension, insurance and mutual funds) to GDP, it is notable that French households had a sum larger than 150 per cent of GDP invested in insurance assets and mutual funds which both held large amounts of equity. Even in Germany, investment funds were equivalent to more than 50 per cent of GDP in 2005. Up to and beyond the 1970s, it was the rewards (not the risk) of funded pensions and home ownership which were palpable in the USA and the UK. Post-war companies and public employers offered defined benefit (DB) pensions which were inflation proofed and linked to final salary. Public companies took their social obligations seriously so that, after the stock market crashed in the 1970s, UK companies topped up pensions from current profits (Davis 2004, p. 14), in marked contrast with giant company responses after the 2000 stock market crash.3 As for home ownership, that was a one-way bet in the 1960s and 1970s for those who bought appreciating house property with depreciating money in an inflationary age with limited downswings in asset prices. As Figure 2 shows, UK nominal house prices went up unsteadily but continuously through the 1970s and 1980s. The first negative equity problems (about houses being currently worth less than the householder owes on a mortgage) did not come until the early 1990s, after which nominal house prices stagnated into the mid-1990s before taking off again into the new century.4 Before continuing this history of household gains and losses, let us now turn to the wholesale and retail innovations, like securitization and credit scoring, which separate the post-1980s period. More than any other sector, finance exploited digital technologies and the falling costs of information to transform the supply side.

Figure 1 Funds under investment compared with GDP, 2005 Source: Adapted from IFSL (2007d, p. 5); estimates based on Watson Wyatt, Bridgewell, Merrill Lynch, ICI, SwissRe and OECD data.

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Figure 2 Average house prices in the UK, 1971–2007 Source: Adapted from Financial Times, ‘House Price Index’, http://www.acadametrics.co.uk/ ftHousePrice.php

Wholesale and retail innovation: ‘marketization of risk’ and manufacture of uncertainty Since the 1970s there has been a period of unprecedented parallel innovation in the wholesale markets and retail finance. In shock and awe terms, this is above all epitomized by the growth of the new instruments called derivatives from nothing in the late 1970s to a value of more than $415 trillion in terms of amounts outstanding by 2006 (Bank for International Settlements, Quarterly Report July 2007). ‘Amounts outstanding’ is the standard industry measure of the size of the derivatives market, which represents the gross nominal or notional value of all deals concluded and not yet settled at the reporting date. In the 1970s, when the business press wrote of the financial markets they generally meant the markets in two kinds of coupon, public company ordinary shares and government bonds. But things have since changed quite dramatically. As the McKinsey Global Institute’s (2007) calculations show in Figure 3, the value of equity securities varies with long swings in equity prices but the asset value of the new instruments (here classified under private debt securities and valued in relation to world GDP) is often not much behind that of equity securities and always much larger than the value of government bonds. The global innovation in wholesale money markets centered on derivatives. Technically, derivatives are instruments (options, swaps, futures, forwards) whose price depends on something else, which could be the value of a physical commodity, a coupon like a share or bond, or a financial ratio like an interest or exchange rate. After the breakdown of the Bretton Woods fixed exchange rate system, derivatives grew rapidly in the foreign exchange markets and then spread to almost everything else on which it was possible for traders to write a future contract. This created a

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Figure 3 The value of global financial assets by type, 1980–2005 Source: Adapted from McKinsey Global Institute (2007, p. 8).

Figure 4 The value of global derivatives traded: ‘over the counter’ (OTC) and exchange traded contracts, 1998–2006 Source: Adapted from BIS Quarterly Review, June 2007. Note: Data refers to amounts outstanding in December.

bewildering variety of new instruments including many of which were not exchange traded, but traded in a variety of other ways, including on a partner-to-partner basis between banks acting for corporate clients or as principals. As Figure 4 shows, most of the growth has come from over-the-counter (OTC) derivatives (contracts privately traded between two parties), rather than derivatives traded on open exchanges like the Eurex or Chicago Mercantile Exchange. The growth in partner-to-partner transactions is driven by interest rate contracts, primarily swaps, which according to the Bank for International Settlements in

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December 2006, accounted for 86 per cent of all OTC amounts outstanding. In a typical interest rate swap, one party would pay a fixed interest rate and the other would pay a floating rate. Figure 5 illustrates the trends for all the major categories of derivative and shows that, in terms of amounts outstanding, interest rate swap values grew 309 per cent between June 1998 and December 2006. As with the growth in foreign-exchange-derivatives, this recent growth in swap volumes represents speculative trading and arbitrage rather than any primary requirement to hedge against exposure to the business risk of interest-rate fluctuation.5 Another component of financial innovation from the early 1980s was securitization, which is perhaps best thought of as old fashioned factoring of invoices turned into a (secondary) coupon business in receivables because, in both cases, what is due but not yet collectable (i.e. a business’ receivables) can be sold at a discount. Thus banks which made mortgage loans or car firms financing car purchase could sell pools of loans which investors could buy in the form of securities collateralized (securitized) on the underlying pool and income stream.6 This was attractive for the originators because banks could lend, sell on their receivables, and lend again without being limited by deposits and their balance sheet. Lenders like auto assemblers with captive credit companies could also escape their often flaky credit ratings because their securitized loans were rated according to the solidity of their customers, not the fragility of their company profits. These innovations in the wholesale markets were arcane. Only market insiders properly understood basic business categories like ‘structured finance’ for securitization, involving the use of finite life special-purpose vehicles or procedures like

Figure 5 Composition of OTC traded derivatives, 1998–2006 Source: Adapted from BIS Quarterly Review, June 2007. Note: Data refers to amounts outstanding in December.

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‘tranching’ for sliced and diced risk, and claims between different coupons and investor groups with benefits for pooled average ratings. But this was everywhere a fast growing business which, as Table 1 shows, became a massive business in the United States where the annual value of securitization issuance was more than $3 trillion in 2006 and the value outstanding at year end was more than $8 trillion. Securitization removed many of the old constraints and inhibitions on lending insofar as the original lender could create credit and pass the loan thereby avoiding risk of future default. The parallel retail revolution did involve changes in everyday life which materialized above all in the altered layout of bank branches in all the advanced countries. Bank branches of the 1970s were dominated by the long counter across which money was paid in and out by bank clerks, while the manager in a side office made decisions about lending to households and businesses. In the 2000s bank branches are dominated by the cubicles and work stations where advisers sell financial service products like mortgages and pensions; while decisions about personal loans are made over the phone in minutes by junior call-centre staff using impersonal criteria. The old practices were part of an administered system of government managed credit rationing which in the UK and USA promoted periodic physical restrictions and no competition between lenders on price. The new practices represented marketing-led corporate policies of credit saturation through proliferation of products and confusion pricing on personal loans with ‘payments protection’ and credit card balance transfer deals, aided by the development and spread of credit rating technologies (Leyshon and Thrift 1999). If we consider revolving debt, i.e. loans and card balances outstanding (excluding the much larger debts incurred for house purchase), the totals have increased sharply in all advanced countries. In the UK, for example, after a six-fold increase in the decade up to 2004, the average amount outstanding on Visa and Mastercard credit cards in the UK has stabilized at about £1,000 per head of population (British Bankers’ Association). Figure 6 shows how credit card debt is a relatively small

Table 1 Annual value of securitization issues, 1996–2006 ($ billion)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

US

Europe

Australia

Japan

685.4 884.5 1,465.2 1,355.4 1,058.5 2,054.5 2,688.1 3,656.1 2,664.1 3,138.5 3,187.4

38.0 48.0 38.0 75.0 71.2 136.6 151.1 247.5 303.2 407.1 576.5

5.9 14.2 13.4 21.2 34.8 56.7 64.4 78.6 87.4 73.8 101.6

— — — 17.6 22.3 28.8 39.1 32.8 50.9 80.8 86.0

Source: Adapted from IFSL (2007a, p. 1).

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Figure 6 Outstanding UK consumer debt, 1987–2007 Source: Adapted from Office for National Statistics.

proportion of all consumer (non-secured) debt in the UK, which had reached over £200 billion by the mid-2000s, or nearly £4,000 per head of population, with noncredit card debt rising sharply through the 1990s. Credit card debts and unsecured loans are, of course, very unequally distributed so that some sections of the UK population (like young workers who have recently graduated from university) are typically significantly indebted, even before house purchase which, as we shall see later, creates more problems.

Banks and stock market: continuous reinvention In the late 1990s and early 2000s, in academic debates about national varieties of capitalism it was conventional to distinguish between stock market-based AngloSaxon economies and bank-based mainland European countries. This rather missed the point that the changed practices in wholesale markets and retail marketing meant that the institutions called ‘bank’ and ‘stock market’ were everywhere being reinvented through continuing processes with major outcomes. The traditional role of banks as intermediaries between deposits and borrowers was completely transformed by the changes in wholesale and retail practice. In the decade after the mid-1990s, investment banks like Goldman Sachs became proprietary traders on their own account in the wholesale markets, with merger and acquisition (M&A) advice and corporate services much less important as sources of income. At the same time, the high street banks from the 1980s became mass retailers who earned fees by selling products (not to firms but) to households, which typically accounted for more than half of borrowing. In both cases, the idea of banks as intermediaries who appraised risk and held it on their balance sheets became obsolete: first, because retail banks could pass it on through securitizing bundles of loans; and, second, because investment banks as proprietary traders were not holding risk but taking often leveraged positions on risk or other peoples’ views of risk. As

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Erturk and Solari (2007) have argued, these reinventions were important everywhere, not just in the Anglo-Saxon countries: Table 2 demonstrates the extent of the change as interest income from the spread on old-style intermediation declined relatively and the share of fee-based (non-interest) income increased. The reinvention of the stock market was a much more public affair driven by changes in the personality of the investor. The idea of an institutional investor had historically been tied up with long-term shareholding and patient support for management, epitomized above all by German bank and insurance company holdings and board representation which effectively could not be unwound until legal and tax changes in 2000.7 But the US and UK fund managers investing mass savings were by the mid-1990s rewarded for short-term performance, increasingly articulate about their requirements for ‘shareholder value’ and prepared to trade more aggressively, even if it proved more difficult for public companies to deliver shareholder value than to talk about it. If shareholder value meant different things to various parties, the possibility of corporate resistance was undermined when corporate governance in all the high-income countries after the Cadbury Report of 1992 required boards to ensure managers delivered value. Furthermore, shareholder activism and voice were not achieved states but behavioral trends, as by the mid-2000s activist investors increasingly harassed corporate managements across Europe as well as America while hedge funds institutionalized short-term position taking in takeover struggles, as when they blocked the Deutsche Börse takeover of London Stock Exchange in 2005 (New York Times, March 8, 2005).8 While the new kinds of articulacy and activism originated in the USA and UK, they spread elsewhere as US fund managers bought into other stock markets so that, for example, in France by the mid-2000s, foreign (mainly US) funds owned 45 per cent of the equity of CAC 40 companies. When the Europeans began to debate the (mainly unwelcome) spread of shareholder value in the late 1990s, it was against the background of a decade-long bull market in all the high-income countries except Japan. The rising equity market had Table 2 Non-interest income of credit institutions as a share of total income, 1984–2003 (%)

1984 1990 1995 2000 2003

France

Germany

Italy

Netherlands

UK

USA

Simple average

n.a. 22.6 45.5 60.9 56.7

18.0 26.8 21.0 35.8 27.1

24.6 22.0 19.8 36.1 30.2

24.7 28.4 33.3 47.0 39.2

35.6 38.7 42.7 43.2 46.4

25.5 28.6 32.9 44.3 40.7

25.5 28.6 32.9 44.3 40.7

Source: Adapted from OECD Bank Profitability Statistics, http://www.oecd.org/statspotal/. Note: The table shows the share of non-interest income in total net income (interest and non-interest income) of all financial institutions – excluding the Central Bank – and their main legal categories. This covers commercial banks, co-operative banks, savings banks, municipal financial institutions, finance companies and specialised financial institutions. The UK and USA data is for commercial banks only.

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encouraged the spread of (exceedingly optimistic) rhetorics in the US about ‘market democracy’ (Frank 2002), which suggested that the publicly visible aspects of change were democratizing hitherto elitist financial institutions and could help ordinary individuals realize their ambitions. Things looked rather different after the tech stock crash in spring 2000 inaugurated a two-year bear market which provoked US and UK giant firms into limiting defined benefit pension commitments. Meanwhile the failure of Enron and World Com exposed greed and fraud on Wall Street as much as inside the corporations. However, none of this represented an end to the growth of ‘finance’, merely the start of a new phase. The US Federal Reserve’s policy response of cutting interest rates fed a credit bubble which, combined with excess liquidity from various kinds of investment funds, empowered hedge funds and private equity until the credit crunch of summer 2007. As Table 3 shows, the number of hedge funds nearly tripled over the ten years from 1996, while the value of their assets increased ten fold. Private equity funds show more cyclicality with a downturn in the early 2000s, but by 2006 the value of both funds raised and funds invested was well above the previous peak of 2000.

Economic uncertainty and instability: when bubbles burst As we argue below, wholesale and retail innovation plus the reinvention of bank and stock market all matters because these innovations have three major outcomes: first, they create new uncertainties and risks of economic instability and turn down; while, second, feeding individual insecurity; at the same time as, third, they have certainly increased inequality. Table 3 The scale of global hedge funds and private equity funds, 1996–2006

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Hedge funds

Private equity

Funds (No.)

Hedge fund assets ($ billions)

Funds raised ($ billions)

Private equity investments ($ billions)

3,000 3,200 3,500 4,000 4,800 5,500 5,700 7,000 8,050 8,500 8,900

130 210 221 324 408 564 592 795 1,000 1,130 1,500

— 108 133 154 262 177 93 88 133 272 335

— 59 70 124 192 103 86 115 110 136 364

Source: Adapted from IFSL (2007b, p. 1 and 2007c, p. 1). Note: Private equity investment refers to equity value of investment not cost acquisitions, which is typically 70% higher because acquisitions are highly leveraged.

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In discussing economic instability we should begin by noting that many current problems in the international economic order did not originate with finance. The financial markets are not responsible for the trade surpluses of low-wage Asian manufacturers or Middle Eastern oil producers, which arise from free trade with huge dollar wage differentials or the resource profligacy that creates energy shortage.9 (The markets have, of course, made a profitable business out of financing the US trade deficit and recycling everybody else’s surplus.) Nor do we wish to write a history of recent financial crises and add to the huge literature on the Asian financial crisis of 1997, or the specialist sources on the Russian bond default of 1998, or the Argentine crisis of 2001. Instead, we wish to argue the case that innovation in the wholesale markets has increased the risk of economic fluctuations and downturn and created new uncertainties. This can be done by briefly considering the dramatic failure of the LTCM hedge fund in 1998 and the global credit crunch of 2007. The first consequence of wholesale market innovation was a new role for energetic ‘financial engineers’ and ‘quants’ with mathematical capability and training in mainstream finance theory but limited imagination about what was outside their models. These financial engineers could devise theoretical models that materialized as products and trading strategies in a world where innovation could then make the world more like finance theory. The classic example of this is the Black–Scholes model of 1973 for valuing options; after Chicago traders adopted the model in their trading, options prices converged on the theoretical prediction (as the extract from MacKenzie and Millo (2003) in section 4 shows). But the world is not for long controlled by practice based on the a priori of theoretical finance models. Consider the case of Long Term Capital Management (LTCM), a heavily leveraged hedge fund which lost nearly $5 billion in 1998. The fund’s board included Myron Scholes and Robert Merton who one year previously had been awarded the Nobel Prize for their role in originating the Black–Scholes model (Lowenstein 2000). LTCM had diverse technical trading strategies in different coupons including government bonds and US stocks. Its losses were incurred because LTCM was heavily leveraged and did not anticipate that, in any serious turbulence, all or most asset classes would move down in the same way; or that illiquidity and flight to quality would quickly become a problem away from the main markets. The effects of such events can nevertheless be salutary because human subjects have the reflexive capacity to trade on suspicions, information, and relations which are outside the model. The point is proved by the shift in Chicago options prices after the unexpected (and never adequately explained) stock market crash in October 1987, which knocked 20 per cent off the value of the Dow Jones Index in less than a fortnight. As MacKenzie and Millo argue, the result was a permanent deviation of prices from the Black–Scholes predictions because traders factored in the possibility of an event which was not in the model. If traders can learn and computers can be reprogrammed, the more serious structural problem about derivatives and securitization is that the marketization of risk and the manufacture of uncertainty are two aspects or phases of the same process. In distinguishing between risk and uncertainty, we follow the distinction

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enunciated by Knight (1921), conserved by Keynes, and more recently generally lost to sight.10 Risk is the measurable and calculable probability of gain or loss, as in a casino where the odds are set by the house; or more contentiously in finance theory where risk in coupon markets is defined as volatility or the standard deviation of the historical returns in a specific investment. Uncertainty is the unmeasurable other of risk involving, for example, disruptive, unprecedented major events like the outbreak of World War Two in 1914 or the global stock market crash of 1987. The market participants in derivatives and securitization understood what they were doing as the so-called ‘marketization of risk’, where the new game was not to hold risk but to pass it on, not once, but many times in ways which created new trading opportunities. With derivatives the markets escaped one-on-one correspondence between the physical transaction, like exporting a car from Germany to the USA, or a single hedge on the dollar/euro exchange rate because it was possible to tier option upon option in ways that created new trading opportunities. With securitization and tranching, the result was long chains of risk passing so that no one knew who was ultimately holding the risk. Significantly, the British Financial Services Authority (FSA) admitted in 2006 that it had difficulty establishing who was holding the debt issued to fund private equity buy outs (FSA 2006). The standard defensive response was that all this made the system more robust because risk was dispersed, though ‘risk management’ is often a rhetoric as much as a set of technical practices (de Goede 2004). But the credit crunch of 2007 showed that the profitable marketization of risk on the upswing of the credit cycle inexorably becomes the debilitating manufacture of uncertainty as soon as confidence falters. The immediate European problem in summer 2007 was illiquidity in the inter-bank market where banks were fearful of lending to each other because nobody knew from the outside (or indeed could calculate on the inside when securities were completely unsaleable) which banks were holding losses in their balance sheets. The irony was that the cause of the problem was the US sub-prime mortgage business, which accounted for a relatively small parcel of derivatives but generated massive uncertainty when nobody knew who was holding that parcel of debt. While all these processes and outcomes are confined to the financial markets, the risk is of economic downturn in output and employment levels unless policy responses are prompt and effective. The standard policy response of modestly varying interest rates is likely to be ineffective against large swings in sentiment and is irrelevant if the problem is liquidity and confidence about bad loans or bad paper after an asset price bubble bursts. Japan after the end of the Hesei boom in 1991 provides a textbook case of the inhibiting effects of depressed asset prices and bad loans on stocks and property, as well as of the limited positive effects of low rates of interest plus Keynesian deficits in stimulating consumer demand when asset prices are falling. The warning was ignored in the other advanced countries as they lived through two asset price bubbles in shares up to 2000 and in property afterwards.

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Individual insecurity: pension funds, house prices and risky assets If financial innovation in the wholesale markets increases the risk of macro-economic instability, the closer connection of the masses with retail finance does not reliably generate security for the individual through funded pensions and home ownership. Of course, the form of pension provision and the extent of home ownership differ considerably between various advanced countries but it is possible in both these cases to construct a general argument while noting exceptions and national peculiarities. Arguments about the financial logic of funded retirement saving must rest mainly on evidence on the UK, USA, and Australia, countries where private pensions account for 70 per cent or more of public pension expenditure. Here, those who want a comfortable retirement must save from income to put into some kind of fund (individual or group) which has generally been invested in the stock markets and then drawn down in retirement. Elsewhere, many mainland European countries have maintained systems of public earnings-related social insurance which are irrelevant in the USA, which has never had social insurance, and in the UK, where the Beveridgean social insurance principle of a low flat rate has never been effectively supplanted. If we consider the simplest case of saving in an individual fund, the fundamental limits are set by the long-run returns on stock market investment and the level of current income, which determines the limits of voluntary contribution, while timing of entry to and exit from funds is also crucial. The evidence on long-run stock market returns is sobering in the UK and USA. Table 4 presents evidence on the UK from the Barclays (2007) Equity Gilt Study which shows that, with all dividends reinvested, the long-term real return on equities since 1900 is 5.3 per cent (and the nominal return is under 10 per cent). If returns are much higher or lower in various decade long sub-periods (or in particular years like 2006), that reflects the alternation of bull and bear markets illustrated in Figure 7. The actual return from long-run investment in equities therefore depends on the timing of exit which adds another element of lottery because most of those who retire have traditionally had very little choice about postponing retirement. If long-term returns on equity investment are modest and variable, the other pressing constraint is individual income levels for much of the population. This point can most easily be demonstrated by considering household income, while remembering that many households include more than one wage earner. In 2005/6 the UK

Table 4 Real annual investment returns by asset class: average annual returns p.a. (%)

Return in 2006 Return over last 10 years Return over last 20 years Return over last 50 years Return over 107 years

Equities

Gilts

Corporate bonds

Index linked

Cash

11.4 4.9 6.9 7.1 5.3

−4.4 4.6 5.6 2.2 1.1

−4.5 6.7 — — —

−2.1 4.5 4.5 — —

0.4 2.6 3.7 2.0 1.0

Source: Adapted from Barclays Capital (2007) Equity Gilt Study, Table 54.

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Figure 7 Major stock market indices, 1987–2007 Source: Adapted from Thomson One Banker Database.

median household disposable income before housing costs was just £18,824 and US median household income was just $46,325,11 with half of UK or US households having incomes below this level. Increasingly, those who make modest contributions out of limited incomes cannot realistically expect that the final, money value of their pension fund will be topped up by an employer. US and UK employers are retreating from their role as underwriters of defined benefit (DB) schemes which related pensions to final salary and increasingly substituting defined contribution (DC) schemes for new employees which typically involve lower levels of employer contribution and commitment. The general story is that blue-chip corporate employers enjoyed pension contribution holidays in the 1990s when share prices rose in the decade-long bull market, but when the stock markets turned down after 2000 giant corporations quickly joined the scramble to limit their obligations to top up DB schemes. By 2003, nearly two-thirds of UK DB schemes were closed to new members and DC membership was increasing from a small base (Langley 2004). In the USA, the number of workers enrolled in DC schemes increased from just 7 million in 1987 to 42 million in 2002 (Dawson 2002) and, as Table 5 shows, the DC share of pension assets has over the same 20-year period increased to more than 60 per cent by 2005. It is possible to increase pension benefits paid out by reducing administrative expense, mandating compulsory contributions and raising the retirement age. But the arithmetic of funded saving in the UK or USA does not add up to comfortable retirements for those in the bottom half of the income distribution who must now look forward to the dis-invention of retirement in the next generation. If many individuals are going to be left on their own with an inadequate fund in retirement, their dependence on gains in house prices becomes more important. As Figure 8 shows, the

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Table 5 The value and type of US private pension fund assets, 1985–2005

1985 1990 1995 2000 2005

Financial assets ($bn)

Of which invested in Defined benefit schemes (%)

Defined contribution schemes (%)

1,226 1,627 2,889 4,355 4,613

64.9 55.3 50.6 43.9 38.3

35.1 44.7 49.4 56.1 61.7

Source: Adapted from Financial Services Factbook, 2006, Insurance Information Institute, New York.

Figure 8 The significance of owner occupation of domestic dwellings Source: Adapted from EMF Eurostat, cited in Deutsche Bank Research, 11 October 2006, ‘US house prices declining: is Europe next?’, http://www.dbresearch.com/PROD/DBR_ INTERNET_EN-PROD/PROD0000000000203236.pdf and Current Population Survey/Housing Vacancy Survey, Series H-111 Reports, Bureau of the Census, Washington, DC, 20233.

variations in the extent of home ownership are quite unlike those in pensions. The stand out major country here is Germany, though home ownership rates in France, Denmark, and the Netherlands are still less than those in Spain, Ireland, or the UK. The problem here is not the level of home ownership in the Anglo-Saxon countries but the coupling of home ownership with a decade of rising house prices after the mid-1990s, which encouraged the unreal expectation that house prices would continue to rise in this way. In an Australian survey by the ANZ bank in 2003 (p. 52) only 12 per cent of respondents were prepared to accept the possibility that the market values of house property could fall. Such unreal expectations were institutionalized by the increasing popularity of the interest-only mortgage in

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countries like the UK which, by 2006, accounted for 26 per cent of mortgage broker business (homemove.co.uk) and the mortgage was here in effect not a means of buying the house but a bet on further house price rises. The continuing rise of house prices meanwhile created exclusion problems as young buyers were priced out of the market and lower-income groups made sacrifices to get onto the housing ladder: the Department for Work and Pensions Family Resources Survey in the UK suggests that households with a disposable income (after tax and social insurance) of less than £1,000 a month spend 39 per cent of that income on mortgage payments. Lower interest rates and imprudent lending permitted the bidding-up of prices. While, as noted above, the rising property market creates problems for lower income households who spend a significant share of disposable income on housing, there is a question as to whether rising household indebtedness matters if, at the same time, households have an appreciating property asset in their balance sheet.12 As Table 6 shows, housing is the driver on both sides of the asset and liability equation: around 75 per cent of household debt is incurred as mortgages in the UK and USA and nonfinancial assets, mainly housing and land, show a sustained increase in value which is greater than that for financial assets. The significance of mortgage liabilities emerges starkly because the value of house assets can go down as well as up whereas the commitments to make mortgage repayments are fixed or increasing if interest rates rise from the historically low level of the 2000s. In earlier forms of discourse about national varieties of capitalism, the difference between European economies was often established by presenting a table of the national equity market in relation to GDP, but this gives a very limited view of the extent of changes across all the high-income countries. The argument so far in this section brings out some of the similarites between European national economies, and we can underline this by presenting a table on the growing importance of ‘risky assets’ in household financial portfolios (Table 7). This table shows that the value of ‘safe assets’ (i.e. cash and government bonds) has not declined since the early 1980s but rather, as portfolios have increased, households in France, Germany, and Italy have held a greater proportion of their total portfolio in risky (increasingly intermediated) assets whose value can go up or down. By the early 2000s, the three mainland countries were holding 60 to 70 per cent of their portfolio in risky assets, which is where the UK started from in 1987.

Financialized masses, intermediary elites and the rise of the working rich Structural problems were sidestepped in official discourses by focusing on corporate governance and financial literacy as remedies which could improve the behaviors of key actors who are generally not up to the job that they are apparently required to do if the retail and wholesale markets are to operate smoothly (Froud et al. 2007). Surveys in many Anglo-Saxon countries in the second half of the 1990s diagnosed a problem about financial literacy that could apparently be solved by increased amounts of financial education, which would build capability in the masses in purchasing financial services products. In a similar way, the challenge of the

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Table 6 Household wealth and indebtedness in the UK and USA, 1994–2005 (%) United Kingdom as a % of disposable income

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Net wealth

Net financial wealth

Non-financial assets

Financial assets

Liabilities

Of which mortgages

558.0 568.7 583.1 633.0 670.9 755.8 750.1 688.6 692.6 727.3 768.0 790.3

260.0 288.5 292.1 337.9 349.1 405.0 372.3 308.7 250.5 255.7 258.6 286.3

298.0 280.1 291.0 295.1 321.8 350.9 377.8 379.9 442.1 471.6 509.4 503.9

367.5 394.8 396.7 442.7 456.4 515.9 486.5 426.8 380.6 397.1 411.7 445.3

107.5 106.3 104.5 104.8 107.3 110.9 114.2 118.1 130.2 141.4 153.1 159.0

79.9 78.3 77.6 76.7 78.2 80.9 83.2 86.0 94.4 104.4 114.4 120.3

Of which mortgages

United States as a % of disposable income

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Net wealth

Net financial wealth

Non-financial assets

Financial assets

Liabilities

482.4 509.6 529.9 564.0 581.1 628.5 575.1 539.3 495.8 538.8 552.8

273.7 302.0 323.3 357.5 371.8 411.5 355.4 312.0 259.1 290.8 293.1

208.7 207.6 206.6 206.5 209.3 216.9 219.7 227.3 236.7 248.1 259.7

365.3 395.4 418.4 453.7 468.9 513.0 458.2 419.0 371.1 410.9 419.8

91.6 93.5 95.1 96.2 97.2 101.5 102.8 107.0 112.0 120.1 126.7

63.6 63.2 63.8 64.3 65.0 67.9 68.6 72.7 78.6 85.9 92.3

Source: Adapted from Office for National Statistics (UK); Federal Reserve (USA). Notes a Assets and liabilities are amounts outstanding at the end of the period. Post-1993 data based on SNA93 and ESA95 data collection systems. b Households include non-profit institutions serving households. Net wealth is defined as non-financial and financial assets minus liabilities; net financial wealth is financial assets minus liabilities. Non-financial assets consist mainly of dwellings and land but also include durable goods. Financial assets comprise currency and deposits, securities other than shares, loans, shares and other equity, insurance technical reserves; and other accounts receivable and payable. See also OECD Economic Outlook Sources and Methods, http://www.oecd.org/eco/sources-and-methods.

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Table 7 Composition of household financial portfolios in France, Germany, Italy and the UK, 1980–2003 France

Germany

1980 1987 1995 2003 1980 1987 1995 2003 Safe assets (% in portfolio) 58.5 Safe assets (% of GDP) 56.7

42.0 54.5

36.5 58.6

30.2 58.5

52.4 52.9

47.2 57.9

41.8 62.6

35.7 65.7

Risky assets (% in portfolio) 41.5 Intermediated 9.3 Non-intermediated 32.2

58.0 9.3 38.6

63.5 19.4 31.2

69.8 33.4 31.1

47.6 23.9 23.7

52.8 25.1 27.7

58.2 33.2 25.1

64.3 41.4 22.9

Risky assets (% of GDP)

75.2

102.0 135.5

48.0

64.8

87.2 118.4

40.1 Italy

UK

1980 1987 1995 2003 1987 1995 2000 2003 Safe assets (% in portfolio) 77.8 Safe assets (% of GDP) 67.6

70.3 87.1

64.6 115.1

33.8 75.7

31.9 63.8

25.3 68.7

21.1 70.4

27.9 75.9

Risky assets (% in portfolio) 22.2 Intermediated 6.0 Non-intermediated 16.3

29.7 11.1 18.7

35.4 14.6 20.8

66.2 28.3 37.8

68.1 48.3 19.8

74.7 54.6 20.2

78.9 57.9 20.9

72.1 57.1 15.0

Risky assets (% of GDP)

36.8

63.0 147.9 136.5 203.5 262.6 196.1

19.4

Sources: Adapted from table in Erturk and Solari (2007), and derived from data from Banca d’Italia, 1980–94, Relazione annuale della banca d’Italia, (1980–94); Banca d’Italia, Relazione annuale della banca d’Italia, (1995–2003), available at: www.bancaditalia.it; Banque de France, Comptes nationaux financiers series longues and conjuncture, available at: www.banque-france.fr/fr/stat/main.htm; Deutsche Bundesbank, Financial Accounts for Germany 1991 to 2003, available at: www.bundesbank.de; Deutsche Bundesbank, German Financial Wealth 1980–1990; and National Statistics Office of the U.K. Financial Statistics Consistent, available at: http://www.statistics.gov.uk/statbase/tsdtimezone.asp. Note: Safe assets are bank deposits and government bonds. German safe assets only include bank deposits in all years. French safe assets do not include government bonds in years 1980 and 1987.

corporate failures after 2000 in the United States and the response of Sarbanes Oxley reinforced a pre-existing problem definition about somnolent directors and delinquent CEOs and the associated prescription of better governance to police executive behaviour and ensure pay for performance which delivered shareholder value. Literacy and governance quickly became global export products. Thus the OECD, which had in the long post-war boom publicized the productivity problem, now adapted to new times. The OECD in 1999 published its first international principles of corporate governance before, in 2005, producing a book-length study of illiteracy and financial education. These close-coupled problem/solution frames were vaguely reassuring in that

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they suggested everything could be fixed by doing more of the same. But on closer inspection, these problem definitions made no sense at all. The work of behavioural finance academics in the USA like Mitchell and Utkus (2004) implied that it might be more sensible to adapt pension choices to the known proclivities of decisionmakers because the classic studies by Kahneman et al. (1982) had long ago established that subjects will buy into risky strategies provided the choice is framed in terms of gains (not losses). This behavioural characteristic is not only a social problem but a private opportunity for the financial services industry to sell to the financialized masses, as we can see from all those adverts which couple the product’s name with pictures of happy families and smiling pensioners. A similar set of confusions underpin repeated demands for more effective board supervision of CEOs. Of course, governance by outside directors has an important role in preventing irresponsible and fraudulent management of the kind disclosed by the Enron and World Com collapses. But it is utopian to imagine that boards of directors could or should establish a relation between senior executive pay and performance. Many of the determinants of value creation in individual companies are outside the control of individual CEOs as market prices rise and fall in bull and bear markets; while the performance of a star CEO like Jack Welch at GE is at least partly about story telling ability. A risk-averse institutional investor will in any case hold not a couple of shares but a portfolio of shares in giant companies and will thereby discover that, over the whole cycle, the demands of the capital market cannot override the limits of the product market. As Froud et al. (2006) demonstrate for the S&P 500 and FTSE 100, return on capital employed (ROCE) does not increase secularly but fluctuates cyclically and sales grow roughly as fast as GDP in groups of large companies since the 1980s. Thus better governance for the creation of long-run value was inevitably ineffectual and, by the mid-2000s, the market’s response was hedge funds and private equity tactics for short-run value extraction. The quest for sustained higher shareholder returns through management effort was always utopian but it did have real consequences, not least because it directly justified high pay for some CEOs with above-average performance and then indirectly encouraged high pay for all through comparability increases. Thus, CEOs in giant companies in mainland Europe as well as the Anglo-Saxon countries claimed real pay increases of 10 per cent per annum or more for some twenty-five years after the early 1980s (with no discernible connection to performance). Less visible than the CEOs were the much larger number of high paid intermediaries such as the hedge fund principals and investment bankers of the 2000s, earning fees from the increased velocity of financial dealing and the larger scale of corporate restructuring plus the supporting legal and accounting services required by dealing and restructuring. Folkman et al. (2007) estimate that in 2004 there were around 16,000 high paid intermediaries in and around the City of London as against only 600 high paid FTSE 100 senior executives in giant companies. Partly in consequence, we have a new stratum of ‘working rich’ where financial intermediaries are a leading element. The period since the early 1980s has been one of sharply increasing income inequalities in the Anglo-Saxon countries as the upper groups draw away from the middle. As Atkinson’s important analysis shows, in the UK and the USA (but not

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France), the top 1 or 5 per cent of income earners have since the 1980s increased their share so as to return us to Edwardian or Victorian levels of top-end inequality and reverse all the gains in equality achieved over some six decades (Atkinson 2003). Although the distribution of wealth has not (yet) shown the same reverse, the downward diffusion of wealth holding is strictly limited by the distribution of income and the price of housing, which limit participation by low-income groups in the ‘ownership society’. There are differences in the (direct or indirect) form of shareholding in the UK and USA but in both countries, only those in the upper half of the income distribution are able to make the significant savings required to build up an equity portfolio. Table 8 presents data on savings flows (including pension contributions) which demonstrates the very low incomes and savings ratios of the bottom 60 per cent. The impact on the distribution of assets between US households is shown in Table 9. While all assets are unequally distributed, financial assets are disproportionately Table 8 Distribution of income and savings in the US and UK, 1996–7 UK distribution of household income and savings (£p.a) 1996–7 Quintile group

Gross income Disposable income Savings and investment Savings and investment as a % of disposable income

Q4 and Q5 as a % of total

Q1

Q2

Q3

Q4

Q5

£5,985 £5,935 £144 2.4

£11,245 £10,746 £487 4.5

£18,656 £16,383 £1,197 7.3

£27,741 £23,160 £2,420 10.4

£48,261 67.9 £37,893 64.9 £5,172 80.6 13.6

US distribution of household income and savings ($p.a) 1996–7 Quintile group

Gross income Disposable income Savings and investment Savings and investment as a % of disposable income

Q4 and Q5 as a % of total

Q1

Q2

Q3

Q4

Q5

$16,331 $16,252 $371 2.3

$24,169 $23,811 $1,122 4.7

$33,625 $32,542 $2,604 8.0

$48,477 $44,510 $6,552 14.7

$98,396 66.2 $86,613 64.4 $30,917 90.1 35.7

Sources: UK: Adapted from Family Spending 1996/7, Office for National Statistics (ONS); US: Consumer Expenditure Survey, Table 45, Bureau of Labor. Note: Gross income is income tax before tax and includes wages and salaries, selfemployment income, private and government retirement income, interest, dividends, and other income. Disposable income is income after tax and benefits. Savings and investments include life and other personal insurance plus pension contributions and other savings.

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Table 9 Distribution of assets by type for US households, 2000 % of total household assets by income quintile Quintile

Equity in own home Equity in motor vehicle Equity in own business Interest earning assets Other interest earning assets Stocks and mutual fund shares IRA or Keogh accounts 401K and thrift saving plans

Q1

Q2

Q3

Q4

Q5

Quintiles 4 and 5

11.5 9.4 3.9 7.1 1.6 3.2 5.9 2.2

14.9 14.7 7.2 14.7 5.7 9.6 13.9 4.2

17.0 18.7 12.3 16.4 10.9 12.1 14.9 10.3

21.3 23.9 17.4 19.9 16.2 20.3 21.1 22.5

35.3 33.3 59.2 41.9 65.6 54.8 44.2 60.8

56.6 57.2 76.6 61.8 81.8 75.1 65.3 83.3

Source: Adapted from Household Economic Studies, May 2003, US Census Bureau Note: a Households are divided into quintile by income, where Q1 are the poorest 20% and Q5 the richest 20%. b Defined benefit schemes guarantee retirement income, typically with the pension set as a % of the final three years salary. In defined contribution schemes retirement income depends on the contributions made and the growth of the investments. In both schemes the employer matches the employee contribution up to a predefined cap. The latter also includes 401(k) plans and 403(b) plans for nonprofit organizations with a significant portion of the investment that is self-directed. Keogh plans are designed for the selfemployed and employees of small businesses. Individual retirement account (IRA) and are funded with post-tax income.

concentrated in the top two quintiles by income, compared with home and car ownership.13 With finance in a leading role, the result so far has been a sharp increase of inequality which reflects uneven participation and distribution of the benefits. Public criticism has been moderated by the experience since the early 1990s of sustained and stable economic expansion without significant downturn in ‘real’ indicators like output and employment. At the time of writing in autumn 2007, it is uncertain whether the past fifteen ‘glorious years’ will continue but two points are clear. First, finance has fed expansion as innovations like securitization have effectively created credit in partly understood ways and the result has been a period partly defined by the construction boom and cranes on the skyline of every world city. Second, the public policies for controlling excess are rudimentary, partly because many central bankers are, like generals fighting the last war, still preoccupied with (wage and commodity) inflation policy problems of the 1970s, not asset price bubbles and liquidity excess/ deficiency which are the policy problems of the 2000s. Such disorders are now spread globally through the credit markets so that problems in the US sub-prime mortgages in the first half of 2007 led before the end of the summer to the failure of two minor German banks, distress borrowing by Barclays, a major British financial conglomerate, and a run on Northern Rock, a major UK mortgage lender.

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The rest of the world relies on the expected US policy response which the markets in the late 1990s described as the ‘Greenspan put’: whenever market excess was being corrected, the Federal Reserve under its chair Alan Greenspan would keep things going by cutting interest rates and loosening money supply. In the early 2000s, this had the unintended effect of starting the next credit cycle which ended in 2007 with credit crunch when Ben Bernanke immediately responded in exactly the same way.

What is financialization? Definitions and deja vu Description is not enough for those who will still want a concept of financialization which is more than a dictionary definition. If, as others have also done,14 it is both possible and useful to explore the scale of financial products, markets and actors, it is still desirable to develop a concept of financialization set in a theoretical frame. This section of our general introduction begins by presenting our conceptual understanding of how present-day financialization is at work through changing conjunctures within the coupon pool frame. If our proposed definition draws financialization into the discursive field of cultural political economy, we would not wish to exclude other definitions proposed in other discursive fields. Hence this reader excerpts work on financialization from at least four different problematics. Liberal collectivist theory of the 1920s and 1930s, agency theory of the 1980s and 1990s, political economy from the 1990s onwards, and cultural economy from 2000 onwards all operate with different working definitions of financialization. Because this reader was designed to illustrate the breadth of work on financialization, it is necessary to illustrate and explore multiple definitions from different fields. But there was also a more fundamental rationale for ranging across different literatures because we aimed not only to propose our own concept but to explore the meaning and significance of financialization by triangulating understanding from different fields as a basis for mixedmethods empirical research. The importance of empirical research is illustrated by the fifth section of this reader, which presents results from recent debates about financialized management that have stimulated new conceptions and challenged preconceptions in ways that show how knowledge involves ex post discovery as much as ex ante definition. We can begin the task of proposing a concept of financialization by noting the limits of a definitional approach which lists the developments that give finance an increasing influence. So, for example, Epstein defines financialization as ‘the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’ (2005, p. 3), which is a useful way of bracketing otherwise unrelated developments and making them accessible to a multi-disciplinary audience. But the problem is that such definitions focus on a development which is hardly new because in the period immediately before 1914 or in the 1920s and 1930s both Marxists and liberal collectivists observed the

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increasing role of finance. As early as 1904, Thorstein Veblen distinguished between a money economy where the product or ‘goods market’ was dominant and a credit economy where the capital market was dominant:15 The goods market, of course, in absolute terms is still as powerful an economic factor as ever but it is no longer the dominant factor in business and industrial traffic as it once was. The capital market has taken first place in this respect. (p. 151) The point is reinforced if we turn from definition to usage and consider those writers who explicitly use the term ‘financialization’. Until recently, those who used the word have been a relatively small and heterogeneous group of academics who have used it to register their distrust of financialization as they rediscover the unwelcome in each new age. Thus, the largest group of those using the term since the 1980s have been the Marxists and neo-Marxists such as David Harvey (2003, 2005), Giovanni Arrighi (1994), and Robin Blackburn (2002, 2006) who are part of a Marxist lineage of discussion which goes via Magdoff and Sweezy (1987) at least as far back as Hilferding’s original 1910 book on finance capital and its seminal ideas about how finance resolved increasing difficulties about accumulation. A different and more diverse group of (largely) political economists has used the word since about 2000 but their usage marks not consensus on a non-Marxist concept but growing social concern about finance and its impact on productive firms. The manifestations here include the contribution of a mixed group of mainly European academics in the two special issues of Economy and Society on shareholder value in 2000 and on the new economy in 2001; as well as the stream of work from post-Keynesian economists such as Stockhammer (2004) or the Amherst group including Epstein (2005) and Crotty (2005). Much the same point could be made about the growing use of the term financialization in economic journalism. The originator here was probably Kevin Phillips who used the term financialization critically from the early 1990s as part of his radical argument about new social divisions and insecurities in US society (see, for example, Phillips 1994). Significantly, by 2007, concerns about ‘unfettered finance’ were being expressed by commentators in the mainstream business press. Martin Wolf, usually known for his pro-market views, wrote two striking articles for the Financial Times in the summer of 200716 which outline how ‘global financial capitalism’ brings ‘the triumph of the global over the local, of the speculator over the manager and of the financier over the producer’, and delivers new regulatory, social and political challenges. Though he does not use the word ‘financialization’ his commentaries tap into the sensibilities around the growth of ‘finance’ and public concerns about risk and insecurity.

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The coupon pool and the conjuncture So, the starting point has to be not ‘what is financialization?’, but how financialization in present-day capitalism is different from what came before. Is increasing anxiety about ‘finance’ justified by what we know about processes and outcomes? In the present day, financialization is at work in the new frame of what we have termed coupon pool capitalism.17 This is immediately different in three respects which distinguish the frame since the later 1980s, because there is a ‘massification’ of household savings (Pineault 2007), a dramatic growth in the group of financial intermediaries and feedback effects on the calculations of firms and households. First, by way of contrast with earlier frames, there is now a much wider and probably irreversible spread of coupon ownership as households in the fortunate 40 per cent provide feedstock for the financial markets, both by directing savings into a coupon pool through a variety of funds and channels and by purchasing products including loans that generate coupons via securitization. The combination of savings feedstock and unrestrained innovation resulted in a growth in the number and types of coupons traded and in the employment of intermediaries who manage financial stocks and flows. Whereas earlier upper middle class investors were passive owners, the fortunate 40 per cent are now virtual owners who are themselves silent but represented by financial intermediaries who speak for the ‘shareholder’ and claim to understand risk and return. ‘Personal finance’ discourses of financial prudence, risk management and individualized responsibility and opportunity then have the task of formatting the savings and borrowing behaviour of the financialized masses within this frame. Second, by way of contrast with earlier frames, this is a period of huge opportunity for fee-earning and deal-driven intermediaries whose leading elements now work for themselves on profit shares in banks or as venture capitalists, private equity partners, and hedge fund managers incentivized on ‘2 and 20’ fee structures (Folkman et al. 2007). The intermediaries are not a class in themselves with a coherent agenda but a distributional coalition (Edwards 2007)18 of individuals and groups whose numbers are increased by the probably irreversible rise of retail mass marketing and wholesale derivatives trading. The retail banking sector is everywhere reconfigured as the mass marketer of savings and loan products which makes financial services the first or second-largest sector on most national stock exchanges; while innovation around new derivative products after the breakdown of Bretton Woods and the introduction of securitization hugely increases dealing volumes in the wholesale markets. Deregulation and technology contribute to financial innovation at wholesale and retail levels so that there are now many more different kinds of coupons, some of which are traded in massive volumes to lever profits from small margins or to generate fee income. While the intermediaries in different ways manage, deploy, and trade the funds of the financialized masses, it is also the case that intermediary activities are more than simply delegated management and associated services when, increasingly, finance feeds finance in creating new opportunities for fees, trades, and margins where the financialized masses figure only as providers of feedstock inputs.

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Third, by way of contrast with earlier frames, productive firms are generally defined as blocks of tradable assets and bundles of operating cash flows with dealing never far away as point concepts of value crystallization become as or more important than stream concepts of value creation. The earlier practices of the Victorian company promoter, the Edwardian financier, and the acquisitive conglomerate CEO are now generalized when public companies (financial and non-financial) are threatened with takeover or loss of support from their institutional shareholders if they do not defensively restructure themselves. The practices of ‘everything for sale’ are also pressed into new areas like the German Mittelstand. As well as being the virtual owners of coupons often on an intermediated basis, the financialized masses are active house capitalists with 50–70 per cent of households directly enrolled as home owners, even before the rise of interest only mortgages and buy-to-let as a form of savings in many national economies. The financier can be generically defined as an intermediary-cum-principal who uses borrowed money to carry out deals where (s)he acts as principal. In this sense, we are all financiers now. If this is the case in a general sense, it is certainly helpful to distinguish between intermediary elite groups and financialized masses. This introduction argues that financial intermediaries have become an increasingly important group of elites who are positioned to take advantage of the economy of permanent restructuring by generating fees and income from trading, dealing, investing, advice, consultancy and so on. Just as the intermediaries are not a coherent group or class, it is equally true that the financialized masses do not constitute any kind of homogenous group in terms of class, position, resources, or motives. When some of the masses have been beneficiaries of the processes of financialization, it would not be reasonable to argue that members of this group are all victims in any general sense. Nonetheless, the idea of the financialized masses is still a useful organizing concept in two ways. First, because it is this group that provides the feedstock of funds that elites manage in various ways; and, second, because it reflects the way that financialization leads not simply to increased general levels of inequality but, as Atkinson (2003), Piketty and Saez (2003), and others have shown, an increasing rift between the top and the middle. The risks and opportunities in financialization are unevenly distributed in a way that fits stereotypes of third world inequality with small self-serving elites, rather than the self-image of high-income democratic countries with Gini co-efficients and discussions about the relative good fortune of ordinary workers and the middle classes. Of course, the old divisions remain important to disemployed workers, the low paid and the aspiring middle classes but, in the new frame of the coupon pool, these divisions are overlaid with another between intermediary elites and all the financialized masses. It is tempting to insert such developments into traditional theorizations about before and after epochal change or national varieties of capitalism resting on new institutional complementarities. In this case, coupon pool capitalism would be represented as an epochal new stage of capitalism which inverts previous system characteristics; or it would be represented as a new national variety of capitalism spreading from its original Anglo-American base. In our view, both positions would be wrong because the frame does not work by establishing system-wide behavioural coherence

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or institutional complementarity of the old fashioned kind and the coupon pool is not a regulatory institution. Equally important, in our view the above developments do not inaugurate a ‘disorganized capitalism’ because, as we argue below, successive conjunctures do represent temporarily organized spaces. From this point of view, the coupon pool frame (without conjunctural analysis) is an incomplete answer to the questions about structuration and outcomes. The question about outcomes and dynamics is further complicated because frame and conjuncture do not establish a logic that excludes all others. To begin with, income from current employment remains primary for most households (and the only thing that matters for most low-wage earners) so present-day financialization does not suspend macro-economic and monetary effects arising from changed employment relations, international wage differences and so on. Furthermore, coupon pool capitalism is marked by internal contradictions and multiple discrepancies which have no single source. But there is nothing new about this because, as Cutler argued in 1978, a general law of value cannot operate in any existing economy where different economic subjects operate in various calculative frames and under different accounting regulations for recognizing profits. The frame does create new dynamics because the stability of coupon pool capitalism requires some balancing of labour, product and capital market demands. However, this balance is inherently problematic because competitive product markets and wholesale financial markets frustrate the delivery of value through earnings, while liquid financial markets are destabilized by speculation and swings in sentiment. Much value is then unstably created and lost through reversible flows of funds which inflate and deflate asset price bubbles. Wholesale markets add further instabilities because innovators cannot prevent rapid imitation and erosion of profit margins so that profits have to be augmented by high velocity trading or by leveraging positions with borrowed funds, which magnifies the consequences of speculation. Just as important as the contradictions are the discrepancies around narrative and performance. The major actors in coupon pool capitalism need a story and also have to put on a performance because everybody knows that talk is cheap in the new polity, where intermediary elites must endlessly rehearse the justification of their positions in terms of general socio-economic benefits. The financialized masses may be virtual owners but they are also voters whose political support for funded saving and light touch regulation of financial services cannot be entirely taken for granted, however strongly the discourses of ‘personal finance’ interpellate the subject. Hence the decisive importance of the conjuncture, defined in a non-Marxist sense as a distinctive combination of circumstances within which events and episodes happen. Conjunctures of typically four to seven years are defined by a capital market configuration of asset prices and the availability of funds supported by appropriate, grand narrative and performance. It is possible to analyze the New Economy from 1996 to 2000 or the excess liquidity period from 2000 to 2007 in these conjunctural terms. In the latter case, we have a two-year fall in the public markets plus their subsequent rise against a background of low interest rates and readily available funds which provided favourable conditions for the growth of hedge funds and private equity. Rhetorics about alternative asset classes and new investment strategies plus a general

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alibi about the ‘marketization of risk’ rationalized and informed the conduct of elite intermediary actors. These actors will carry on making money until the contradictions and discrepancies outside their models and experience overwhelm their money making and impose a fundamental rethink of their modus operandi. Unsound fundamentals and impending crashes are irrelevant for most intermediaries, whose general mentality is nicely summed up by the Citigroup CEO Chuck Prince just before the credit crunch: ‘as long as the music is playing, you’ve got to get up and dance. We’re still dancing’ (Financial Times, 9 July 2007). When in the 1960s the Chinese communist leader Chou En Lai was asked about the effects of the French revolution in 1789, he famously replied that ‘it is too soon to tell’. In the same spirit, our line in the late 2000s on the effects of coupon pool capitalism would be that our interim verdict needs to be revised and updated every five years or thereabouts in line with the changing conjuncture. Hence our title Financialization at Work, which presents financialization as unfinished business. Multiple contradictions and discrepancies make coupon pool capitalism inherently unstable in terms of economic outcomes. Major declines in output and mass unemployment would most probably only result if the Federal Reserve in the USA or the European Central Bank made major policy errors; but periodic ‘corrections’ in asset prices are likely to be more painful than the tech stock crash in 2000 and, of course, the business cycle has not been abolished. The clearest empirical result so far is increased inequality of income and the presumption must be that inequalities of income and wealth are powerfully inscribed in the frame of coupon pool capitalism19 where the distinction between elite intermediaries and financialized masses is reworked but not abolished. In each new conjuncture a changing group of elite intermediaries is well placed to act as a distributional coalition skimming value from revenue flows and asset trading.20 As for the financialized masses, they move on different trajectories depending on whether their property assets and savings funds are large enough to provide security or comfortable retirement, although their pooled savings and individual borrowings provide the basis for the operations of financier intermediaries. From a social democratic point of view, the justifiable political fear is that, because of its scale and scope, coupon pool capitalism increasingly divides the common polity and undermines the policies of social inclusion and decent minima which require a common experience to sustain the democratic will to pay for them through taxation.

Different concepts: 1980s agency theory vs. 1930s liberal collectivism This line of argument about the coupon pool takes us a long way from many of the claims and assumptions in existing and previous literatures on financialized capitalism. But, it is not our aim to disparage these other literatures because the differences between the literatures are both interesting and instructive and provide the basis for a new triangulated understanding. Hence the strategy behind this general introduction and the reader whose first four sections are each focused on a different literature from liberal collectivists of the 1920s and 1930s, agency theorists of the 1980s,

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political economists from the 1990s, and cultural economists of the 2000s. The five section introductions each describe a distinctive problematic about finance or financialization after which the reader can turn to three or four major extracts which illustrate the arguments and empirics deployed in that literature’s internal debate. This book is consequently constructed around two axes of difference which make a new triangulated understanding appear and that understanding provides the essential context for our own concept of financialization. The first axis of difference between the literatures is about for or against and this axis is established within the reader by the contrast between agency theory’s endorsement of shareholder rights from the 1980s onwards in section 2 and the reformist liberal collectivist critique of the rentier and the financier from the 1920s and 1930s in section 1. The second axis of difference is about concepts of the economy and this is established by the contrast between the political economy concept of the economy as an independently existing mechanism of quantities and relations in section 3 and the cultural economy concept of a socially constructed economy that runs on narrative and performance in section 4. These four perspectives along two axes provide the basis for a mixed methods approach to financialization because each literature contributes a durable core proposition which merits consideration plus supporting arguments or empirics which should not be ignored. The most obvious starting point is agency theory as developed by US mainstream finance academics like Michael Jensen and Eugene Fama (in section 2) who were originally financial markets theorists concerned to defend financial markets as a way of pricing assets and also to rationalize corporate finance as the allocation of capital. Their world depended on assumptions about micro-economic rationality. But, in the 1960s and 1970s, these assumptions were challenged by managerial theories of the firm from authors like Marris (1964) and Galbraith (1967), who emphasized how managers in giant firms could deviate from profit maximization and pursue discretionary objectives like growth. The defensive response from mainstream finance rested on the implicit core proposition that the pursuit of discretionary management objectives was not in the (financial) interest of owner-shareholders so that it was desirable to limit the management prerogative. Within this narrow micro-economic frame, any enforcement of the shareholder’s (financial) priorities would then deliver social benefits. These propositions were then in the 1980s developed as ‘agency theory’ though, as section 2 explains, this could be thought of not as a single theory but a series of loose metaphors about the firm as a ‘nexus of contracts’ between shareholder/principals and manager/agents. Mainstream finance also provided relevant empirics as their proposition opened a new agenda for research. Systematic empiricist techniques were used to investigate the restraining effects of various disciplinary mechanisms including capital market threat of takeover, proceduralized governance involving non-executive directors and performance-based pay contracts for senior managers. As section 2 argues, the main empirical contribution of mainstream finance over the next twenty years was to demonstrate that none of these disciplinary mechanisms were effective. Agency theory remains a very influential (and highly rhetoricized) approach to understanding issues around the control of the corporation, but it has been very slow

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to engage with coupon pool-related developments such as the rise of intermediary investment bankers, fund managers, and such like, as analysed by Folkman et al. in section 2. Meanwhile, serious intellectual critics of agency, (like Ireland (2000) in section 2) argue that agency theory was always flawed because it never considered the nature of ownership and did not answer the prior question of whether shareholders were owners with responsibilities as well as rights. Despite the founding oversimplifications of agency theory, mainstream finance has made a contribution through systematic empiricist research which has effectively demonstrated the negative by establishing that the corporate world does not operate on a disciplinary basis as agency theorists hoped it would. Beyond this, our view is that academic finance can deliver interesting and positive insights when it rejects mainstream assumptions about rationality and explores the decision-making of irrational subjects, as illustrated by the fruitfulness of research by the Wharton behavioural finance researchers.21 As well as registering the limits of agency-based perspectives, we aim more broadly to relativize and open out narrow debates by providing historical context. So, this reader begins with a first section on the critique of the rentier and financier which reprints extracts from US and UK liberal collectivists of the 1920s and 1930s. The liberal collectivists had a variety of different party political affiliations when, for example, R. H. Tawney was Labour but J. M. Keynes was Liberal and Adolph Berle was a New Deal Democrat. But, in the 1920s and 1930s they all shared overlapping reformist agendas for making capitalism more stable and equitable and shared a presumption in favour of the market where possible and the state and voluntary action as necessary, which decisively influenced the post-1945 policy settlements. In our view, the arguments of the liberal collectivists remain enduringly relevant to questions of capitalist reform in a way that Marxist theory did not. Hence, our decision to include extracts from the liberal collectivists, which set out their positions and incidentally correct the subsequent misrepresentation of their arguments by agency theorists who sometimes enlist Berle and Means as precursors of their position. Thus, the first task is to recover the core propositions of the liberal collectivists whose criticism of the rentier and financier contrasts directly with agency’s endorsement of shareholder claims. Liberal collectivism argues two key propositions about finance which are represented in the section 1 extracts. First, from Tawney’s (1923) text, there is the proposition that the classical liberal defence of the rights of property does not extend to passive owners, like shareholding ‘rentiers’, ground landlords or mineral rights owners, whose claims should be resisted and reduced as part of a process of ‘euthanasia of the rentier’. Second, from Berle and Means (1932) and Keynes’ (1936) texts, comes the proposition that the corollary of (passive) shareholding is a liquid market in coupons which inevitably brings ‘speculation’ or buying and selling driven not by fundamental considerations but by attempts to outguess the market. For liberal collectivists, liquidity and speculation are therefore associated with swings in sentiment and boom–bust fluctuations in asset prices. Some years after the 1929 crash, Keynes developed liberal collectivist received ideas into his 1936 ‘general theory’ of the instability of finance-led capitalism. However, the subsequent re-packaging of ‘Keynesianism’ in ways which made it acceptable to mainstream

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economics led to an assimilation which effectively buried the novelty of Keynes which we must now try to recover. The liberal collectivist arguments of Keynes are brilliant because they answer the questions previously posed within the problematic and his answers are characteristically not inhibited by any need for supporting empirics. But, those who read section 2 must ask whether and how the classical arguments are still relevant in the very different empirical context of present-day coupon pool capitalism. First, the liberal collectivist critique of the rentier was developed when shareholders were a narrow upper middle-class social stratum; it is not true that ‘we are all shareholders now’ but the empirics do show that in the USA and UK many of those in the upper half of the income distribution now have significant direct or indirect shareholdings. And, as a corollary, the passive coupon clipping shareholder of the 1920s is replaced by the virtual shareholder of the 2000s represented by a fund manager. Second, the liberal collectivist critique of the financier and speculation was developed as finance was (rightly or wrongly) blamed for recession and economic crisis; but finance in our time brought a long cycle of prosperity from the early 1990s to summer 2007 when the credit crunch complicated matters. In our view, the liberal collectivist idea remains relevant in ways indicated by the two quotations from Tawney about security and Keynes about investment which preface this general introduction. The liberal collectivists help us to frame the two fundamental questions about finance in mass democracy which remain relevant in the early 2000s. First, how does finance both directly through savings, and indirectly through feedback effects from the credit markets, meet the (financialized) masses’ need for security during and after a working life against a present day background of increasing life expectancy? Second, how can finance contribute to meeting the requirement for infrastructural renewal in high-income countries which all need to spend trillions on sustainable technologies against a present-day background of global warming? When the questions for the 2000s are posed in this way, the old liberal collectivist arguments from the 1920s and 1930s resonate for us because they challenge the conventional wisdom of the 1990s and 2000s. In recent times, the conventional wisdom has been to aim for higher returns in the general financial interest of the shareholder and the specific individual future of the pensioner. By way of contrast, the liberal collectivists envisaged lower returns in the general physical interest of society from investment in appropriate technologies whose prospective financial returns are uncertain and low, even though our collective future depends on such technology. In recent times also, the conventional wisdom has been that unfettered financial innovation brings benefits and few risks, a view that was reinforced when the tech stock crash of 2000 did not lead to a recession. By way of contrast, the liberal collectivists (or, more exactly, Keynes) saw that financial markets are both good servants and bad masters because the price of liquidity is speculation which leads to asset price bubbles, uncontrollable by variation in interest rates, and, therefore, leading to cyclical fluctuations of output and employment. At the same time, the liberal collectivists do not provide any kind of ‘what is to be done’ handbook for reform. The great liberal collectivist, Keynes, emphasized the

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‘roundabout repercussions’ of policy measures when arguing about the effects of real wage cuts in the General Theory. Subsequently, in the 1940s Keynes understood that it was economic growth in the post-war conjuncture which would make Beveridgean social insurance work rather than vice versa. The implication is that the old liberal collectivist problem definition about insecurity and instability in a finance-led economy probably never had simple corollary policy solutions. And that must be even more so today given the absence of any theoretical grip on financialization and the difficulty of finding points of intervention. It is, however, quite remarkable that discussion of reasonable restraints on the financial markets has more or less slipped off the policy agenda since the 1980s. At the same time, serious questions about whether funded savings can deliver security for lower-income groups have been deflected through the promotion of pseudo-problems about financial literacy. As we have criticized the preoccupation with financial literacy elsewhere (Erturk et al. 2007), we will here concentrate on the question of restraining the financial markets. The issue of restraining the markets was avoided by the diversion onto questions of corporate governance after the Enron and WorldCom collapses as executives and stock market analysts were blamed, just as the ratings agencies were blamed after the 2007 credit crunch where one of the first casualties was the head of Standard and Poors (Wall Street Journal, 3 September 2007). Meanwhile, discussion of market restraint through margin requirements or taxes on turnover has vanished from the mainstream. Consider the Tobin tax proposal to put some sand in the machine of derivative, currency trading by imposing a modest tax of 0.1 to 0.25 per cent on all foreign exchange transactions. It was formulated in the mainstream of early 1970s policy discussion (after the breakdown of the Bretton Woods system) by a centreright economist, James Tobin, who afterwards insisted in a rather pained way that he supported institutions like the IMF and World Bank. By the late 1990s, the centre of gravity in policy discussion had moved so far rightwards that the Tobin tax proposal was revived by anti-globalization activists taking up the rallying call of Ignacio Ramonet in Le Monde Diplomatique (December 1997), who suggested the proceeds of the tax could be applied to ending world poverty which was being prolonged by the policies of the IMF and the World Bank. The mainstream centre-left and centre-right would not then countenance discussion of this or any other proposal to fetter finance in the 1990s and 2000s.

Different concepts: political economy of quantities and cultural economy of performativity In early 2007, a panic about the growth of private equity in the UK and the EU led to high profile, media debate about how one group of financial intermediaries, private equity general partners, were earning multi-million-pound rewards on which they were paying tax at a rate no higher than 5 to 10 per cent. The underlying issue here is about how, without announcement or discussion, income tax in many advanced countries has become voluntary for the working rich, even though other citizens must pay at rates of up to 40 per cent. But it is quite difficult to move on from panic and

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media debate towards analysis and theorization because of the differences between political and cultural economy about how we understand the process and outcomes of financialization. Political and cultural economy represent two different paradigmatic understandings of the economy, which are often represented as alternatives. Political economists do not necessarily endorse positivist hypothesis testing but do conceive of the economy as a machine of quantities and relations between categories like profit and liquidity whose enduring logic is discovered and operates independently of analysis. Cultural economy takes a more social constructivist line about how the economy is formatted by discourses: the economy is then a performance which combines stories and enactment through saying and doing so that the world can become more like our theories. Rather than deny or fudge these differences, which have become increasingly important since the early 2000s, we have selected extracts in sections 3 and 4 which illustrate the difference of a priori and results in cultural and political economy. In doing so, we have quite deliberately made the contrast between the two kinds of research into the second axis of difference about financialization. At this point, it is worth noting one further complication, which is that the discourses of political and cultural economy (just like agency) have not yet vindicated empirically the understanding of finance and markets which they initially assumed and proposed. From our point of view, this is good fortune which brings extra insight because, in economic discourses as in life, it is possible to make interesting empirical discoveries along the way which confound expectation. With political economy we reach a discourse that, from the late 1990s, explicitly uses the term ‘financialization’. In this discourse, financialization is one among several overlapping terms (including globalization and neo-liberalism) which are all in different ways attempts to characterize what came after the ‘Fordism’ of the long postwar boom that ended in the 1970s. This quasi-epochal approach fuses with political economy’s prevailing mechanical concept of the economy, so that the political economists originally searched for new causal relations or quantitative indicators which shifted decisively with the transition to a new epoch. The extracts from Stockhammer (2004) and Krippner (2005) in section 3 indicate some of the ensuing difficulties encountered by those who take this approach. To begin with, it is relatively easy to establish empirical correlation and possible to analyze outcomes but much more difficult to understand the directional arrows between cause and effect. Furthermore, empirical indicators are ambiguous because of category problems and internal differences within political economy about which indicators matter when some believe the financialization process is about accumulation while others argue it is about innovation. Thus, Krippner’s work on the USA highlights the rise of financial income in non-financial companies which Marxists argue is an important shift that indicates a new regime of accumulation. But, the corollary rise in ‘financial assets’ in non-financial companies is more puzzling and may partly indicate category problems in social accounting because ‘financial assets’ is a dustbin category which includes everything including goodwill from acquisitions. Some of these empirical measurement problems are perhaps inevitable given the size and complexity of the task of understanding finance. Boyer’s (2000)

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macro-economic theory (section 3) avoids these issues by taking a more theorized approach in emphasizing from a Regulationist perspective that a financialized economy will be troubled by asset price bubbles and could (if wealth effects are strong enough) cut workers’ wages and increase aggregate demand. But, these are theoretical conjectures derived from a simplified model where, for example, all workers have significant shareholdings whose price fluctuations induce wealth effects. Such conjectures are unlikely to be confirmed by tests using data from actually existing national economies. So, if we seek a core proposition endorsed by most political economists, that has to be the empirical discovery that income inequality has increased sharply in the UK, USA and elsewhere since the early 1980s as a new group of ‘working rich’ pull away, and with the effective return to pre-1914 levels of income inequality in most high-income countries. Political economists disagree about how to frame this discovery theoretically when many would reject the Marxist arguments of Duménil and Lévy about how inequality is based on new class alliances. But most researchers accept that financial intermediaries in and around the financial markets were the leading group of working rich in the 1990s and the 2000s. Cultural economy introduces a different concept of the economy as something that runs on stories and performances. These ideas are radical and they have been formulated within a group which disagrees internally about whether the narrative and performative insight requires a stand alone discourse or needs to be hybridized with old problematics to create what Langley (2004) and others have termed ‘cultural political economy’. As it is, the field of concern with the narrative and performative is already so broad that it sustains several different styles of work. Martin’s (2002) work on mobilizing narratives of finance and everyday life dispenses with the familiar sequential order of empirically based discourse whereas MacKenzie and Millo’s (2003) work on performativity and the effects of the Black–Scholes model on options pricing provides an empirical investigation of a proposition by Michel Callon which is formally stated at the beginning of the article. If the new discourse of cultural economy sustains several styles, it has been so far focused onto one central debate on performativity. Three of the four extracts in section 4 take up the issue of performativity in the same way by questioning Callon’s claims about the capacity of the discourse of economics to format the economy by constituting its own conditions of existence. The three contributions operate on different scales when Thrift (2001), for example, examines what might be called grand narrative and performance in sustaining the New Economy in the late 1990s while MacKenzie and Millo focuses sectorally on new finance theory models of option prices. But interestingly both Thrift and MacKenzie and Millo register the limits of performativity: the narrative of the new economy may have been performed by new ideas about management as passion but still the dotcoms crashed. In just the same way, option prices converged on the Black–Scholes model predictions until the 1987 stock market crash, which was not in the model. ‘Up to a point, Professor Callon’ is the verdict of these British empirical studies on Callon’s claims about economic performativity which nevertheless deserve the credit for stimulating a new social constructivist way of looking at finance, financial markets, and corporate management. Cultural economy therefore adds a new core proposition about how

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discourses of finance and of management shape rather than observe processes of financialization; along with the qualification that performativity with discrepancy and infelicity is the norm in the empirical cases so far examined.

From debates to a new research agenda The fifth and last section of the reader changes the focus because it is not concerned with one specific problematic like political or cultural economy, but with a debate about the outcomes of (more) financialized giant firm management which has engaged researchers from several problematics, including political and cultural economists who have turned up interesting empirical results that once again challenge preconceptions about forms of ‘management control’ and constraints on the ‘discretionary objectives’ of giant firm management. If we consider the importance of innovation in the wholesale money markets or new kinds of subjectivities in households, financialization of course includes much more than the public company.22 But, rapid innovation and conjunctural change bring ceaseless change and rapid obsolescence to the financial markets and leave academics struggling to keep up. By way of contrast, the giant firm is a durable institution. The large public firm was at the centre of earlier liberal collectivist discussion and the forms of control in giant firms have since been analyzed in a classic academic literature from Alfred Chandler onwards. The current debates about financialized management in giant firms are also interesting in themselves because since 2000 or thereabouts, the forms of analysis and empirical conclusions about capital market pressures on giant firms have changed in ways which refute any preconceptions about a disciplinary market whose fund managers and analysts determine management strategy from outside. None of the extracts in section 5 endorse this view. Fligstein (1990) argued that corporate management operates through changing internal ‘conceptions of control’. Within this kind of frame, Lazonick and O’Sullivan (2000) argued in an influential article that US giant firm managers had in the 1980s adopted strategies of ‘downsize and distribute’ with the aim of maximizing shareholder value. The other two extracts raise more fundamental issues. Thus Kädtler and Sperling (2002) from industrial sociology consider the (German) large firm workplace as a site where target rates of return and such like conflict with other non-financial calculative logics as workforce contests with management. Or Froud et al. (2006) argue that giant firm strategy after financialization involves narratives of corporate purpose and achievement with supporting performative enactment through initiatives. The suspicion that the capital market would or could have its way with giant firms in any mechanical kind of manner is certainly open to challenge and the core proposition from recent research into giant firms is that capital market pressures do not have simple general outcomes but do make things more complicated. What than do the four literatures on financialization and the debate about financialized management add to the coupon-pool-plus-conjuncture concept which we proposed at the beginning of this section in an attempt to get beyond descriptive

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definitions focused on the increasing influence of the capital market on firms and individual lives? The starting point has to be liberal collectivism which vanished from view in the 1990s. From a reformist, historically literate point of view, financialization is about the changing answers to the fundamental questions originally posed by Tawney and Keynes, whose underlying political concern was always with the social and economic participation necessary to make mass democracy work. In today’s terminology, the questions are: what is the role of financial markets in guaranteeing social security for the mass of the population and also in generating economic inequality and insecurity? The answers are changing because the conjuncture and our understanding of it are both shifting. Our review of recent research into financialization demonstrates the increasing fragmentation of knowledges as the methods of systematic empiricism in mainstream finance are irrelevant to cultural economists whose notions of performativity, in turn, hardly fit with Marxist political economy about financialization as a new phase of accumulation built on class alliance. The core propositions in the different discursive fields do overlap so that themes about income inequality or managerial discretion will almost certainly not go away; but no one can say how they will (re)present in combination with other themes like instability as the conjuncture changes within the coupon pool frame. So the prospect of general agreement on one durable, concept of financialization is remote and that is no bad thing in a capitalism of changing conjunctures. If like other protagonists we would of course defend our own concept of financialization, we also believe that attempts to control the concept by drawing it into one theoretical frame are self-defeating insofar as they deny the contributions of other discourses. These contributions are often usable outside their field of origin because numbers and narratives can usually be reassembled in different ways. If we triangulate concepts, methods and results from different fields and consider the core propositions from the different discourses and debates, they fit together to define a new agenda for research into financialization around three sets of issues. First, there is a set of issues about rapid innovation in the wholesale and retail financial markets, where permissive regulation has allowed untrammeled technical innovation which diffuses rapidly in the absence of property rights. Second, new forms of influence on the conduct of firms as well as individuals and households are important because present-day changes are not simply about numerical quantities and relations but also involve mobilizing narratives and performative enactment. Third, there is a set of issues about the impact of the financial markets on inequality and on uncertainty and instability, complicated by feedback effects, panic, and noise with intermediary elites and financialized masses differently placed and on different kinds of trajectories. In all three cases, the findings of one discourse could be used by others and this might encourage more permeable boundaries of the kind that already exist between political and cultural economy. The collective end result would be a mixed-methods approach to a capitalism of multiple logics and discrepancies where there is no simple linear relation between objectives, initiatives, practices and outcomes.

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Notes 1

2

3 4

5 6

7 8 9

10 11 12 13 14 15 16

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The manuscript was submitted in late September 2007. The last section to be drafted was this general introduction, written during the early weeks of the credit crunch in late August and early September 2007. At that point, it was clear to us that events in the financial markets would lead to a change of conjuncture, with the ending of a period of excess liquidity and cheap credit for all which had defined developments in wholesale and retail finance and the macro-trajectory of the economy since 2000. But, it was not possible to predict the course and outcomes of events in the debt and equity markets over the next few months, nor to determine medium-term outcomes. Nevertheless, the analysis and positions taken in this introduction remain relevant to those outcomes where we believe that the distinctions between risk and uncertainty and frame and conjuncture are vital. For this reason, we did not attempt to update this introduction during the production of the book but would ask the reader to bear in mind that this represents our analysis as of late September 2007. Readers will, of course, wish to set our analysis in the context of their understanding of subsequent events and conjunctural change. One thing is certain: a new conjuncture does not spell the end of financialization, but only a new phase in the old frame as actors identify new opportunities for financial innovation. The growth of pension funds in the US prompted Drucker’s book, The Unseen Revolution (1976). Here, he uses the growth of such funds, so that pension funds ‘control’ more than one third of the largest 1,000 US industrial companies, to explore the idea of ‘pension fund socialism’ (p. 2). See the extract from Langley (2004) in section 4 for an analysis of the post-2000 pensions ‘crisis’. Negative equity only becomes a serious problem for those who need to sell their houses for various reasons. In the mid-late 2000s, the potential fall-out from a housing market crisis is likely to be more serious than in the early 1990s because loan to income ratios are higher. Small increases in interest rates from a historically low base can have a significant effect on the default rate, as happened in the USA and as predicted by Alan Greenspan to happen in the UK (Financial Times, 17 September 2007). For an analysis of the growth and significance of derivatives, see Bryan and Rafferty (2006a and 2006b). On the development of securitization in mortgages and consumer credit see Langley (2006) and Montgomerie (2006) respectively; on the general trend towards turning assets into cash flows see Leyshon and Thrift’s (2007) argument about the ‘capitalisation of everything’. On the breakdown of the German company network see Höpner and Krempel (2004). See Harmes (1998 and 2001) for analysis of the actions and effects of active institutional investors. These investment funds, collectively known as sovereign wealth funds, have become the subject of increased media and political interest as they have acquired blocks of ownership in European and North American companies such as UK food retailer, Sainsbury. For recent exceptions see McGoun (1995), Reddy (1996) and Froud (2003) following from Shackle (1955). This data is derived from the UK Family Resources Survey equivalised data and US Census Bureau, http://www.census.gov/hhes/www/income/histinc/h05.html. Apart from the household level effects of appreciating or falling house prices, there are potential wealth effects on consumer demand at a macro-economic level. In the UK the available data on household balance sheets does not permit a comparable analysis. See also, for example, reviews of the growing importance of finance by Glyn (2006) and Blackburn (2006). We are grateful here to Jamie Morgan who draws attention to Veblen’s argument in his 2007 working paper on private equity. See Martin Wolf ‘The new capitalism. How unfettered finance is fast reshaping the global

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economy’ (19 June 2007) and ‘Risks and rewards of today’s unshackled global finance’ (27 June 2007), both in the Financial Times. An earlier version of this argument, which discussed the idea of coupon pool capitalism, was developed in Froud et al. (2002). The earlier exposition was differently developed because its approach was less cultural and it was still struggling to disengage from the varieties of capitalism problematic. A recent University of Leeds doctoral thesis by Ian Edwards takes up Mancur Olson’s (1982) idea of distributional coalition and argues that the City of London since 1870 is a distributional coalition which seeks to redistribute income and wealth to itself. The extract from Duménil and Lévy (2004) in section 3 of this book explores the growing inequalities between the top and the middle-income groups in the USA. In some cases there have also been public concerns about whether some intermediary groups are paying a fair amount of tax. In addition to general issues about domicility and tax status, in the case of private equity, partners benefit from a relatively generous tax arrangement which treats their carried interest or their share of the profits of the fund as capital gains (taxed at 10 per cent), not income. As one industry insider commented in 2007, private equity partners ‘pay less tax than a cleaning lady’ (Financial Times, 3 June 2007). See, for instance, Mitchell and Utkus (2004) on pensions. Of course, if space had allowed it would have been possible to construct several ‘current debates’ sections that could have focused on a range of issues where researchers interested in finance and financialization have made important contributions. For example, it would be interesting and valuable to include work: on the geographies of financialization (see, for instance, Engelen undated; French et al. 2007); on the policies and practices of pensions and other funds (see, for instance, Harmes 1998; Cutler and Waine 2001; Engelen 2003); or on comparative national analysis (see, for instance, Morgan and Takahashi 2002; Jürgens et al. 2000; Morin 2000).

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Folkman, P., Froud, J., Johal, S., and Williams, K. (2007) ‘Working for themselves: capital market intermediaries and present day capitalism’, Business History, 49(4): 552–72. French, S., Leyshon, A. and Wainwright, T. (2007) ‘Financializing space’, paper presented at the RGS-IBG 2007 conference, London, August 29–31. Frank, T. (2002) One Market Under God. Extreme Capitalism, Economic Populism and the End of Economic Democracy, London: Vintage. Froud, J. (2003) ‘The PFI: risk, uncertainty and the state’, Accounting Organizations and Society, 28(6): 567–90. Froud, J., Johal, S. and Williams, K. (2002) ‘Financialisation and the Coupon Pool’, Capital and Class, 78: 119–52. Froud, J., Johal, S., Leaver, A., and Williams, K. (2006) Financialization and Strategy. Narrative and Numbers, London: Routledge. Froud, J., Leaver, A., Williams, K. and Zhang, W. (2007) ‘The quiet panic about financial illiteracy’, in L. Assassi, A. Nesvetailova, and D. Wigan (eds), Global Finance in the New Century, Basingstoke: Palgrave Macmillan. Galbraith, J. K. (1967) The New Industrial State, Boston: Houghton Mifflin. Glyn, A. (2006) Capitalism Unleashed. Finance, Globalization and Welfare, Oxford: Oxford University Press. Government Actuary’s Department (2006) ‘Occupational Pension Schemes 2005: the thirteenth survey by the government actuary’, June 2006, http://www.gad.gov.uk/ Publications/docs/13th_Occupationa_PensionvSchemes_Survey_05.pdf. Harmes, A. (1998) ‘Institutional investors and the reproduction of neoliberalism’, Review of International Political Economy, 5(1): 92–121. Harmes, A. (2001) Unseen Power: How Mutual Funds Threaten the Political and Economic Wealth of Nations, Toronto: Stoddart. Harvey, D. (2003) The New Imperialism, Oxford: Oxford University Press. Harvey, D. (2005) A Brief History of Neoliberalism, New York: Oxford University Press. Hilferding, R. (1910) Finance Capital, London: Routledge and Kegan Paul (repr. 1981). Höpner, M. and Krempel, L. (2004) ‘The politics of the German company network’, Competition and Change, 8(4): 339–56. IFSL (2007a) Securitisation, March 2007, London: International Financial Services. IFSL (2007b) Hedge Funds, April 2007, London: International Financial Services. IFSL (2007c) Private Equity 2007, August 2007, London: International Financial Services. IFSL (2007d) Fund Management 2007, September 2007, London: International Financial Services. Ireland, P. (2000) ‘Defending the rentier: corporate theory and the reprivatisation of the public company’ in J. Parkinson, A. Gamble, and G. Kelly (eds), The Political Economy of the Company, Oxford: Hart Publishing, 141–73. Jürgens, U., Naumann, K., and Rupp, J. (2000) ‘Shareholder value in an adverse environment: the German case’, Economy and Society, 29(3): 54–80. Kädtler, J. and Sperling, H.-J. (2001) ‘After globalisation and financialisation: logics of bargaining in the German auto industry’, Competition and Change, 6(2): 149–68.

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Kahneman, D., Slovic, P., and Tversky, A. (Eds) (1982) Judgment under Uncertainty: Heuristics and Biases, New York: Cambridge University Press. Keynes, J. M. (1936) A General Theory of Employment, Interest and Money, London: Macmillan. Knight, F. (1921) Risk, Uncertainty and Profit, London: Harper. Krippner, G. R. (2005) ‘The financialization of the American economy’, Socio-Economic Review, 3(2): 173–208. Langley, P. (2004) ‘In the eye of the “perfect storm”: the final salary pensions crisis and the financialisation of Anglo-American capitalism’, New Political Economy, 9(4): 539–58. Langley, P. (2006) ‘Securitising suburbia: the transformation of Anglo-American mortgage finance’, Competition and Change, 10(3): 283–99. Lazonick, W. and O’Sullivan, M. (2000) ‘Maximising shareholder value: a new ideology for corporate governance’, Economy and Society, 29(1): 13–35. Leyshon, A. and Thrift, N. (1999) ‘Lists come alive: electronic systems of knowledge and the rise of credit-scoring in retail banking’, Economy and Society, 28: 434–66. Leyshon, A. and Thrift, N. (2007) ‘The capitalisation of almost everything: the future of finance and capitalism’, paper presented at the IWGF workshop on Financialization, London, February 12–13. Lowenstein, R. (2000) When Genius Failed. The Rise and Fall of Long-term Capital Management, New York: Random House. Magdoff, H. and Sweezy, P.M. (1987) Stagnation and the Financial Explosion, New York: Monthly Review Press. MacKenzie, D. and Millo, Y. (2003) ‘Constructing a market, performing theory: the historical sociology of a financial derivatives exchange’, American Journal of Sociology, 109: 107–45. Marris, R. (1964) The Economic Theory of ‘Managerial’ Capitalism, London: Macmillan. Martin, R. (2002) The Financialization of Daily Life, Philadelphia: Temple University Press. McGoun, E. (1995) ‘The history of risk “measurement” ’, Critical Perspectives on Accounting, 6: 511–32. McKinsey Global Institute (2007) Mapping the Global Capital Market: Third Annual Report, McKinsey & Company, http://www.mckinsey.com/mgi/publications/third_ annual_report/index.asp. Mitchell, O. S. and Utkus, S. P. (eds) (2004) Pension Design and Structure: New Lessons from Behavioral Finance, Oxford: Oxford University Press. Montgomerie, J. (2006) ‘The financialization of the American credit card industry’, Competition and Change, 10(3): 301–19. Morgan, G. and Takahashi, Y. (2002) ‘Shareholder value in the Japanese context’, Competition and Change, 6 (1): 169–92. Morgan, J. (2007) ‘Private equity finance: how it works, what its effects are, can it be justified?’, Working Paper no. 3, Centre of Excellence in Global Governance Research, University of Helsinki. Morin, F. (2000) ‘A transformation in the French model of shareholding and management’, Economy and Society, 29(1): 36–53.

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SECTION ONE

The historical critique of the rentier and financier EDITORS’ INTRODUCTION

T

H E M O D E R N C O R P O R A T I O N I S a mid-nineteenth-century innovation,

facilitated in the UK by legislation of the 1844 and 18561 Acts which made it easier to issue tradable shares to investors with limited liability. The railway companies in the UK became the prototype for subsequent giant firms with dispersed share ownership. If the shareholder role has existed for some hundred and fifty years, the social construction of that role has changed quite dramatically, however, so the shareholder is also a (re)invention of recent date (Ireland 1999). When we analyse these changes in social construction, we find that there is a dramatic break between current ideas about shareholders and those of the inter-war period, which is signaled by a change in terminology. The term rentier (and the more pejorative coupon clipper) was widely used in the 1920s and 1930s for the actor now known as shareholder. The economic value attached to the role also changes with the terminology because, as we shall see, the centre left’s bad rentier of the 1920s and 1930s is discussed as a parasite, whereas the right’s good shareholder of the 1990s and 2000s is viewed as economically and socially beneficial. This striking shift largely relates to changing assumptions about the social basis of shareholding when rentiers were in the 1920s assumed to be a distinct minority stratum whereas in the present day we are supposedly all shareholders now. And this in turn relates to a fundamental difference about whether the claims of the shareholder should be encouraged or limited. Shareholder-value discourse of the 1990s or activist investor rhetoric in the 2000s suppose that the enforcement of the shareholder’s rights will resolve the agency problem and produce benefits for all when shareholders are us; whereas, centre-left ideologues of the 1920s and 1930s wanted to limit what they viewed as the rentier’s parasitic claims and financier activity, both of which fed economic instability and social inequality.2 This debate is at the centre of this section of the book and the subsequent section on agency theory and the value maximizing manager. The first step in historical understanding is to read the classic inter war texts by authors such as R.H. Tawney or John Maynard Keynes and recognize their difference. However, most present-day academics have a very muddled idea of the history of social discourses about shareholding. The fundamental misunderstanding is produced by reading the distinctive anti-shareholder discourses of the 1920s and 1930s about resisting rentier claims and financier activity through the prism of 1980s and

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the historical critique of the rentier and financier

1990s pro-shareholder discourse, which was classically framed by supporters for shareholder value against a background of the growing dominance of agency theory. On this basis, one classic inter war text, the Berle and Means (1932) book on The Modern Corporation and Private Property, is conventionally enrolled as a precursor, or indeed the origin, of current problem definitions because these authors supposedly discovered the separation of ownership and control in the early 1930s. This claim is factually wrong because, as one of the extracts in this section shows, Tawney made the discovery more than ten years earlier with what he termed the distinction between ‘ownership and management’ (1923, p. 202).3 The conventional framing of current problems in terms of Berle and Means’ separation of ownership and control is also procrustean in that it is an anachronistic attempt to impose a later problematic on an earlier body of work which existed in a different socio-economic context. The practical consequences are intellectually serious because the general editing out of the inter-war critique of the rentier and financier encourages the misconception that financialization is a novelty of our time which begins de novo in the late 1980s. This assumption has usefully been challenged empirically by authors like Krippner (2005), who cites the growing importance of financial income for US non-financial corporations as an index of how some of the important measurable changes go back to the 1970s. But, as this section shows, discursively the critique of financialized capitalism goes back much further to the 1920s and earlier so that current debates in the 2000s only resume and vary previous debates about the dominance of finance in inter-war capitalism. The current misreading of inter-war discourses of shareholding rests above all on the misrepresentation of the work of Adolf A. Berle, the Columbia University corporate lawyer and public intellectual. If we consider Berle’s work in the inter-war period, the key texts are the Harvard Law Review articles of 1932 produced in his debate with E. Merrick Dodd4 and the 1932 book The Modern Corporation and Private Property written with economist Gardiner Means. The Berle and Means book must figure as one of the most cited5 and least read of classic twentieth-century texts and provides a warning about how lazy academics can cut and paste titles into bibliographies without seriously troubling about contents. The debate with Dodd is relevant because it provides apparent corroboration of the precursor position insofar as Berle at that time insisted that corporate managers were by law trustees ‘required to run their affairs in the interests of their security holders’ (1932, p. 1365). But that quote only gives half the story because Berle endorsed the primacy of shareholder interests only so far as management should not ‘relinquish one position . . . leaving the situation in flux until a new order shall emerge’. Significantly, Berle was a public as well as an academic figure in the USA: by 1932 Berle was already a member of President Roosevelt’s brains trust and would afterwards take an active role in formulating and implementing New Deal policies to build the new order. Most interestingly perhaps, the final chapter of The Public Corporation and Private Property develops a vision of that new order which disproves the supposition that Berle and Means were in any sense precursors of agency theory and the corollary enforcement of shareholder rights. Berle and Means did provide measurements of the separation of ownership and control in the USA in the

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1930s, and in doing so made a significant empirical contribution, but they quite explicitly did not then recommend either the subordination of the corporation to the shareholder interest or the incentivization of managers to act in the shareholder interest. Instead their vision was of the assertion of a ‘community interest’ through New Deal policies at the expense of both the rentier’s ‘passive property’ income and the management control prerogative: Neither the claims of ownership nor those of control can stand against the paramount interests of the community . . . Should the corporate leaders, for example, set forth a program comprising fair wages, security to employees, reasonable service to their public, and stabilization of business, all of which would divert a portion of profits from the owners of passive property . . . the interests of private property owners would have to give way . . . (As for) ‘control’ of the great corporations that should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community. (Berle and Means, 1932, p. 312) If we wish to understand the background to this US centre-left reformist position of 1932 we must first go back twenty years earlier to pre-1914 European Marxist and radical liberals who argued that metropolitan capitalism had taken a financial turn in an era of domestic monopoly and global imperialism These arguments were synthesized by Lenin in his 1916 pamphlet on imperialism, which remixed arguments and empirics from earlier work by J. A. Hobson6 and by Rudolf Hilferding, whose 1910 book was titled Finance Capital: A Study of the Latest Phase of Capitalist Development. Hilferding’s argument was that capitalist competition was being superseded within the national economies through innovations which were ‘resolving more successfully the problem of the organization of the social economy’. In particular, he highlighted the rise of monopolizing industrial corporations and cartels and the fusion of banking and industrial capital ‘under the common direction of high finance’ (p. 301). This created new opportunities for ‘money capitalists’ including financiers making ‘promoter’s profits’ and rentiers who held the tradable paper issued by corporations. Within this frame, the idea of a parasitic rentier stratum was subsequently classically developed by Nikolai Bukharin (1927) in the Economic Theory of the Leisure Class, which represented the inter war period as the age of the rentier because increased circulation of ‘financial paper’ had encouraged an increasingly numerous rentier stratum. For the Marxist Bukharin, this stratum represented parasitic consumption: It participates directly neither in the activities of production nor in trade . . . Consumption is the basis of the entire life of the rentiers . . . concerned only with riding mounts, with expensive rugs, fragrant cigars and the wines of Tokay. (Bukharin, 1927, p. 9) Continental Marxists thus discovered financialized capitalism and their legatees

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(including Arrighi (1994, 2005) and Harvey (2003, 2005, 2007) in our own time) have since rediscovered it several times. But, more important from our point of view, the critique of the rentier and financier was developed in a different problematic by Anglo-American liberal collectivists who had diverse party allegiances as Democrats in the USA like Berle or as Labour Party socialists like Tawney or Liberal supporters like Keynes and Beveridge in the UK. Their development of the critique of rentier and financier was different from that of Bukharin or Hilferding because they all accepted private property, the profit motive and wage labour but wished through collective reform to limit product, labour, and capital market effects which obstructed economic stability and social security. This is the position which Cutler et al. (1986) characterized as liberal collectivist and then illustrated through close analysis of Beverdidge’s work (Williams and Williams, 1987). All three extracts in this section are taken from this liberal collectivist tradition because their reformist aim of making capitalism work better was (and is) more relevant to UK and US politics in the late twentieth and early twenty-first century. The immediate question is how did these liberal collectivist reformists of the 1920s and 1930s vary the original ‘finance capital’ problem and solution set up by the Marxists. The agenda-setting text here is Tawney’s (1923) The Acquisitive Society, whose problem definitions were borrowed and reworked a decade or more later by both Berle and Means and Keynes. As a Labour party intellectual and Christian socialist, Tawney’s intellectual starting point was not Marxist economics but liberal theories of (conditional) rights to property whereby the rentier makes contestable and illegitimate claims for income without service and represents property without function. As for the changes in capitalist organization, the starting point is not monopoly but what Tawney in 1921 termed the ‘separation of ownership and management’ (p. 202) which created a new class of managers with solid technical abilities and modest salaries, so that management was Tawney’s ‘intellectual proletariat’. The corollary policy fixes are then the liberal collectivist plans adumbrated by Tawney, who proposed capping the claims of the rentier in 1921; these were then subsequently developed after the 1929 crash by Berle and Means and by Keynes as the basis for stable prosperity in a reformed capitalism. These inter-war ideas are important both in themselves and because they show that it is possible to recognize the managerial revolution without necessarily adopting an agency theory approach. The liberal collectivists thought differently because their fundamental starting point and final aim was always political (not economic) when classic debates about property and liberty were never far away. At least since Locke and the revolutions of 1776 and 1789, liberals have been engaged in a theoretical debate and a political contest to justify the acquisition of wealth and the enjoyment of property. For interwar liberal collectivists, the issue was not property per se but the distinction between legitimate and illegitimate forms of property, neatly encapsulated in Hobson’s (1937) distinction between ‘property’ and ‘improperty’. Others, such as Tawney or Berle distinguished been ‘active’ and ‘passive’ property so that Tawney (1923) condemns mineral rights, ground rents and shares as forms of passive property that yield income not related to the needs for the owner to perform any (productive) service or function.

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In modern industrial societies the greater mass of property consists . . . of rights of various kinds such as royalties, ground rents, and above all, of course shares in industrial undertakings, which yield an income irrespective of any personal service rendered by their owners. (Tawney, 1923, p. 66) Tawney recognized the legitimacy of pure interest as the necessary price of capital (pp. 67–8 and p. 123), just as Keynes explicitly accepted the rewards for risk taking. But the rentier sought an extra profit because he held coupons ‘as an instrument for the acquisition of gain’ (pp. 65–6). When it came to policy fixes, the liberal collectivists combined idiosyncratic and standardized remedies. Thus, Tawney’s idiosyncratic alternative vision was of a society organized on the basis of functions with industry and commerce governed by trade boards which did not interest either Berle and Means or Keynes. But Tawney also proposed the interim reformist measure of reducing the privileges of private ownership of industrial capital by converting the ‘ordinary shareholder’ into a debenture holder entitled to a fixed-rate of interest (p. 123); and this proposal was then taken up by others including Keynes who, in Chapter 24 of the General Theory, rather startlingly proposed the ‘euthanasia of the rentier, of the functionless investor’ (1936, p. 376). The whole liberal agenda of capitalist reform in the 1920s and 1930s rested on the assumption that the good society would limit the claims of the rentier; quite the opposite of current assumptions about how enforcing shareholder claims will produce a better economy with more efficient allocation of capital. Read through the lens of the late twentieth or early twenty-first century, such arguments now seem all the more remarkable, especially if we remember that key liberal collectivist figures like Keynes and Berle were not academic cranks but highlevel political advisers to national governments. If the inter-war era was one of general centre-left hostility to finance, that must be understood in historical context. The general acceptance of financialization processes in the period since the early 1990s reflects implicit political tolerance of increasing inequality against a background of taken-for-granted economic stability so that centre-left and centre-right both accept policies of extending and perfecting product and capital markets. But the liberal collectivist hostility to finance in the twenty years after 1918 was stoked by economic instability and mass unemployment after the initial collapse of the post-war boom and then again after 1929 so that the centre-left blamed finance and sought stability by curbing its influence. For example, after the 1931 UK political crisis, when the Labour government split over demands for expenditure cuts, a moderate Labour newspaper (the Daily Herald) popularized the idea that the crisis was a ‘bankers’ ramp’ (Williamson, 1984). On the key question of what to do in terms of curbing finance, the key liberal collectivist contribution here comes from J. M. Keynes with the 1936 General Theory. Whereas Berle and Means in 1932 have no more than a political vision of how society could be different, Keynes in 1936 provides a compelling technical economic justification for the capping of rentier claims which Tawney had recommended fifteen years previously. Keynes was an original economic theorist, creative public servant, and successful

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stock market speculator with a genius for finding a way through difficulties which defeated others. His 1936 General Theory is now obscured by layers of anachronistic misunderstandings because the many talents of mainstream economics never recognized Keynes’ individual genius: so the economic orthodoxy (which Keynes undermined) subsequently assimilated and perhaps trivialized his achievements. Thus, some thirty years after publication of the General Theory, Leijonhufvud (1968) tried to rescue Keynes from the Hicksian style of ‘Keynesian’ economics and the idea that Keynes dealt in the trivial special case of equilibrium with sticky wages. And now, some seventy years after first publication, when the General Theory has largely been dropped from undergraduate reading lists, it is surely time to revalue Keynes and recognize the achievement of the General Theory as the first intellectually respectable (non-Marxist) economic theory of the inherent economic instability of financialized capitalism. In explaining the technical causes of instability and unemployment, Keynes started from steady state under-consumption on the assumption that the ‘marginal propensity to consume’ was steadily less than one because consumers generally do not spend all of their increments in income. The technical problem then was that unemployment ensued because the volume of investment fluctuated and did not always or usually compensate for under-consumption. This was then referred back to the fluctuating ‘marginal efficiency of capital’ or expectations of return in the specific context of a stock market capitalism, where the price of liquidity is speculation with violent fluctuations in the shallow and conventional judgments of stock market investors. In conditions of laissez-faire, the avoidance of wide fluctuations in employment may, therefore, be impossible without a far reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands. (Keynes, 1936, p. 320) Keynes’ solution was not to offer the ‘rentier’ more but to engineer a reduction in the ‘marginal efficiency of capital’ resulting in interest rates so low that the ‘pure rate of interest’ (i.e. without a premium for risk) would be zero. This would both boost investment and thus aggregate demand and ensure ‘a gradual disappearance of a rate of return on accumulated wealth’ (Keynes 1936, pp. 220–1). The visionary Keynes therefore identified ‘the rentier aspect of capitalism as a transitional phase’ (1936, p. 376) but, inevitably perhaps, he did not clearly explain how the euthanasia of the rentier would be achieved, and he certainly underestimated the political capacity of financial interests to resist a socialisation of investment through capital flight and gilts strike (Cutler et al. 1986, p. 36). In an unanticipated way, it was events rather than policy which then did for the rentier or, more exactly, undermined the idea of a distinct rentier stratum; though Keynes did indirectly play a part when the Bretton Woods settlement and Keynesianism in the UK participated in caging finance for nearly thirty years after 1945. Certainly, the wealth and income distribution figures in the USA and UK do show

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a measurable decline of the rentier for fifty or more years after 1920. Saez (2004) shows the share of the wealthiest 1 per cent declined between 1920 to 1980 from 60 per cent in the UK and around 40 per cent in the USA to around 20 per cent in both countries. If we consider high-income earners, Saez (2004) also shows that (rentier) income from capital accounts for a declining share of the total income of high-income groups. While capital income contributed around half of total income in the 1920s and 1930s, by the 1980s this was less than a fifth. One of the reasons for the decline in the significance of rentier income is the shift in ownership of equity from individuals to institutions which creates what Epstein and Jayadev (2005) characterize as a new kind of ‘rentier’. In effect, after 1950 the idea of a narrow upper middle-class rentier stratum was killed off by the rise of mass investment in the UK and the USA, particularly through funded occupational pensions. There are important and persisting differences between the USA and the UK but there is also a basic similarity in that by the mid-1990s share ownership is now more widely spread in both countries, although even now only those households in the top half of the income distribution generally have significant stock market investments (Froud et al., 2002). The inter-war critique of the rentier and finance is still relevant, first, because the novelty of present-day capitalism is generally overestimated by the historically illiterate and, second, because critical accounts of finance then resonate with debates about financialization now. The general partners of private equity funds who had their moment as the new kings of capitalism in the mid-2000s (Froud and Williams 2007) are perhaps only reincarnations of Hilferding’s company promoters or Tawney’s financiers in Lancashire cotton (p. 89). Equally, the differences in process and policy stance are important above all because the liberal collectivists on finance challenge the current conventional wisdom about the benefits of extending financial markets and the marketization of risk which has ossified since financial deregulation in the late 1980s (see for example Shiller 2003). The contrary assumption of the liberal collectivists is that the politico-social objective of security for the masses is threatened by finance: equality and stability in the long run depend on the curbing of the role of finance in capitalism. It would be premature to suppose that such positions have been buried along with Keynes because the most fundamental lesson of the inter-war period is surely that finance will always be blamed when things go wrong.

NOTES 1

2 3

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These were the 1844 Railway Act and the 1856 Joint Stock Companies Act, where the former dispensed with the need for a special charter to establish a company, while the latter broadened the scope of the status of liability. On the development of the public company see Micklethwait and Wooldridge (2003). See, for instance Rappaport (1998). Indeed, others argue that the ownership/control separation was observed still earlier by Alfred Marshall in 1890 or William W. Cook in 1891; see Hovenkamp (1991). The issue here is not so much, who first made the observation about how

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4 5 6

the historical critique of the rentier and financier the public company and dispersed shareholding changed the nature of ownership, but about how the academic and political debate about the implications of this separation shifted markedly over the twentieth century. This debate in helpfully summarized in Ireland 2001 – see extract from this work in section 2 of this book. See, for instance William W. Bratton (2001, p. 7381), who presents citation data on Berle and Means and compares this with other volumes. See for instance, Problems of Poverty (1881), Imperialism (1902) and The Industrial System (1909).

REFERENCES Arrighi, G. (1994) The Long Twentieth Century: Money, Power and the Origins of Our Time, London: Verso. Arrighi, G. (2005) ‘Hegemony unraveling II’, New Left Review, 33 (May–June): 83–116. Berle, A. A. (1931) ‘Corporate powers as powers in trust’, Harvard Law Review, 44: 1049–74. Berle, A. A. (1932) ‘For whom corporate managers are trustees: a note’, Harvard Law Review, 45: 1365–72. Berle, A. A. and Means, G. C. (1932) The Modern Corporation and Private Property (revised edn 1968) New York: Harcourt, Brace & World, Inc. Bratton, W. W. (2001) ‘Berle and Means Reconsidered at the Century’s Turn’, Journal of Corporation Law, spring: 737–70. Bukharin, N. (1927) Economic Theory of the Leisure Class, New York: International Publishers. Cutler, T., Williams, K. and Williams, J. (1986) Keynes, Beveridge and Beyond, London: Routledge Kegan Paul. Dodd, E. M. (1932) ‘For whom are corporate managers trustees?’, Harvard Law Review, 45: 1145–63. Epstein, G. and Jayadev, A. (2005) ‘The rise of rentier incomes in OECD countries: financialization, central bank policy and labor solidarity’, in G. Epstein (ed.), Financialization and the World Economy, London: Edward Elgar. Froud, J. and Williams, K. (2007) ‘Private equity and the culture of value creation’, New Political Economy, 12(3): 405–20. Froud, J., Johal, S. and Williams, K. (2002) ‘Financialisation and the coupon pool’, Capital and Class, 78: 119–52. Harvey, D. (2003) The New Imperialism, Oxford: Oxford University Press. Harvey, D. (2005) A Brief History of Neoliberalism, New York: Oxford University Press. Harvey, D. (2007) ‘Neoliberalism as creative destruction’, Annals of the American Academy of Political and Social Science, 610: 21–44. Hilferding, R. (1910) Finance Capital, London: Routledge and Kegan Paul (repr. 1981). Hobson, J. A. (1881) Problems of Poverty, London: Methuen. Hobson, J. A. (1902) Imperialism, London: J. Nisbet. Hobson, J. A. (1909) The Industrial System, London: Longmans, Green & Co.

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Hobson, J. A. (1937) Property and Improprety, London: Victor Gollancz. Hovenkamp, H. (1991) Enterprise and American Law: 1836–1937, Boston, MA: Harvard University Press. Ireland, P. (1999) ‘Company law and the myth of shareholder ownership’, Modern Law Review, 62 (1): 32–57. Ireland, P. (2000) ‘Defending the rentier: corporate theory and the reprivatisation of the public company’ in J. Parkinson, A. Gamble, and G. Kelly (eds), The Political Economy of the Company, Oxford: Hart Publishing, 141–73. Keynes, J. M. (1936) A General Theory of Employment, Interest and Money, London: Macmillan. Krippner, G.R. (2005) ‘The financialization of the American economy’, Socio-Economic Review, 3(1), 173–208. Leijonhufvud, A. (1968) On Keynesian Economics and the Economics of Keynes: A Study of Monetary Theory, London: Oxford University Press. Lenin, V. I. (1917) Imperialism. The Higher Stages of Capitalism, Moscow: Progress Publishers (repr. 1966). Micklethwait, J. and Wooldridge, A. (2003) The Company. A Short History of a Revolutionary Idea, London: Weidenfeld & Nicolson. Rappaport, A. (1998) Creating Shareholder Value, 2nd edn, New York: Free Press. Saez, E. (2004) ‘Income and Wealth Concentration in a Historical and International Perspective’, http://emlab.berkeley.edu/users/saez/. Shiller, R. (2003) The New Financial Order. Risk in the twenty-first Century, Princeton, NJ: Princeton University Press. Tawney, R. H. (1923) The Acquisitive Society, London: G. Bell and Sons. Williams, K. and Williams, J. (1987) A Beveridge Reader, London: Allen & Unwin. Williamson, P. (1991) ‘1931 Revisited: the political realities’, Twentieth Century British History, 2 (3): 328–38.

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Chapter 1

R. H. Tawney

AGAINST THE RENTIER AND FINANCIER

Introduction to extract from R. H. Tawney (1923), The Acquisitive Society, London: G. Bell and Sons Ltd

EDITORS’ COMMENTARY R. H. Tawney’s 1923 book makes a founding contribution to the liberal collectivist argument of the 1920s and 1930s about the elements of capitalism that are objectionable and why, as well as how, these might be reformed to deliver security for the masses. His arguments are sometimes not easy to follow because of Tawney’s prose style and the often convoluted sentences which pile up more and more parenthetical qualifications between new sets of commas. But Tawney’s widespread influence was secured by the robust simplicity and force of his argument. The excerpts here work through two binary oppositions, first, between good and bad property and, second, between productive management and financially orientated business. Together, these oppositions set up a subtle version of the narrative about ownership and control which, in the context of an industry (not the firm), are not separated because financial calculation and control are represented inside and outside the firm by the significant figures of the financier and the rentier. The first section on ‘the divorce of ownership and work’ provides a theoretical basis for critique of the shareholder as ‘rentier’. Tawney does not dispute the rights of property but instead distinguishes between different forms of property and property rights, and in particular between good property and bad ‘improperty’ (pp. 65–8). Good property is associated with ‘creative activity’ and personal service. Here the property right secures the owner ‘the produce of his toil’ as in the case of an individual author’s copyright or inventor’s patent rights. Bad property is associated with ‘passive ownership’ and income unaccompanied by personal service. Here ‘the fruits are the

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proprietor’s and the labour that of someone else’ as in the case of urban ground rents or mineral royalties which are no more than ‘private taxation’. Shares in limited companies represent a slightly different case but are in principle bad property because the rentier shareholder draws income unaccompanied by personal service and has rights which can be inherited by descendents. Note that Tawney’s criticism of the rentier as social parasite does not imply hostility to the payment of (pure) interest which is a necessary cost if individuals or community are to be persuaded to abstain from consumption. This acceptance of economic interest, but hostility to the rentier as social parasite, then provides the basis for Tawney’s policy interest in limiting the claims of the rentier. The second section on ‘the separation of business and industry’ develops a conceptual basis for the critique of the financier who, in Tawney’s terminology, is the ‘businessman’. Again this argument works by setting up a binary distinction. In earlier periods there was a unitary ‘employer’ because one individual combined the functions of manager-cum-technician and capitalist. But modern organization separates two kinds of personnel and distinct functions: first, there is the cadre of ‘technical and managerial staff’, managers whose semi-Taylorist mission is to organize the business of production in an efficient way; second, there is a directing group of ‘business men who ultimately control industry’ and are concerned with financial gains from company promotion and product market control. The businessman is a kind of financier (inside or outside the firm) ‘interested in the actual making of goods only in so far as financial results accrue from it’. In Tawney’s view the separation of (technical) management from (financial) business is momentous because it opens the way to the pursuit of profits without achieving productive efficiency. Indeed, cases such as flotation of Lancashire cotton mills in the brief boom after the 1914–18 war, show how a ‘London syndicate’ can make profits with ‘hardly any connection with production at all’ (p. 215). R. H. Tawney (1880–1962) was a distinguished economic historian who taught at the London School of Economics, a pioneer of adult education and a Labour Party activist, whose contribution includes co-writing the 1928 Labour Party general election manifesto. His publications include The Acquisitive Society (1923) and Equality (1931), as well as agenda-setting economic history texts, including Religion and the Rise of Capitalism (1926).

The divorce of ownership and work 1, 2

T

which differentiates most modern property from that of the pre-industrial age, and which turns against it the very reasoning by which formerly it was supported, is that in modern economic conditions ownership is not active, but passive, that to most of those who own property to-day it is not a means of work but an instrument for the acquisition of H E C H A R A C T E R I S T I C FA C T,

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gain or the exercise of power, and that there is no guarantee that gain bears any relation to service, or power to responsibility. For property which can be regarded as a condition of the performance of function, like the tools of the craftsman, or the holding of the peasant, or the personal possessions which contribute to a life of health and efficiency, forms an insignificant proportion, as far as its value is concerned, of the property rights existing at present. In modern industrial societies the great mass of property consists, as the annual review of wealth passing at death reveals, neither of personal acquisitions such as household furniture, nor of the owner’s stock-in-trade, but of rights of various kinds, such as royalties, ground rents, and, above all, of course shares in industrial undertakings, which yield an income irrespective of any personal service rendered by their owners. Ownership and use are normally divorced. The greater part of modern property has been attenuated to a pecuniary lien or bond on the product of industry, which carries with it a right to payment, but which is normally valued precisely because it relieves the owner from any obligation to perform a positive or constructive function. Such property may be called Passive Property, or Property for Acquisition, for Exploitation, or for Power, to distinguish it from the property which is actively used by its owner for the conduct of his profession, or the upkeep of his household. To the lawyer the first is, of course, as fully property as the second. It is questionable, however, whether economists should call it ‘Property’ at all, and not rather, as Mr. Hobson has suggested, ‘Improperty,’ since it is not identical with the rights which secure the owner the produce of his toil, but is the opposite of them. A classification of proprietary rights based on this difference would be instructive. If they were arranged according to the closeness with which they approximate to one or other of these two extremes, it would be found that they were spread along a line stretching from property which is obviously the payment for, and condition of, personal services, to property which is merely a right to payment from the services rendered by others, in fact a private tax. The rough order which would emerge, if all details and qualifications were omitted, might be something as follows: 1 2 3 4 5 6 7 8 9

Property in payments made for personal services. Property in personal possessions necessary to health and comfort. Property in land and tools used by their owners. Property in copyright and patent rights owned by authors and inventors. Property in pure interest, including much agricultural rent. Property in profits of luck and good fortune: ‘quasi rents’. Property in monopoly profits. Property in urban ground rents. Property in royalties.

The first four kinds of property clearly accompany, and in some sense condition, the performance of work. The last four clearly do not. Pure interest has some affinities with both. It is obvious that an undertaking or a society which saves itself need not pay other persons to save for it; it is equally obvious that, if it is to save itself and thus avoid the creation of class of rentiers, it must not use for

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current consumption the whole of the wealth annually produced. Pure interest, therefore, represents a necessary economic cost, the equivalent of which must be borne whatever the legal arrangements under which capital is held, and is thus unlike the property represented by profits (other than the equivalent of salaries and payment for necessary risks), urban ground-rents and royalties. . . . It is rarely realized . . . how extremely modern are those typical forms of property in which the practical world of to-day is principally interested. The most salient example is the share. Of all types of property it is the commonest and most convenient. It is a title to property stripped of almost all the encumbrances by which property often used to be accompanied. It yields an income and can be disposed of at will. It makes its owner heir to the wealth of countries to which he has never travelled and a partner in enterprises of which he hardly knows the name. To thousands of men to-day shares and property are almost convertible terms. The share is a product of the joint-stock company, and in England the joint stock company began its career in the sixteenth century. But it took nearly 300 years for the share to develop the characteristic attributes which lend it its peculiar attractiveness to-day. . . . The ‘Joint-stock’ of the East India Company – to take an example from the greatest, though not the earliest, of all corporate enterprises – had for the greater part of a century no financial continuity. It was subscribed afresh for every voyage, or series of voyages, and repaid after it. It was not until 1657 that the practice of dividing capital as well as profits was abandoned; it was not until after the Restoration that the shares became transferable. The ‘Bubble’ Act of 1719 tried to put down joint-stock finance . . . altogether, except in companies possessing royal or parliamentary authorization. Well into the nineteenth century the law continued to look with suspicion on the transferable share, as a new and dubious form of property. . . . Even in 1837 it could be held that a joint stock company, with shares assignable at the will of the holder, was illegal. Even in 1859, four years after the first general Limited Liability Act, it was not certain that a broker who dealt in the shares of an unincorporated company was acting lawfully. The existence of this body of opinion at a time so near to our own is significant. What it means is that, down to less than two generations ago, the type of property which is to-day most popular and most universal was still regarded with suspicion as a dubious invention to be tolerated only in the special case of companies incorporated by Royal Charter or by Act of Parliament. The assumption of the law and of the business world was that, in the normal undertaking, ownership and management were vested in the hands of the same person. Corporate finance, based on the existence of a large body of shareholders, which is now the rule, was then the exception. The contrast offered by that attitude with the facts of industrial organization as they exist to-day is an indication of the revolution in the nature of property in capital which has taken place since the establishment of Limited Liability in 1855 and the Companies Act of 1862. In modern industrial communities the general effect of recent economic development has been to swell proprietary rights which entitle the owners to payment without work, and to diminish those which can properly be described as functional. The expansion of the former, and the process by which the simpler forms

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of property have been merged in them, are movements the significance of which it is hardly possible to over-estimate. There is still, of course, a considerable body of property which is of the older type. But though working landlords, and capitalists who manage their own businesses, continue to be in the aggregate a numerous body, the organization for which they stand is not that which is most representative of the modern economic world. . . . Whatever may be the justification of these types of improperty, it cannot be that which was given for the property of the peasant or the craftsman. . . . For, if a legal right which gives £50,000 a year to a mineral owner in the North of England and to a ground landlord in London ‘secures the fruits of labour’ at all, the fruits are the proprietor’s and the labour that of someone else. . . . In reality, whatever conclusion may be drawn from the fact, the greater part of modern property belongs to the category of property which is held, not for use or enjoyment, but for acquisition or power. Sometimes, like mineral rights and urban ground rents, it is merely a form of private taxation which the law allows certain persons to levy on the industry of others; sometimes like property in capital, it consists of rights to payment for instruments which the capitalist cannot himself use but puts at the disposal of those who can. In either case, it has as its essential feature that it confers upon its owners income unaccompanied by personal service. In this respect, the ownership of land and the ownership of capital are normally similar, though from other points of view their differences are important. To the economist rent and interest are distinguished by the fact that the latter, though it is often accompanied by surplus elements which are merged with it in dividends, is the price of an instrument of production which would not be forthcoming for industry if the price were not paid, while the former is a differential surplus which does not affect the supply. To the business community and the solicitor land and capital are equally investments, between which, since they possess the common characteristics of yielding income without labour, it is inequitable to discriminate. Though their significance as economic categories may be different, their effect as social institutions is the same. It is to separate property from creative activity, and to divide society into two classes, of which one has its primary interest in passive ownership, while the other is mainly dependent upon active work. . . . Th[e] need for security is fundamental, and almost the gravest indictment of our civilization is that the mass of mankind are without it. Property is one way of organizing it. . . . In fact, however, property is not the only method of assuring the future, nor, when it is the way selected, is security dependent upon the maintenance of all the rights which are at present normally involved in ownership. . . . Property is not simple but complex. That of a man who has invested his savings as an ordinary shareholder comprises at least three rights, the right to interest, the right to profits and (in legal theory) the right to control. In so far as what is desired is the guarantee for the maintenance of a stable income, not the acquisition of additional wealth without labour – in so far as his motive is not gain but security – the need is met by interest on capital. It has no necessary connection either with the right to residuary profits or the right to control the

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management of the undertaking from which the profits are derived, both of which are vested to-day in the shareholder. If all that were desired were to use property as an instrument for purchasing security, the obvious course – from the point of view of the investor desiring to insure his future the safest course – would be to assimilate his position as far as possible to that of a debenture holder or mortgagee, who obtains the stable income which is his motive for investment, but who neither incurs the risks nor receives the profits of the speculator. The elaborate apparatus of proprietary rights which distributes dividends of thirty per cent to the shareholders in Coats, and several thousands a year to the owner of mineral royalties and ground-rents, and then allows them to transmit the bulk of the gains which they have not earned to descendants who in their turn will thus be relieved from the necessity of earning, is property run mad. . . . Functionless property appears natural to those who believe that society should be organized for the acquisition of private wealth, and attacks upon it perverse or malicious, because the question which such persons ask of any institution is, ‘What does it yield?’ And such property yields much to those that own it. Those, however, who hold that social unity and effective work are possible only if society is organized and wealth distributed on the basis of function, will ask of an institution, not, ‘What dividends does it pay?’ but ‘What service does it perform?’ To them the fact that much property yields income irrespective of any service which is performed or obligation which is recognized by its owners will appear, not a quality but a vice. They will see in the social confusion which it produces, payments disproportionate to service here, and payments without any service at all there, and dissatisfaction everywhere, a convincing confirmation of their argument that to build on a foundation of rights and of rights alone is to build on quicksand. . . . Profits may vary in a given year from a loss to 100 per cent. But wages are fixed at a level which will enable the marginal firm to continue producing one year with another; and the surplus, even when due partly to efficient management, goes neither to managers not to manual workers, but to shareholders. The meaning of the process becomes startlingly apparent when, as recently in Lancashire, large blocks of capital change hands at a period of abnormal activity. The existing shareholders receive the equivalent of the capitalized expectation of future profits. The workers, as workers, do not participate in the immense increment in value. And when, in the future, they demand an advance in wages, they will be met by the answer that profits which before the transaction would have been reckoned large, yield shareholders after it only a low rate of interest on their investment. The truth is that, whereas in earlier ages the protection of property was normally the protection of work, the relationship between them has come in the course of the economic development of the last two centuries to be very neatly reversed. . . .

The increasing separation of ‘business’ and industry 3 . . . [P]ublic ownership does not appear to confront the brain worker with the danger of unintelligent interference with his special technique, of which he is,

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quite naturally, apprehensive. It offers him, indeed, far larger opportunities of professional development than are open to all but a favoured few to-day, when considerations of productive efficiency, which it is his special métier to promote, are liable to be overridden by short-sighted financial interests operating through the pressure of a Board of Directors who desire to show an immediate profit to their shareholders and will ‘cream’ the pit, or work it in a way other than considerations of technical efficiency would dictate. . . . For the economic developments of the last thirty years have made the managerial and technical personnel of industry the repositories of public responsibilities of quite incalculable importance, which, with best will in the world, they can hardly at present discharge. The most salient characteristic of modern industrial organization is that production is carried on under the general direction of business men, who do not themselves necessarily know anything of productive processes. ‘Business’ and ‘industry’ tend to an increasing extent to form two compartments, which though united within the same economic system, employ different types of personnel, evoke different qualities and recognize different standards of efficiency and workmanship. The technical and managerial staff of industry is, of course, as amenable as other men to economic incentives. But their special work is production, not finance; and provided they are not smarting under a sense of economic injustice, they want, like most workmen, to ‘see the job done properly’. The business men who ultimately control industry are concerned with the promotion and capitalization of companies, with competitive selling and the advertisement of wares, the control of markets, the securing of special advantages, and the arrangement of pools, combines and monopolies. They are preoccupied, in fact, with financial results, and are interested in the actual making of goods only in so far as financial results accrue from it. The change in organization which has, to a considerable degree, specialized the spheres of business and management is comparable in its importance to that which separated business and labour a century and a half ago. It is specially momentous for the consumer. As long as the functions of manager, technician and capitalist were combined, as in the classical era of the factory system, in the single person of ‘the employer’, it was not unreasonable to assume that profits and productive efficiency ran similarly together. In such circumstances the ingenuity with which economists proved that, in obedience to ‘the law of substitution’, he would choose the most economical process, machine, or type of organization wore a certain plausibility. . . . With the drawing apart of the financial and technical departments of industry – with the separation of ‘business’ from ‘production’ – the link which bound profits to productive efficiency is tending to be snapped. There are more ways than formerly of securing the former without achieving the latter; and, when it is pleaded that the interests of the captain of industry stimulate the adoption of the most ‘economical’ methods, and thus secure industrial progress, it is necessary to ask ‘economical for whom?’ Though the organization of industry which is most efficient, in the sense of offering the consumer the best service at the lowest real cost, may be that which is most profitable to the firm, it is also true that profits are constantly made in ways which

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have nothing to do with efficient production, and which sometimes, indeed, impede it. The manner in which ‘business’ may find that the methods which pay itself best are those which a truly ‘scientific management’ would condemn may be illustrated . . . In the first place the whole mass of profits which are obtained by the adroit capitalization of a new business, or the reconstruction of one which already exists, have hardly any connection with production at all. When, for instance, a Lancashire cotton mill capitalized at £100,000 is bought by a London syndicate which refloats it with a capital of £500,000 – not at all an extravagant case – what exactly has happened? In many cases the equipment of the mill for production remains, after the process, what it was before it. It is, however, valued at a different figure, because it is anticipated that the product of the mill will sell at a price which will pay a reasonable profit not only upon the lower, but upon the higher capitalization. If the apparent state of the market and prospects of the industry are such that the public can be induced to believe this, the promoters of the reconstruction find it worth while to recapitalize the mill on the new basis. They make their profit not as manufacturers, but as financiers. They do not in any way add to the productive efficiency of the firm, but they acquire shares which will entitle them to an increased return. . . . In so far, then, as ‘Business’ and ‘Management’ are separated, the latter being employed under the direction of the former, it cannot be assumed that the direction of industry is in the hands of persons whose primary concern is productive efficiency. That a considerable degree of efficiency will result incidentally from the pursuit of business profits is not, of course, denied. What seems to be true, however, is that the main interest of those directing an industry which has reached this stage of development is given to financial strategy and the control of markets because the gains which these activities offer are normally so much larger than those accruing from the mere improvement of the processes of production. It is evident, however, that it is precisely that improvement which is the main interest of the consumer. He may tolerate large profits as long as they are thought to be the symbol of efficient production. But what he is concerned with is the supply of goods, not the value of shares, and when profits appear to be made, not by efficient production, but by skilful financiering or shrewd commercial tactics, they no longer appear meritorious. If, in disgust at what he has learned to call ‘profiteering’, the consumer seeks an alternative to a system under which production is controlled by ‘business’, he can hardly find it except by making an ally of the managerial and technical personnel of industry. They organize the service which he requires; they are relatively little implicated, either by material interests or by psychological bias in the financial methods which he distrusts; they often find the control of their professions by businessmen, who are primarily financiers, irritating in the obstruction which it offers to technical efficiency, as well as sharp and close fisted in its treatment of salaries. . . . It is this gradual disengagement of managerial technique from financial interests which would appear to be the probable line along which ‘the employer’ of the future will develop.

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EDITORS’ NOTES 1 2

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Reproduced with permission from Dover Publications. The extract is in two sections: ‘The divorce of ownership and work’ and ‘The increasing separation of business and industry’. The first section of the extract is taken from chapter V, ‘Property and Creative Work’ (pp. 65–7, 70–3, 78–9, 83–7) and the section head is used by Tawney on p. 64. The extract is taken from Chapter X, ‘The Position of the Brain Worker’ (pp. 212–15) and the heading is used by Tawney on p. 213.

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Chapter 2

Adolf A. Berle and Gardiner C. Means

CONTROL, LIQUIDITY AND THE ‘COMMUNITY INTEREST’

Introduction to extract from Adolf A. Berle and Gardiner C. Means (1932), The Modern Corporation and Private Property (revised edition, 1968), New York: Harcourt, Brace and World

EDITORS’ COMMENTARY Contrary to many accounts of the development of the public company, Berle and Means in 1932 were not the original discoverers of the separation of ownership and control, as the previous extract from Tawney’s The Acquisitive Society showed. However, The Modern Corporation and Private Property is significant, not only in the way that their clear articulation of this shift gained sustained attention,1 but equally because, as this extract shows, Berle and Means did not call for the enforcement of shareholder claims as the desirable solution to the separation of ownership and control that they presented. Instead, in the context of the argument within inter-war liberal collectivism, Berle and Means made an important contribution to the development of the intellectual debate around the public company, not least by adding new measures of the dispersion of ownership. The intellectual innovations in their 1932 book also changed the focus of the debate from that in Tawney’s figure of the financier, who vanishes in The Modern Corporation and Private Property, and shifts the concern to the concepts of ownership and control, which set up a distinction between inside and outside at individual firm level. If the financier vanishes, Berle and Means refocus the rentier debate so that it is subsequently less about the shareholder as social actor and more about the stock market as an economic institution which creates liquidity. However, this does not mean that Berle and Means have a purely economic account of the firm and its legal nature. Significantly, they do articulate an alternative

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vision of what the firm might be if it was subordinated to the community and reconciled the interests of different groups. From this point of view, intellectually as well as chronologically, Berle and Means are precisely what comes between Tawney and Keynes.2 The first section of this extract on ‘shareholders exchange liquidity for control’ shows how Berle and Means represent liquidity as the stock market’s compensation for loss of corporate control. ‘Controlling management’ is under a nominal duty to run the firm for the benefit of shareholders but shareholders are effectively powerless because they cannot demand that managers ‘do or refrain from doing any given thing’ (p. 244). In an earlier era the insider shareholder was a ‘quasipartner’; but with dispersed ownership the outsider shareholder is just another supplier of capital with few rights except for the ultimate sanction of changing management (p. 246). Yet the institution of the stock market does bring compensating benefits. The ‘quasi-partner’ was the owner of non-liquid property and ‘married’ to the firm in ways which meant he could not avoid active responsibilities for its decision-making (p. 249). But the market in shares allows individual shareholders to become passive absentee owners which may well suit some individuals, while collectively the liquid market allows any shareholder to sell at a price which reflects expectations of future distributions by management. In developing these arguments, Berle and Means challenge Tawney’s earlier completely negative view of ‘passive property’, though they do not reach Keynes’ later conclusion that liquidity itself becomes the problem, as outlined in the next extract from Keynes’ General Theory. The second section of this extract on ‘the assertion of community interests’ brings out the point that, although Berle and Means countenanced passive ownership and active stock market trading, they quite explicitly resisted the idea that the firm should be operated in the sole interest of passive shareholder owners; or for that matter in the interest of any other ‘controlling group’, including management. Instead, they argue that the ‘great corporation’ combines concentration of power and diverse interests which can only be managed and reconciled by asserting ‘the paramount interests of the community’. Berle and Means’ vision was that corporate control could become a benevolent and ‘neutral technology’ balancing claims and making distributions to different groups. Their 1932 discussion of how this might be effected is brief and envisages corporate managements introducing a National Recovery Act (NRA)-type programme of fair wages and cartels under which shareholders would accept dividend cuts. But the NRA lasted just two years from 1933 to 1935 before it sank under the burden of legal rulings and political unpopularity. Like Margaret Blair (1995), Will Hutton (1995), and others who discussed stakeholder capitalism in the 1990s, Berle and Means found reconciling interests is easier to envisage than achieve. Adolf A. Berle (1895–1971) combined an academic career as a Professor of Corporate Law at Columbia Law School (1927–64) with terms working for the US government under F. D. Roosevelt on projects like the New Deal and the Good Neighbour Policy and, later, for John F. Kennedy’s administration. In addition to The

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adolf a. berle and gardiner c. means

Modern Corporation and Private Property written with Means in 1932, Berle’s books include The Twentieth Century Capitalist Revolution (1954) and Power Without Property (1959). Gardiner C. Means (1896–1988) worked with Berle at Harvard on the empirical content of The Modern Corporation and Private Property. Like Berle he combined an academic career with periods of work for government, in this case a role in the NRA in the 1930s. Means’ other works include The Structure of the American Economy (1939), The Corporate Revolution in America (1962) and A Monetary Theory of Employment (a response to Keynes’ General Theory, written in 1947 but not published until 1995).

NOTES 1

2

As Bratton argues, Berle and Means are generally credited with this ‘discovery’, which remains ‘corporate law’s principal source of unsolved problems’ (2001, p. 751). See also Hutchinson (2007) on the enduring and contemporary relevance of The Modern Corporation and Private Property. Intellectually, Berle and Means are an interesting pair of co-authors. Bratton argues that (rather unusually) it was the economist, Means, who persuaded the lawyer, Berle, that government intervention, not self-regulation, was the appropriate response to the empirical problem of US corporate enterprise that Means outlined (Bratton 2001, pp. 752–3).

REFERENCES Blair, M. (1995) Ownership and Control: Rethinking Governance for the Twenty First Century, Washington, DC: Brookings Institute Press. Bratton, W. W. (2001) ‘Berle and Means reconsidered at the century’s turn’ Journal of Corporation Law, spring: pp. 737–70. Hutchinson, A. C. (2007) ‘Public policy and private cupidity: Berle and Means revisioned’, Law Research Institute Research Paper Series, Research Paper 3/2007. Hutton, W. (1995) The State We’re In, London: Vintage.

Shareholders exchange liquidity for control 1, 2 E S H A R E H O L D E R I N T H E modern corporate situation has sur[T]Hrendered a set of definite rights for a set of indefinite expectations. The

whole effect of the growth of powers of directors and ‘control’ has been steadily to diminish the number of things on which a shareholder can count; the

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number of demands which he can make with any assurance that they must be satisfied. The stockholder is therefore left as a matter of law with little more than the loose expectation that a group of men, under a nominal duty to run the enterprise for his benefit and that of others like him, will actually observe this obligation. In almost no particular is he in a position to demand that they do or refrain from doing any given thing. Only in extreme cases will their judgment as to what is or is not to his interest to be interfered with. And they have acquired under the corporate charter power to do many things which by no possibility can be considered in his interest – whether or not they can be considered in the interest of the enterprise as a whole. As a result, we have reached a condition in which the individual interest of the shareholder is definitely made more subservient to the will of a controlling group of managers, even though the capital of the enterprise is made up out of aggregated contributions of perhaps many thousands of individuals. The legal doctrine that the judgment of the directors must prevail as to the best interests of the enterprise, is in fact tantamount to saying that in any given instance the interests of the individual may be sacrificed to the economic exigencies of the enterprise as a whole, the interpretation of the board of directors as to what constitutes an economic exigency being practically final. . . . The shift of powers from the individual to the controlling management combined with the shift from the interests of the individual to those of the group have so changed the position of the stockholder that the current conception with regard to him must be radically revised. Conceived originally as a quasi-partner, manager and entrepreneur, with definite rights in and to property used in the enterprise and to the profits of that enterprise as they accrued, he has now reached an entirely different status. He has, it is true, a series of legal rights, but these are weakened in varying degree (depending upon the completeness with which the corporation has embodied in its structure the modern devices) by the text of the contract to which the stockholder is bound. His power to participate in management has, in large measure, been lost to him, and become vested in the ‘control’. He becomes simply a supplier of capital on terms less definite than those customarily given or demanded by bondholders; and the thinking about his position may be qualified by the realization that he is, in a highly modified sense, not dissimilar in kind from the bondholder or lender of money. This similarity is heightened as the typical bondholder comes to rely increasingly on the success of a going enterprise and less on items of its property (whether mortgaged to him or not) which may, and usually do, become almost valueless if the enterprise is discontinued. Both the change in the form of many new bond contracts, and the evolution of receivership and reorganization practice have led to a situation in which many bondholders, though still somewhat stronger as far as their legal position is concerned, can no longer make effective the absolute rights which would appear from the lettering on their bonds or the covenants contained in the underlying indentures. Though the law still maintains the conception of a sharp dividing line recognizing the bondholder as a lender of capital and the stockholder as a quasipartner in the enterprise, economically the positions of the two have drawn

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together. Consequently, security holders may be regarded as a hierarchy of individuals, all of whom have supplied capital to the enterprise, and all of whom expect a return from it. . . . The common stockholder has the weakest position of all. His expectation is based weakly on the fact that, if any common stockholder is treated well by way of distribution, all must be treated alike including himself; and that if the management is unfaithful to its trust he may, in extreme cases, either revolt, thereby changing the management, or through legal steps materially upset the situation. . . . The net result of stripping the stockholder of virtually all his power within the corporation is to throw him upon an agency lying outside the corporation itself – the public market. It is to the market that most security holders look both for an appraisal of the expectations on their security, and by a curious paradox, for their chance of realizing them. . . . One of the recognized functions of modern finance has been to make mobile the wealth otherwise locked up. In other words, to permit the use for ready exchange or as security for loans of properties otherwise not available for either purpose. For example, a man may be the owner of a gold mine in Alaska, worth many millions of dollars, and yet he may starve to death in the streets of Chicago, unless some method can be devised by which his properties can be used as collateral for a loan, or may be exchanged for cash or commodities. Throughout the entire history of finance there is apparent a constant struggle so as to arrange matters that values anywhere may be made available anywhere. This involves two subsidiary processes: the first being a method for assigning recognized value to property; and the second the devising of instrumentalities by which participations representing an interest in such properties may be created and made saleable more or less universally. From the days when Roman Merchants arranged to discount drafts against wheat on the Alexandrian triremes plying between Egypt and the Tiber so that the wheat afloat could be readily converted into money at Rome, to the present time, when a share of stock may be turned into cash at any one of many points throughout the financial world, the demand for liquidity or mobility of value has been constantly apparent. . . . With this increased liquidity have come corresponding changes in the whole property relationship. These result from two characteristics. First, the relationship of the so-called owner to the property is itself shifted. Second, the machinery by which liquidity is created – in our case the public market – itself introduces a set of elements which in and of themselves affect values. The owner of non-liquid property is, in a sense, married to it. It contributes certain factors to his life, and enters into the fixed perspective of his landscape. . . . At the same time, the quality of responsibility is always present. It is never possible, save with the irresponsible, the spendthrift, or the disabled, to decline decisions. . . . Physically the owner cannot absent himself very much; he must either be on the ground, or be close enough so that by communication (however long his range) his people on the ground can keep in touch with him. To some extent, non-liquid property immobilizes the owner by its own immobility. At the same time such property is in turn immobilized by the necessity that it should have an attentive owner whose activity is indispensable to its continued

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usefulness. Only as the energy or resources of an owner are spent in feeding a horse or tilling a farm are they capable of rendering a service to him. So long then, as a property requires a contribution by its owner in order to yield service, it will tend to be immobile. For property to be easily passed from hand to hand, the individual relation of the owner to it must necessarily play little part. It cannot be dependent for its continued value upon his activity. Consequently, to translate property into liquid form the first requisite is that it demand as little as possible of its owner – the most liquid form, cash, demanding nothing save the minor necessity of safe-keeping. . . . Most striking of all, a liquid token acquires a value purely and simply because of its liquidity. Property in non-liquid form is worth one price. Property represented by liquid tokens is worth another price, which may be higher or lower as the bulk of the community demands this liquid quality or avoids it. The privilege of being able to borrow upon property at once, or the ability to turn it into cash on twenty-four hours’ notice may in itself be worth paying for and thereby enhance the value of the token. Or the very sensitiveness of the value of liquid property to unreasoned surges of popular fear may detract from its value. Finally, as the token becomes more and more separated from the physical properties through the interposition of managements and their endowment with legal power which can be traced through to the physical assets, the ‘jus disponendi’ over the physical property ceases to be in the owner of the token. His real right of disposition is a right of disposition over the token itself, over any returns which may be distributed to him, and over the proceeds of its sale. He has, in fact, exchanged control for liquidity. It is thus plain that the concept of a share of stock must now be vigorously changed. No longer can it be regarded, from the point of view of the investor as primarily a pro rata share in an asset fund, or as a continuing, pro rata participation in earnings. It is true that legally, both the underlying assets (to a small extent) and the participation in earnings (to a far greater extent) are supposed to measure the legal right of a shareholder and exercise their influence over its actual value. But the factual concept must be not what these legal participations and rights are, but what expectation the shareholder has of their being fulfilled in the form of distributions and what appraisal an open market will make of these expectations. Tersely, the shareholder has a piece of paper with an open market value, and as holder of this paper may receive from time to time, at the pleasure of the management, periodic distributions. He is forced to measure his participation, not in assets, but in a market quotation; and this market quotation ‘discounts’ or appraises the expectation of distributions. This idea does not accord either with the popular or legal concept of a shareholder. Economically, however it seems inescapable. . . . [T]he various socalled ‘legal rights’ or the economic pressures which may lead a management to do well by its stockholders, in and of themselves are merely uncertain expectations in the hands of the individual. Aggregated, interpreted by a public market, and appraised in a security exchange, they do have a concrete and measurable value; and it is to this value that the shareholder must and in fact does address himself. His thinking is colored by it; and in large measure the corporate security system is based on it. . . .

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The new concept of the corporation and the assertion of community interests 3 Most fundamental to the new picture of economic life must be a new concept of business enterprise, as concentrated in the corporate organization. In some measure, a concept is already emerging. Over a decade ago, Walter Rathenau wrote concerning the German counterpart of our great corporation. No one is a permanent owner. . . . The claims to ownership are subdivided in such a fashion, and are so mobile that, that the enterprise assumes an independent life, as if it belonged to no one; it takes an objective existence, such as in earlier days was embodied only in state and church, in a municipal corporation, in the life of a guild or religious order. The institution here envisaged calls for analysis, not in terms of business enterprise but in terms of social organization. On the one hand it involves a concentration of power in the economic field comparable to the concentration of religious power in the mediaeval church or of political power in the nation state. On the other hand, it involves the interrelation of a wide diversity of economic interests – those of ‘owners’ who supply capital, those of workers who ‘create’, those of consumers who give value to the products of enterprise, and above all those of the control who wield power. Such a great concentration of power and such a diversity of interests raise the long fought issue of power and its regulation – of interest and its protection. A constant warfare has existed between the individuals wielding power, in whatever form, and the subjects of that power. Just as there is a continuous desire for power, so also there is a continuous desire to make that power the servant of the bulk of individuals it affects. The long struggles for the reform of the Catholic Church and for the development of constitutional law in the states are phases of this phenomenon. . . . Observable throughout the world, and in varying degrees of intensity, is this insistence that power in economic organization shall be subjected to the same tests of public benefit which have been applied in their turn to power otherwise located. . . . In the strictly capitalist countries, and particularly in time of depression, demands are constantly put forward that the men controlling the great economic organisms be made to accept responsibility for the wellbeing of those who are subject to the organization, whether workers, investors or consumers. . . . In proportion as an economic organisation grows in strength and its power is concentrated in a few hands, the possessor of power is more easily located, and the demand for responsible power becomes increasingly direct. How will this demand be made effective? To answer this question would be to foresee the history of the next century. We can here only consider and appraise certain of the more important lines of possible development. By tradition, a corporation ‘belongs’ to its shareholders, or, in a wider sense, to its security holders, and theirs is the only interest to be recognized as the object of corporate activity. Following this tradition, and without regard for the

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changed character of ownership, it would be possible to apply in the interests of the passive property owner the doctrine of strict property rights . . . By the application of this doctrine, the group in control of a corporation would be placed in a position of trusteeship in which it would be called on to operate or arrange for the operation of the corporation for the sole benefits of the security owners despite the fact that the latter have ceased to have power over or to accept responsibility for the active property in which they have an interest. Were this course followed, the bulk of American industry might soon be operated by trustees for the sole benefit of inactive and irresponsible security owners. In direct opposition to the above doctrine of strict property rights is the view, apparently held by the great corporation lawyers and by certain students of the field, that corporate development has created a new set of relationships, giving to the groups in control powers which are absolute and not limited by any implied obligation with respect to their use. This logic leads to drastic conclusions. For instance, if, by reason of these new relationships, the men in control of a corporation can operate it in their own interests, and can divert a portion of the asset fund of income stream to their own uses, such is their privilege. Under this view, since the new powers have been acquired on a quasi-contractual basis, the security holders have agreed in advance to any losses which they may suffer by reason of such use. The result is, briefly, that the existence of the legal and economic relationships giving rise to these powers must be frankly recognized as a modification of the principle of private property. If these were the only alternatives, the former would appear to be the lesser of two evils. Changed corporate relationships have unquestionably involved an essential alteration in the character of property. But such modifications have hitherto been brought about largely on the principle that might makes right. Choice between strengthening the rights of passive property owners, or leaving a set of uncurbed powers in the hands of control therefore resolves itself into a purely realistic evaluation of different results. We might elect the relative certainty and safety of a trust relationship in favor of a particular group within the corporation, accompanied by a possible diminution of enterprise. Or we may grant the controlling group free rein, with the corresponding danger of a corporate oligarchy coupled with the probability of an era of corporate plundering. A third possibility exists, however. On the one hand, the owners of passive property, by surrendering control and responsibility over the active property, have surrendered the right that the corporation should be operated in their sole interest, – they have released the community from the obligation to protect them to the full extent implied in the doctrine of strict property rights. At the same time, the controlling groups, by means of the extension of corporate powers, have in their own interest broken the bars of tradition which require that the corporation be operated solely for the benefit of the owners of passive property. Eliminating the sole interest of the passive owner, however, does not necessarily lay a basis for the alternative claim that the new powers should be used in the interest of the controlling groups. The latter have not presented, in acts or words, any acceptable defense of the proposition that these powers should be so used. No tradition supports that proposition. The control groups have, rather, cleared the way for the claims of a group far wider than either the owners or the

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control. They have placed the community in a position to demand that the modern corporation serve not alone the owners or the control but all society. This third alternative offers a wholly new concept of corporate activity. Neither the claims of ownership nor those of control can stand against the paramount interests of the community. The present claims of both contending parties now in the field have been weakened by the developments described in this book. It remains only for the claims of community to be put forward with clarity and force. Rigid enforcement of property rights as a temporary protection against plundering by control would not stand in the way of the modification of these rights in the interest of other groups. When a convincing system of community obligations is worked out and is generally accepted, in that moment the passive property right of today must yield before the larger interests of society. Should the corporate leaders, for example, set forth a programme comprising fair wages, security to employees, reasonable service to their public, and stabilization of business, all of which should divert a portion of the profits from the owners of passive property, and should the community generally accept such a scheme as a logical and human solution of industrial difficulties, the interests of passive property would have to give way. Courts would almost of necessity be forced to recognize the result, justifying it by whatever of the many legal theories they might choose. It is conceivable – indeed it seems almost essential if the corporate system is to survive – that the ‘control’ of the great corporations should develop into a purely neutral technology, balancing a variety of claims by various groups in the community and assigning to each a portion of the income stream on the basis of public policy rather than private cupidity. EDITORS’ NOTES 1 2

3

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Copyright (1932) by Transaction Publishers. Reprinted by permission of the publisher. This extract comprises two sections: ‘Shareholders exchange liquidity for control’ and ‘The new concept of the corporation and the assertion of community interests’. The first section of the extract is taken from The Modern Corporation and Private Property, Book II, Chapter VIII, ‘The resultant position of the shareholder’ (pp. 244–52), with the subheading added by the editors This section of the extract is taken from The Modern Corporation and Private Property, Book IV, Chapter IV, ‘The new concept of the corporation’ (pp. 309–12), with the subheading added by the editors.

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Chapter 3

John Maynard Keynes

SPECULATION, CYCLICALITY AND THE EUTHANASIA OF THE RENTIER

Introduction to extract from John Maynard Keynes (1936), The General Theory of Interest, Employment and Money (reprinted 1964), London: Macmillan

EDITORS’ COMMENTARY Liberal collectivism is, at one level, a problematic defined by its political a priori which argues for government intervention only insofar as it is needed to deal with market failure. At the same time, liberal collectivists were also concerned with more than market failure in an abstract sense and contributed to developing arguments about the nature of specific economic and social problems, as well as debating possible policy interventions. The two key creative figures from liberal collectivism are Beveridge, whose contribution was the redesign of social security designs (Williams and Williams, 1987), and Keynes, through his economic theory. It will be obvious from reading the extract from The General Theory that Keynes’ idea of economic theory is rather different from that of present-day economics, which tends to hide its rhetoric under a formal technical cover. In the extracts below, Keynes gloriously mixes wild assertions about consumption and investment behaviour, a stylized history of firm organization, the practical understanding of a stock market player, and the language of marginal economics. All this reflects not indiscipline but the undeclared serious purpose of avoiding the fate of J. A. Hobson, his radical liberal precursor. Keynes proposed a theory of how under-consumption and fluctuating investment led to cyclicality and under-employment without provoking a breach with marginalism as Mummery and Hobson (1889) did and without proposing wholesale nationalization and redistribution as in Hobson’s The Industrial System (1909). The price of this strategy was, of course, the ambiguity that then allowed orthodox economists to read their own discourse into Keynes’ text.

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The first section of the extract from The General Theory shows how Keynes recognizes the Berle and Means insight about how the stock market creates liquidity and in characteristic style drives the point home with his ‘as though’ image of the farmer tapping his barometer and withdrawing his capital from the farming business between 10 and 11 before reconsidering return to it later in the week (p. 151). But Keynes adds the essential qualification that liquidity brings speculation as the market’s trading game is not about ‘making superior long term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public’ (p. 154). Again the point is driven home by the (now rather outdated) metaphor about the newspaper competition where the prize goes to the individual competitor who guesses the collective opinion of prettiest faces (p. 156). Thus Keynes builds on the distinction between the fundamental necessity of ‘enterprise’ or forecasting long-term returns from investment in machines or infrastructure and ‘speculation’ or forecasting ‘the psychology of the market’ (pp. 158–9). The corollary is a warning that speculation and casino-type mentality may undermine ‘the capital development of a country’ and the practical policy implication that stock markets are best when made ‘inaccessible and very expensive’ so that mass participation is limited (pp. 159–60). The second section of the extract explains Keynes’ enthusiasm for ‘the euthanasia of the rentier, the functionless investor’ (p. 376) as the return on shares was deliberately driven down. It shows how Keynes’ account of cyclicality and unemployment is built on the foundation of a theory of successive over- and underinvestment resulting from the inherent ‘psychology of investment markets’. Consumption is permanently deficient because the ‘marginal propensity to consume is always less than one’; and investment fails to steadily compensate because speculation is associated with a cycle of errors of optimism and pessimism about returns from investment which cannot be compensated by any conceivable central bank adjustment of rates of interest. The solution is to deliberately engineer a glut of capital and drive down the rate of return on ordinary shares (which would then become rather like boring low-yield bonds). Keynes is enthusiastic about a world of low returns on capital investment because he understood that the aim of (physical) investment is to facilitate the production of private and social goods and services which is the larger economic good; and his background assumption was that mass security could be achieved through a combination of managing the economy for high employment and redesigning redistributive social security for the unwaged. From this point of view, it would seem perverse for a society to pursue security through encouraging mass investment in the secondary market. But that perception was lost in a world which, after the 1970s, was increasingly besotted with the secondary market, partly because mainstream finance changed the frame and denied most of the propositions which liberal collectivists maintained, while the altered political landscape embraced both deregulation of markets and individualized responsibility. John Maynard Keynes (1883–1946) was a distinguished Cambridge economist whose influence in macro-economic policy making in the twentieth century was just as important as his influence on the academic discipline of economics. The General

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Theory of Employment, Interest and Money (1936) is generally considered to be his most significant book, which helped to give rise to the term ‘Keynesian’ economics, though there has been much subsequent dispute about the correct interpretation of Keynes. He became an economic advisor to the British Government during World War One and was invited to the Versailles peace conference in 1918, after which he wrote the influential and highly critical book, The Economic Consequences of the Peace (1919). When World War Two broke out Keynes published How to Pay for the War and returned to the Treasury where he was engaged not only in war time finance but in planning the post-war economic order, including leading the UK delegation to the 1944 Bretton Woods conference which helped shape the economic landscape for the next thirty years.

REFERENCES Hobson, J.A. (1909) The Industrial System, London: Longmans, Green and Co. Mummery, J. F. and Hobson, J. A. (1889) The Physiology of Industry: Being an Exposure of Certain Fallacies in Existing Theories of Economics, London: J. Murray. Williams, K. and Williams, J. (1987) A Beveridge Reader, London: Allen and Unwin.

Liquidity and speculation about market psychology 1, 2

T

H E O U T S TA N D I N G FA C T I S the extreme precariousness of the basis of knowledge on which estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market. In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not relying on a precise calculation of prospective profit. The affair was partly a lottery, though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average. Some would fail and some would succeed. But even after the event no one would know whether the average results in terms of the sums invested had exceeded, equalled or fallen short of the prevailing rate of interest; though if we exclude the exploitation of natural resources and monopolies, it is probable that the actual average results of investments, even

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during periods of progress and prosperity, have disappointed the hopes which prompted them. Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand. . . . Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week. But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater that that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out quite so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. . . . Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organised investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes

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reasonably ‘safe’ for the individual investor over short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual. It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak spots. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment. Some of the factors which accentuate this precariousness may be briefly mentioned. (1) As a result of the gradual increase in the proportion of equity in the community’s aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by those who own them or contemplate purchasing them has seriously declined. (2) Day-to-day fluctuations in the profits of existing investments which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even absurd, influence on the market. . . . (3) A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. . . . (4) But, there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. . . . Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called ‘liquidity’. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources on the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment

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should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd and to pass the bad, or depreciating, half-crown to the other fellow. [. . . .] Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitor as a whole; so that each competitor has to pick, not those faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks are the prettiest. We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be. . . . These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. . . . These tendencies are a scarcely avoidable outcome of our having successfully organised ‘liquid’ investment markets. It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges. That the sins of the London Stock Exchange are less that those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inaccessible and very expensive. . . .

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Cyclicality, the vision of a managed economy and euthanasia of the rentier 3 Thus with markets organised and influenced as they are at present, the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations that it cannot be sufficiently offset by corresponding fluctuations in the rate of interest. Moreover the corresponding movements in the stock market [prices and hence effects on the marginal propensity to consume]4 may . . . depress the propensity to consume just when it is most needed. In conditions of laissez faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands. [. . . .] [I]t is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of say, 6 per cent and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary ‘error of pessimism’, with the result that the investments which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing . . . We reach a condition where there is a shortage of houses but nobody can afford to live in the houses that there are. Let us assume that steps are taken to ensure that the rate of interest is consistent with the rate of investment which corresponds to full employment. Let us assume, further, that State action enters in as a balancing factor to provide that the growth of capital equipment shall be such as to approach saturation-point at a rate which does not put a disproportionate burden on the standard of life of the present generation. On such assumptions I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation; so that we should attain the conditions of a quasi-stationary community where change and progress would result only from changes in technique, taste, population and institutions, with the products of capital selling at a price proportionate to the labour, etc., embodied in them on just the same principles as govern the prices of consumption-goods into which capital-charges enter in an insignificant degree. If I am right in supposing it to be comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism. For a little reflection will show what enormous social changes would result from gradual disappearance of a rate of return on accumulated wealth. A man would still be free to accumulate his earned income with a view to spending it at a later date. But his accumulation would not grow. . . . Though the rentier would disappear, there would still be room, nevertheless, for enterprise and skill in the estimation of prospective yields about which

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opinions could differ. For the above relates primarily to the pure rate of interest apart from any allowance for risk and the like, and not to the gross yield of assets including the return in respect of risk. Thus unless the pure rate of interest were to be held at a negative figure, there would still be a positive yield to skilled investment in individual assets having a doubtful prospective yield. Provided there was some measurable unwillingness to undertake risk, there would also be a positive net yield from the aggregate of such assets over a period of time. But it is not unlikely that, in such circumstances, the eagerness to obtain a yield from doubtful investments might be such that they would show in the aggregate a negative net yield. I feel sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure. This would not mean that the use of capital instruments would cost almost nothing, but only that the return from them would have to cover little more than their exhaustion by wastage and obsolescence together with some margin to cover risk and the exercise of skill and judgment. In short, the aggregate return from durable goods in the case of short-lived goods, just cover their labour-costs of production plus an allowance for risk and the costs of skill and supervision. Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest to-day rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce. I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution. Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of

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the financier, the entrepreneur et hoc genus omne (who are certainly so find of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward. EDITORS’ NOTES 1 2

3

4

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Reprinted by permission of the publisher, Palgrave Macmillan. The extract has two sections: ‘Liquidity and speculation about market psychology’ and ‘Cyclicality, the vision of a managed economy and euthanasia of the rentier’. This first section of the extract is taken from the General Theory Chapter 12, ‘The state of long-term expectation’ (pp. 149–59) with the subhead added by the editors for purposes of clarity. This section of the extract combines three passages from the General Theory. The first two paragraphs are taken from chapter 22 ‘Notes on the Trade Cycle’ (pp. 320–2), the next four paragraphs are taken from chapter 16 ‘Sundry observations on the nature of capital’ (pp. 220–1), with the aim of providing a context for the final famous four paragraphs from chapter 24 ‘Concluding Notes’ (pp. 375–7). The subheading has been added by the editors. These three passages are separated by asterisks Readers should note that the order of the passages in Keynes’ original text is changed in this extract where a passage from chapter 22 precedes a passage from chapter 16. This reordering has been done to improve intelligibility and is possible because although Keynes outlines an economic system, his mode of exposition in the General Theory is much less linear and sequential than in most economics texts. The text in parentheses is added by the editors.

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SECTION TWO

Agency theory and the value maximizing manager EDITORS’ INTRODUCTION

M

A I N S T R E A M A C A D E M I C F I N A N C E , B A S E D on assumptions of economic rationality, generally presents itself as a technical investigation of security pricing and financial market properties. Of course, finance has become a highly technical discipline, replete with theories and models and a scientistic justificatory rhetoric about ‘financial engineering’. But it is also important to understand that finance is as much a political project as the liberal collectivism discussed in the previous section of this book, albeit one with the quite opposite aim of dispelling the aura of speculation and disreputability which has historically surrounded the securities markets. Since the 1960s, the mainstream finance project is bounded by two sets of propositions. First, in the efficient market hypothesis, as formulated by Eugene Fama in the early 1960s, current securities prices could incorporate all known information so that under conditions of rational expectations and random reactions the game of outguessing the stock market would be futile (Fama 1970). Second, in the Black– Scholes model, as elaborated by Robert Merton in the early 1970s, the present value of options on securities could be rationally calculated so that the futures market could be something different from gambling (Merton 1973). For the mainly USbased finance professors who were vindicating capital market rationality, the theory of the firm was then an intellectually awkward problem. By the 1970s, so-called managerial theorists of the firm, like Marris (1964) and Galbraith (1967), envisaged a world where giant firms escaped any market discipline to profit maximize as their (uncontrolled) managers pursued discretionary objectives such as growth or market share. If the economy was then the sphere of power relations within and between giant firms, that apparently undermined the determining role of rational financial calculation. The agency theory of the firm can be seen as the hugely influential reaction to this threat. These issues acquired a new importance in the historical context of US capitalism from the 1970s onwards with the institutional mutation of the US system towards pension fund capitalism and the performance challenges of slower growth and successful Asian competitors after the long post-war boom ended with the 1970s oil crises. It was Peter Drucker in 1976 who highlighted the growth of corporate pensions and the consequence that pension funds owned one-third of the stock of equity and controlled the 1,000 largest companies; by the mid-1990s the flow of long-term savings onto the secondary market accounted for 10 per cent of US GDP

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or a sum roughly equal to corporate fixed capital investment. Drucker himself represented this as ‘pension fund socialism’ because the workers had become owners, albeit virtual ones, who delegated management to an assortment of intermediaries. It was, therefore, now much more plausible to equate the shareholder interest with the social interest as the agency theorists routinely did; and to assume that social and shareholder interests coincided as though the economy were a giant portfolio investor concerned with capital allocation and higher returns. The conjunctural shift after the 1970s oil crises was equally important. US giant firms had been exemplars of success for the rest of the world but, through the 1990s and 1980s, had to adjust first to slower growth and then to unexpected reverses as Japanese competitors took market share in cars and electronics. Interestingly, this context of US retreat figures prominently in the extract in this section from Jensen (1993) where US giant-firm managements are not successful exemplars for the rest of the world but dysfunctional actors in need of domestic restraint and discipline. The emphasis here is on the assumption that mature and retreating firms are much more likely to hoard cash; and the background assumption is that the new task of US management is often to manage decline, which often includes allowing capital to exit particular firms or industries. How were these contexts and impressions elaborated as agency theory? ‘Agency theory’ is something of a misnomer because this is not a tightly specified theory but a metaphoric way of thinking about problems which was compellingly attractive to economists from neoclassical backgrounds.1 In very general terms, it includes more or less everything in economy and society if agency theory is ‘the study of the inevitable conflicts of interest that occur when individuals engage in cooperative behaviour’ (Jensen 1993, p. 870). The focus comes from the translation of such broad issues into a much narrower ‘principal–agent problem’, which occurs when a principal hires an agent to perform some service on his/her behalf under conditions of incomplete and asymmetric information. Classically this arises in employer–employee relations but shareholder/ manager relations can easily be conceived in the same way. This apparently simple principal–agent conceptualization launched a thousand articles after Jensen and Meckling (1976) coupled it with the concept of the firm as a nexus of contracts between maximizing individuals which is generally credited to Alchian and Demsetz (1972). The agency concept of the firm was at the very least a neat defensive move. The neoclassical economists were threatened by the arguments of Galbraith and others about managerial discretion and firms that escaped the market discipline of profit maximization which the product market could not enforce under conditions of oligopoly and monopoly. Their defensive ploy was to fall back on the idea of maximizing individuals which would save the behavioural presuppositions required for the credibility of a market-based theory. On this economic terrain, all the ‘factors’ entering into production (including capital and management) are entitled to their reward by virtue of their essential contribution to production. The pay problem is then to secure optimal contracting arrangements between the shareholder principals and their management agents and this ostensibly sets up management pay on the terrain of efficiency, thereby evicting the politics and morality which had suffused earlier liberal collectivist discussion of the shareholders’ rights.

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Nevertheless, the practical importance of optimal pay contracts could nevertheless be disputed because there were several different sources of external and internal disciplines on the firm. Thus, Michael Jensen in the 1980s put the main emphasis on external capital market discipline through the market for corporate control as wasteful incumbent managements were challenged by other teams who could manage corporate resources more efficiently (see, for example, Jensen 1986, 1988). As our extract in this volume demonstrates, Jensen (1993) had a strikingly optimistic view of the efficiency gains and social benefits realized through corporate takeovers and restructuring and, later, through leveraged buyouts which used debt to take companies private.2 Nevertheless, management pay acquired new importance for Jensen after the cyclical turndown in the early 1990s slowed takeovers and blocked leveraged buyouts. If the capital market provided more limited opportunities for exit, discipline and incentive could instead be added through changes in the way that managers were paid, including adding more performance-based elements. By way of contrast, Eugene Fama in his pioneering article of 1980 largely rested the case for the viability of the public firm with widely diffused ownership on management pay and incentives. The viability of the large corporation with diffuse security ownership is better explained in terms of a model where the primary disciplining of managers comes through managerial labor markets, both within and outside of the firm, with assistance from the panoply of internal and external monitoring devices that evolve to stimulate the ongoing efficiency of the corporate form, and with the market for outside takeovers providing discipline of the last resort. (Fama 1980, p. 295) In effect, Fama’s thesis is that ‘separation of security ownership and (management) control can be explained as an efficient form of economic organization’ (p. 289) provided management’s pursuit of discretionary objectives could be curbed by the managerial labour market. In Fama’s 1980 formulation, there would be settling up on the basis of managers’ reputation and performance. However, other agency theorists have quickly become more interested in the disciplinary effects of governance arrangements around pay (including such mechanisms as the role of boards of directors, mandatory disclosures, shareholder voting and so on), rather than the idea of the managerial labour market having a direct disciplinary effect. If Tawney had insisted managers were a new kind of proletariat, agency theorists had sixty years later discovered the importance of piece rate which could make them rich. As with most such discoveries the intellectual rationale for the position was initially much stronger than the technical practice of pay for performance, even if everyone could agree that at least part of managers’ remuneration should relate to their performance and hence justify the notion of a reward. In this respect, there were two important innovations in the 1990s which framed a new technical practice for relating management pay to (value creating) performance: first, proceduralized corporate governance after the Cadbury report of 1992 in the UK, which pioneered

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codes of practice in this area; second, the development of value-based management and its associated metrics as a consultancy product from firms like Stern Stewart. In the 1990s form of pension fund capitalism, the practical problem was the effective absence of the ultimate principal (the virtual saver or pension fund member) and the passivity of intermediaries (like pension fund managers). Hence the importance of reports from British establishment businessmen (Cadbury 1992; Greenbury 1995; Hampel 1998) who, in response to various corporate scandals and concern about ‘fat cat’ pay, proposed to enlist the board more actively in a new system of proceduralized governance in the shareholder interest. The reports recommended performance-related management pay so as to retain and motivate managers, but they also recognized that many existing performance targets and stock option schemes were too soft and did not do this. These problems were attacked by changes in the composition of the board and proceduralization. Thus, Cadbury in the UK initiated the separation of chair and CEO positions (still often combined in the USA) and also put a new emphasis on the role of independent non-executive directors. Proceduralization was represented via remuneration and audit committees, with the latter for Hampel (1998) to consist entirely of non-executives. The UK approach was to encourage such changes through a voluntary Combined Code of corporate good practice. In contrast, the US approach was more peremptory and punitive after the Sarbanes Oxley Act of 2002, which responded to the tech stock crash and the Enron scandal. But the basic principle of corporate governance was the same in both countries: the board (more especially the non-executive members) should motivate and police incumbent corporate managers in the interests of shareholders. The second key innovation was ‘value based management’ (VBM) as a consultancy product which was initially pioneered by Stern Stewart and LEK/Alcar before being imitated by other firms (Froud et al. 2000). Essentially VBM was a set of measures to encourage value creation (through improved asset utilization, better cash flow management etc.) plus an ‘implementation package’ which promised to push pay for performance down the firm. The most well known and widely used of the new consultancy measures were Economic Value Added (EVA) and Market Value Added (MVA) from Stern Stewart (Stern et al. 1995). MVA was the difference between the current market value of a company and the total invested capital. It directed attention to the company’s share price because (in the parlance of the 1990s) managers should create value by delivering higher share prices. EVA was the lump of profit remaining after deducting the cost of capital because managers (again in the parlance of the 1990s) should not destroy value by investing in projects or retaining businesses which destroyed value by earning less than the cost of capital. Of course, such measures were neither new nor unproblematic. EVA was a variant on a fairly standard residual income measure (Bromwich and Walker 1998), with some proprietary adjustments such as the capitalization of research and development. But the metrics were important because, if performance was straightforwardly measurable as consultants and some academic argued in the 1990s, then surely the pay-for-performance problem was practically soluble within the new frame of good governance.

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On this basis, we would expect to find an empirical break in the trends of management pay in the mid-1990s as the new technical practice empowered boards. The evidence on management pay is, of course, complex and the USA is different from Europe because the level of CEO pay was consistently 5 or 6 times higher than in Europe and stock options were much more important as drivers of management pay in the USA. But the basic story about pay increases for CEOs of giant companies is the same in the USA, the UK, and continental Europe. In all these areas, the break in the trend comes in the late 1970s or 1980s, since when giant-firm CEOs (and their inner circle of senior executives) have typically obtained real increases of 15 per cent per annum (which were not of course available to ordinary workers). The result has been an explosion in pay relativities as the high-earning CEOs pulled away from their employees. In the case of the UK, for example, the average FTSE 100 CEO pay (in constant prices) was £200,000 in 1978–9 and £1.4 million in 2002–3; and the topto-bottom ratio opened up so that the British CEO who had earned a modest 9 times the pay of the ordinary worker in 1979 earned 54 times the pay of such workers in 2002–3 (Erturk et al. 2005). Paradoxically, the new performance measures and governance techniques made it easier for CEOs to claim large pay increases in the 1990s. In the USA, management pay was connected to share prices via stock options But an unprecedented decade-long bull market through the 1990s lifted most share prices by 10–15 per cent per annum so that stock options were usually in the money regardless of management effort or competence. Elsewhere, as in the UK, stock options were much less important but it proved equally difficult to relate pay and performance. It is, of course, generally difficult to attribute a large and complex outcome like corporate performance to the efforts of any particular strategy or actor; when actors generally claim success and deny responsibility for failure; the difficulties are doubled if the aim is to specify ex ante performance thresholds, triggers, and targets that help determine pay because such triggers are powerfully influenced by unforeseeable, external fortuity. For these reasons, the results of pay for performance will most likely end up as unsatisfactory in terms of either shareholder or manager interests. However, the equally important observation is that increased disclosure of executive pay in public companies and proceduralized governance that brings remuneration committees and use of consultants have almost certainly made it easier for CEOs to claim comparability increases against their peers, regardless of performance. The general explosion in CEO pay since the 1980s occasioned recurrent media panics about management pay and reinforced existing academic interest in testing whether there was any empirical relation between pay and performance. In the USA the 1991–2 panic produced an indictment of executive ‘excess’ (Crystal 1992) and noisy recrimination after 2000 about the general enrichment of top managers through stock options in the bull market. In the UK, there was a panic about the pay of privatized utility ‘fat cats’ and then recrimination about ‘rewards for failure’ in the early 2000s (DTI 2003; Isles 2003). The indignant popular perception is usually based on individual outrageous cases. But, if we shift from the individual case to the substantial body of academic analysis using systematic empiricist techniques on large data sets, the general academic

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conclusion is that there is a weak or non-existent relation between pay and performance.3 This negative result is robust because it holds regardless of the methods used for establishing causal relations, the data set or the measures of company performance; and this point emerges very strongly in the extract in this section from Tosi et al.’s (2000) meta-study based on 137 separate previous studies. Interestingly, the same studies have generally found a strong positive relation between pay and company size because CEOs in larger companies claim bigger salaries (Conyon and Murphy 2000). This last finding must have caused wry amusement amongst a (now retired) earlier generation of managerial theorists like Marris because it is surely not so very different from what they predicted. More generally, the most enduring and valuable legacy of agency theory must be the body of empirical research into management pay not the theory itself which has become increasingly strained in this area. When systematic empiricist techniques have such prestige in mainstream finance, we might expect a crisis would be occasioned by the negative results about pay for performance. But agency theory is in some ways now immunized against disproof because, if the revolution fails, this must be because it is incomplete. Hence the importance of recent work by Lucien Bebchuk, who accepts the empirical failure to control management pay but explains it in ways which allow him to retain the theoretical syllogisms of agency and endorse the practical prescriptions. As for what’s gone wrong, Bebchuk and Fried (2004) advance a ‘managerial power’ explanation whereby rents are being extracted by managers who have suborned the boards of directors who, in turn, have failed ‘to bargain at arms length with executives’ so as to safeguard the shareholder interest. The explanation then is that governance has failed and the performative solution is more effective governance. We need to turn the official story of executive compensation and board governance, which features directors as the dedicated guardians of shareholder interests, from fiction into reality. (Bebchuk and Fried, 2004, p 201) Bebchuk’s critique of imperfect execution makes sense against the intellectual background of the 1990s and 2000s which saw increased endorsement (or at least acceptance) of the primacy of shareholder interests. An interesting barometer here is Hansmann and Kraakman’s (2001) paper, ‘The end of history for corporate law’,4 in which the authors argue, based on ‘logic and experience’, that there is now ‘a broad normative consensus that shareholders alone are the parties to whom corporate managers should be accountable’ (p. 441). The corollary of this is a convergence on the Anglo-American model of corporate governance, with its emphasis on equitable treatment for all shareholders, including minorities, so that it is the refinement of the technologies of governance that have become the overriding academic and policy concern. While the development of an agency theory approach to the public company has opened up a distinctive new field of empirical research since the 1980s, it could be argued that what began as a smart defensive move against managerial theories of

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the firm has ended up limiting broader thinking about the public company and the context in which it operates. The final two extracts in this section pose challenges to the agency approach in two ways: first, by looking beyond the shareholder–manager relation to consider financial intermediaries as important capitalist actors in their own right; and, second, by challenging the fundamental principle that firms should be run primarily in the interests of their shareholders. The now widely-used litany about the shareholder–principal and senior manager– agent in much academic research on the public company suppresses the point that there are a whole series of principal/agent relations between the ultimate owner/ vitual investor saver and firm managers in giant corporations or other busineses. As Folkman et al. point out in their extract included in this section, the financial intermediary groups managing fund flows in the capital markets of the City of London contain many more highly paid individuals than the senior management groups of FTSE 100 or S&P 500 companies. Their new focus is on the 15,000 senior intermediaries of the City of London, (including investment bankers, corporate lawyers, hedge fund, private equity, and other fund managers) who are the main group of beneficiaries of present-day financialized capitalism, not the 500 or so senior managers of FTSE 100 giant companies. Yet such intermediaries are generally invisible in much business and finance research, not least because they cannot easily be researched from the standard databases which cover public companies and their directors and which give information on pay, amongst other things. Rather than assuming that intermediaries are here to help with solving the agency problem, Folkman et al. argue that intermediaries are also, or instead, ‘working for themselves’ via positional rewards. For example, private equity general partners in successful large funds made as much as £50 million from one fund through various fees. In this sense they are (like the classic ‘financiers’) very effective principals in the deals they do, as well as also serving as ambiguous agents using borrowed funds.5 It is likely that the agency problem definition could be extended to include intermediaries, but it is not clear how standard remedies to deal with classic agency problems can be employed in the case of intermediaries who are several layers away from public company shareholders. If Folkman et al. are concerned to understand new actors in financialized capitalism, the focus of the extract from Ireland’s 2000 book chapter is to re-examine fundamental questions about the rights of shareholders with few responsibilities. Ireland does this from a legal perspective which includes a scholarly knowledge of the 1920s and 1930s debates about shareholding and shareholder rights. Within agency theory and mainstream corporate governance discourse, the shareholder (or more strictly his/her intermediary representative) is responsible for becoming more active (just as non-executive directors are charged with acting in the interests of shareholders). Traditionally, this has led to concerns about investor passivity, often evidenced by low levels of voting by many fund managers; while, more recently, there have been different concerns about whether hedge funds bring the right kind of activism. But, as Ireland observes, in a political sense the great achievement of agency theory is that it starts from and thereby naturalizes the assumption that the firm should be run in the interest of the (passive and absentee) shareholder.6 Some

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academics such as Margaret Blair (1995) have tried to justify a stakeholder version of capitalism against the primacy of the shareholder but they have failed to convert the mainstream, not least because of practical questions about how the interests of the different stakeholders are to be articulated and reconciled. As Ireland argues, the prior question is about whether the passive owner has the right to establish himself or herself as sole beneficiary. Tawney would have been pleased to see the debate returned to fundamentals.

NOTES 1 2 3 4 5

6

Agency theory has also been widely adopted in other parts of business and social science. See, for instance, Eisenhardt (1989). Jensen’s 1989 article on LBOs was titled ‘The eclipse of the public corporation’. See also Bruce and Buck’s (2005) review of empirical findings of pay which finds similarly mixed results. This provocative claim has not, of course, gone unchallenged, especially in Europe. See, for example, Aglietta and Reberioux (2005) and Ireland (2005). The collapse of Enron and the ending of the new economy boom did lead to considerable soul searching and scapegoating in the USA about what went wrong and who was to blame. Most obviously, the implication in its financial fraud of Enron’s auditors, Arthur Andersen, led directly to the collapse of the accounting firm. Other groups were also blamed, including Wall Street analysts, where conflicts of interest within financial conglomeraters as well as individual hubris were at the root of bad investment advice. Interestingly, Jensen then wrote a critical piece on the role of the analysts (Jensen and Fuller 2002) though there has not been any wider or sustained interest in such capital market intermediaries from those working within the agency approach. See also Engelen (2002) who uses a different approach to develop a critique of shareholder ideology based on a challenge of the prudential, functional and moral claims of the shareholder.

REFERENCES Aglietta, M. and Reberioux, A. (2005) Corporate Governance Adrift: A Critique of Shareholder Value, Cheltenham: Edward Elgar. Alchian, A. A. and Demsetz, H. (1972) ‘Production, information costs and economic organization’, American Economic Review, 62 (5): 777–95. Bebchuk, L. and Fried, J. (2004) Pay Without Performance: The Unfulfilled Promise of Executive Compensation, Cambridge, MA: Harvard University Press. Blair, M. M. (1995) Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century, Washington, DC: Brookings Institution Press. Bromwich, M. and Walker, M. (1998) ‘Residual income past and future’, Management Accounting Research, 9 (4): 391–420.

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Bruce, A. and Buck, T. (2005) ‘Executive pay and UK corporate governance’, in K. Keasey, S. Thompson, and M. Wright (Eds), Corporate Governance. Accountability, Enterprise and International Comparisons, Chichester: John Wiley & Sons Ltd. Cadbury, A. (1992) Report of the Committee on the Financial Aspects of Corporate Governance, London: Gee & Co. Conyon, M. J. and Murphy, K. J. (2000) ‘The prince and the pauper? CEO pay in the United States and United Kingdom’, Economic Journal, 110: F640–71. Crystal, G. S. (1992) In Search of Excess: The Overcompensation of American Executives, New York: Norton. DTI (2003) ‘Rewards for Failure’: Directors’ Remuneration – Contracts, Performance and Severance, Consultation paper, London: DTI. Drucker, P. F. (1976) The Unseen Revolution: How Pension Fund Socialism Came to America, London: Heinemann. Eisenhardt, K. M. (1989) ‘Agency theory: an assessment and review’, Academy of Management Review, 14(1): 57–74. Engelen, E. (2002) ‘Corporate governance, property and democracy: a conceptual critique of shareholder ideology’, Economy and Society, 31 (3): 391–413. Erturk, I., Froud, J., Johal, S., and Williams, K. (2005) ‘Pay for performance or pay as social division’, Competition and Change, 9(1): 49–74. Fama, E. F. (1970) ‘Efficient capital markets: a review of theory and empirical work’, Journal of Finance, 25: 383–417. Fama, E. F. (1980) ‘Agency problems and the theory of the firm’, Journal of Political Economy, 88(2): 288–307. Folkman, P., Froud, J., Johal, S., and Williams, K. (2007) ‘Working for themselves: capital market intermediaries and present day capitalism’, Business History, 49 (4): 552–72. Froud, J., Haslam, C., Johal, S., and Williams, K. (2000) ‘Shareholder value and financialisation: consultancy promises, management moves’, Economy and Society, 29 (1): 80–120. Galbraith, J. K. (1967) The New Industrial State, Boston, MA: Houghton Mifflin. Greenbury, R. (1995) Directors’ Remuneration: Report by a Study Group Chaired by Sir Richard Greenbury, London: Gee Publishing. Hampel, R. (1998) Committee on Corporate Governance: Final Report, London: Gee. Hobson, J. A. (1937) Property and Improperty, London: Gollancz. Hansmann, H. and Kraakman, R. (2001) ‘The end of history for corporate law’, Georgetown Law Journal, 89: 438–68. Ireland, P. (2000) ‘Defending the rentier: corporate theory and the reprivatisation of the public company’, in J. Parkinson, A. Gamble, and G. Kelly (eds), The Political Economy of the Company, Oxford: Hart Publising, 141–73. Ireland, P. (2005) ‘Shareholder primacy and the distribution of wealth’, Modern Law Review, 68 (1): 49–81. Isles, N. (2003) Room at the Top, London: Work Foundation. Jensen, M. C. (1986) ‘Agency costs of free cash flow: corporate finance and takeovers’, American Economic Review, 76: 323–9.

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Jensen, M. C. (1988) ‘Takeovers: their causes and consequences’, Journal of Economic Perspectives, 2: 21–48. Jensen, M. C. (1989) ‘The eclipse of the public corporation’, Harvard Business Review, 67: 61–74. Jensen, M. C. (1993) ‘The modern industrial revolution, exit and the failure of internal control systems’, Journal of Finance, 48 (3): 831–80. Jensen M. C. and Fuller, J, (2002) ‘Just say no to Wall Street’, Journal of Applied Corporate Finance, 14 (4): 41–6. Jensen, M. C. and Meckling, W. H. (1976) ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3(4): 305–60. Marris, R. (1964) The Economic Theory of ‘Managerial’ Capitalism, London: Macmillan. Merton, R. C. (1973) ‘Theory of rational option pricing’, Bell Journal of Economics and Management Science, 4 (1): 141–83. Stern, J., Stewart, G. III and Chew, D. (1995) ‘The EVA financial management system’, Journal of Applied Corporate Finance, 8(2): 32–46. Tosi, H. L., Werner, S., Katz, J. P., and Gomez-Mejia, L. R. (2000) ‘How much does performance matter? A meta-analysis of CEO pay studies’, Journal of Management, 26 (2): 301–39.

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Chapter 4

Michael C. Jensen

MAKING INTERNAL CONTROL SYSTEMS WORK

Introduction to extract from Michael C. Jensen (1993), ‘The modern industrial revolution, exit and the failure of internal control systems’, Journal of Finance, 48(3): 831–80

EDITORS’ COMMENTARY Michael Jensen’s 1993 paper is concerned with the extent to which internal control mechanisms within the firm can offer underperforming firms the kind of restructuring discipline that might otherwise be provided by the capital market. Jensen’s paper is very different in form to that of Fama, in offering historical context and interpretation of US corporate behaviour and performance: the original paper is some fifty pages long and uses the industrial revolutions of the nineteenth century ‘to enlighten our understanding of current economic trends’ (p. 833). For Jensen, the key problem for US corporations in the 1980s and early 1990s is that of over-capacity resulting from increased global competition1 and the necessary adjustments that must take place as firms react to changing external circumstances. This need for adjustment is set up as a social as much as a private, corporate issue where, according to Jensen, managers too often are irresponsible in failing to respond appropriately: ‘In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest. When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society’ (p. 847). The extract which follows reflects Jensen’s inherently optimistic view of the capacity of the capital market to help solve the economic and social problem of excess capacity in US non-financial firms. The problem of excess capacity is, in Jensen’s view, exacerbated by the ‘the difficulty of exit’ after the collapse of the LBO boom at

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the end of the 1980s when the market for corporate control was effectively (though of course only temporarily) shut down. Under other circumstances, Jensen’s view is that the capital market can perform a disciplinary role that is far more effective than those that result from either external regulatory systems or internal control system (p. 850). Jensen uses the example of US industries like tyre manufacturing and anecdotes about particular companies, as well as time series data on R&D and capital expenditure to develop his argument about the shortcomings of US corporations in managing retreat and decline. By financial standards and on a cursory examination, giant company managements are not very good at dealing with these problems, partly because of explicit and implicit high cost and rigid contracts with stakeholders like employees and suppliers. The attempt to formulate general arguments about corporate management, however, leads Jensen to stray into good company/bad company kinds of comparisons. Jensen argues based on a study of 432 giant firms that internal use of cash on R&D and capital expenditure between 1980 and 1990 has been wasteful as far as shareholder value is concerned in majority of the firms; and this result is buttressed by a vignette comparison of good GE2 against bad GM and IBM, where firms are differentiated according to the quality of their internal control systems. In Jensen’s view, the capital market had been delivering a solution in the late 1980s because the results of leveraged buyouts (LBOs) had been very positive especially ‘in low growth or declining firms’, where the agency costs of free cash flow are large. But, it is argued that ‘the era of the control market came to an end . . . in late 1989 and 1990’, for reasons which Jensen does not elaborate. These reasons include the market and regulatory reaction to insider trading and over-leveraging (thus leaving firms exposed to cyclical downturns). Analysis of the collapse of the 1980s LBO boom, however, does provide an interesting counterweight to the argument that the capital market can meet private economic and social needs in facilitating corporate restructuring. In this paper, the absence of capital market discipline, and the divergence between managers’ decisions and those that are optimal from society’s standpoint, can be resolved by other, internal control mechanisms through the board of directors. Jensen believes these control mechanisms are inferior to the market for control because they tend to be late and take longer in adjustments but, if control via the capital market is blocked, internal control mechanisms should be reformed. Jensen’s proposals for such reform include smaller boards, separation of chair and CEO roles, more equity ownership for managers, encouragement of activist investors, and imitation of the venture capital and LBO close supervision model. Thus, ‘making the internal control systems of corporations work is the major challenge facing economists and management scholars’. And the scene is thus set for the 1990s development of corporate governance, the growth of stock options and such like, which will create opportunities for more empirical research into consequences. Michael C. Jensen is Emeritus Professor of Business Administration at Harvard Business School, which he joined in 1990 from the University of Rochester, New

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York. He is the author of numerous articles on asset pricing, stock options and corporate governance (including Jensen and Meckling 1976 and Jensen and Ruback 1983) and several books, including Foundations of Organizational Strategy (1998), and Theory of the Firm: Governance, Residual Claims, and Organizational Forms (2000).

NOTES 1

Jensen’s arguments about the causes of over capacity at the beginning of the 1990s are discussed at length in the original paper but not included in this extract for reasons of space. See the extract from Froud et al. (2006) later in this volume for a discussion of GE’s financial performance in the 1980s and 1990s.

2

REFERENCES Froud, J., Johal, S., Leaver, A. and Williams, K. (2006) Financialization and Strategy. Narrative and Numbers, London: Routledge. Jensen, M. C. and Meckling, W. H. (1976) ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, 3(4): 305–60. Jensen, M. C. and Ruback, R. S (1983) ‘The market for corporate control: the scientific evidence’, Journal of Financial Economics, 11: 5–50.

I. Introduction 1, 2 [. . .] Outline of the paper 3

I

I review the industrial revolutions of the nineteenth century and draw on these experiences to enlighten our understanding of current economic trends. Drawing parallels to the 1800s, I discuss in some detail the changes that mandate exit in today’s economy. I address those factors that hinder efficient exit, and outline the control forces acting on the corporation to eventually overcome these barriers. Specifically, I describe the role of the market for corporate control in affecting efficient exit, and how the shutdown of the capital markets has, to a great extent, transferred this challenge to corporate internal control mechanisms. I summarize evidence, however, indicating that internal control systems have largely failed in bringing about timely exit and N T H I S PA P E R ,

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downsizing, leaving only the product market or legal/political/regulatory system to resolve excess capacity. Although overcapacity will in the end be eliminated by product market forces, this solution generates large, unnecessary costs. I discuss the forces that render internal control mechanisms ineffective and offer suggestions for their reform. Lastly, I address the challenge this modern industrial revolution poses for finance professionals; that is, the changes that we too must undergo to aid in the learning and adjustments that must occur over the next several decades. [. . .]

III. The modern Industrial Revolution 4 The major restructuring of the American business community that began in the 1970s and is continuing in the 1990s is being brought about by a variety of factors, including changes in physical and management technology, global competition, regulation, taxes, and the conversion of formerly closed, centrally planned socialist and communist economies to capitalism, along with open participation in international trade. These changes are significant in scope and effect; indeed, they are bringing about the Third Industrial Revolution. To understand fully the challenges that current control systems face in light of this change, we must understand more about these general forces sweeping the world economy, and why they are generating excess capacity and thus the requirement for exit. [. . .]

IV. The difficulty of exit 5 The asymmetry between growth and decline Exit problems appear to be particularly severe in companies that for long periods enjoyed rapid growth, commanding market positions, and high cash flow and profits. In these situations, the culture of the organization and the mindset of managers seem to make it extremely difficult for adjustment to take place until long after the problems have become severe, and in some cases even unsolvable. In a fundamental sense, there is an asymmetry between the growth stage and the contraction stage over the life of a firm. We have spent little time thinking about how to manage the contracting stage efficiently, or more importantly how to manage the growth stage to avoid sowing the seeds of decline. In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest. When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society. The tire industry is an example Widespread consumer acceptance of radial tires meant that worldwide tire capacity had shrunk by two-thirds (because radials last three to five time longer than bias ply tires). Nonetheless, the response by the managers of individual companies was often equivalent to: ‘This business is going through

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some rough times. We have to make major investments so that we will have a chair when the music stops’. . . . Information problems Information problems hinder exit because the high-cost capacity in the industry must be eliminated if resources are to be used efficiently. Firms often do not have good information on their own costs, much less the costs of their competitors; it is therefore sometimes unclear to managers that they are the high-cost firm which should exit the industry. Even when managers do acknowledge the requirement for exit, it is often difficult for them to accept and initiate the shutdown decision. For the managers who must implement these decisions, shutting plants or liquidating the firm causes personal pain, creates uncertainty, and interrupts or sidetracks careers. Rather than confronting this pain, managers generally resist such actions as long as they have the cash flow to subsidize the losing operations. Indeed, firms with large positive cash flow will often invest in even more money-losing capacity-situations that illustrate vividly what I call the agency costs of free cash flow . . . Contracting problems Explicit and implicit contracts in the organization can become major obstacles to efficient exit. Unionization, restrictive work rules, and lucrative employee compensation and benefits are other ways in which the agency costs of free cash flow can manifest themselves in a growing, cash-rich organization. Formerly dominant firms became unionized in their heyday (or effectively unionized in organizations like IBM and Kodak) when managers spent some of the organization’s free cash flow to buy labor peace. Faced with technical innovation and worldwide competition (often from new, more flexible, and nonunion organizations), these dominant firms cannot adjust fast enough to maintain their market dominance (see DeAngelo and DeAngelo (1991) and Burnham (1993)). Part of the problem is managerial and organizational defensiveness that inhibits learning and prevents managers from changing their model of the business (see Argyris (1990)). Implicit contracts with unions, other employees, suppliers, and communities add to formal union barriers to change by reinforcing organizational defensiveness and inhibiting change long beyond the optimal time – even beyond the survival point for the organization. In an environment like this a shock must occur to bring about effective change. We must ask why we cannot design systems that can adjust more continuously, and therefore more efficiently. The security of property rights and the enforceability of contracts are extremely important to the growth of real output, efficiency, and wealth. Much press coverage and official policy seems to be based on the notion that all implicit contracts should be unchangeable and rigidly enforced. Yet it is clear that, given the occurrence of unexpected events, not all contracts, whether explicit or

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implicit can (or even should) be fulfilled. Implicit contracts, in addition to avoiding the costs incurred in the writing process, provide opportunity to revise the obligation if circumstances change; presumably, this is a major reason for their existence. Indeed the gradual abrogation of the legal notion of ‘at will’ employment is coming close to granting property rights in jobs to all employees. While casual breach of implicit contracts will destroy trust in an organization and seriously reduce efficiency, all organizations must evolve a way to change contracts that are no longer optimal. For example, bankruptcy is essentially a state-supervised system for breaking (or more politely, rewriting) contracts that are mutually inconsistent and therefore, unenforceable. All developed economies evolve such a system. Yet, the problem is a very general one, given that the optimality of changing contracts must be one of the major reasons for leaving many of them implicit. . . .

V. The role of the market for corporate control The four control forces operating on the corporation There are only four control forces operating on the corporation to resolve the problems caused by a divergence between managers’ decisions and those that are optimal from society’s standpoint. They are the

• • • •

capital markets, legal/political/regulatory system, product and factor markets, and internal control system headed by the board of directors.

. . . the capital markets were relatively constrained by law and regulatory practice from about 1940 until their resurrection through hostile tender offers in the 1970s. Prior to the 1970s capital market discipline took place primarily through the proxy process. (Pound (1993) analyzes the history of the political model of corporate control.) The legal/political/regulatory system is far too blunt an instrument to handle the problems of wasteful managerial behavior effectively. . . . While the product and factor markets are slow to act as a control force, their discipline is inevitable – firms that do not supply the product that customers desire at a competitive price cannot survive. Unfortunately, when product and factor market disciplines take effect it can often be too late to save much of the enterprise. To avoid this waste of resources, it is important for us to learn how to make the other three organizational control forces more expedient and efficient. Substantial data support the proposition that the internal control systems of publicly held corporations have generally failed to cause managers to maximize efficiency and value. More persuasive than the formal statistical evidence is the fact that few firms ever restructure themselves or engage in a major strategic redirection without a crisis either in the capital markets, the legal/political/

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regulatory system, or the product/factor markets. But there are firms that have proved to be flexible in their responses to changing market conditions in an evolutionary way. For example, investment banking firms and consulting firms seem to be better at responding to changing market conditions. Capital markets and the market for corporate control The capital markets provided one mechanism for accomplishing change before losses in the product markets generate a crisis. While the corporate control activity of the 1980s has been widely criticized as counterproductive to American industry, few have recognized that many of these transactions were necessary to accomplish exit over the objections of current managers and other constituencies of the firm such as employees and communities. For example, the solution to excess capacity in the tire industry came about through the market for corporate control. Every major U.S. tire firm was either taken over or restructured in the 1980s. In total, 37 tire plants were shut down in the period 1977 to 1987 and total employment in the industry fell by over 40%. . . . The pattern in the U.S. tire industry is repeated elsewhere among the crown jewels of American business. Capital market and corporate control transactions such as the repurchase of stock (or the purchase of another company) for cash or debt creates exit of resources in a very direct way. When Chevron acquired Gulf for $13.2 billion in cash and debt in 1984, the net assets devoted to the oil industry fell by $13.2 billion as soon as the checks were mailed out. In the 1980s the oil industry had to shrink to accommodate the reduction in the quantity of oil demanded and the reduced rate of growth of demand. This meant paying out to shareholders its huge cash inflows, reducing exploration and development expenditures to bring reserves in line with reduced demands, and closing refining and distribution facilities. The leveraged acquisitions and equity repurchases helped accomplish this end for virtually all major U.S. oil firms. . . . Exit also resulted when Kohlberg, Kravis, and Roberts (KKR) acquired RJR–Nabisco for $25 billion in cash and debt in its 1986 leveraged buyout (LBO). Given the change in smoking habits in response to consumer awareness of cancer threats, the tobacco industry must shrink, and the payout of RJR’s cash accomplished this to some extent. Furthermore, the LBO debt prohibits RJR from continuing to squander its cash flows on the wasteful projects it had undertaken prior to the buyout. Thus, the buyout laid the groundwork for the efficient reduction of capacity by one of the major firms in the industry. Also, by eliminating some of the cash resources from the oil and tobacco industries, these capital market transactions promote an environment that reduces the rate of growth of human resources in the industries or even promotes outright reduction when that is the optimal policy. The era of the control market came to an end, however, in late 1989 and 1990. Intense controversy and opposition from corporate managers, assisted by charges of fraud, the increase in default and bankruptcy rates, and insider trading prosecutions, caused the shutdown of the control market through court

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decisions, state antitakeover amendments, and regulatory restrictions on the availability of financing (see Swartz (1992), and Comment and Schwert (1993)). . . . The demise of the control market as an effective influence on American corporations has not ended the restructuring, but it has meant that organizations have typically postponed addressing the problems they face until forced to by financial difficulties generated by the product markets. Unfortunately the delay means that some of these organizations will not survive – or will survive as mere shadows of their former selves.

VI. The failure of corporate internal control systems With the shutdown of the capital markets as an effective mechanism for motivating change, renewal, and exit, we are left to depend on the internal control system to act to preserve organizational assets, both human and nonhuman. Throughout corporate America, the problems that motivated much of the control activity of the 1980s are now reflected in lackluster performance, financial distress, and pressures for restructuring. Kodak, IBM, Xerox, ITT, and many others have faced or are now facing severe challenges in the product markets. We therefore must understand why these internal control systems have failed and learn how to make them work. By nature, organizations abhor control systems, and ineffective governance is a major part of the problem with internal control mechanisms. They seldom respond in the absence of a crisis. The recent GM board revolt (as the press have called it) which resulted in the firing of CEO Robert Stempel exemplifies the failure, not the success, of GM’s governance system. General Motors, one of the world’s high-cost producers in a market with substantial excess capacity, avoided making major changes in its strategy for over a decade. The revolt came too late: the board acted to remove the CEO only in 1992, after the company had reported losses of $6.5 billion in 1990 and 1991. . . . Unfortunately, GM is not an isolated example. IBM is another testimony to the failure of internal control systems: it failed to adjust to the substitution away from its mainframe business following the revolution in the workstation and personal computer market. . . . Like GM, IBM is a high-cost producer in a market with substantial excess capacity. It too began to change its strategy significantly and removed its CEO only after reporting losses of $2.8 billion in 1991 and further losses in 1992 while losing almost 65 percent of its equity value. [. . .] General Electric (GE) under Jack Welch, who has been CEO since 1981, is a counterexample to my proposition about the failure of corporate internal control systems. GE has accomplished a major strategic redirection, eliminating 104,000 of its 402,000 person workforce (through layoffs or sales of divisions) in the period 1980 to 1990 without the motivation of a threat from capital or product markets. But there is little evidence to indicate this is anything more than the vision and persuasive powers of Jack Welch rather than the influence of GE’s governance system. [. . .]

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Although the strategic redirection of General Mills provides another counterexample (Donaldson (1990)), the fact that it took more than ten years to accomplish the change leaves serious questions about the social costs of continuing the waste caused by ineffective control. It appears that internal control systems have two faults. They react too late, and they take too long to effect major change. Changes motivated by the capital market are generally accomplished quickly – within one and a half to three years. . . . In summary, it appears that the infrequency with which large corporate organizations restructure or redirect themselves solely on the basis of the internal control mechanisms in the absence of crises in the product, factor, or capital markets or the regulatory sector is strong testimony to the inadequacy of these control mechanisms. [. . .]

VIII. Reviving internal corporate control systems 6 Remaking the board as an effective control mechanism The problems with corporate internal control systems start with the board of directors. The board, at the apex of the internal control system, has the final responsibility for the functioning of the firm. Most importantly, it sets the rules of the game for the CEO. The job of the board is to hire, fire, and compensate the CEO, and to provide high-level counsel. Few boards in the past decades have done this job well in the absence of external crises. This is particularly unfortunate given that the very purpose of the internal control mechanism is to provide an early warning system to put the organization back on track before difficulties reach a crisis stage. The reasons for the failure of the board are not completely understood, but we are making progress toward understanding these complex issues. The available evidence does suggest that CEOs are removed after poor performance, but the effect, while statistically significant, seems too late and too small to meet the obligations of the board. I believe bad systems or rules, not bad people, underlie the general failings of boards of directors. Some caution is advisable here because while resolving problems with boards can cure the difficulties associated with a nonfunctioning court of last resort, this alone cannot solve all the problems with defective internal control systems. . . . Board culture Board culture is an important component of board failure. The great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms is both a symptom and cause of failure in the control system. CEOs have the same insecurities and defense mechanisms as other human beings; few will accept, much less seek, the monitoring and criticism of an active and attentive board. . . . The result is a continuing cycle of ineffectiveness: by rewarding consent and

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discouraging conflicts, CEOs have the power to control the board, which in turn ultimately reduces the CEO’s and the company’s performance. This downward spiral makes the resulting difficulties likely to be a crisis rather than a series of small problems met by a continuous self-correcting mechanism. The culture of boards will not change simply in response to calls for change from policy makers, the press, or academics. It only will follow, or be associated with, general recognition that past practices have resulted in major failures and substantive changes in the rules and practices governing the system. Information problems Serious information problems limit the effectiveness of board members in the typical large corporation. For example, the CEO almost always determines the agenda and the information given to the board. This limitation on information severely hinders the ability of even highly talented board members to contribute effectively to the monitoring and evaluation of the CEO and the company’s strategy. Moreover, the board requires expertise to provide input into the financial aspects of planning – especially in forming the corporate objective and determining the factors which affect corporate value. Yet such financial expertise is generally lacking on today’s boards. Consequently, boards (and management) often fail to understand why long-run market value maximization is generally the privately and socially optimal corporate objective, and they often fail to understand how to translate this objective into a feasible foundation for corporate strategy and operating policy. Legal liability The factors that motivate modern boards are generally inadequate. Boards are often motivated by substantial legal liabilities through class action suits initiated by shareholders, the plaintiffs’ bar, and others – lawsuits which are often triggered by unexpected declines in stock price. These legal incentives are more often consistent with minimizing downside risk rather than maximizing value. Boards are also motivated by threats of adverse publicity from the media or from the political/regulatory authorities. Again, while these incentives often provide motivation for board members to cover their own interests, they do not necessarily provide proper incentives to take actions that create efficiency and value for the company. Lack of management and board member equity holdings Many problems arise from the fact that neither managers nor nonmanager board members typically own substantial fractions of their firm’s equity. While the average CEO of the 1,000 largest firms (measured by market value of equity) holds 2.7 percent of his or her firm’s equity in 1991, the median holding is only

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0.2 percent and 75 percent of CEOs own less than 1.2 percent . . . Encouraging outside board members to hold substantial equity interests would provide better incentives. Stewart (1990) outlines a useful approach using leveraged equity purchase plans or the sale of in-the-money options to executives to resolve this problem in large firms, where achieving significant ownership would require huge dollar outlays by managers or board members. By requiring significant outlays by managers for the purchase of these quasi-equity interests, Stewart’s approach reduces the incentive problem created by the asymmetry of payoffs in the typical option plan. Boards should have an implicit understanding or explicit requirement that new members must invest in the stock of the company. . . . The recent trend to pay some board member fees in stock or options is a move in the right direction. Discouraging board members from selling this equity is important so that holdings will accumulate to a significant size over time. Oversized boards Keeping boards small can help improve their performance. When boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control. Since the possibility for animosity and retribution from the CEO is too great, it is almost impossible for those who report directly to the CEO to participate openly and critically in effective evaluation and monitoring of the CEO. Therefore, the only inside board member should be the CEO. Insiders other than the CEO can be regularly invited to attend board meetings in an ex officio capacity. Indeed, board members should be given regular opportunities to meet with and observe executives below the CEO – both to expand their knowledge of the company and CEO succession candidates, and to increase other top-level executives’ understanding of the thinking of the board and the board process. Attempts to model the process after political democracy Suggestions to model the board process after a democratic political model in which various constituencies are represented are likely to make the process even weaker. To see this we need look no farther than the inefficiency of representative political democracies (whether at the local, state, or federal level), or at their management of quasi-business organizations such as the Post Office, schools, or power generation entities such as the TVA. This does not mean, however, that the current corporate system is satisfactory as it stands; indeed there is significant room for rethinking and revision. [. . .] As equity holdings become concentrated in institutional hands, it is easier to resolve some of the free-rider problems that limit the ability of thousands of individual shareholders to engage in effective collective action. In principle such institutions can therefore begin to exercise corporate control rights more effectively. Legal and regulatory restrictions, however, have prevented financial

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institutions from playing a major corporate monitoring role. . . . Therefore, if institutions are to aid in effective governance, we must continue to dismantle the rules and regulations that have prevented them and other large investors from accomplishing this coordination. The CEO as chairman of the board It is common in U.S. corporations for the CEO to also hold the position of chairman of the board. The function of the chairman is to run board meetings and oversee the process of hiring, firing, evaluating, and compensating the CEO. Clearly, the CEO cannot perform this function apart from his or her personal interest. Without the direction of an independent leader, it is much more difficult for the board to perform its critical function. Therefore, for the board to be effective, it is important to separate the CEO and chairman positions. . . . Resurrecting active investors A major set of problems with internal control systems are associated with the curbing of what I call active investors (Jensen (1989a, 1989b)). Active investors are individuals or institutions that simultaneously hold large debt and/or equity positions in a company and actively participate in its strategic direction. Active investors are important to a well-functioning governance system because they have the financial interest and independence to view firm management and policies in an unbiased way. They have the incentives to buck the system to correct problems early rather than late when the problems are obvious but difficult to correct. Financial institutions such as banks, pensions funds, insurance companies, mutual funds, and money managers are natural active investors, but they have been shut out of board rooms and firm strategy by the legal structure, by custom, and by their own practices. [. . .] Using LBOs and venture capital firms as models of successful organization, governance, and control Organizational experimentation in the 1980s Founded on the assumption that firm cash flows are independent of financial policy, the Modigliani-Miller (M&M) theorems on the independence of firm value, leverage, and payout policy have been extremely productive in helping the finance profession structure the logic of many valuation issues. The 1980s control activities, however, have demonstrated that the M&M theorems (while logically sound) are empirically incorrect. The evidence from LBOs, leveraged restructurings, takeovers, and venture capital firms has demonstrated dramatically

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that leverage, payout policy, and ownership structure (that is, who owns the firm’s securities) do in fact affect organizational efficiency, cash flow, and, therefore, value. Such organizational changes show these effects are especially important in low-growth or declining firms where the agency costs of free cash flow are large. Evidence from LBOs LBOs provide a good source of estimates of value gain from changing leverage, payout policies, and the control and governance system because, to a first approximation, the company has the same managers and the same assets, but a different financial policy and control system after the transaction. Leverage increases from about 18 percent of value to 90 percent, large payouts to prior shareholders occur, equity becomes concentrated in the hands of managers (over 20 percent on average) and the board (about 20 and 60 percent on average, respectively), boards shrink to about seven or eight people, the sensitivity of managerial pay to performance rises, and the companies’ equity usually become nonpublicly traded (although debt is often publicly traded). The evidence of DeAngelo, DeAngelo and Rice (1984), Kaplan (1989), Smith (1990), and others indicates that premiums to selling-firm shareholders are roughly 40 to 50 percent of the prebuyout market value, cash flows increase by 96 percent from the year before the buyout to three years after the buyout, and value increases by 235 percent (96 percent market adjusted) from two months prior to the buyout offer at the time of going public, sale or recapitalization about three years later on average. Clinical studies of individual cases demonstrate that these changes in financial and governance policies generate value-creating changes in behavior of managers and employees. A proven model of governance structure LBO associations and venture capital funds provide a blueprint for managers and boards who wish to revamp their top-level control systems to make them more efficient. LBOs and venture capital funds are, of course, the preeminent examples of active investors in recent U.S. history, and they serve as excellent models that can be emulated in part or in total by virtually any corporation. The two have similar governance structures, and have been successful in resolving the governance problems of both slow growth or declining firms (LBO associations) and high growth entrepreneurial firms (venture capital funds). [. . .] LBO associations and venture funds also solve many of the information problems facing typical boards of directors. First, as a result of the due diligence process at the time the deal is done, both the managers and the LBO and venture partners have extensive and detailed knowledge of virtually all aspects of the business. In addition, these boards have frequent contact with management, often weekly or even daily during times of difficult challenges. This contact and information flow is facilitated by the fact that LBO associations and venture funds

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both have their own staff. They also often perform the corporate finance function for the operating companies, providing the major interface with the capital markets and investment banking communities. Finally, the close relationship between the LBO partners or venture fund partners and the operating companies facilitates the infusion of expertise from the board during times of crisis. . . .

IX. Implications for the finance profession One implication of the foregoing discussion is that finance has failed to provide firms with an effective mechanism to achieve efficient corporate investment. . . . Agency theory (the study of the inevitable conflicts of interest that occur when individuals engage in cooperative behavior) has fundamentally changed corporate finance and organization theory, but it has yet to affect substantially research on capital-budgeting procedures. No longer can we assume managers automatically act (in opposition to their own best interests) to maximize firm value. Conflicts between managers and the firm’s financial claimants were brought to center stage by the market for corporate control in the last two decades. This market brought widespread experimentation, teaching us not only about corporate finance, but also about the effects of leverage, governance arrangements, and active investors on incentives and organizational efficiency. These events have taught us much about the interdependencies among the implicit and explicit contracts specifying the following three elements of organizations: 1 2

3

Finance – I use this term narrowly here to refer to the definition and structure of financial claims on the firm’s cash flows (e.g., equity, bond, preferred stock, and warrant claims). Governance – the top-level control structure, consisting of the decision rights possessed by the board of directors and the CEO, the procedures for changing them, the size and membership of the board, and the compensation and equity holdings of managers and the board. Organization – the nexus of contracts defining the internal ‘rules of the game’ (the performance measurement and evaluation system, the reward and punishment system, and the system for allocating decision rights to agents in the organization).

The close interrelationships between these factors have dragged finance scholars into the analysis of governance and organization theory. In addition, the perceived ‘excesses of the 1980s’ have generated major reregulation of financial markets in the United States affecting the control market, credit markets (especially the banking, thrift, and insurance industries), and market microstructure. These changes have highlighted the importance of the political and regulatory environment to financial, organizational, and governance policies, and generated a new interest in what I call the ‘politics of finance’. The dramatic growth of these new research areas has fragmented the finance

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profession, which can no longer be divided simply into the study of capital markets and corporate finance. Finance is now much less an exercise in valuing a given stream of cash flows (although this is still important) and much more the study of how to increase those cash flows – an effort that goes far beyond the capital asset-pricing model, Modigliani and Miller irrelevance propositions, and capital budgeting. This fragmentation is evidence of progress, not failure; but the inability to understand this maturation causes conflict in those quarters where research is judged and certified, including the academic journals and university departments. Specialists in different subfields have tended to react by labeling research in areas other than their own as ‘low-quality’ and ‘illegitimate.’ Acknowledging this separation and nurturing communication among the subfields will help avoid this intellectual warfare with substantial benefit to the progress of the profession. [. . .]

X. Conclusion For those with a normative bent, making the internal control systems of corporations work is the major challenge facing economists and management scholars in the 1990s. For those who choose to take a purely positive approach, the major challenge is understanding how these systems work, and how they interact with the other control forces (in particular the product and factor markets, legal, political, and regulatory systems, and the capital markets) impinging on the corporation. I believe the reason we have an interest in developing positive theories of the world is so that we can understand how to make things work more efficiently. Without accurate positive theories of cause and effect relationships, normative propositions and decisions based on them will be wrong. Therefore, the two objectives are completely consistent. Financial economists have a unique advantage in working on these control and organizational problems because we understand what determines value, and we know how to think about uncertainty and objective functions. To do this we have to understand even better than we do now the factors leading to organizational past failures (and successes): we have to break open the black box called the firm, and this means understanding how organizations and the people in them work. In short, we’re facing the problem of developing a viable theory of organizations. . . .

References Argyris, Chris, 1990, Overcoming Organizational Defenses (Allyn and Bacon, Needham, Mass.). Burnham, James D., 1993, Changes and Challenges: The Transformation of the U.S. Steel Industry, Policy Study No. 115 (Center for the Study of American Business, Washington University, St. Louis, Mo.). Comment, Robert, and G. William Schwert, 1993, Poison or placebo? Evidence on the

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deterrent and wealth effects of modern antitakeover measures, unpublished manuscript, Simon School of Business, University of Rochester. DeAngelo, Harry and Linda DeAngelo, 1991, Union negotiations and corporate policy: A study of labor concessions in the domestic steel industry during the 1980s, Journal of Financial Economics 30, 3–43. —— , and Edward Rice, 1984, Going private: Minority freezeouts and stockholder wealth, Journal of Law and Economics 27, 367–401. Donaldson, Gordon, 1990, Voluntary restructuring: The case of General Mills, Journal of Financial Economics 27, 117–141. Jensen, Michael C., 1989a, Eclipse of the public corporation, Harvard Business Review 67(5), 61–74. —— , 1989b, Active investors, LBOs, and the privatization of bankruptcy, Journal of Applied Corporate Finance 2, 35–44. Kaplan, Steven N., 1989, The effects of management buyouts on operating performance and value, Journal of Financial Economics 24, 581–618. Pound, John, 1993, The rise of the political model of corporate governance and corporate control, unpublished manuscript, Harvard University, Kennedy School of Government. Smith, Abbie J., 1990, Corporate ownership structure and performance: The case of management buyouts, Journal of Financial Economics 27, 143–164. Stewart, G. Bennett, III, 1990, Remaking the public corporation from within, Harvard Business Review 68(4), 126–137. Swartz, L. Mick, 1992, The impact of third generation antitakeover laws on security value, Unpublished manuscript, University of Manitoba. EDITORS’ NOTES 1 2

3 4 5 6

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Reprinted by permission of the publisher, Blackwell Publishing Ltd, © The American Finance Association. This extract from Jensen’s 46-page paper excludes the first section (introduction) and sections 2 and 3 on industrial revolutions except for a couple of contextualizing paragraphs from sections 1 and 2. Sections 4 and 5 on the ‘market for corporate control’ and sections 7 and 8 on ‘internal control systems’ are included largely intact. These sections cover the key themes and arguments of this paper. Readers are referred to the original for empirical investigation of value creation at the US firms between 1980 and 1990 which forms the contents of the excluded section 6 and the appendix. The last two sections, 9 and 10, entitled ‘implications for finance profession’ and ‘conclusion’ respectively are abridged. The extract moves from p. 831 to p. 833 here. The extract moves from p. 833 to p. 835. This extract contains only the scene setting first paragraph of section III which runs from p. 835 to p. 847. The extract moves from p. 835 to p. 847. The extract moves from p. 854 to p. 862.

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Chapter 5

Eugene F. Fama

CONTRACTS, DISCIPLINE AND MANAGEMENT PAY

Introduction to extract from Eugene F. Fama (1980), ‘Agency problems and the theory of the firm’, Journal of Political Economy, 88 (2): 288–307

EDITORS’ COMMENTARY Eugene F. Fama, like Michael Jensen whose paper is also included in this section, is widely recognized as one of the most influential researchers in the field of finance. Fama’s work in the 1960s and 1970s on asset pricing and efficient market theory (see, for example, Fama 1965 and 1970) helped to frame subsequent mainstream finance ideas about the unpredictability of stock movements and the difficulty of outguessing the market when all the relevant information is in the price. In terms of direct influence, he pioneered the event study as a form of empirical investigation which was widely replicated and his 1980 Journal of Political Economy article, which appears here in abridged form, made a decisive contribution to present-day agency theory by making a strong connection between the theory of the firm as a nexus of contracts and ideas about the managerial labour market as a source of discipline. In the years before 1980, US finance professors such as Alchian and Demsetz (1972) had acknowledged the death of the ‘entrepreneur’ and the ‘classical firm’, accepted the separation of ownership and control, and proposed a concept of the firm as a nexus of contracts, where controlling managers were primarily disciplined by security owners. Fama starts by rehearsing the thesis that ‘the two functions usually attributed to the entrepreneur, management and risk bearing, are treated as naturally separate factors within the set of contracts called a firm’ (p. 289). His significant contribution in this paper was then to develop a model of the firm where the agency costs are minimized primarily through an efficient market for managerial labour.

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Fama’s model assumes efficient capital markets because owners of securities can hold a diversified portfolio of securities and thus minimize their exposure to the specific managerial performance risk in a single firm. Managers’ human capital, on the other hand, is not a tradable security in capital markets and therefore managers’ wealth, which depends mostly on the rental rates of their human capital, is directly related to the success or failure of the firm which competes in product markets. On this basis, the managerial labour market is where managers capitalize their property rights and logically, therefore, where the disciplining mechanism is located. In Fama’s model of the viable firm, controlling managers design optimal sets of contracts between factors of production because otherwise their payoffs in the managerial labour market are at risk. The managerial labour market is both internal and external. The internal managerial labour market is relevant to lower levels of management whose reputation and wealth depend on top managements’ performance and therefore they play an internal disciplining role complementing the external disciplining by the managerial labour market. In Fama’s model the external managerial labour market is assumed to rationally revalue the senior managers’ worth because there is a full ex post settling up of the ex ante wages if there is a variation attributable to managers’ performance. Fama develops a formulaic and statistically defined model to show how this works: our extract leaves out the formulas and their demonstration for reasons of space and the interested reader is encouraged to consult the full-length paper. The result is a formal, theoretical demonstration of how potential incentive problems under the separation of security ownership and control can be resolved through the managerial labour market. And this was very influential partly because it helped to define an empirical agenda of research about the open question of whether pay really was being used to incentivize senior managers, as Fama showed it could be. As the extract by Tosi et al. later in this section shows, however, the findings of this subsequent empirical research raise very interesting questions about the extent to which pay had or could be used to appropriately incentivize managers. Eugene F. Fama is Professor of Finance at the University of Chicago Graduate School of Business, where he has taught since completing his thesis there in the 1960s. His main areas of research interest in finance are portfolio theory and asset pricing where he has published both theoretical and empirical work. He has published numerous papers and several books, including The Theory of Finance (with Merton Miller in 1972).

REFERENCES Alchian, A. A. and Demsetz, H. (1972) ‘Production, information costs and economic organization’, American Economic Review, 62(5): 777–95. Fama, E. F. (1965) ‘The behavior of stock market prices’, Journal of Business, 38: 34–105.

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Fama, E. F. (1970) ‘Efficient capital markets: a review of theory and empirical work’, Journal of Finance, 25: 383–417.

this paper1 is that separation of security ownership and control can be explained as an efficient form of economic organization within the ‘set of contracts’ perspective.2 We first set aside the typical presumption that a corporation has owners in any meaningful sense. The attractive concept of the entrepreneur is also laid to rest, at least for the purposes of the large modern corporation. Instead, the two functions usually attributed to the entrepreneur, management and risk bearing, are treated as naturally separate factors within the set of contracts called a firm. The firm is disciplined by competition from other firms, which forces the evolution of devices for efficiently monitoring the performance of the entire team and of its individual members. In addition, individual participants in the firm, and in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside of the firm.

T

HE MAIN THESIS OF

The irrelevance of the concept of ownership of the firm To set a framework for the analysis, let us first describe roles for management and risk bearing in the set of contracts called a firm. Management is a type of labor but with a special role – coordinating the activities of inputs and carrying out the contracts agreed among inputs, all of which can be characterized as ‘decision making.’ To explain the role of the risk bearers, assume for the moment that the firm rents all other factors of production and that rental contracts are negotiated at the beginning of each production period with payoffs at the end of the period. The risk bearers then contract to accept the uncertain and possibly negative difference between total revenues and costs at the end of each production period. When other factors of production are paid at the end of each period, it is not necessary for the risk bearers to invest anything in the firm at the beginning of the period. Most commonly, however, the risk bearers guarantee performance of their contracts by putting up wealth ex ante, with this front money used to purchase capital and perhaps also the technology that the firm uses in its production activities. In this way the risk bearing function is combined with ownership of capital and technology. We also commonly observe that the joint functions of risk bearing and ownership of capital are re-packaged and sold in different proportions to different groups of investors. For example, when front money is raised by issuing both bonds and common stock, the bonds involve a combination of risk bearing and ownership of capital with a low amount of risk bearing relative to the combination of risk bearing and ownership of capital inherent in the common stock. Unless the bonds are risk free, the risk bearing function

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is in part borne by the bondholders, and ownership of capital is shared by bondholders and stockholders. However, ownership of capital should not be confused with ownership of the firm. Each factor in a firm is owned by somebody. The firm is just the set of contracts covering the way inputs are joined to create outputs and the way receipts from outputs are shared among inputs. In this ‘nexus of contracts’ perspective, ownership of the firm is an irrelevant concept. Dispelling the tenacious notion that a firm is owned by its security holders is important because it is a first step toward understanding that control over a firm’s decisions is not necessarily the province of security holders. The second step is setting aside the equally tenacious role in the firm usually attributed to the entrepreneur.

Management and risk bearing: a closer look The entrepreneur (manager-risk bearer) is central in both the Jensen-Meckling and Alchian–Demsetz analyses of the firm. For example, Alchian–Demsetz state: ‘The essence of the classical firm is identified here as a contractual structure with: 1) joint input production; 2) several input owners; 3) one party who is common to all the contracts of the joint inputs; 4) who has the right to renegotiate any input’s contract independently of contracts with other input owners; 5) who holds the residual claim; and 6) who has the right to sell his central contractual residual status. The central agent is called the firm’s owner and the employer’ (1972, p. 794). To understand the modern corporation, it is better to separate the manager, the agents of points 3 and 4 of the Alchian–Demsetz definition of the firm, from the risk bearer described in points 5 and 6. The rationale for separating these functions is not just that the end result is more descriptive of the corporation, a point recognized in both the Alchian–Demsetz and Jensen–Meckling papers. The major loss in retaining the concept of the entrepreneur is that one is prevented from developing a perspective on management and risk bearing as separate factors of production, each faced with a market for its services that provides alternative opportunities and, in the case of management, motivation toward performance. Thus, any given set of contracts, a particular firm, is in competition with other firms, which are likewise teams of cooperating factors of production. If there is a part of the team that has a special interest in its viability, it is not obviously the risk bearers. It is true that if the team does not prove viable factors like labor and management are protected by markets in which rights to their future services can be sold or rented to other teams. The risk bearers, as residual claimants, also seem to suffer the most direct consequences from the failings of the team. However, the risk bearers in the modern corporation also have markets for their services – capital markets – which allow them to shift among teams with relatively low transaction costs and to hedge against the failings of any given team by diversifying their holdings across teams. Since he holds the securities of many firms precisely to avoid having his wealth depend too much on any one

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firm, an individual security holder generally has no special interest in personally overseeing the detailed activities of any firm. In short, efficient allocation of risk bearing seems to imply a large degree of separation of security ownership from control of a firm. On the other hand, the managers of a firm rent a substantial lump of wealth – their human capital – to the firm, and the rental rates for their human capital signaled by the managerial labor market are likely to depend on the success or failure of the firm. The function of management is to oversee the contracts among factors and to ensure the viability of the firm. For the purposes of the managerial labor market, the previous associations of a manager with success and failure are information about his talents. The manager of a firm, like the coach of any team, may not suffer any immediate gain or loss in current wages from the current performance of his team, but the success or failure of the team impacts his future wages, and this gives the manager a stake in the success of the team. The firm’s security holders provide important but indirect assistance to the managerial labor market in its task of valuing the firm’s management. A security holder wants to purchase securities with confidence that the prices paid reflect the risks he is taking and that the securities will be priced in the future to allow him to reap the rewards (or punishments) of his risk bearing. Thus, although an individual security holder may not have a strong interest in directly overseeing the management of a particular firm, he has a strong interest in the existence of a capital market which efficiently prices the firm’s securities. The signals provided by an efficient capital market about the values of a firm’s securities are likely to be important for the managerial labor market’s revaluations of the firm’s management. We come now to the central question. To what extent can the signals provided by the managerial labor market and the capital market, perhaps along with other market-induced mechanisms, discipline managers?. . . .

The viability of separation of security ownership and control of the firm: general comments The outside managerial labor market exerts many direct pressures on the firm to sort and compensate managers according to performance. One form of pressure comes from the fact that an ongoing firm is always in the market for new managers. Potential new managers are concerned with the mechanics by which their performance will be judged, and they seek information about the responsiveness of the system in rewarding performance. Moreover, given a competitive managerial labor market, when the firm’s reward system is not responsive to performance the firm loses managers, and the best are the first to leave. There is also much internal monitoring of managers by managers themselves. Part of the talent of a manager is his ability to elicit and measure the productivity of lower managers, so there is a natural process of monitoring from higher to lower levels of management. Less well appreciated, however, is the monitoring that takes place from bottom to top. Lower managers perceive that

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they can gain by stepping over shirking or less competent managers above them. Moreover, in the team or nexus of contracts view of the firm, each manager is concerned with the performance of managers above and below him since his marginal product is likely to be a positive function of theirs. Finally, although higher managers are affected more than lower managers, all managers realize that the managerial labor market uses the performance of the firm to determine each manager’s outside opportunity wage. In short, each manager has a stake in the performance of the managers above and below him and, as a consequence, undertakes some amount of monitoring in both directions. All managers below the very top level have an interest in seeing that the top managers choose policies for the firm which provide the most positive signals to the managerial labor market. But by what mechanism can top management be disciplined? Since the body designated for this function is the board of directors, we can ask how it might be constructed to do its job. A board dominated by security holders does not seem optimal or endowed with good survival properties. Diffuse ownership of securities is beneficial in terms of an optimal allocation of risk bearing, but its consequence is that the firm’s security holders are generally too diversified across the securities of many firms to take much direct interest in a particular firm. If there is competition among the top managers themselves (all want to be the boss of bosses), then perhaps they are the best ones to control the board of directors. They are most directly in the line of fire from lower managers when the markets for securities and managerial labor give poor signals about the performance of the firm. Because of their power over the firm’s decisions, their market determined opportunity wages are also likely to be most affected by market signals about the performance of the firm. If they are also in competition for the top places in the firm, they may be the most informed and responsive critics of the firm’s performance. Having gained control of the board, top management may decide that collusion and expropriation of security holder wealth are better than competition among themselves. The probability of such collusive arrangements might be lowered, and the viability of the board as a market-induced mechanism for lowcost internal transfer of control might be enhanced, by the inclusion of outside directors. The latter might best be regarded as professional referees whose task is to stimulate and oversee the competition among the firm’s top managers. In a state of advanced evolution of the external markets that buttress the corporate firm, the outside directors are in their turn disciplined by the market for their services which prices them according to their performance as referees. Since such a system of separation of security ownership from control is consistent with the pressures applied by the managerial labor market, and since it likewise operates in the interests of the firm’s security holders, it probably has good survival properties. This analysis does not imply that boards of directors are likely to be composed entirely of managers and outside directors. The board is viewed as a market-induced institution, the ultimate internal monitor of the set of contracts called a firm, whose most important role is to scrutinize the highest decision makers within the firm. In the team or nexus of contracts view of the firm, one

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cannot rule out the evolution of boards of directors that contain many different factors of production (or their hired representatives), whose common trait is that their marginal products are affected by those of the top decision makers. On the other hand, one also cannot conclude that all such factors will naturally show up on boards since there may be other market-induced institutions, for example, unions, that more efficiently monitor managers on behalf of specific factors. All one can say is that in a competitive environment lower-cost sets of monitoring mechanisms are likely to survive. The role of the board in this framework is to provide a relatively low-cost mechanism for replacing or reordering top managers; lower cost, for example, than the mechanism provided by an outside takeover, although, of course, the existence of an outside market for control is another force which helps to sensitize the internal managerial labor market. The perspective suggested here owes much to, but is nevertheless different from, existing treatments of the firm in the property rights literature. Thus, Alchian (1969) and Alchian and Demsetz (1972) comment insightfully on the disciplining of management that takes place through the inside and outside markets for managers. However, they attribute the task of disciplining management primarily to the risk bearers, the firm’s security holders, who are assisted to some extent by managerial labor markets and by the possibility of outside takeover. Jensen and Meckling (1976) likewise make control of management the province of the firm’s risk bearers, but they do not allow for any assistance from the managerial labor market. Of all the authors in the property-rights literature, Manne (1965, 1967) is most concerned with the market for corporate control. He recognizes that with diffuse security ownership management and risk bearing are naturally separate functions. But for him, disciplining management is an ‘entrepreneurial job’ which in the first instance falls on a firm’s organizers and later on specialists in the process of outside takeover. . . . The viability of the large corporation with diffuse security ownership is better explained in terms of a model where the primary disciplining of managers comes through managerial labor markets, both within and outside of the firm, with assistance from the panoply of internal and external monitoring devices that evolve to stimulate the ongoing efficiency of the corporate form, and with the market for outside takeovers providing discipline of last resort.

The viability of separation of security ownership and control: details . . . We now examine somewhat more specifically conditions under which the discipline imposed by managerial labor markets can resolve potential incentive problems associated with the separation of security ownership and control of the firm. To focus on the problem we are trying to solve, let us first examine the situation where the manager is also the firm’s sole security holder, so that there is clearly no incentive problem. . . . In contrast, when the manager is no longer sole security holder, and in the absence of some form of full ex post settling up for deviations from contract, a manager has an incentive to consume more on the job than is agreed in his

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contract. . . . Assessments of ex post deviations from contract will be incorporated into contracts on an ex ante basis; for example, through an adjustment of the manager’s wage. Nevertheless, a game which is fair on an ex ante basis does not induce the same behavior as a game in which there is also ex post settling up. Herein lie the potential losses from separation of security ownership and control of a firm. There are situations where, with less than complete ex post settling up, the manager is induced to consume more on the job than he would like, given that on average he pays for his consumption ex ante. Three general conditions suffice to make the wage revaluation imposed by the managerial labor market a form of full ex post settling up which resolves the managerial incentive problem described above. The first condition is that a manager’s talents and his tastes for consumption on the job are not known with certainty, are likely to change through time, and must be imputed by managerial labor markets at least in part from information about the manager’s current and past performance. Since it seems to capture the essence of the task of managerial labor markets in a world of uncertainty, this assumption is no real restriction. The second assumption is that managerial labor markets appropriately use current and past information to revise future wages and understand any enforcement power inherent in the wage revision process. In short, contrary to much of the literature on separation of security ownership and control, we impute efficiency or rationality in information processing to managerial labor markets. In defense of this assumption, we note that the problem faced by managerial labor markets in revaluing the managers of a firm is much entwined with the problem faced by the capital market in revaluing the firm itself. Although we do not understand all the details of the process, available empirical evidence . . . suggests that the capital market generally makes rational assessments of the value of the firm in the face of imprecise and uncertain information. This does not necessarily mean that information processing in managerial labor markets is equally efficient or rational, but it is a warning against strong presumptions to the contrary. The final and key condition for full control of managerial behavior through wage changes is that the weight of the wage revision process is sufficient to resolve any potential problems with managerial incentives. In this general form, the condition amounts to assuming the desired result. . . . Example 1: marketable human capital 3 Suppose a manager’s human capital, his stream of future wages, is a marketable asset. Suppose the manager perceives that, because of the consequent revaluations of future wages, the current value of his human capital changes by at least the amount of an unbiased assessment of the wealth changes experienced by other factors, primarily the security holders, because of his current deviations from contract. Then, as long as the manager is not a risk preferrer, these revaluations of his human capital are a form of full ex post settling up. The

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manager need not be charged ex ante for presumed ex post deviations from contract since the weight of the wage revision process is sufficient to neutralize his incentives to deviate. [. . . .] Example 2: stochastic processes for marginal products 4 The next example of ex post settling up through the wage revision process is somewhat more formal than that described above. We make specific assumptions about the stochastic evolution of a manager’s measured marginal product and about how the managerial labor market uses information from the process to adjust the manager’s future wages in a manner which amounts to precise, full ex post settling up for the results of past performance. . . . In fact, the process by which future expected marginal products are adjusted on the basis of past deviations of marginal products from their expected values leads to a precise form of full ex post settling up. . . . For our purposes, the interesting fact is that, although he is paid his ex ante expected marginal product, the manager does not get to avoid his ex post marginal product. . . .

Contractual settling up The literature on optimal contracting . . . suggests uniformly that when there is noise in the manager’s marginal product, that is, when the deviation of measured marginal product from its expected value cannot be traced unambiguously and costlessly to the manager’s actions (talents, effort exerted, and consumption on the job), then a risk-averse manager will always choose to share part of the uncertainty in the evaluation of his performance with the firm’s risk bearers. He will agree to some amount of ex post settling up, but always less than 100 percent of the deviation of his measured marginal product from its ex ante expected value. In short, the contracting models suggest that we must learn to live with the incentive problems that arise when there is less than complete ex post enforcement of contracts. The contracting literature is almost uniformly concerned with 1-period models. In a 1-period world, there can be no enforcement of contracts through a wage revision process imposed by the managerial labor market. The existence of this form of ex post settling up in a multiperiod world affects the manager’s willingness to engage in explicit contractual ex post settling up. [. . . .] Looked at from this perspective, however, the manager might simply contract to take the ex post measured value of his marginal product as his wage and then himself use the capital market to smooth his measured marginal product over future periods. Since the same asset (his human capital) is involved, the manager should be able to carry out these smoothing transactions via the capital market on the same terms as can be had in the managerial labor market. The

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advantage to the manager in smoothing through the capital market, however, is that he can then contract to accept full ex post settling up period by period (he is paid his measured marginal product), which means he can avoid any risk discount in his wage that might be imposed when he is paid the expected value of his marginal product with the possibility of unanticipated switches to other firms. It is important to recognize that using the capital market in the manner described above allows the manager to ‘average out’ the random noise in his measured marginal product. . . . This happily, but only coincidentally, resolves incentive problems by imposing full ex post settling up. The allocation of the current marginal product to future expected marginal products in fact occurs because the current marginal product has information about future expected marginal products. . . . The manager can achieve the same result by contracting to be paid the measured value of his marginal product and then using the capital market to smooth his marginal product. This power of the capital market to reduce the terror in full contractual ex post settling up is lost in the 1-period models that dominate the contracting literature.

Conclusions The model summarized . . . is one specific scenario in which the wage revision process imposed by the managerial labor market amounts to full ex post settling up by the manager for his past performance. The important general point is that in any scenario where the weight of the wage revision process is at least equivalent to full ex post settling up, managerial incentive problems – the problems usually attributed to the separation of security ownership and control of the firm – are resolved. No claim is made that the wage revision process always results in a full ex post settling up on the part of the manager. There are certainly situations where the weight of anticipated future wage changes is insufficient to counterbalance the gains to be had from ex post shirking, or perhaps outright theft, in excess of what was agreed ex ante in a manager’s contract. On the other hand, precise full ex post settling up is not an upper bound on the force of the wage revision process. There are certainly situations where, as a consequence of anticipated future wage changes, a manager perceives that the value of his human capital changes by more than the wealth changes imposed on other factors, and especially the firm’s security holders, by his current deviations from the terms of his contract. The extent to which the wage revision process imposes ex post settling up in any particular situation is, of course, an empirical issue. But it is probably safe to say that the general phenomenon is at least one of the ingredients in the survival of the modern large corporation, characterized by diffuse security ownership and the separation of security ownership and control, as a viable form of economic organization.

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References Alchian, Armen A. ‘Corporate Management and Property Rights.’ In Economic Policy and the Regulation of Corporate Securities, edited by Henry G. Manne. Washington: American Enterprise Inst. Public Policy Res., 1969. Alchian, Armen A. and Demsetz, Harold. ‘Production, Information Costs, and Economic Organization.’ American Economic Review 62 (December 1972): 777–95. Jensen, Michael C. and Meckling, William H. ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.’ J. Financial Econ. 3 (October 1976): 305–60. Manne, Henry G. ‘Mergers and the Market for Corporate Control.’ Journal of Political Economy 73, no. 2 (April 1965): 110–20. —— . ‘Our Two Corporate Systems: Law and Economics.’ Virginia Law Rev. 53 (March 1967): 259–85. EDITORS’ NOTES 1 2

3 4

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Reprinted by permission of the publisher, University of Chicago Press, © 1980 University of Chicago. This extract excludes the contextualizing literature review on p. 289. Readers are referred to pp. 297–304, which are not in the extract, for the formal modelling of the managerial labour market as a disciplining mechanism on managers in the section entitled ‘Viability of separation of security ownership and control: details’. All footnotes from the original are excluded in the extract. This extract excludes the theoretical justification of how labour market efficiency creates the equilibrium stated in the following paragraph. This section of the extract excludes the formal mathematical modelling of wage revision process under the assumption of stochasticity and the examples of robustness of the model between pp. 298 and 304.

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Chapter 6

Henry L. Tosi, Steve Werner, Jeffrey P. Katz and Luis R. Gomez-Mejia TESTING THE PAY–PERFORMANCE RELATION

Introduction to extract from Henry L. Tosi, Steve Werner, Jeffrey P. Katz and Luis R. Gomez-Mejia (2000), ‘How much does performance matter? A metaanalysis of CEO pay studies’, Journal of Management, 26 (2): 301–39

EDITORS’ COMMENTARY Empirical testing of the relation between executive pay and corporate performance has been important for two reasons: first, there was the question of whether the world had discovered appropriate pay incentives for managers, before Fama (1980) highlighted the issue from an agency perspective; second, there was the question of whether pay practices would change as academics like Michael Jensen, as well as official reports, highlighted the possibility of better governance. The division of labour is such that, while much of the theoretical development in finance has been concentrated in elite US institutions, the empirical testing to identify relations in large datasets has been much more dispersed and has been facilitated by improvements in both the technology and the availability of datasets that academics can access. In the case of this extract, it should be noted that Tosi et al. are all researchers from the management field, not from within the finance discipline, which perhaps helps to explain their observation in the final section of their paper that ‘there are other factors, political and organizational in nature, about which we have little knowledge with respect to their effect on CEO pay’ (p. 330), as well as indicating an interest in the issue of executive pay across the business school. The combination of theory, data, and techniques has contributed to a vast and diverse literature that explores the results of empirical tests on pay and performance. The results are striking: regardless of method and dataset, researchers generally find a weak or non-existent relation between pay and performance. Since the mid-1980s,

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the absence of any positive relation between pay and performance has become an endlessly re-confirmed test result, much like the general finding that takeovers destroy value for the acquiring company. As Tosi et al. argue in their extract, ‘the findings of studies on executive pay as a control mechanism are remarkably inconsistent not only with the theory but with each other’ (p. 305). Interestingly, however, many of the empirical tests do highlight the positive relation between pay and company size which Conyon and Murphy (2000) describe as ‘the best documented empirical finding in the executive compensation literature’. The large volume of empirical studies of pay and performance do, however, open up the possibility of meta-analysis as in Tosi et al.’s article which tests the sensitivity of executive pay to competing independent variables of firm size and firm performance by quantitatively analyzing the findings of previous tests. Tosi et al. explain how they deal with different measures of variables like executive pay, firm size and firm performance in a corpus of 137 published articles or unpublished manuscripts. The abridged version of the article included in this section includes Table 1 where these variables are listed; another nine tables showing the results of the tests are omitted but the abridged version of the article does include the description of the statistical methods used by Tosi et al. After a meta-analytical review of the literature on the determinants of CEO pay, Tosi et al. construct a database for factor analysis using COMPUSTAT and data drawn from 1,000 firms from 4 different sectors between 1987 and 1991. There are 46 variables of which 16 are size variables and 30 relate to performance. These then are reduced to 3 size factors and 8 performance factors for factor analysis. Given the results of earlier studies, it is not surprising that Tosi et al.’s metastudy found that firm size explains nine times the amount of variance in total CEO pay than the most highly correlated performance measure. If firm size accounts for more than 40 per cent of the variance in total CEO pay and firm performance accounts for less than 5 per cent of this variance, the caution is that there is still a large unexplained variance in CEO pay which may be explained by different measures of performance or, indeed, other variables like tenure and age. At the beginning of the article, in their discussion of theories of the firm, Tosi et al. distinguish between ‘managerialism’ (from Berle and Means’ original statement and developed by others such as Marris (1964) and Aoki (1984)), and post-1980 agency theory. The results of the meta test do show that corporate boards are not solving an agency problem by aligning the interest of owners and managers by linking executive pay to performance. The fact that pay and performance have not been effectively connected, despite the theoretical insights and policy developments that should in principle support such an alignment, raises important questions about the inherent feasibility of the pay-forperformance project. Henry L. Tosi is Professor of Management at the University of Florida at Gainsville. Steve Werner is Associate Professor at the University of Houston. Jeffrey P. Katz is at Kansas State University Luis Gomez-Mejia is Professor of Management at Arizona State University. Tosi, Werner and Gomez-Mejia have, in varying combinations, written a range of papers on aspects of corporate governance, including pay

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and performance (see, for example, Gomez-Mejia and Balkin 1992 Tosi et al. 1997 and Werner and Tosi 1995.

REFERENCES Aoki, M. (1984) The Cooperative Game Theory of the Firm, Oxford: Clarendon Press. Conyon, M. J. and Murphy, K. J. (2000) ‘The prince and the pauper? CEO pay in the United States and United Kingdom’, Economic Journal, 110: F640–71. Fama, E. F. (1980) ‘Agency problems and the theory of the firm’, Journal of Political Economy, 88 (2): 288–307. Gomez-Mejia, L. R. and Balkin, D. B. (1992) Compensation, Organizational Strategy and Firm Performance, Cincinnati, OH: South Western. Marris, R. (1964) The Economic Theory of ‘Managerial’ Capitalism, London: Macmillan. Tosi, H. L., Katz, J. P., and Gomez-Mejia, L. R. (1997) ‘Disaggregating the agency contract: the effects of monitoring, incentive alignment, and term in office on agency decision-making’, Academy of Management Journal, 40: 584–602. Werner, S. and Tosi, H. L. (1995) ‘Other people’s money: effects of ownership on compensation strategy and managerial pay’, Academy of Management Journal, 38: 1672–91.

F

O R AT L E A S T T H E last decade there has been spirited debate in both the popular press and the academic press surrounding the question of whether top executives, particularly chief executive officers (CEOs), earn their pay.1 ,2 . . . While the issues raised by the public press focus on the fairness of such large CEO compensation packages, those raised by the academic press lie in the contradictory results often found in the research literature. In this paper we use meta-analysis to shed some light on the academic debate by assessing the effects of two important theoretical antecedents of CEO pay: firm size and firm performance. We focus on these two factors because they have received the most conceptual and empirical attention (Gomez-Mejia, 1994; Gomez-Mejia & Wiseman, 1997), with studies going back as far as the mid-1920s (Taussig & Barker, 1925).

Control mechanisms and executive pay Much of the attention in CEO compensation research centers on the issue of control, that is, to what extent CEOs are held accountable to some external party (normally shareholders) for compensation received. This is a fundamental concern both on academic and practical grounds because most CEOs are hired professional managers entrusted with the responsibility to act on behalf of absen-

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tee firm owners in exchange for compensation packages that often exceed six figures. Accountability is not an issue in the classical theory of the firm because the CEO and the firm owner are embodied in the same person. . . . Goal incongruency between owners and managers is the focus of two control-oriented theories that have guided most of the CEO compensation research in this century: managerialism and agency theory. Each of these is discussed in turn, leading to the hypotheses to be tested in this study. The theories and the evidence 3 The findings of studies on executive pay as a control mechanism are remarkably inconsistent not only with the theory but with each other. For instance, studies by Belkaoui and Picur (1993), David, Kochhar, and Levitas (1998), and Gray and Cannella (1997) report correlations as low as 0.107, 0.110, and 0.170 between firm size and CEO pay, while studies by Boyd (1994), Finkelstein and Boyd (1998), and Sanders and Carpenter (1998) report correlations of 0.62, 0.50, and 0.42 between these two variables. Equally divergent results characterize studies of relationships between compensation and firm performance. For example, Finkelstein and Boyd (1998) report correlations of 0.13 and 2.03 between return on equity (ROE) with cash compensation and long-term pay. Similarly, Johnson (1982) found ROE to be correlated with executive pay at 0.003. At the other end, Belliveau, O’Reilly, and Wade (1996) found the ROE–CEO pay correlation to be 0.410. Gomez-Mejia (1994: 199) concludes that ‘the literature on executive pay is rather extensive [yet] . . . it is amazing how little we know about executive pay in spite of the massive volume of empirical work available on this topic’. A number of explanations account for this divergence: different methods of data collection, different statistical techniques, different samples, the presence of moderator variables, and differences in how the constructs of interest have been operationalized in the various studies. These could be the reasons that it is difficult to reach firm conclusions based on reported results, as seen in the conclusions of the several extensive reviews of the executive compensation literature that have been published during the past 25 years . . . Without exception, these reviews rely on a traditional narrative approach that critically compares, contrasts, and integrates a large number of studies using a ‘clinical’ methodology that leaves the interpretation of results up to the author. Not surprisingly, these synthetic works suffer from the same malady as the single studies they review, with some authors concluding that firm performance is an important predictor of CEO pay . . . and others concluding that the evidence fails to support such a relationship . . .

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Contrasting hypotheses Meta-analysis provides a powerful analytical tool to estimate the magnitude of the relationships among the variables of interest in a more systematic and rigorous approach than could be possible in a typical literature review. This metaanalysis examines the empirical evidence in support of the agency argument that CEO pay will be linked to firm performance outcomes and the managerialist assertions that CEO pay will be largely decoupled from performance and tied more closely to scale of operations. Formally stated, the two contrasting hypotheses tested in this study are as follows: H1: H2:

Firm performance is an important determinant of CEO compensation (agency prediction). CEO compensation is largely insensitive to firm performance and primarily determined by firm size (managerialist prediction).

Method This meta-analysis focuses on the relationships between CEO pay and firm performance, and CEO pay and firm size. By quantitatively analyzing all relevant studies on a topic, meta-analysis can facilitate the interpretation of the seemingly contradictory conclusions of the narrative reviews. It is an alternative, empirical approach to integrate the findings of the large number of studies relating compensation to firm size and firm performance that have been reported to date. It makes it possible to obtain a better estimate of the true strength of the relationships between CEO compensation and variables such as organizational size and organizational performance. The strengths of meta-analysis include its scientific rigor, little bias in the inclusion of studies, objective weighting of the studies, allowing the examination of moderating variables, allowing estimations of relationship stability, and its ability to overcome many of the problems of traditional narrative research reviews . . . The criticisms of meta-analysis include its low power in detecting moderating relationships, the possible role judgments play in the results, the inclusion of ‘poor’ studies that may bias results, a bias towards published results, and comparing studies with too dissimilar methods . . . Meeting certain assumptions addresses many of these criticisms. These assumptions include (1) retrieved studies reflect the population of studies; (2) independence between study results used; and (3) grouping only studies with homogeneous methods . . . For this study, we have attempted to address each of the assumptions. The conventional databases (e.g., ABI Inform, SocLit, Business Periodicals Index, Dissertation Abstracts) were surveyed for articles on CEO, manager, or executive pay, wages, salary, or compensation for all available years. We also searched the bibliographies and references of numerous books and articles. We identified a final sample of 137 articles or unpublished manuscripts that analyzed CEO pay and either firm size or performance. Most of these papers failed to report the simple correlations needed for meta-analysis, but only regression

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coefficients, which cannot be used. Because simple correlations were not reported, 85 first authors were sent a letter requesting (1) the simple correlations, and (2) any working papers or unpublished manuscripts they knew about. The dependent variable: CEO pay Total CEO pay was used as the dependent variable when available. This includes salary, bonus, and the value of both short- and long-term incentives, if reported. Stock options were generally valued with (1) the Black–Scholes method . . ., (2) a heuristic valuation . . . or (3) by measuring only actual stock gains . . . If total pay was not available, total cash pay (salary + bonus) was used. Where neither total pay nor total cash measures were used, salary was used. This should not be a problem for a meta-analysis because these variables all measure the same construct and they are highly correlated. It has been demonstrated that simple measures of cash compensation are an excellent proxy for total pay for CEOs . . . Furthermore, a sample of studies reported an average r between salary and total cash of 0.75 (k = 8, n = 1400 . . .). The independent variables: firm performance and firm size A problem that we faced in executing the meta-analysis is the large number of different independent variables used as performance and size measures to predict CEO pay, raising the issue of how to group these different measures within and across studies . . . For example, size has been operationalized by firm sales, the square root of sales, the log of sales, the number of employees, total assets, and log of total assets, to name a few measures. Performance has been similarly operationalized as the market value of the assets relative to book value, ROE, return on investment (ROI), changes in the market value of the firm, and so forth. The final set of studies used in the meta-analysis consisted of 46 different size and performance predictors of CEO pay. Of these 46 variables, 16 were measures of size and 30 were measures of performance (See Table 1 for a list and explanation of all variables.) Because these measures of firm size and firm performance are relatively objective, reliable, and available through secondary data sources, we took the approach of combining them based on the results of a principal components factor analysis, suggested by Rosenthal as a ‘procedure that seems not to have been used in meta-analysis work, but which may hold some promise . . .’ (Rosenthal, 1984: 37). Because factor analysis is used to find the underlying patterns and relationships for a large number of variables, we used it to find the underlying constructs measured by a large number of performance and size variables. We could not, however, perform the factor analysis using only the studies that would be included in the meta-analysis because each of them only examined a small number of the 46 different variables, making it impossible to create the necessary simple correlation matrix that is the first step in the factor analysis. We

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Table 1 Dictionary of variable names

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46.

Variable

Definition

D5SALES DSALE-I DSALE-ID D1SALES D1PROFTS D1DIVIND MRKTVAL ROE EPS MRKTGAIN LOGSALES SALES SALEST-1 SALEST-2 SQRSALES ROE-IROE D1ROE-I MRKTRET PROFITS PTAXPRFT PROFT-1 PROFT-2 D1PTXPRF ROA ROA-IROA Y2ROEAVG MKTVL/AS MKT/BOOK D1ROE MRKRET-1 Y2MRTAVG Y5ROEAVG Y5ROE-I Y5ROE-ID Y5EPSAVG Y5EPS-I Y5EPS-ID D1NIBEX D1WRKCAP D1CSHFLW EMPS ASSETS LOGASSTS LOGMRKVL D1ASSETS STOCKEQ

5-year change* in sales. 5-year change in sales compared with industry. Dummy of DSALE-I. Change in sales over 1 year. Change in profits over 1 year. Change in dividends per share over one year. Value of common dividend by outstanding. Return on equity – one year. Earnings per share – one year. Change in stock price times outstanding. Log of sales – one year. Sales-current year. Sales for previous year. Sales for two years ago. Square root of sales – current year. Return on equity minus industry average ROE. Change in ROE over 2 years compared with industry ROE. Stock return plus dividend issued for one year. Net income for one year (before extraordinary items). Pre-tax profits for one year. Net income for previous year. Net income for two years ago. Change in pre-tax profits for one year. Return on assets – one year. ROA compared with average industry ROA. Average of ROE over two years. Market value over assets for one year. Market value divided by book value on a per-share basis. Change in ROE over one year. Market return for the previous year. Average of market return over two years. Average of ROE over 5 years. Avg. 5 year ROE compared with industry 5-year ROE average. Dummy of Y5ROE-I. Average of EPS over 5 years. Avg. EPS over 5 years compared with industry 5-year avg. Dummy of Y5EPS-I. Change in before-tax profits over one year. Change in working capital over one year. Change in cash ow over one year. Number of employees – one year. Total assets – one year. Log of assets. Log of market value for one year. Change in assets over one year. Stockholder’s equity – one year.

Note: *Change scores were calculated as percentage changes (i.e., variable at time t minus variable at time t 2 1 all divided by variable at time t 2 1 for 1-year change scores).

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solved this problem by analyzing the factor structure of these 46 different variables in a sample of 1,000 firms drawn from COMPUSTAT from four different industries. . . . These industries are also heavily represented in prior CEO pay studies. They are pharmaceutical preparations, semiconductors and related devices, electro-medical equipment, and food/beverage. Data were used from the years 1987–1991 to allow for generalizations across time. We then computed the values for the 46 different size and performance variables for the firms and used these values for the factor analysis, but only if data were available for all 46 variables. The final factored sample consisted of 899 firms. The factor analysis We performed two factor analyses one for the 16 size variables and one for the 30 performance variables. We extracted three organizational size factors and eight performance factors, after applying the following criteria to determine the number of factors: cutoff of eigenvalues greater than 1, a scree plot analysis, and interpretability. . . . Variables were retained in the factor when their loading was greater than 0.50. The 0.50 cutoff was chosen because such a high loading is considered to be very significant . . . The factors The 16 size variables yielded a three-factor solution that accounted for 44.9% of the variance. To examine the stability of the solution, we randomly split the data in half and performed a factor analysis on each part. A comparison of the solutions with each other and that obtained from the complete data set showed solution stability . . . Specifically, only very minor differences emerged, and when looking at the factors actually used in the meta-analysis, the three solutions were identical. 1

2 3

Absolute firm size. This factor appears to be an absolute size measure with market value, assets, stock equity, sales, and number of employees loading on it. It has very high internal consistency (Cronbach’s alpha = 0.97; 11 items). Change in size. The second factor is a growth measure, weighted by measures of change in sales. Its internal consistency is high (Cronbach’s alpha = 0.83; 3 items).4 . . . Transformed firm size. The variables loading on this factor are size measures that have undergone some mathematical transformation. They are: log of market value, log of assets, changes in assets and a dummy variable of change in sales compared with industry averages. This factor has low internal consistency (Cronbach’s alpha = 0.66; 4 items).

Using the same criteria above for the determination of the factor structure, the factor analysis of the 30 performance variables resulted in a relatively clean solution of eight factors that account for 70.3% of the variance. Stability of the

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solution was assessed in the same manner as for the size factors. Again, we found only very minor differences, and when looking at the factors actually used in the meta-analysis, the three solutions were identical. . . . 1

2

3

4

5 6 7 8

Absolute financial performance levels. This factor includes a variety of measures that represent the total dollar amount of financial indicators, such as total profits, pre-tax profits, and market gain. Its internal consistency is very high (Cronbach’s alpha = 0.97; 5 items). Changes in financial performance. This factor assesses the change in organizational financial performance. Change in net income, change of ROE, and change in profits load on this factor. The internal consistency is high (Cronbach’s alpha = 0.90; 5 items). Stock performance. This factor measures the performance of firms’ stock in the equity market, with short- and long-term earnings per share having loadings greater than our cutoff of 0.50. Its internal consistency is relatively high (Cronbach’s alpha = 0.82; 3 items). Return on equity short term. This factor is a measure of short-term organizational financial performance. ROE, ROE versus the industry, and twoyear average of ROE load on this factor. Its internal consistency is high (Cronbach’s alpha = 0.90; 3 items). Return on assets. This factor assesses the firms’ use of financial assets with loadings of ROA and ROA compared with industry average. Its internal consistency is high (Cronbach’s alpha = 0.93; 2 items). Return on equity long term. This factor assesses long-term ROE. The internal consistency is very high (Cronbach’s alpha = 0.99; 2 items). Market returns. The variables on this factor are market return measures. However, the internal consistency is low (Cronbach’s alpha = 0.66; 2 items). Internal performance indicators. The variables that load on this factor are internal indicators of firm performance, that is, market-to-book ratio and change in working capital. The internal consistency is very low (Cronbach’s alpha = 0.22; 2 items).

Grouping the independent variables Unlike a conventional meta-analysis in which the studies report a single correlation between a dependent variable and the independent variable, we were faced with the possibility that a study might report correlations between a dependent variable (e.g., CEO pay) and one of the factored constructs (e.g., Absolute Firm Size) that comprised several variables. For example, Lewellen (1968) correlated CEO pay with three factors that load on the Absolute Firm Size factor (market value, sales, and assets). Thus, it was necessary in some way to combine these three variables to arrive at a ‘correlation’ that we would use from Lewellen (1968) in the meta-analysis. We chose a method that would yield an adjusted composite correlation that would take into account the sample size in each study and the factor loading of the specific variable on the factor construct, as well as

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adjust for colinearity of the variables that loaded on the factor . . . We calculate this adjustment because computing the simple mean of the items in a factor implies equal weights for each variable, while the factor analysis shows substantial differences in the factor loadings. However, it should be noted that because of measurement error and rounding effects, it is possible that unit weightings may more closely match the latent factor than artificially precise factor scores. Thus, we report both the adjusted and unadjusted correlations.5 [. . . .]

Analysis In executing the meta-analysis we were faced with two decisions. First, because we combined a group of variables to create a factor, we were able to compute the reliability of the construct, permitting us to eliminate those with unacceptably low levels. Second, a very small number of studies existed from which we could obtain the necessary correlations for some of the factors. We therefore adopted the following rules for including factors in the meta-analysis. First, we eliminated any factor with a Cronbach alpha below .80, . . . as a lower limit for basic research. Second, we included factors in the meta-analysis only if there were at least five studies using at least one of the variables that loaded on a factor. For the firm size measures, the only factors that met this criterion were Absolute Firm Size and Change in Size. For the firm performance measures, the only factors that met this criterion were Absolute Financial Performance Levels, Changes in Financial Performance, Return on Equity Short Term, and Return on Assets. We did not believe that it was necessary to correct for problems of range restriction, reliability, and clerical errors because the data used in CEO pay studies are generally archival ‘hard data’ that do not suffer from reliability issues as seriously as the sorts of psychological measures that are more likely to suffer from systematic error. Because the reliabilities are likely to be very high and we prefer conservative estimates, we chose to not correct for any reliability problems or other errors. Thus, we believe that the findings are less likely to overstate the actual correlations between CEO pay and performance or size. [. . . .]

Results 6 All adjusted composite correlation values were transformed into Fisher’s Z . . . for grouping across studies. The meta-analysis was performed using the Schmidt–Hunter method on the adjusted and unadjusted composite correlations. This method addresses differences in the sample sizes of the studies. Only one correlation was used per study unless (1) several correlations were reported for independent samples (e.g., samples were separated by industry), or (2) several correlations were reported for different time periods. . . . In all cases, the 95% confidence interval does not include zero, providing strong evidence that relationships exist between CEO pay and firm size, and

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CEO pay and firm performance. However, as we will see shortly, firm performance is a very weak predictor of CEO pay in comparison with firm size. The estimated true correlation between CEO Pay and Absolute Firm Size is .520. However, before reaching any conclusion about the effect of firm size on CEO pay, we were prompted to reconsider whether the Absolute Firm Size factor is the best size indicator. The reason is that we note that the correlation between the factor scores for Absolute Financial Performance Levels and Absolute Firm Size for firms in the COMPUSTAT sample (n = 899) is r = 0.84. Examination of the variables that loaded on the Absolute Financial Performance Levels factor actually appear to be measures of the scale of the firm, that is, larger firms will, on average, have greater absolute profit levels than smaller firms. Thus, though previous studies have classified the variables as performance measures, as we have done in the original factor analysis, it is our intuition now that these absolute performance level variables are better measures of firm size. ‘Firms with large assets and sales revenues also have large accounting profits in absolute terms. The common factor, bigness, is at work’ . . . Based on this premise, we performed a factor analysis (unreported) that included all 46 of the original variables. The result is that all the variables from both the Absolute Financial Performance Levels factor and the Absolute Firm Size factor loaded on a single factor that we call Aggregated Firm Size, while the other factors emerged as in the original analysis, further supporting the stability of the solutions. We then calculated the adjusted composite correlations for the Aggregated Firm Size factor. These were then used in an additional meta-analysis. . . . We found that the estimated true correlation between CEO pay and the Aggregated Firm Size factor is .643, meaning that firm size accounts for more than 40% of the variance in CEO pay levels. The estimated true correlation between CEO Pay and Return on Equity Short Term is .212. Thus, this financial performance measure accounts for 4.5% of the variance in CEO pay levels. The estimated true correlation between CEO Pay and Return on Assets is 0.117. Thus, this other financial performance measure accounts for less than 2% of the variance in CEO pay levels. The adjusted composite correlation between Change in CEO Pay and Change in Financial Performance is .203, accounting for about 4% of the variance. The adjusted composite correlation between Change in CEO Pay and Change in Size is .225, accounting for about 5% of the variance in changes in CEO pay. . . . [O]nly two of the chi-square tests reached statistical significance at the .05 level, corresponding to the relationship between CEO pay and ROE and CEO pay and ROA. This indicates that for the rest of the correlations there is evidence of heterogeneity. This is informative because a nonsignificant chi-square in a meta-analysis of this sort would indicate that moderators might be suspected to affect the strength of these correlations.

Discussion In our judgment, the results are consistent with those theoretical explanations that emphasize organizational size as an important determinant of total CEO pay; that is, indicators of firm size, taken together, explain almost nine times the

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amount of variance in total CEO pay than the most highly correlated performance measure. A lesser effect is demonstrated in the findings regarding pay sensitivity as well as in the difference in the pay/performance or pay/firm growth sensitivities. Changes in firm performance account for only 4% of the variance in CEO pay, while changes in firm size account for 5% of the variance in CEO pay. These results are consistent with Jensen and Murphy’s (1990) conclusion that ‘incentive alignment’ as an explanatory agency construct for CEO pay is weakly supported at best. These authors found that the pay performance sensitivity for executives is approximately $3.25 per $1,000 change in shareholder wealth, ‘small for an occupation in which incentive pay is expected to play an important role’ . . . Evidence from the meta-analysis, however, suggests that moderator variables may affect these relationships. The chi-square tests indicate that there are likely to be moderators that affect the relationships between (1) size and total pay, (2) changes in size and changes in pay, and (3) changes in performance and changes in total pay . . . Only the unadjusted relationships between CEO pay and ROE short term and pay and ROA appear not to be affected by moderators. Although there are number of good candidates for moderators, such as level of diversification . . . organizational structure . . . and human capital . . ., we believe that the best first candidate is the ownership structure. Both managerialism and agency theory argue that the separation of ownership and control is an enabling condition that allows executives to take advantage of their privileged position to seek their interest at the expense of owners. As noted by agency theorists, monitoring and incentive alignment mechanisms may be effective in curbing these self-serving tendencies on the part of the executive. However, these mechanisms may be rather weak or inert in management-controlled firms (where they are needed the most because external owners are more dispersed) as shown in several studies . . . Therefore, it is likely that firm size rather than performance is the strongest predictor of CEO pay in management controlled firms (as argued by managerialism), while the reverse may be true in ownercontrolled firms (as argued by agency theory). Consistent with an ownership moderator effect . . . firm size was related to total pay in management-controlled firms but not owner-controlled firms, suggesting that managerial control is a moderator of the pay/size relationship. We found evidence of a moderator effect on this same relationship in our metaanalysis. Furthermore, both studies found similar results for pay sensitivity: Changes in pay were linked to changes in performance in owner-controlled firms while changes in pay were related to changes in firm size in managementcontrolled firms. This means that the ownership structure may likely be a moderator for the relationship between changes in pay and both changes in size and changes in performance. The meta-analysis indicated the presence of moderators for both of these same relationships. Still, one must wonder how much variance may be accounted for were it possible to assess the effects of any of these moderators noted above. The reason is that there are other factors, political and organizational in nature, about which we have little knowledge with respect to their effect on CEO pay. One of these, for example, is the nature of the performance criteria used to assess CEOs.

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Without exception, the research used in the meta-analysis used archival databases to create proxy dependent and independent variables. Furthermore, the researcher tends to assess the premise that pay judgments are based on economically rational criteria that these proxies represent. Researchers express shock when they find pay/performance sensitivities are low and the results inconsistent with their theory. We suggest that there is a distinct possibility that perhaps the archival performance criteria may be deficient because they typically tap only a small portion of the CEO’s job performance requirements, and therefore contain a large amount of noise, making unambiguous causal attributions for observed results very difficult . . . Knowing this, boards of directors might well turn to measures of performance that include objective indicators as well as judgmental, clinical, and subjective assessments of other job-relevant dimensions. Such criteria are more likely to represent a holistic, multidimensional assessment of executive performance. Thus, the objective performance measures found in the executive compensation literature may be ‘deficient’ for evaluation purposes by those responsible for corporate governance, who in turn then use a subjective evaluation process to assess the executive’s contributions. If this is the case, it would not be surprising that weak empirical relationships using archival-based criteria are found. This could mean, then, that the theoretical predictions are not disconfirmed, but only that the methodology employed does not properly measure the performance construct on which the agency contract is based. If this is so, then it may be premature to infer from the research that uses archival data of this sort . . . that there is little support for the notion of ‘optimal contracting’ to align interests. We are left with the conclusion that there is a large unexplained variance in CEO pay, some of which might be accounted for if the sort of data required for meta-analysis were available from the studies that are reported in other disciplines. Had this been available, we might have been able to assess, for example, the effect of some human capital variables such as tenure and age or the role of the ownership structure. Until the body of literature on CEO pay is larger in the organizational literature, which requires such statistics, or researchers in other fields begin to report such information, we are limited to the speculative sorts of arguments that we have discussed here to explain the relationship between CEO compensation and firm performance.

References Belkaoui, A. and Picur, R. 1993. An analysis of the use of accounting and market measures of performance, CEO experience and nature of deviation from analyst forecasts. Managerial Finance, 19 (2): 20–32. Belliveau, M. A., O’Reilly, C. A., and Wade, J. B. 1996. Social capital at the top: Effects of social similarity and status on CEO compensation. Academy of Management Journal, 39: 1568–1593. Boyd, B. K. 1994. Board control and CEO compensation. Strategic Management Journal, 15: 335–344. David, P., Kochhar, R., and Levitas, E. 1998. The effects of institutional investors on the

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level and mix of CEO compensation. Academy of Management Journal, 41 (2): 200–208. Finkelstein, S. and Boyd, B. 1998. How much does the CEO matter? The role of managerial discretion in the setting of CEO compensation. Academy of Management Journal, 41 (2): 179–199. Gomez-Mejia, L. R. 1994. Executive compensation. In G. Ferris (ed.), Research in personnel and human resources management, 12: 175–213. Greenwich, CT: JAI Press. Gomez-Mejia, L. R. and Wiseman, R. M. 1997. Reframing executive compensation: An assessment and outlook. Journal of Management, 23: 291–374. Gray, S. R. and Cannella, A. A., Jr. 1997. The role of risk in executive compensation. Journal of Management, 23: 517–540. Jensen, M. and Murphy, K. 1990. Performance pay and top-management incentives. Journal of Political Economy, 98 (2): 225–264. Johnson, B. 1982. Executive compensation, size, profit and cost in the electric utility industry. Unpublished doctoral dissertation. Florida State University. Lewellen, W. G. 1968. Executive compensation in large industrial corporations. New York: National Bureau of Economic Research. Rosenthal, R. 1984. Meta-analytic procedures for social research. London: Sage. Sanders, W. G. and Carpenter, M. A. 1998. Internationalization and firm governance: The roles of CEO compensation, top team composition, and board structure. Academy of Management Journal, 41 (2): 158–178. Taussig, F. W. and Barker, W. S. 1925. American corporations and their executives: A statistical inquiry. Quarterly Journal of Economics, 3: 1–51. EDITORS’ NOTES 1 2

3

4 5 6

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Reprinted by permission of the publisher, Sage Publications Inc., © 2000 by Elsevier Science Ltd. This extract from Tosi et al.’s paper includes the sections on hypothesis formulation, methodology, model specification and findings of the tests on the determinants of executive pay. The literature review sections on ‘managerialism’ and ‘agency theory’ are excluded. The extract includes Table 1 where the variables used in the models are listed and described. All other nine tables showing the results of the tests are extracted. The two consecutive sections entitled ‘managerialism’ and ‘agency theory’ which are literature reviews of these respective topics are excluded. The extract moves from p. 302 to p. 305. Table 2 on p. 310 which follows this paragraph and shows the results of factor analysis of independent size variables is excluded. Table 3 on p. 312 showing the results of factor analysis of independent performance variables is excluded. Tables 4 to 10 on pp. 315–28 are excluded. Tables 4–9 show the regression results of individual studies that Tosi et al.’s meta-analysis is based on. Table 10 shows the regression results of the meta-analysis.

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Chapter 7

Paddy Ireland

WHOSE COMPANY IS IT ANYWAY?

Introduction to extract from Paddy Ireland (2001), ‘Defending the rentier: corporate theory and the reprivatisation of the public company’, in J. Parkinson, A. Gamble and G. Kelly (Eds), The Political Economy of the Company, Oxford: Hart Publishing, 141–73

EDITORS’ COMMENTARY If agency theory in the 1980s and 1990s presented itself as a source of testable empirical propositions about behaviour, Ireland’s criticism shifts the emphasis back onto agency as a theory about the nature of companies and relations between social actors. From this viewpoint, agency is not so much rigorous theory as ‘a nexus of metaphors’ (Ireland p. 163), which smuggle in contestable assumptions about the private nature of the company and legitimize the idea that the company should be run in the interests of the shareholder. The legal arguments of Ireland are part of the intellectual struggle of memory against forgetting because Ireland has the legal scholarship to understand that agency displaced the historical critique of the rentier which he now wishes to revive. This is a nice illustration of how historical misunderstandings about important figures like Berle will usually be corrected in an intellectually plural world, though not perhaps by those who spread the confusions. The first issue in this extract is whether the corporation is a private institution. Agency theory’s notion of the firm as nexus of contracts presupposes that firms are ‘voluntaristic private affairs’ where shareholder/principals and manager/agents enter into ‘freely negotiated contractual exchanges’ which are ipso facto just and efficient. By way of contrast, Ireland sees the corporation as a public institution with broad social responsibilities. He supports ‘stakeholding theories’ of the firm, which hold

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that a wide range of groups (including employees, customers, and the community) have a stake in public companies and should therefore be represented in corporate legal and managerial structures including company boards. Through much of the 1990s, stakeholding theories of the firm were argued by academics like Margaret Blair (1995) against the criticism that it was very difficult to articulate and reconcile a multiplicity of different sectional stakeholding interests. Authors such as Will Hutton (1995) recommended the German corporate model which involved two-tier boards with worker representation. But that would have required wrenching change in the UK and USA, where the primacy of the shareholder is legally entrenched. There was never enough intellectual leverage or political momentum to sustain radical change and to little surprise the UK Company Law Steering Group (1999) endorsed ‘enlightened shareholder value’ as the relevant principle. The novelty of Ireland’s position then emerges as he defends stakeholding against agency theory. Ireland does not try to vindicate stakeholding by arguing the strength and legitimacy of the putative claims by employees, suppliers, or other stakeholder groups; instead, his tactic is to attack agency by denying the legitimacy of the real claims of the shareholder to be an owner with natural rights to impose contracts on other stakeholders. He does this by drawing on the historical literature from the 1930s to the 1950s on the critique of the rentier shareholder and by observing that the classic liberal defence of property by Locke and others presumes active ownership where owners have responsibilities as much as rights. Tawney would surely approve of the revival of such fundamental political arguments and of Ireland’s economic scepticism about whether mergers represent disciplinary control by the capital market. As for Hansmann and Kraakman (2001), perhaps they should recognise it was premature to announce the complete and final victory of shareholder rights because issues about the functionless investor and passive property will not go away, even if they now need to be set in the new context of intermediary power. Paddy Ireland is Professor of Law at the University of Kent Law School. His research interests cover the historical development of company law, corporate theory and contemporary corporate governance, where his contribution has been to challenge orthodoxies, such as that about the status of shareholders in relation to public companies. See also, for example, Ireland (1999 and 2005).

REFERENCES Blair, M. (1995) Ownership and Control: Rethinking Governance for the Twenty First Century, Washington, DC: Brookings Institute Press. Company Law Review Steering Group (1999) Modern Company Law for a Competitive Economy, London: Department for Trade and Industry (DTI). Hansmann, H. and Kraakman, R. (2001) ‘The end of history for corporate law’, Georgetown Law Journal, 89: 438–68. Hutton, W. (1995) The State We’re In, London: Vintage.

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Ireland, P. (1999) ‘Company law and the myth of shareholder ownership’, Modern Law Review, 62(1): 32–57. Ireland, P. (2005) ‘Shareholder primacy and the distribution of wealth’, Modern Law Review, 68(1): 49–81.

A

law embody and reflect particular assumptions about the nature of companies and the relations between those who participate in their activities.1, 2 In other words, they are all underlain by a theory of the company. While the presence of this theory usually goes largely unacknowledged, in recent years, as the issue of so-called corporate governance has risen to prominence, the nature of the company and, in particular, of the large corporations which dominate the economy has become the subject of considerable debate. With this, corporate theory has moved much closer to the centre of the company law stage and although the claim that this has precipitated a ‘crisis in corporate law’ (Millon 1993, p. 1371) is rather exaggerated, there is no doubt that in an environment in which there is growing international interest in the relationship between corporate governance and competitiveness (and to a lesser extent social justice), the debates about corporate theory are proving to be of more than purely academic interest. . . . The two alternative approaches to company law identified by the Company Law Review Steering Group (1999), one labelled ‘enlightened shareholder value’, and the other ‘pluralism’, broadly reflect the two principal rivals within Anglo-American corporate theory: contractual or agency theory, based in lawand-economics, and stakeholding theory. Contractual theories, which began to crystallise in the USA in the 1970s and whose influence in the United Kingdom and elsewhere has since steadily grown, perceive the company as a nexus of contracts, most crucially between shareholder-principals and director-agents, characterising even large publicly quoted companies as fundamentally voluntaristic, private affairs, the products of freely negotiated contractual exchanges. For contractual theorists, the fact that existing corporate structures are the supposed products of such processes is prima facie evidence that they are ‘efficient’, ‘efficiency’ in the specific and narrow sense in which the term is used within orthodox economic theory being, in their view, what company law and corporate governance are (and should be) about. Contractual theories thus have a clear political slant, simultaneously legitimating, as both just and efficient, existing corporate structures and the priority that company law gives to the pursuit of the shareholder interest. . . . They also, of course, contrast sharply with stakeholding theories which argue, in different ways, that the interests of a wide range of groups with ‘stakes’ in public companies – employees, customers, the community at large – should be recognised and, in some cases, represented in corporate legal and managerial structures. L L B O D I E S O F C O M PA N Y

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Locating corporations on the public–private axis 3 . . . This chapter argues that, historically, contractual theories of the corporation, with their emphasis on efficiency-based justifications, emerged as an attempt to defend and legitimate the rights and privileges of rentier shareholders in face of the increasing difficulties involved in characterising corporations as private property and shareholders as corporate ‘owners’ (Carter 1989). Relying less on the fundamental moral principles traditionally associated with the ideas of private property and ownership (such as natural right, liberty, moral desert) and more on the alleged instrumental value of shareholder rights in contributing to productivity and efficiency, contractual theories of the corporation, it suggests, seek to give legitimacy to a legal status quo in which corporations are run exclusively for the private benefit of shareholders despite their overwhelmingly social and public nature. Indeed, in recent years, it argues, as both the power and the influence of financial capital and inequalities of wealth and income have grown, the new legitimations of shareholder rights provided by contractual theories have become ever more important. . . .

Radical entity theory and the question of corporate ownership 4 . . . As the externality of shareholders from production and management, and their lack of purpose became ever more apparent – and by this time the great majority of shareholders had not only ceased to contribute to management but to be significant sources of new capital for companies – the ideas that shareholders were corporate ‘owners’ and that corporations were their private property came increasingly to be challenged. In the USA, in particular, there was growing recognition that the rise of the modern corporation had contributed to fundamental changes in the nature of property and property rights. Thorstein Veblen, for example, argued that ownership, which had previously entailed the control of tangible material assets and carried with it various duties and responsibilities, had come with the rise of the modern joint stock corporation to entail mere passive possession of intangible corporate capital. Corporate shareholders, he argued, had been reduced to the status of ‘anonymous pensioners’ detached from the process of production; they were ‘absentee owners’ possessing claims to ‘unearned or free income’ (Veblen 1923). . . . Ideas of this sort provided the basis for the radical reinterpretation of entity theory offered by E. Merrick Dodd in the early 1930s in his celebrated exchange with Adolf Berle (Ireland 1999). Concerned about the growing unaccountability of many American corporate managers, Berle had some years earlier argued for a strengthening and tightening of the fiduciary duties compelling them to pursue the shareholder interest. He did so not so much for reasons of principle but because he could see no other way of preventing managers from feathering their own nest and making them accountable to someone (Berle 1926, 1931). Dodd responded by contesting the close identification of corporations with their shareholders that this entailed, arguing that important changes were taking place in

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‘public opinion’ on the corporation in which society saw business not as a purely private enterprise but as something with wider social obligations. Some corporate managers, he argued, had responded by accepting that they had ‘social responsibilities’ and the judiciary were showing tolerance towards the resulting changes in managerial orientation, notwithstanding the view that charity had no business to sit at boards of directors. Crucially, according to Dodd, while such an extended view of corporate managerial responsibility was ‘difficult to justify if [one] insist[ed] on thinking of the business corporation as merely an aggregate of stockholders’, it could easily be reconciled with a view of the corporation as a real entity, ‘as an institution which differs in the nature of things from the individuals who compose it’. Once one recognised the corporation as a truly separate ‘person’, he suggested, there was no reason why it should not operate, through its managerial agents, as a ‘good citizen . . . with a sense of social responsibility’. In short, Dodd used entity theory to provide a theoretical basis for the idea of the corporation as a partially, if not predominantly, public institution with broad social responsibilities (Dodd 1932, 1935). By the time of the publication of The Modern Corporation and Private Property in late 1932 Berle’s own position had begun to shift. The rise of the modern corporation, he argued with Gardiner Means, ‘involved an essential alteration in the character of property’, giving rise to important questions about both the orientation of the ‘great public’ corporations and the allocation of rights in them. Because shareholders were now the owners of ‘passive’ rather than ‘active’ property, the ‘traditional logic of property’ was no longer applicable to them. Having relinquished so many of the rights traditionally associated with ownership, they could no longer properly, or accurately, be called the corporation’s owners. They had ‘surrendered the right that the corporation should be operated in their sole interest’ . . . (Berle and Means 1932). After the Second World War, as many commentators came to question the belief that shareholders were corporate owners in the traditional sense of the word, sentiments of this sort became quite commonplace. There was, however, considerable disagreement as to how shareholders should be reconceived and, consequently, as to how corporations should be viewed and treated. Some began to designate shareholders ‘investors’ rather than ‘owners’, but continued nevertheless to treat their position as one akin to ownership and their rights as akin to private property rights over the corporation and its assets. They thus defended and promoted shareholder corporate primacy, though seeking to secure the interests of shareholders by means of investor protection rather than by means of measures aimed at rekindling shareholder participation. For others, however, the recognition that shareholders were ‘investors’ rather than ‘owners highlighted their resemblance to creditors and the weakness of their proprietary claims over the corporation itself. As Edward Mason explained in The Corporation in Modern Society, an influential collection of essays published in 1959, with the ‘equity holder . . . joining the bond holder as a functionless rentier’ and having ‘only the vaguest idea where “his property” is or of what it entails’, ‘the traditional justifications . . . of private enterprise [and] of private property [had] gone forever’. The old Lockean and Jeffersonian arguments that private property ownership was essential to the ‘full development or personality, to the maintenance of

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individual freedom . . . and to the formation of a citizenry capable of selfgovernment’ might still be valid in relation to ‘individual possessory holdings’ but were increasingly irrelevant to corporations whose ‘owners’ had been converted into rentiers. [. . .]

Henry Manne and the reprivatisation of the corporation 5 By [the 1950s], then, not only was the idea of shareholder corporate ‘ownership’ under question, the old traditional, ownership and private-property-based justifications for the rights and privileges of shareholders were becoming progressively less persuasive. It is in this context that the rise of contractual theories of the corporation needs to be viewed. In this respect, the work of those most frequently associated with contractarian theory – Alchian and Demsetz, Jensen and Meckling, Easterbrook and Fischel – is in many ways less revealing than the work of Henry Manne, one of the founding fathers of law and economics. It is clear that by as early as the mid-1950s Manne was concerned with the threat posed by contemporary thinking on the corporation, which he traced back to Berle and Means, both to shareholder rights and to the capitalist market economy as a whole. He blanched at suggestions that shareholders should receive only a ‘fair’ return on their capital and that the interests of groups other than shareholders should be considered by managers. The movement for corporate social responsibility, he argued, was undermining market mechanisms. Raising the suspicion that a ‘radically altered for of economy [was] being proposed’ in which ‘the ideal of the market as a resource allocator . . . [was being] abandoned’ (Manne 1956, 1962). . . . Manne’s account of the nature of corporate shareholding prefigured contractarian and agency theories of the company, propelling him not only into unpersuasive and inelegant historical distortions as he tried to explain away the earlier partnership (and ‘ownership’) based rules of company law (Manne 1966), but also into confused and confusing assertions about the nature of the shareholder’s property and property rights. . . . Manne argued, the only essential characteristic of a private property system was that owners ‘assumed the risk of a rise or fall in the market value of [their] property’ (1962, pp. 406–7). An owner was not bound to use his property at all and was perfectly entitled to delegate control over it to managerial agents. Lacking a dynamic historical concept of capitalism, Manne was utterly unable to grasp that Berle and Means had simply been trying to address the practical and ethical problems thrown up by the changing nature of corporations, corporate property and corporate shareholding; and, in particular, by the transformation of the shareholder into a functionless, passive investor (a money capitalist) external to the corporation. He could not see that the nature of both shareholding and ideas and forms of property were subject to change. This was something of a paradox, for it was, of course, precisely the historical changes which had occurred in the economic and legal nature of the share which provided the foundation of Manne’s own analysis, with its emphasis on the importance of

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the functioning of the market for corporate control. In his attacks on Berle, Manne simply confused and conflated the two property forms which had emerged, sometimes identifying the shareholders’ property with the corporation’s assets, sometimes with its shares. In short, while he was keen to embrace the modern conception of shareholders as mere ‘investors’ he was quite unwilling to confront the implications of this historical change in status for the nature and ethical defensibility of their corporate rights. [. . . .]

Governance and the growing power of finance While Berle derided Manne’s theories (Berle 1962), many economists began to see them as marking a path whereby corporations could be brought back within orthodox economic analysis. For many years, companies had been treated within neoclassical economics as unproblematic, conflict-free, profit-maximising, productive ‘black boxes’. Not even growing oligopolisation, nor Coase’s famous (1937) article on ‘the nature of the firm’, with its mildly subversive suggestion that firms entailed the supercession of the price mechanism by administrative decision, had dented this view. Indeed, Coase’s work had been largely ignored, and, in the wake of Berle and Means, theories of the corporation (such as they were) tended to be managerialist and non-market in nature. This began to change in the late 1960s. In what turned out to be a pivotal moment, Manne co-ordinated a symposium on securities legislation and economic policy. The contributors included the economists Armen Alchian, Harold Demsetz, Michael Jensen, William Meckling and Oliver Williamson, as well as lawyers such as Bayless Manning and Wilbur Katz. The principal purpose of the symposium, as Manne explained, was to ‘bring the techniques of economics to bear on a broad spectrum of securities regulation problems’, including capital allocation theory and the theory of the firm – issues which the economists involved readily admitted they had neglected (Manne 1969). As a foretaste of the future, most revealing, perhaps, were the contrasting contributions of Williamson and Alchian. Examining the efficacy of the various markets described by Manne and others, Williamson concluded that while they operated so as to constrain managerial discretion, they did not entirely eliminate it. As a result, managerial approaches to the firm still ‘ha[d] something to be said in their behalf’ and it was therefore necessary to ‘supplement’ neoclassical theory with organisational theory to get ‘to grips with some of the bureaucratic realities of large organisations’ (Williamson 1969, p. 373). . . . By contrast, Alchian argued that as long as there was no interference with the ability to make profits or with the ability freely to capitalise and to sell corporate property rights, the operation of the market would ensure efficient organisational forms. ‘In reality’, he argued ‘the firm is a surrogate of the marketplace’, from which he concluded that the traditional theory of profits, of private property, market and competition was far from obsolete (Alchian 1969, pp. 337, 348–50). [. . . .] The lack of empirical support for Alchian’s emerging theology did not go

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unnoticed. Alchian, remarked one respondent, ‘very cleverly . . . refuses to do empirical work’ (Steiner 1969, p. 367). Very soon, however, the empirical validity or otherwise of the various claims being made about the operation of the stock market became secondary to their ideological usefulness, for it was around this time that the long post-war boom came to an end and that the power of finance and of rentier investors began significantly to grow (see, for instance, Fitch and Oppenheimer 1970; Kotz 1978). This precipitated the demise of managerialism and, in Britain, sounded a death knell to meaningful plans for worker participation. By the 1980s, the influence of the financial sphere had become greater than at any time since the 1920s and the corporate world which was emerging bore little resemblance to that described by Galbraith, Berle and others during the long post-war boom. For many, the takeovers and divestitures of the 1980s marked the final reversal of the trend towards managerial ‘non-shareholder-wealth-maximising behaviour’ that had developed in the postwar period (Hubbard and Palia 1998). Indeed, the influence of finance now extends well beyond the heart of government policy, most notably in promoting tight monetary and fiscal policies aimed at controlling inflation and boosting the prices of financial assets. By the early-mid 1990s, it was quite clear, if it had not been before, that the post-war ‘Golden Age’ – of social democracy, of expanding welfare states, of managerialism, of Berle’s ‘People’s Capitalsim’ – had come to an abrupt end. In form, the influence now exerted by the financial sphere and its rentiers over Anglo-American corporations differs from that of earlier periods. The direct control by banks which was so marked in the USA in the early decades of the century, for example, has gone, banned in the USA by the financial reforms of the 1930s. What we have instead seen is the rise and fall of devices such as the leveraged buy-out (LBO) and, more recently and ubiquitously, by gradual growth, prompted in the USA and the United Kingdom, in particular, by the increasing power of institutional investors, of what has come to be called ‘shareholder activism’. It is not insignificant that the principal academic champion of the LBO has been Michael Jensen, one of the founding fathers of contractual theory. In the 1970s Jensen began writing about the problems created by the divergence of interest between shareholders and managers, the so-called principal–agent problem. Initially, his favoured solution was the extensive use of share options as part of executive pay so as to realign the interests of managers with those of shareholders (Jensen and Meckling 1976). By 1983, however, he was changing his mind, celebrating the market for corporate control as a market in which ‘alternative managerial teams compete for the rights to manage corporate resources’ (Jensen and Ruback 1983). Pursuing this, he had by the end of the decade become a leading advocate of the leveraged buy-out, which he championed, somewhat prematurely as it turned out, as the new corporate form (Jensen 1989). By the late 1980s, the idea of the ‘liquid’ market for corporate control was ever more celebrated in the popular and academic literature, peaked during the leveraged boom of 1989. The difference was that while the buyers in Manne’s market for corporate control had been corporations, hence its focus on ‘mergers’, the buyers in the late 1980s were financiers, bankers and deal-makers such as the LBO boutique Kohlberg Kravis Roberts, rather than firms in related

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industries, hence the emphasis on the ‘liquidity’ of the market. The era of the LBO proved short-lived, however, and after various buy-outs suffered financial distress, the fashion for them waned, to be replaced by rentier assertiveness in the form of ‘shareholder activism’ by institutional investors. . . . The beginnings of a marked and sustained departure from the previously well-established passivity of institutional investors can be traced back to the 1980s, by which time not only had the proportion of shares held by institutions, particularly in the USA and United Kingdom, scaled new heights, the competition between and within institutions had begun significantly to increase. Since then, with money managers increasingly judged on their quarterly performance, corporate managers have been confronted by an activism whose whole point is ‘to increase the profit share of national income, and to claim a larger proportion of that profit share for rentiers’. As Henwood says, shareholders today ‘are far less passive, boards less rubber-stampish, and management less autonomous than at any time since Berle and Means’ (Henwood 1997, p. 293). While direct intervention in corporations by institutional investors remains relatively rare, the enormous impact that their monitoring and cajoling has had on corporate managerial culture in the USA and beyond cannot be doubted. In recent years, it has become increasingly de rigueur for corporate managers, faced by increasing pressure from demanding rentiers, to pay homage to the God of ‘shareholder value’. . . . If Manne’s work in the 1950s and 1960s made the ‘marketisation’ of the corporation and its return to orthodox economic analysis theoretically imaginable, the growing power of the rentier and of finance in recent years has made it ideologically indispensable.

A priori efficiency and the contractualisation of the corporation It is far from clear even now, thirty years after Manne first posited its existence, whether the market for corporate control operates so as to weed out inefficient managers in anything like the way advertised. On the contrary, the historical record suggests that mergers and acquisitions often bring little in the way of efficiency gains. ‘There is’, the authors of one study typically conclude, ‘no broad-gauged support for the “inefficient management displacement” hypothesis that acquired companies [are] subnormal performers’ and the evidence ‘mandates considerable scepticism toward the claim that mergers are on average efficiency enhancing’ (Ravenscraft and Scherer 1989 p. 101). This view has broadly been endorsed by other studies (see Caves 1989; Franks and Meyer 1996, 1998). There is, moreover, evidence that even where the market for corporate control does contribute to the disciplining of poorly performing companies, its overall effect may nevertheless be to encourage short-termism and to discourage longer-term investments (Lazonick 1992). The empirical validity (or otherwise) of the theories associated with the market have, however, become increasingly less important as their ideological value has grown. Thus, despite the doubts about the way in which the stock market actually operates, the claims made for its contribution to economic efficiency are nevertheless ‘among the least restrained to be found in agency

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theory’ (Campbell 1997, p. 362). Whatever the reality, the alleged existence and efficacy of the market for corporate control and of a close correlation between corporate managerial efficiency and the market price of a corporation’s shares has become one of the theory’s bedrocks. As David Campbell explains, the significance of Manne’s ‘discovery’ of the market for corporate control lay in its suggestion that corporate managers were subject to market disciplines and that it was, therefore, possible to construct a market-based theory of the firm to rival the non-market based theories spawned by managerialism. The idea of the properly functioning market for corporate control is ‘the fundamental concept of agency theory’ precisely because, theoretically at least, it ‘places [the managerially controlled company] back under the market’ (Campbell 1997, p. 359). The contractual or agency theories of the corporation are able to offer neoclassical economists a solution to the problems generated by the ostensibly non-market nature of firms, enabling them to assert the efficiency of existing corporate structures, is also due in significant part, however, to the peculiar nature of their concept of ‘efficiency’. Within orthodox economic theory, no attempt is made to evaluate the goal of efficiency relative to other competing goals; and the efficiency, or otherwise, of different arrangements or resource allocation is assessed, not by careful, wide-ranging, empirical comparison, but by reference only to the formal nature of the arrangements and the processes of which they are a product. Put simply, if arrangements can be presented as the product of a process of free market exchange, they are deemed, a priori, to be ‘efficient’. As John Parkinson says, once it has been presumed that a governance structure is the product of contracting, ‘it follows that it must be efficient’ (1996, p. 125). Spurred on by the ‘discovery’ of the markets for corporate control and for managers themselves, contractual theorists have made precisely that presumption, leaving their only remaining task that of identifying and elaborating the ‘contracts’ involved. It is hardly surprising, therefore, that they have engaged in endless contortions purporting to show that existing corporate arrangements are, indeed, essentially the products of free market contractual exchanges. Discovering ‘contracts’ in every conceivable corporate nook and cranny, they have generated in Biblical proportions the theology for which Katz called. . . . As David Campbell says, because the goal is simply to ‘bring the company within the theory’, ‘real’ contracts are placed on the same ontological plane as ‘unreal’ (but theoretically necessary) contracts, contracts that, in empirical reality, simply do not exist (1997, pp. 360–1). As a result, despite its claims to tough, hard-nosed realism, contractual theory is, in fact, strikingly unrealistic and empirically inaccurate (Wolfe 1993, p. 1680). Hence Campbell’s conclusion that, although it describes the company as a nexus of contracts, there are, in fact, ‘no contracts . . . only a nexus of metaphors’; that it ‘is not an empirically based theory at all, but is rather ‘carried by metaphor and assertion based on that metaphor’, as a result of which it is ‘not readily open to rational debate’ (Campbell 1997, p. 360). . . . For all the metaphorical differences between the various contractual theories that have merged, in one important and crucial respect they are more or less indistinguishable: they all conclude that the retention by shareholders of their residual income and control rights is legitimate and justifiable, not so much on grounds of shareholder corporate ‘ownership’ but on

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grounds of efficiency. As Parkinson observes, the central purpose of the nexusof-contracts theorising has been ‘to establish that the large publicly-owned company . . . is efficient, notwithstanding the wide dispersal of shareholdings’ (Parkinson 1996, p. 122); or, to put it another way, to reprivatise the public company.

Agency theory and the problem of ownership 6 The question of ownership is not, however, one that contractual theorists find easy to escape. Contractual theory generally tries to circumvent it and to avoid questions concerning the initial allocation of corporate (property) rights by conceptualising the corporation or ‘firm’ out of existence. Viewed as a nexus of contracts, the corporation is deemed to be, in Jensen and Meckling’s words, ‘just a legal fiction which serves as a focus of the complex process in which the conflicting objectives of individual . . . are brought in equilibrium within a framework of contractual relationships’ (1976, p. 312). With the corporation diminished in this way, there is within agency theory a tendency to see nothing (no ‘thing’) to be owned. Corporate governance is thus treated as little more than a more complex version of standard contractual governance and shareholders once again characterised, as they were by Manne in his exchange with Berle, as the owners and providers of ‘capital’, one of the factors of production, rather than as the redundant, functionless rentiers, the buyers and sellers of titles to revenue, which in empirical reality they now are. The kinds of questions that agency theorists pose reflect this mythology, presuming that shareholders actually give something to corporations, rather than simply place bets on their future profitability. ‘How does it happen’, Jensen and Meckling innocently ask, ‘that millions of individuals are willing to turn over a significant fraction of their wealth to organisations run by managers who have so little interest in their welfare?’ Or, as Kenneth Scott puts it, ‘why are shareholders’ – who ‘furnish inputs into the business’ – ‘wiling to turn large sums of money over to other people (managers) on very ill-defined terms?’ (1998, p. 26). Reinvigorated in this way, shareholders are subtly returned to former glories: no longer redundant traders in titles to revenue, they are re-elevated to their earlier, more exalted status of ‘real’ investors, restored to an entrepreneurial function as risk-taking ‘providers of capital’. The reality that the contemporary stock market ‘counts for little or nothing as a source of finance’ is studiously ignored (Henwood 1997, p. 292). Once again, this recharacterisation – or ‘misdescription’ – of the shareholder and the corporation elides the distinction between the corporate assets and shares. The two distinctive and autonomous property forms which emerged with the development of the modern joint stock corporation and the reduction of the shareholder to the status of a pure rentier completely external to the company are conflated under the rubric ‘capital’, a process which discretely reunites the shareholder with the corporate assets. The curious effect of this is to eliminate the corporate entity as an owner of property, other than in a purely formal sense. Indeed, with shareholders characterised as the providers of capital, and with assets and shares conflated, the corporation more or less disappears,

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reduced to a mere cipher through which the owners of different factors of production are brought contractually together. The corporation, writes Eugene Fama, is ‘just the set of contracts covering the way inputs are joined to create outputs and the way receipts from outputs are shared among inputs’ (1980, p. 288). While the various factors of production employed in a firm must be owned by someone, he explains, ‘ownership of capital should not be confused with ownership of the firm’ for ownership of the firm is ‘an irrelevant concept’ (Fama 1980). The conceptual elimination of the corporation not only places shareholders in direct touch with the corporate assets (the ‘capital’), it also places them, in theory at least, in direct touch with corporate managers, for with no corporate entity of substance to come between them, the relationship between shareholders and managers is correspondingly characterised as a pure agency relationship. Corporate governance tends in consequence to be seen as involving not highly complex questions of productive organisation, social wellbeing and social justice, but simply the difficulties facing shareholder-principals trying to negotiate sufficiently binding contracts with agent-managers. Curiously, therefore, agency theory tries in many ways to turn the corporate-theoretical clock back to the purely artificial, fictional entity, harking back to the days when corporation and shareholders were perceived, for most purposes, as one and the same; when the shareholders were the corporation. Politically attractive though it is to defenders of rentier rights and corporate non-interventionism, however, the wholesale contractualisation of the firm is itself the source of a variety of conceptual problems. Most importantly, perhaps, one of the effects of the reduction of the corporation to a nexus of contracts is that, in accordance with neo-classical ideology about the nature of markets, it tends to flatten the hierarchical elements within corporations, suggesting that they lack any in-built structure of authority. Alchian and Demsetz, for example, recognise that it is ‘common to see the firm as characterised by the power to settle issues by fiat, by authority, or by disciplinary action superior to that available in the conventional market’, but argue that this is a ‘delusion’ (1972, p. 193). As a ‘highly specialized surrogate market’ they insist, the firm has no power of fiat, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting’. To speak of the management or direction of workers is merely ‘a deceptive way of noting that the employer continually is involved in renegotiation of contracts on terms that must be acceptable to both parties’. In fact, they reiterate, ‘authoritarian, dictational, or fiat attributes’ are simply ‘not relevant to the conception of the firm or its efficiency’. As William Lazonick wryly observes, Alchian and Demsetz’ firm, with its denial of disciplinary power, appears not to be a capitalist firm at all (1991, pp. 181–8). It does, however, at least entail a central agent, referred to as the firm’s ‘owner’ or ‘the employer’, who possesses, inter alia, the right to renegotiate the contracts of all the suppliers of inputs. [. . . .]

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From the myth of ownership to the myth of efficiency: private property and the public–private divide 7 . . . Changes in the constitution of corporate property and corporate rights mark the completion of a historic process – inherent in the joint stock company as an economic form of organisation – whereby the shareholder has been externalised from the company and transformed into a functionless rentier, a pure money capitalist standing outside the process of production. An important aspect of this has been the relinquishment by shareholders not only of any significant managerial, supervisory or capital-providing function, but of many of the rights traditionally associated with asset (or company) ‘ownership’. Reflecting their redundancy, the bundle of rights which they have come to possess by virtue of their share ownership (the bundle of rights that constitute the share as a separate form of property) has gradually shrunk, coming to comprise but a few of the rights that would constitute ‘ownership’ of the corporate assets (or corporation) in the traditional sense. Severed both from the productive purpose and from the rest of the rights in the ‘thing-ownership’ bundle, the moral basis for the remaining rights of rentier shareholders, rights which, despite their attenuated nature are a source of extraordinary economic and social power, has become increasingly difficult to discern. With the justifications associated with the ‘robust unitary conception of ownership’ weakened, it is, then, not only capitalism but rentier shareholders who are forced to seek legitimacy in ‘other, more instrumental, values’ (Grey 1980, p. 78). It is in this context that the ascendancy of contractual theories of the corporation and their efficiency-based defence of shareholder property rights needs to be seen. Although usually out forward as neutral, theoretical accounts of reality, these theories are more accurately seen as attempts to legitimate rentier rights in instrumental terms; as prescriptive rather than descriptive theories. No matter how vociferous their advocates however, claims based on grounds such as ‘efficiency’ are inherently weaker and less compelling than the more fundamental, ethical claims surrounding the traditional ideas of private property and ownership, not least because as soon as one begins to offer a purposive account of why shareholders should possess these rights, arguing that they are justified for essentially instrumental reasons in terms of their effects, one invites not only an assessment of their effectiveness in achieving the stated goals, but an evaluation of those goals relative to other competing ones. There is certainly no doubting the current popularity of contractual theory. But this popularity rests less on its empirical accuracy, validity or intellectual merit and more on its consonance with certain powerful class interests. Contemporary company law, even if it does not yet explicitly embrace these theories, shares many of their presuppositions and values, and resembles them in its shareholder-orientation. And the current political climate, with its underlying neoliberalism, its belief in the inescapability of market imperatives (‘globalisation’) and its overriding emphasis on identifying the most’ competitive’ and ‘efficient’ (meaning profitable) forms of production and governance, is very much more congenial to contractualism and its marketisation of the corporation than it is to stakeholding rivals. . . . [T]he struggle between contractarians and stakeholders is, ultimately,

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more about ends than means, for stakeholding is animated as much by ideas or right and justice as it is by ideas of competitiveness; by a conception of the good, rather than of the efficient life. Indeed, stakeholders are ill-advised to try to fight the governance battle on the terrain of efficiency, in part because, whatever its current appeal, it is a terrain which pushes one into a contractual conception of the corporation, with all that implies, and in part because as a goal ‘efficiency’ in the abstract lacks meaning: what exactly is it that we are trying to do efficiently? At present the goal of corporate governance is, in reality, the efficient maximisation of rentier wealth, a task it carries out with aplomb. In practice this means maximising the wealth of a few, for the financial property forms constituted and protected by contemporary company law and contemporary mechanisms of governance enable a small minority to appropriate a grotesquely disproportionate share of total social wealth and production, both nationally and internationally. The question is whether the ‘efficient’ attainment of this goal is defensible, let alone desirable.

References Armen Alchian, ‘Corporate Management and Property Rights’, in Henry Manne (ed.), Economic Policy and the Regulation of Corporate Securities: A Symposium (Washington, DC, American Enterprise Institute for Public Policy Research, 1969). Armen Alchian and Harold Demsetz, ‘Production, Information Costs, and Economic Organization’ (1972) 62 American Economic Review 777. Adolf Berle, ‘Non-voting Stock and Bankers Control’ (1926) 39 Harvard Law Review 673. —— , ‘Corporate Powers as Powers in Trust’ (1931) 44 Harvard Law Review 1049. —— , ‘Modern Functions of the Corporate System’ (1962) 62 Columbia Law Review 433. Adolf Berle and Gardiner Means, The Modern Corporation and Private Property (New York, Macmillan, 1932; revised edn, New York, Harcourt Brace, 1967). David Campbell, ‘The Role of Monitoring and Morality in Company Law’ (1997) 7 Australian Journal of Corporate Law 343. Alan Carter, The Philosophical Foundations of Property Rights (Hemel Hempstead, Harvester Wheatsheaf, 1989). Richard E. Caves, ‘Mergers, Takeovers, and Economic Efficiency: Foresight vs Hindsight’ (1989) 7 International Journal of Industrial Organisations 151. Ronald Coase, ‘The Nature of the Firm’ (1937) 4 Economica 386. Company Law Review Steering Group, Modern Company Law for a Competitive Economy: the Strategic Framework (London, DTI, 1999). E. Merrick Dodd, ‘For Whom Are Corporate Managers Trustees?’ (1932) 45 Harvard Law Review 1147. —— , ‘Is the Effective Enforcement of the Fiduciary Duties of Corporate Managers Practicable?’ (1935) 2 University of Chicago Law Review 194. Eugene Fama, ‘Agency Problems and the Theory of the Firm’ (1980) 88 Journal of Political Economy 288. Robert Fitch and Mary Oppenheimer, ‘Who Rules the Corporation’ (1970) 1 Socialist Revolution 73–107. Julian Franks and Colin Meyer, ‘Hostile Takeovers and the Correction of Managerial Failure’ (1996) 40 Journal of Financial Economics 163.

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—— , ‘Ownership and Control in Europe’, in Peter Newman (ed.), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998). Thomas C. Grey, ‘The Disintegration of Property’ (1980) 22 Nomos 69. Doug Henwood, Wall Street (London, Verso, 1997). R. Glen Hubbard and Darius Palia, ‘The Market for Corporate Control’, in Peter Newman (ed.), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998), 611. Paddy Ireland, ‘Back to the Future: Adolf Berle, the Law Commission and Directors’ Duties’ (1999) 20 Company Lawyer 203–9. Michael Jensen, ‘Eclipse of the Public Corporation’ (1989) 89 Harvard Business Review (September–October) 61. Michael Jensen and William Meckling, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305. Michael Jensen and Richard Ruback, ‘The Market for Corporate Control’ (1983) 11 Journal of Financial Economics 5. David M. Kotz, Bank Control of Large Corporations in the United States (Berkeley and Los Angeles, University of California Press, 1978). William Lazonick, Business Organisation and the Myth of the Market Economy (Cambridge, Cambridge University Press, 1991). —— , ‘Controlling the Market for Corporate Control: The Historical Significance of Managerial Capitalism’ (1992) 1 Industrial and Corporate Change 445–88. Henry Manne, Book Review of Richard Eells, Corporation Giving in a Free Society in (1956) 24 University of Chicago Law Review 194. —— , ‘The “Higher Criticism” of the Modern Corporation’ (1962) 62 Columbia Law Review 399. —— , Insider Trading and Stock Market (New York, Free Press, 1966). —— , ‘Introduction’ to Henry Manne (ed.), Economic Policy and the Regulation of Corporate Securities: A Symposium (Washington, DC, American Enterprise Institute for Public Policy Research, 1969). David Millon, ‘Communitarians, Contractarians, and the Crisis in Corporate Law’ (1993) 50 Washington and Lee Law Review 1371. J. E. Parkinson, ‘The Contractual Theory of the Company and the Protection of Nonshareholder Interests’, in David Feldman and Frank Miesel (eds), Corporate and Commercial Law: Modern Developments (London, Lloyds, 1996), 121. David J. Ravenscraft and F. M. Scherer, ‘The Profitability of Mergers’ (1989) 7 International Journal of Industrial Organisation 101. Kenneth Scott, ‘Agency Costs and Corporate Governance,’ in Peter Newman (ed.), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998) Peter Steiner, ‘Discussion’, in Henry Manne (ed.), Economic Policy and the Regulation of Corporate Securities: A Symposium (Washington, DC, American Enterprise Institute for Public Policy Research, 1969). Thorstein Veblen, Absentee Ownership and Business Enterprise in Recent Times (New York, Huebsch, 1923) Oliver Williamson, ‘Corporate Control and the Theory of the Firm,’ in Henry Manne (ed.), Economic Policy and the Regulation of Corporate Securities: A Symposium (Washington DC, American Enterprise Institute for Public Policy Research, 1969). Alan Wolfe, ‘The Modern Corporation: Private Agent or Public Actor’ (1993) 50 Washington and Lee Law Review 1673.

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3 4 5

6

7

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Reprinted by permission of the publisher, Hart Publishing Ltd. This extract from Ireland’s book chapter in Parkinson et al. (eds) excludes one full section, entitled ‘From owning assets to owning companies: the rise of entity theory’ (pp. 145–8) which provides a legal history of joint stock company and shareholder as rentier. Only a short extract from the last paragraph of the section entitled ‘Locating corporations on the public-private axis’ (pp. 142–5) describing the objectives of the book chapter is included. The excluded part of this section (pp. 142–4) gives a historical account of the representations of corporations as private versus public entities. The extract moves from p. 142 to p. 144. The extract moves from p. 145 to p. 148. The following extract from this section excludes a detailed coverage of Manne’s pro-market views on the role of corporations between pp. 153 and 155, and also Berle’s counter-arguments against Manne between pp. 156 and 157. The extract from section excludes the last two pages (166–8) where the explicit arguments and implicit assumptions in the contractual views of the firm regarding the shareholders’ rights over the assets of the firm are criticized as being inconsistent and lacking a convincing logic. The extract of this section (pp. 168–73) excludes pp. 168–71, where Ireland discusses the moral implications of the changing nature of the ideas about private property, and the last page (p. 173) of the paper, where the social context of the debate is re-emphasized.

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Chapter 8

Peter Folkman, Julie Froud, Sukhdev Johal and Karel Williams INTERMEDIARIES (OR ANOTHER GROUP OF AGENTS?)

Introduction to extract from Peter Folkman, Julie Froud, Sukhdev Johal and Karel Williams, (2007), ‘Working for themselves: capital market intermediaries and present day capitalism’, Business History, 49(4): 552–72

EDITORS’ COMMENTARY In mainstream finance, there is a clear methodological emphasis on algebraic formalization and quantitative methods applied to large datasets, rather than the kind of unsystematic and impressionistic case study that dominates in many other areas of the social sciences. This discursive preference shapes the field of the visible by reinforcing the initial theoretical preoccupation with corporate managers and directors as actors, not least because it is easy to obtain biographical and career information on corporate actors from electronic databases in research libraries, while there are mandated disclosures on corporate pay and performance and this data is again readily available from standard sources. In the absence of comparable sources and disclosure, fee-earning capital market intermediaries remain in the area of the invisible. Folkman et al.’s article discusses these intermediaries, including fund managers of all kinds, private equity general partners, investment bankers, and corporate lawyers, who variously provide services to giant firms, initiate corporate restructuring, and operate within the capital market. The issue here is not how markets work but with understanding the City (in London) and Wall Street (in New York) as part of financialized capitalism. Appropriately, the first named author of this article is not an academic but a private equity veteran. Folkman et al.’s article brings together fragments of evidence to answer questions about what senior intermediaries do, how are they paid and whether they form a coherent group in terms of agenda or project (as corporate managers were supposed

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to do in the 1960s managerial theories of their firm). They observe that the number of high-paid capital market intermediaries is much larger than the number of senior managers. No more than some six hundred CEOs, CFOs and divisional directors hold high-paid executive director positions in the giant firms of the FTSE 100. But Folkman et al. estimate there are some sixteen thousand senior intermediaries in the City of London. The intermediary group is a kind of distributional coalition driven by the shared motive of individual enrichment through fees which brings huge wealth to those like a private equity general partner who can earn $50–100 million from one successful fund in five years. Although cultural heterogeneity and diverging pecuniary interests prevent them being a class in itself and for itself, the intermediaries may yet have a kind of group effect when ‘all the different groups of intermediaries have a stake in an economy of permanent restructuring because deals (be it acquisition or demerger, new issuers or buy backs, securitisation or re bundling risks) are the source of fees’ (p. 561). These arguments are both interesting in themselves and have dramatic implications because agency theory, as developed by mainstream finance, gives only limited insights into the actors involved in financialized capitalism. There is much discussion about whether two classes of agents, senior managers and (non-executive) directors pursue the shareholder interest, which is proxied by various measures of profit and share price. But the more remarkable point is that the ultimate owner/principal (the pension fund contributor or mutual fund investor) is completely absent; and the space left vacant by the ultimate principal is occupied by a growing army of intermediary helpers1/agents. Some intermediaries promise to help the investor in return for a fee but most are (also) helping themselves insofar as intermediary remuneration is tied to transaction fees which are driven by deals and business volume, so that the pay of private equity partners increases with fund size, just like CEO pay and company size. At the same time, intermediaries also constitute themselves as the virtual representatives of the absent shareholder who, as Drucker (1976) observed, usually does not know what he wants. Though we could characterize intermediaries as both principals and agents (just as we could argue that senior managers also sometimes assume both roles), the implication of Folkman et al. is rather to shift the terrain of the debate away from principal–agent kinds of formulations. Instead, intermediaries should be considered in a broader political sense to understand their role in financialized capitalism. Peter Folkman is a retired private equity general partner. Julie Froud and Karel Williams work at Manchester Business School and are also members of the ESRCfunded Centre for Research in Socio-Cultural Change (CRESC), where Williams is co-director. Sukhdev Johal is from Royal Holloway, University of London, where he is a member of the School of Management. Froud, Johal and Williams are (with Adam Leaver) author of various articles on financialization and of the book Financialization and Strategy. Narrative and Numbers (Routledge, 2006).

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NOTE 1

See Warren Buffett’s letter to shareholders in the 2005 annual report and accounts, which uses the idea of the ‘Helper’ rather ironically to characterise the army of intermediaries who are available to ‘help’ investors (Buffet 2006, pp. 18–19).

REFERENCES Buffett, W. E. (2006) ‘Chairman’s letter’, Berkshire Hathaway Inc 2005 Annual Report, 3–23. Drucker, P. F. (1976) The Unseen Revolution: How Pension Fund Socialism Came to America, London: Heinemann.

Introduction 1, 2

T

H I S A R T I C L E I S A B O U T understanding the role and possible effects of a new group of actors, the fee-earning capital market intermediaries, who have taken a much more prominent role in Anglo Saxon and European capitalism since the 1980s. The group includes corporate lawyers, hedge fund managers, private equity fund partners and investment bankers, who provide services to giant firms and initiate some corporate activity such as merger and acquisition (M&A), as well as operating and innovating within the capital market. The managerial revolution is relevant as a point of reference because that created a group of salaried managers in giant firms who supposedly took control from owners and allegedly imposed new priorities. The questions for analysis in this paper are about: whether and how a new group of actors, the capital market intermediaries, have now taken a leading role, partly by constraining the power of the giant firm managers; and, if so, what are the broader effects? Questions about intermediary power have already been raised in two recent literatures: first in the academic literature on the interaction of giant firms with a stock market which now demands shareholder value; second, in the non-academic literature produced by public interest critics of City power in Britain. From Morin (2000) to Roberts et al. (2006), an ethnographic literature has documented how giant firm managers in Europe as much as the USA must now justify their strategies to value seeking fund managers . . . The non-academic literature on the UK is much more emphatic when recent books by journalists and former capital market and giant firm insiders all allege that capital market intermediaries are now running the show. If such accounts do not present conclusive evidence, they do indicate growing concern about the increasing influence of unaccountable intermediaries and the consequences for investors, employees and others. The retired British investment banker, Philip Augar, alleges that ‘during my

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time, the profession appeared to move from putting the client first to putting itself first’ (2005, p.xiii) and observes that investment banks have become active promoters of deal-driven activity like M&A. Former FTSE 100 director, Don Young, agrees and concludes ‘what seems to be emerging is a strong sense that the intermediaries in the markets have been turning the game to their own advantage, at the expense of the “real” shareholders, not to mention employees, customers, etc.’ (Young and Scott 2004, p. 46). The journalist . . . Hywel Williams, sets this in a broader perspective as the post-Thatcherite triumph of a City elite: ‘the City has won all the necessary battles for command and control. It now absorbs and directs the aims of all other power elites and thereby makes those elites subordinate to its own interests’ (2006, p. 215). The City is officially ‘one of the glories of Britain’ (p. 165) and effectively dominates our whole economy and society. In this paper we aim to add relevant argument and evidence and to frame the issues about the nature and significance of intermediaries by returning to the debates about the managerial class or elite. . . .

Managerial capitalism and the new capital market intermediaries . . . It was Tawney’s influential 1923 book, The Acquisitive Society, which introduced a new language to register ‘the divorce of ownership and work’ or ‘the separation of ownership and management’. Tawney argued that the rise of salaried professional managers was an important development which changed the nature of capitalism (1923, pp. 64, 202). His agenda-setting analysis of what was subsequently constructed as separation of ownership and control opened the way for the development of many different positions on how the rise of a professional managerial class enabled discretionary management strategies at enterprise level and new social compromises between capital and labour at national level, as well as unaccountable elite projects. The resulting literatures could be described as a series of explorations (starting from different assumptions and exploring different implications) which can be summarised by making three points. First, different discourses like economics and sociology assimilated managers as new actors into their a priori so that preexisting analytical frameworks and preoccupations (with firm objectives in economics or class identity in sociology) were taken up in a new context. Second, . . . the arguments and empirics of authors like Nichols (1969) discredited hypotheses about a new managerial class, but not conjecture about managerial elites. Third, despite these differences, the argument was always about connecting the internal economic agenda of a firm-based group with external socioeconomic effects. This was on the assumption that shared social identity provided a basis for group cohesion of managers who were not working for themselves because managerial rewards were individually and collectively modest. Economics started from the assumption that salaried managers were unitary calculating subjects with consistent preferences and executive discretion about goals and policy. Hence, for example, Marris’ (1964) theory of managerial capitalism, which supposed ‘managers . . . maximise the rate of growth of the firm they are employed in subject to a constraint imposed by the security

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motive’. This was rooted in behavioural psychology about growth as the test of ‘professional competence’ and the basis for advancement of individual and group (Marris 1964, pp. 47, 102). From a politico-legal perspective, Berle enrolled managers rather differently as the subjects of history and the social basis for (new deal type) social compromises that civilised capitalism by reconciling different social interests. The classic Berle and Means text, which announced the separation of ownership and control, envisaged a kind of stakeholder firm whose technocratic managers would not serve shareholders but ‘balance a variety of claims by various groups in the community’ (1932, p. 312). As for Berle in the 1950s and after, he believed that unionism, anti-trust legislation and such like had socialised corporations in ways that proved they could be ‘checked by public conscience and disciplined by political intervention’ (1960, p. 157). Empirical sociology produced a much more nuanced account which questioned any such premise about managers as subjects of history. Nichols (1969), for example, argued managers were a heterogeneous group with different values and calculative frames so that they could not plausibly be a ‘new class’ in itself or for itself: the influence of background was mediated by ideology, socialisation within the firm and the position of the firm within product market and institutional nexus. . . . If this disposed of the hypothesis that the whole group of managers was a class, it still left open the possibility that a small group of managers at the apex of corporate and other bureaucracies acted as an elite. Questions about unaccountable managerial elites were raised by Wright Mills’ (1956) argument about how top US military, political and industrial executives pursued the national project of cold war. The managerial elite thesis was empirically corroborated by evidence on what Wright Mills called ‘motive’, arising from shared backgrounds and rotation between positions. This could be demonstrated with tables and network diagrams, but did not establish the stronger thesis about a coherent elite project. [. . . .] [However] . . . the old debates frame new questions about capital market intermediaries who are the new actors of the present day, just as professional managers were the new actors of the 1920s and 1930s. After reading authors like Hywel Williams on the City and the more academic literature on fund managers, we can ask: to what extent are the intermediaries collectively unified and a coherent group? If not a class, are the intermediaries an elite; and, if so, do they have a project? Are we entering an era of intermediary capitalism where corporate and other strategies are defined by the priorities of the functionaries of finance? It is much easier to ask these questions than to answer them because the publicly available evidence about intermediaries is much more modest than the evidence about managers of public companies. But, as the rest of this paper shows, it is possible to say something. . . .

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Who are the capital market intermediaries and what do they do? . . . Who are the intermediaries? In terms of definition, the intermediary group can be internally classified and externally delimited in many different ways according, for example, to whether they are intermediating financial or information flows or act as principals or agents around transactions. And when there is rapid innovation in financial intermediation, the classifications of one period may be inappropriate in the next. Against this background, we find it useful to distinguish two intermediary groups: responsive functionaries and proactive initiators. (1) Responsive functionaries meet the operating and compliance requirements of a regulated, juridicalised market capitalism with huge, institutionalised fund flows into the secondary markets in shares and bonds, This group includes facilitators of compliance such as audit partners in accounting or remuneration consultants on executive pay. It also includes providers of specialist expertise such as corporate lawyers on contract or property rights as well as pension fund managers and stock market analysts involved in the management of pooled assets. Much of this is routine and all of it is necessary; the intermediaries provide constant advice and input to giant firm decision making, facilitating compliance with governance norms as well as communicating with capital markets. (2) Proactive initiators of deals, corporate restructuring and investment arbitrage opportunities were traditionally led by investment bankers providing M&A advice and new issues but also now include hedge fund managers and other activist investors, as well as an assortment of traders and dealers on own account or bank pay roll. These change agents are the marine corps of the intermediary groups who live by deals and novelty. One part of this group deals with non-routine demands from corporate clients and may have a much larger role in shaping corporate agendas given that the new breed of activist is always in pursuit of the next value-enhancing move. Though they provide services for public corporations, they also (or increasingly) operate in their own right as market actors with no obvious external client; that is, they undertake activities that are intended inter alia to raise their own revenues. Another important part of this group is responsible for the hyper-innovation within the capital markets that produces billion dollar turnovers in various kinds of coupons that are increasingly held by firms and households. Such intermediary groups are generally co-located in activity clusters around the world’s few major financial centres, including London, where official statistics allow us to measure the resulting employment in financial services. Information on deal and trading flows confirms London’s status as a significant financial centre with, for instance, 70 per cent of international bond trading, 50 per cent of European investment banking (IFSL 2006a) and more than 40 per cent each of over-the-counter derivatives and credit derivatives trading (IFSL 2006b). The Centre for Business and Economics Research (2006) estimates that London has 41 per cent of all the ‘City-type’ financial services in the EU and that this in total sustained some 328,000 jobs in London in 2005. . . . If we are interested in the idea of capital market intermediaries constituting a new and important group, the numbers of senior intermediaries employed at a

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principal or partner level would be a more interesting indicator. Questions about the number of seniors in different intermediary groups are frustratingly difficult to answer because many intermediaries are not members of established professional groups or associations where numbers are collected, or they work in large organisations which provide very limited breakdown of the numbers involved in particular activities. It is fairly easy to determine that the top four law and accounting firms in the UK have a total of around 4,500 partners in 2004 (Fame database; thelawyer.com). . . . Such fragments of information may be few in number but they do quickly help to show that there are many times more senior intermediaries than senior giant firm managers when the number of executive directors in the FTSE 100 companies is no more than 600. If we conjectured that principals and partners accounted for around 5 per cent of the total numbers employed in City-type activities, this would imply at least 16,000 senior intermediaries. If the problem with counting the senior intermediaries is the limits of the publicly available sources, the problem about analysing what they do is the limits of our understanding. This is especially so if we pose the question broadly to include the implications and effects of their activities. If we look back at the literature on the managerial revolution, the master questions about the old group of managers remain relevant for the new group of intermediaries. The master question is whether (senior) intermediaries form a coherent or homogeneous group in terms of internal composition or in terms of external effects. This question about an elite in itself and for itself was traditionally posed in sociofunctional terms so that the issues were two fold. First, does the group have a common social background or set of beliefs. Second, does the group have a common agenda or project which motivates both the actions of individual members and the group with strategic consequences for economy and society. . . . [P]rimary sources suggest and secondary sources confirm considerable cultural heterogeneity which almost certainly divides (senior) intermediaries into many fragmented sub-groups. City banks regularly figure in the press through court cases about inappropriate behaviour or discrimination on pay and promotion . . . By way of contrast, FTSE100 corporations are more formally correct (even if their boardrooms are still mainly white and male). Likewise, professional service partners must be house-trained because they sell to and advise the FTSE officer class and must also manage a hierarchy of juniors employed on an up or out basis. . . . Prima facie, the heterogeneity is such that the intermediaries are implausible as a distinct new class in itself, but that leaves the important question about their effects on corporations and markets. Current understandings of these issues are framed in terms of finance theory and shareholder value ideology. If the role of capital markets is to allocate capital and risk efficiently to maximise the returns for investors, one hypothesis about the agenda of the intermediaries is that their increasing influence would contribute to shareholder value creation by constraining discretionary management strategies. Interestingly, the political economy literature on shareholder value and financialisation has now produced a body of empirical work which discredits the hypothesis. . . . In the UK and USA, shareholder value for owners has become a more

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explicit objective through the disciplinary interactions of analysts and fund managers with senior corporate executives (Roberts et al. 2006), who are then under pressure to deliver narratives of corporate purpose and achievement (Froud et al. 2006). Lazonick and O’Sullivan (2000) have argued that in the US case, pressure from activist investors changed giant firm priorities in the 1980s ‘from retain and reinvest’ to ‘downsize and distribute’ . . . To begin with, the larger part of the long term increase in total shareholder returns derives not from what managers do to increase earnings but from how the market values earnings through rising price earnings ratios. Over the period 1983–2002, share price appreciation accounted for 63 per cent of total shareholder returns (TSR) in UK FTSE 100 firms and 70 per cent in the S&P500 (Froud et al. 2006, pp. 77–8). The evidence on payout ratios is complex and the trends are different in the UK and USA. In the UK, there has been an upward shift in dividends paid from 13–20 per cent of cash in the 1980s to 20–35 per cent in the 1990s and early 2000s (pp. 88–9). In the USA, the position is complicated by the substitution of debt for equity and by buy backs. But, if all cash distributions to capital providers are added together, there is a pattern of cyclical variation and no evidence of any secular US increase in (total) distributions over the 1980s and 1990s, nor of any secular increase in rates of return on sales or capital employed. . . . [As an interesting contrast,] the French case suggests that managerial strategies of growth are not constrained because the efforts of demanding intermediaries in the secondary market are counterbalanced by facilitating intermediaries in the primary market (see Johal and Leaver 2007). The evidence so far considered is partial because it focuses on firm/capital market interaction, not hyper-innovation within the markets. But the evidence is important because it suggests that capital market intermediaries are not a unitary, calculating, collective subject with one straightforward agenda [although] this does not mean that intermediary activity has no effects. . . . The end result is to increase the volume of restructuring as the disciplinarians require new value-creating moves which make money for investment bankers, partly by undoing what they previously facilitated. All the different groups of intermediaries have a stake in an economy of permanent restructuring because deals (be it acquisition or demerger, new issues or buybacks, securitisation or rebundling risks) are the source of fees. . . .

Intermediary business models: organised for enrichment In the managerial revolution literature, the discussion of organisation focuses on how it is a response to external product market opportunities or challenges. This is illustrated by Chandler’s (1977) argument in The Visible Hand or his earlier thesis that m-form solved the problems of managing diversified giant firms. In the case of intermediaries, we would argue that the focus should be shifted onto business models and the internal requirement of reward for seniors whose bonuses figure in media stories. . . . [T]he nature and basis of rewards for senior intermediaries can be clarified by analysing intermediary business models which all allow a small number of senior employees to claim a large part of revenue and profits. . . .

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Business models include some viability requirement of ‘cost recovery’ (Williams et al. 1995); that is, organisations must cover costs by relating expenditure and income over the medium to long term, when the private sector must also deliver a profit or surplus from income. However, a business model is not simply about meeting financial targets; it is also about securing credibility in the eyes of key stakeholders who define opportunity. It includes a way of framing options and evaluating success and, on that basis, satisfying politically and socially constructed stakeholder expectations, which have important feedback repercussions on key variables such as share price in the private sector or the assessment of value for money in the public sector. . . . There is no single intermediary business model because intermediary activities and organisational forms are so bewilderingly diverse. In terms of activity, routine auditing of FTSE 100 accounts is very different from the crisis management of investment bank advice during hostile takeover. Some activities, like own account trading, require constant innovation and new kinds of trades in the absence of property rights on previous innovation; while others involve selling to corporate clients in the box at Twickenham. The possibilities of revenue growth and the incidence of cyclicality are very different in such activities. And so are organisational forms when intermediaries sometimes work in public companies and more often in partnerships or private companies. . . . [C]loser examination of business models . . . brings out two key commonalities. First, despite activity and organisational differences, intermediary business models all involve strong internal stakeholder accountability to senior members of the workforce (principals and partners) which, in the case of intermediaries working for public companies, always limits the claims of external shareholders. Second, regardless of differences in the formal rights of partners or principals to surpluses, all intermediary business models, under favourable conditions, allow a relatively small number of principals and partners to capture substantial shares of turnover and profits. In this respect intermediary organizations are decisively different from the giant PLCs in the FTSE 100 or S&P 500 where multi-million salaries for the CEO or a small number of senior executives attract public attention but account for a small proportion of turnover or profits. . . . Private equity 3 . . . Private equity raises a fund from institutions or wealthy individuals, which is then invested as equity in several businesses whose purchase is financed mainly by issuing debt in a fairly standard ratio of 20 per cent debt to 80 per cent equity. The aim is to sell on within three to five years for the profit of the equity investors. If the businesses generate cash to pay down the debt and can subsequently be sold on at profit, the leveraged rewards for equity are considerable. Originally associated with high tech in the USA or divisions of public companies in the UK, the funds have recently scaled up dramatically. Private equity funds range in size from more than $15 billion for the largest US players like Texas Pacific Group to less than £500 million. Many of the largest fund raisers are now

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public companies although, like investment banks, they operate in a way that is distinctively different from standard notions of the corporation. In this case our analysis is based on publicly available sources, supported by evidence on representative figures which is based on general discussion of typical distributions and range of variation with several senior industry figures who have direct experience of the industry over many years. The private equity organisation is a new kind of holding company (with an explicit commitment to sell its holdings) whose labour requirement is modest. A management company with funds of £2 billion might have as few as 20 staff members, of whom a quarter are partners and many of the rest are relatively junior support staff. Nevertheless, between 50 and 70 per cent of the annual revenues are paid out to the employees. Table 1 provides illustrations of the structure and rewards of two sizes of private equity organisation, the first a mid-market fund that would typically raise between £250 and £500 million (with around 25 staff in total), and the second a large buyout fund where capital is usually in the range $8 to $16 billion (employing about 100 staff). The data is based on real funds, though suitably anonymised to conceal the identity of particular funds. The private equity business model is known as ‘2 and 20’ because the fund management company has two forms of income: first, a management fee, typically around 2 per cent per annum of the value of the committed capital; and, second, carried interest (known as the ‘carry’) which is normally about 20 per cent of the profits realised by the fund and usually paid out after the capital has been repaid to investors. The carry is intended to incentivise management and, where the fund performs well it offers the possibility of large returns. As Table 1 shows, all the partners in both sizes of fund are entitled to a share of the profits: in the midmarket fund the 6 to 10 partners typically get all the carry, while in the larger fund up to 30 per cent is shared with senior investment executives. Where the fund management company is part of an investment bank or other institution, part of the carry is paid to that institution as a franchise fee of around 25 per cent. This can provide very good returns for the bank in exchange for little more than sponsoring the fund, in addition to the return on any proprietary capital committed. As with investment banks, basic salaries for senior employees are typically set fairly low, but supplemented by a bonus which for partners may equal or exceed the basic. The significant rewards, however, come in the form of the carry, where a partner in a mid-market firm could expect £5 to £15m after five years; for partners in the much smaller number of very large funds, the rewards might be of the order of £50–150m. It is however important to note that Table 1 illustrates successful funds; as the literature on private equity shows, performance is highly variable with a significant number of firms producing very limited returns (Swensen 2000). The unsuccessful partner will have been well-paid for the life of the fund but will not have been rewarded at the end in a way that allows significant wealth accumulation. Furthermore, unsuccessful private equity groups usually cannot raise another fund. Private equity thus ratchets up the rewards and risk. The balance between the two is partly exogenously determined by, for example, the availability of sensibly priced companies for the fund to buy, as well as the market for companies at the time when investments are realised via trade sale or initial public offering (IPO).

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Table 1 Illustrations of the private equity business model

Funds under management Revenue Management fees (% of committed capital) Carry (% carried interest on fund performance)

Staffing Full partners Investment executives Head office staff

Remuneration Full partners Directors Senior executives

Mid-market fund

Large buyout fund

£250–£500 million

$8–$16 billion

1.75–2.25%

1.75–2.0%

20%

20%

No.

No. with carry

% of carry

No.

No. with carry

% of carry

6–10 5–12 5

All None None

100%

20–30 40–80 15–20

All Most None

70–80% 20–30%

Basic

Bonus

Carry (over 5 years)

Basic

Bonus

Carry (over 5 years)

£150k £100k

£150k £50k

£5–£15m

$600k $150k

$2.4m $50k

$50–$100m

Source: Care has been taken to ensure that these figures on private equity are representative of typical funds in these two size groups, but they are not averages. Each set of figures is based on a set of private equity (internal) management accounts, supplied by an actual fund, which were then checked by an experienced industry insider familiar with differently sized funds, who vouched for their representativeness.

Conclusion The questions and conclusions about the old group of managers help us to understand the new group of intermediaries. However, we need to recognise the differences which separate them and now because capitalism, and our own understanding of it, have both moved on in the 85 years since Tawney first analysed managers as a social group. This article has highlighted two differences. First, in the old debates about managers as class or elite, the argument was about coherent group agendas like growth or projects like fighting the cold war, which perhaps continue into our own time if we consider French aggrandisement of national industry. By way of contrast, the power of intermediaries comes from multiple and contradictory sectional agendas. These agendas have effects both of constraint and permissiveness, which do not cancel each other out but rather speed up the huge expansion of restructuring which, as we have argued elsewhere, means breach of implicit

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social contract for other stakeholders (Froud et al. 2006, pp. 109–22). Second, in the old debates about managers, motive and organisation were understood to be other directed and outward looking as in Marris on growth or Chandler on m-form. By way of contrast, intermediary business models are inwardly accountable and invariably designed to enrich a few seniors who can dig deep into revenue and profits. The social outputs of intermediary activity are thus restructuring and enrichment which is itself collectively a social process. As Piketty and Saez (2005) and Atkinson (2003) note, high income groups in the USA and UK have generally increased their share of incomes in economies where the value of just one form of restructuring (corporate M&A) is equivalent to 65–75 per cent of fixed investment since 1980. . . . [T]he power of financial markets and actors meets many kinds of resistance but finance has permeated large sections of the firm and household economy in advanced capitalist economies, changing opportunities and motives, as well as imposing new requirements (Krippner 2005; Martin 2002) . . . The context is an economy of permanent restructuring (Froud et al. 2007), where everything is for sale and where assets and risks can be bundled, unbundled and traded through coupons, against a background of sharply increasing inequalities in income, wealth and security. . . .

References Atkinson, Anthony, B. ‘Top income in the United Kingdom over the twentieth century’, mimeo, Nuffield College, Oxford, (2003), available at: http://www.nuff.ox.ac.uk/users/atkinson/TopIncomes20033.pdf Augar, Phillip. The Greed Merchants. London: Penguin, 2005. Berle, Adolf, A. Power Without Property. London: Sidgwick and Jackson, 1960. —— and Gardner C. Means. The Modern Corporation and Private Property. London: Macmillan, 1932. Centre for Economics and Business Research. ‘City bonuses to reach £7.5 billion this winter as bounce in activity feeds through’, London: Centre for Economics and Business Research, 12 January 2006. —— ‘City jobs break dot.com record and there’s more to come’, London: Centre for Economics and Business Research, 26 March 2006. Chandler, Alfred, D. The Visible Hand. The Managerial Revolution in American Business. Cambridge, MA: Belknap Press, 1977. Froud, Julie, Sukhdev Johal, Adam Leaver and Karel Williams. Financialization and Strategy. Narrative and Numbers. London: Routledge, 2006. Froud, Julie, Gindo Tampubolon and Karel Williams. ‘Everything for sale: how non-executive directors make a difference’, mimeo, University of Manchester, 2007. International Financial Services London (2006a) Banking. London: International Financial Services, London (IFSL). International Financial Services London (2006b) Hedge Funds. London: International Financial Services, London (IFSL). Johal, S. and Leaver, A. ‘Is the stock market a disciplinary institution? French giant firms and the regime of accumulation’, New Political Economy, 12, no. 3 (2007): 349–68

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Krippner, Greta R. ‘The financialization of the American economy’, Socio-Economic Review 3, no. 2 (2005): 173–208. Lazonick, William and Mary O’Sullivan. ‘Maximising shareholder value: a new ideology for corporate governance’, Economy and Society 29, no.1, (2000): 13–35. Marris, Robin. The Economic Theory of ‘Managerial’ Capitalism. London: Macmillan, 1964. Martin, Randy, The Financialization of Everyday Life. Philadelphia: Temple University Press, 2002. Mills, C. Wright. The Power Elite. New York: Oxford University Press, 1956. Morin, Francois. ‘A transformation in the French model of shareholding and management’, Economy and Society 29, no.1 (2000): 36–53. Nichols, Theo. Ownership, Control and Ideology. An Enquiry into Certain Aspects of Modern Business Ideology. London: George Allen and Unwin, 1969. Piketty, Thomas and Emmanuel Saez. ‘Income inequality in the United States, 1913– 1998’, NBER Working Paper no. w8467, Cambridge, MA: National Bureau for Economic Research, 2005. Roberts, John, Paul Sanderson, Richard Barker and John Hendry. ‘In the mirror of the market: the disciplinary effects of company/fund manager meetings’, Accounting, Organizations and Society 31, no.3 (2006): 277–94. Swensen, David, F. Pioneering Portfolio Management. New York: Free Press (2000). Tawney, Richard H. The Acquisitive Society. London: G. Bell and Sons, 1921. Williams, Hywel. Britain’s Power Elites. The Rebirth of a Ruling Class. London: Constable, 2006. Williams, Karel, Colin Haslam, John Williams, Sukhdev Johal, Andy Adcroft and Robert Willis. ‘The crisis of cost recovery and the waste of the industrial nations’, Competition and Change 1, no.1 (1995): 67–93. Young, Don and Pat Scott. Having Their Cake. How the City and Big Bosses are Consuming UK Business. London: Kogan Page, 2004. EDITORS’ NOTES 1 2

3

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Reprinted by permission of the publisher, Routledge, © 2007 Taylor and Francis Group. This extract of Folkman et al.’s paper excludes the subsections on ‘Investment banking’ and ‘Corporate law’ (pp. 563–6) in the section entitled ‘Intermediary business models: organized for enrichment’. The original paper also considers the business model in two additional intermediary areas: investment banking and corporate law. The analysis in this section draws on the common findings from these three cases. The extract moves from p. 563 to p. 566 at this point.

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SECTION THREE

Political economy: accumulation and innovation EDITORS’ INTRODUCTION

W

I T H T H E P O L I T I C A L E C O N O M Y texts in this section, we finally reach a

major post-1990 literature which not only takes financialization as its object but also often uses the term. So, here for the first time we have an explicit discussion about the definition and measurement of a post-1970 financialization process, as well as argument about the drivers and consequences of this process. It is entirely appropriate that the political economy section of this reader appears between mainstream finance and cultural economy because the distinctiveness of this literature can partly be understood in terms of its differences from these other approaches and our first task in this section is to explain the distinctive political economy approach to present-day capitalism.1 Unlike mainstream economics and finance, political economy aims to produce a more socio-historical, contextualized understanding of capitalist relations. Various kinds of institutionalists, post-Keynesians and Marxists have constructed that context very differently but generally believe that capitalism is a dynamic system. The system is internally unified for Marxists by the imperatives of extracting surplus value and unified for most other political economists by the institutional forms for mobilizing labour and capital for production. The associated promise is that capitalism can reach structural stability, as for example in a Marxist regime of accumulation or an institutional configuration such as a national model with economic performance correlates. On this basis, capitalism is not a field of multiple discrepant logics generating definite outcomes. But, most kinds of political economists also recognize change and some, such as the Schumpeterians and their fellow travellers, emphasize the primary role of creative destruction. Capitalism as a dynamic system exhausts old possibilities and finds new ones. Profit sources, major technical innovations or institutional armatures such as labour-market regulation are unlikely to sustain prosperity for more than a few decades. This theoretical position is animated through a collectively agreed version of recent capitalist history where the 1970s sees the end of the long post-war boom and the ‘Fordist’ era of stable mass prosperity. The accounts of Fordism differ between authors and schools but all of them reinforce the powerful generic idea of a lost golden age from 1945 to 1973 which French authors sometimes call les trentes glorieuses. The result has been waiting and worrying. Thus the French Regulationists have spent the periods since the 1970s considering whether and how

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political economy: accumulation and innovation

each new development can contribute to the ‘restoration of coherence’ between regime of accumulation and mode of regulation. More generally, the worrying establishes a difference of tone. Unlike the agency theorists in the second section of this reader, the political economists included in this section are troubled by financialization and analyse economic and/or social consequences including the passing of risk to households amidst rising inequality and threatened macro instability. Thus political economy brings back a critical verdict on finance as these authors highlight finance in our time as a source of possible instability and of actual inequality as it enables new kinds of class or elite power. But, political economists remain as epistemologically conservative about knowledge as they are theoretically conservative about capitalism. The cultural economists in the fourth section of this reader have embraced and explored the constitutive power of discourse and the limits on how a discourse like economics formats the economy. By way of contrast, political economists generally adhere to an empiricist concept of knowledge whereby the categories of economics appropriate a prior and independently existing world of the economy. But, unlike mainstream finance and economics, the political economists have never been diverted by snobbery about the higher and lower forms of knowledge. Whereas the mainstream privileges algebraic formalization and testing using large datasets, anything goes in political economy where algebra is optional, while table and commentary exposition is also perfectly respectable. Thus, political economy’s prescribed task is to understand the mechanics of capitalist systematicity by defining dominant socio-economic logics, determining cause–effect relations and finding ways to map empirical quantities, changes, or outcomes. But there are then open possibilities about adding all kinds of interesting empirics as well as making arguments about drivers and consequences and sometimes bold speculations about possible causes and effects. In consequence of this openness, political economy has contributed more than any other discourse to current understanding of financialized capitalism (while it has failed to find the systematicity which its a priori emphasizes). Let us begin by considering the interrelated questions about formal definitions and empirical measures of financialization. Here, difficulties about periodization or key indicators have been thoroughly explored as different political economists have proposed and criticized competing definitions of financialization. The most obvious strarting point is the most general definition of financialization as a multi-faceted, general tendency of capitalism in our time. This kind of definition is proposed, for example, by Epstein (2005), who defines financialization as ‘the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’ (p. 3). This general tendency type of definition is immediately attractive because researchers from a variety of disciplinary backgrounds in sociology, politics, and economics can situate their own research projects within its broad remit and it does also help reflect the general sense that finance is everywhere. However, the general tendency/ increasing influence type of definition runs into trouble when questions of periodization arise. First, as we noted in the general introduction, a variety of earlier authors, including Veblen in the early twentieth century

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(1904), had much the same perception about the growing importance of the capital markets. For political economists, present-day financialization is different because this is what comes after Fordism, as the Regulation School explicitly argue (see Boyer (2000) or Aglietta (2000), Aglietta and Breton (2001)). But, do we date the new era from the end of the old order in the 1970s with the two oil shocks and the breakdown of Bretton Woods or from the beginning of the new with developments such as leveraged buyouts in the 1980s or shareholder value as management ideology in the 1990s? Second, the general tendency definition licenses multiple measures but the different empirical indicators do not all move in the same way at the same time. If we consider the US case and the value of ordinary shares in relation to GDP, that increases rapidly with the decade long bull market in the 1990s and then falls back after the tech stock crash in the early 2000s. Meanwhile, the steady growth of corporate holdings of financial assets suggests an altogether different trajectory with change beginning in the 1970s. As Krippner’s (2005) paper clearly shows, the empirical measures disclose an uneven process because, for example, in the US economy since the 1970s, financial sources of profit become more important but the growth of employment in financial services is much more muted. These confusions appear to vindicate the preference of most political economists for more theorized definitions of the process of financialization which would incidentally resolve the problems of which measures mattered. The two theoretical lenses used to frame financialization are those of accumulation and innovation. From this point of view, financialization is either an unprecedented period of financial innovation in the wholesale or retail markets or a new kind of regime of accumulation of capital. These two approaches will now be considered in turn. Current ideas about the regime of accumulation are not so much formal theories as restatements of the original Marxist perception that capitalism is driven by the requirement to realize profit on capital with supporting empirics about new sources of profit and sites of accumulation; the concept of accumulation then covers investment of capital in means of production, coupons, and property. In neo-Marxist terms, financialization is then defined in terms of the dominance of finance as a vehicle for accumulation in a context of shifting class relations, conflict, and the search for new profit sources. Arrighi (1994) for instance defines capitalism in classically Marxist terms as a system of accumulation before going on to explore the growing importance of finance, rather than trade or commodity production, as a source of profit in the US.2 Krippner (2005)3 follows on from Arrighi when she argues the empirics show the US economy is financialized (not post-industrial or service based) because profit from US financial activities relative to that of total US corporate profits grew from the beginning of the 1970s, with income from finance and real estate now more significant than manufacturing or services. The influence of accumulation-based thinking is apparent elsewhere in macroeconomic work on financialization by the non-mainstream economist Crotty, the post-Keynesian Stockhammer, or the Regulationist Boyer who are (like Krippner) not Marxists in the sense that they use Marxist categories. But, it is clear from this body of work that the accumulation approach does not escape old problems of measurement about how Marxist arguments and conclusions can be supported from official

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statistics in bourgeois categories. Thus the accumulation approach needs to consider the growth of assets as much as the sources of profit but category difficulties make it very difficult to measure this growth or know what it means. For example, Crotty (2005) notes the striking increase in corporate holdings of financial assets which in the US quadrupled in value from $1.5 billion in 1973 to more than $6 billion in real terms by 2000. But, as Crotty explains, it is hard to know what this signifies when ‘corporate financial assets’ is a kind of dustbin category in official statistics which includes everything that is not tangible fixed assets (including goodwill arising from acquisitions).4 Maybe, therefore, Boyer (2000) has a helpful strategy when he downplays the empirics and adds conjecture about a putative new finance-led growth regime. It is difficult to develop a macro-economic model of an economy with finance at its centre but that theoretical task is easier than empirically measuring accumulation. If the accumulation-based approach is problematic, others prefer to define and measure financialization in terms of financial innovation in the wholesale markets and in practices like credit scoring used in the retail provision of credit. Effectively, the primary focus here is on meso-economic analysis of changes inside the financial sector with supplementary arguments about the implications of such changes for the rest of the economy. There is an established, even alarmist, tradition of writing about the growth of new financial instruments since the breakdown of Bretton Woods. This was led by international political economy scholars like Susan Strange on ‘mad money’ (1998) and ‘casino capitalism’ (1986); later joined by neo-Marxists like David Harvey (1999) who revived Marx’s idea of ‘fictitious capital’ to highlight flows of money capital detached from commodity transaction as in the foreign exchange markets. More soberly, authors like Sassen, (2001) or Tickell, (1999) have in different ways highlighted the explosion of financial trading and new modes of transacting, as well as the related development of new financial instruments;5 while, others like Montgomerie (2006) have described retail innovation through practices like credit scoring. This cumulating body of work on financial innovation has, by the mid-2000s, effectively produced a working definition of financialization as ‘financial innovation and its consequences’ which allows particular aspects or examples of innovation in financial products and markets to be explored. This has then been conflated with the idea that finance is everywhere and maybe doing the same thing. Thus, in generalizing the idea of innovation, Phillips6 (2002b) defines financialization as ‘in essence making everything into finance or financial instruments, of securitizing income streams, of reselling participations in loans for everything from snowmobiles to who knows what’. The limits and tendencies of this process are unclear especially after the credit crunch ended excess liquidity in summer 2007; on this basis, many would reject Nitzan’s (1998) attempt to imbue innovation with an epochal logic where the aim (in capitalism’s latest stage) is to make all assets liquid. This kind of epochalism may be implausible but it does serve to diffuse concern with financial innovation which is now strongly influencing neo-Marxists like Blackburn. His 2006 New Left Review article defines financialization as, ‘the growing and systematic power of finance and financial engineering (which) . . . runs the gamut from corporate strategy to personal finance’ (p. 39). Blackburn inflects the

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ideas about innovation with class analysis when he argues that a pact between financial and corporate elites is cemented by the making and trading of new services and ‘products’. Blackburn also believes that ‘fourth dimension operations’ by hedge funds, private equity, investment banks, and pension funds result in the proliferation of ‘shadier practices’ where ‘relations of ownership and responsibility become weakened or blurred’ (p. 41). If there is some convergence onto the idea of financialization as a marked development of financial innovation, there is certainly some difference of emphasis when it comes to outlining the structural and ideological drivers of the process. Notwithstanding such differences, as outlined below, there is more of a consensus about the empirical consequences of financialization. For example, there are clear differences of emphasis and interpretation within the neo-Marxist approach, where one group of authors interprets financialization as a global development driven by US imperialist aspirations and another group focuses on national drivers in the form of new class alliances within the US. The imperialist interpretation combines classical Marxist concepts of capitalism as a global system of domination led by a national super power with Polanyian sensitivity to the institutional embeddedness of economic activity and the role of international institutions. Authors like Best (2003) argue that US pressure, partially articulated through institutions like the IMF, has forced through a marketization of financial relations which disembeds global finance from national programmes of governance and accumulation. Similar themes are taken up by other authors who highlight an emergent neoliberal hegemony which universalized market-based principles leading to the growth of internationally footloose capital, market speculation, and the subsequent reshaping of national controls to meet these new demands (Cerny 1999, Scholte 2002). For Panitch and Gindin (2005) ‘the globalization of finance has included the Americanization of finance and the deepening and extension of financial markets has become more than ever fundamental to the reproduction and universalization of American power’ (p. 47). One logical outcome of this imperialism is ‘the decline of national varieties of capitalism’ as we know them (Soederberg et al. 2005) as the juggernaut of financialization-cum-globalization caries all before it. Such positions imply that national institutions lack the kind of adaptability and resilience to counter such threats. Other political economy authors put much more emphasis on national class alliance for sectional advantage within the USA and other Anglo-Saxon countries. This is coherent with the many earlier analyses of the Fordist long boom which emphasized the role of national class compromise and labour/ capital settlements in sustaining prosperity. The connection is explicit in the work of Grahl and Teague (2000) for whom the breakdown of the class compact between workers and Fordist enterprises led to the emergence of a new financialized development model. Perhaps the most influential statement of the national alliance position comes from Duménil and Lévy (2005). They have agreed agree that neoliberalism and globalization are ‘expressions of finance’ but in an earlier paper they emphasize that US politics hinges on the self-interested alliance of the top 15 per cent of salary earners with capital. For Duménil and Lévy (2004), the development of pension funds provided the

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material basis for a broad class alliance between the upper salariat and the owners of capital, both of whom favour economic restructuring to bolster capital income and capital gains which fund the salariat’s consumption in retirement. These two authors briefly allude to structural factors like the dollar crisis, the breakdown of Bretton Woods and the rise of TNCs which helped secure this neoliberal covenant, but their main argument is that financialization exists because this is in the material interests of the upper echelons of US society. If the US haute bourgeoisie has an executive committee, regrettably it does not publish its minutes. And, without direct evidence of interested calculations, the Marxist arguments about the new class alliance (behind financialization) will probably convince sceptics. It is therefore unsurprising to find that some Marxists and most post-Keynesians have highlighted structural drivers of financialization and put the main emphasis on intensifying competition and slow growth of demand. A key text here is Arrighi’s (1994) book which argues that non-financial firms diverted funds from productive investment to financial activities as their profit margins were eroded in response to margin pressures caused by intensifying international product market competition and labour militancy at home. This thesis is developed by Krippner (2005) in this section who shows that the ratio of portfolio income to cash flow for non-financial firms began to rise in the early 1970s and is particularly pronounced in manufacturing where levels of workforce militancy and international competition were more acute. For Krippner, these empirics are a decisive indicator of a systematic shift in terms of firm activity and profit source because interest rather than capital gains or dividends is the principal component of portfolio income growth. This argument about structural drivers quickly becomes complicated, however, because it is difficult to decide whether variables like declining rates of profit or slower growth are cause or consequence of financialization, Thus, Engelbert Stockhammer argues that financialization after the 1970s may not be just a response to slowdown, but its primary cause. Stockhammer uses a post-Keynsian theory of the firm to argue that, when managerial capitalism gave way to shareholder-oriented capitalism, management priorities changed with deleterious effects on the growth and efficiency of financialized firms. Under the growing influence of financial actors and institutions, corporate management prioritized profits for shareholders over the physical investment which would have delivered growth. Similar points about underinvestment are made by Crotty (2005) who adds the argument that this process was driven by a slowdown in aggregate demand caused by neoliberal policies pursued by the US state, as well as increasing product-market competition. For Crotty, all this caused a shift from patient finance seeking long-term growth to impatient finance seeking higher returns more quickly; and this, in turn lowered profits, increased debt, and shortened planning horizons. In Stockhammer (2004) and Crotty (2005), the discussion of financialization drivers is mixed with consideration of consequences in ways which revive and develop old liberal collectivist ideas about finance against production and shareholders against managers. Indeed it could be argued that Stockhammer defines a new financialized order of priorities by inverting the old managerialist theory of the firm arguments about how managers pursued growth at the expense of profits. Crotty

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more explicitly explores this theme in noting that the drivers include the emergence of a new class alliance between well-paid company CEOs and financial investors, as well as noting the role played by changing ideas or conceptions of control, particularly in relation to governance relations within the firm. Whereas Crotty develops the table and commentary type of exposition which is commonplace in much political economy, Stockhammer uses formal specification and regression analysis to test empirically his hypothesis about the consequences for output growth of a possible shift in management priorities towards profits. This produces interestingly mixed results in different national cases: whereas financialization (as new priorities) explains roughly one-third of the US economy’s slowdown, it has little impact on the UK where post-war underperformance continues. Or again, his results are that financialization results in significant slow down in France but not in Germany where he claims that the resilience of the bank-based German model insulated it from the effects of financialization.7 This theme about the absence of simple, predictable, invariant, general consequences emerges strongly from other less technical recent work on national cases. In the French case, Morin (2000) highlighted the increasing disciplinary power of US institutional investors over French managers in the 1990s; but Johal and Leaver (2007) point out that the 1990s were also a decade of global expansion for relatively unprofitable French giant firms because the disciplinary efforts of US fund managers in the secondary market were countervailed by the permissive attitudes of investment bankers in the primary market who offered new issues of stocks and bonds to fund global expansion. Much the same point could be made about mixed and complicated results if we consider the consequences of financial innovation for system risk. From Strange (1986) onwards, many of the international political economy authors writing on financial innovation have suspected that all those trillions in derivatives or the passing of risk through collateralized debt obligations could cause a major crash if not bring the system down, whatever bankers say about how dispersion of risk makes the system more secure. Interestingly, Boyer’s (2000) paper discusses the key role of central banks in ensuring stability in a finance-led growth regime; in the credit crunch of summer 2007, the central banks made an early intervention to try to inject liquidity and confidence into debt markets paralysed by uncertainty. Several years earlier, the failure of the hedge fund Long Term Capital Management (LTCM) in 1998 was contained (see Lowenstein 2000) and, despite concerns, the financial system was not seriously affected. Wisdom in economics is often a matter of timing and the apocalyptic vision of financialization will not convince sceptics until after the next big crash. Meanwhile, we could fall back onto two more modest hypotheses about the role of finance, as argued in the general introduction to this book. First, finance is now the driver of conjunctural change as when the lower interest rates after the tech stock crash in 2000 fed the excess liquidity which in due course led to the correction and credit crunch of 2007. Second, finance is also the most likely trigger of cyclical downturn in output and employment in countries like the USA and UK where wealth effects are potentially much more important via the new importance of house prices for the masses and the correlation of falling prices across different asset classes whenever

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things go wrong. Against this background, the paradox of the period since the early 1990s is that the high-income countries (excluding Japan) have had many glorious years of sustained growth and low employment which owe something to creditcreating financial innovations like securitization which have helped boost consumer demand. If many political economists agree on the importance of financial innovation, their discussion of drivers is inconclusive as their empirical research uncovers a complex world which confounds their a priori about general effects and chains of ascertainable cause and consequence. However, the extracts in this section do make important contributions to understanding both the dimensions and the complexities of financialization. Political economists do this negatively by demonstrating empirically that financialization is not an epochal process with a simple general story line about before and after; this point emerges very strongly in the extracts from Krippner and Stockhammer reprinted in this section. Political economists do this positively through bold theoretical conjecture and empirical concern with distributive outcomes; thus two other extracts in this section make complementary contributions. Boyer (2000) provides bold theoretical conjecture about the dynamics of a financialized economy while Duménil and Lévy (2004) emphasize increasing income inequality. French Regulationists and neo-Marxists do not operate in any kind of liberal collectivist problematic but the style and scope of their argument nonetheless continues the great tradition of Tawney and Keynes. From this point of view, as Ireland’s work stands out in the last section, so Boyer’s stands out in this section on political economy. Unlike Keynes, Boyer engages in formal macro-economic modelling of a financialized economy where the masses are both wage earners and securities holders. But the theoretical conjecture has the same scale and scope which marks a major contribution that the rest of us must come to terms with. First, the General Theory’s arguments about the economy of high wages and the futility of wage cuts should be reconsidered because, in a financialized economy, wage cuts may stimulate demand if they boost securities prices and have positive wealth effects. Second, the old Fordist problem of commodity price inflation related to labour market pressures may be replaced by asset price bubbles in a financialized economy whose central bankers could well end up like generals fighting the last war. The simplifications in the model are quite notable because all workers here own shares and there is no foreign trade or government sector. But Boyer’s analysis of a finance-led growth regime is certainly original and challenging (see also Aglietta 2000). Duménil and Lévy are included in this section because their empirics focus on outcomes and their empirics demonstrate that financialization has involved a massive redistribution to the rich. This is an essential counterpoint to the claims by agency theorists and others that we are all shareholders now, and hence that the pursuit of shareholder wealth maximization will deliver social benefits. Using US data, Duménil and Lévy highlight the redistributive outcomes of financialization which has benefited not traditional rentiers with incomes from assets but a new stratum of the working rich concentrated in and around Wall Street. Duménil and Lévy empirically demonstrate the growth of a new stratum of super-rich households who

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between the end of the 1970s and the early 2000s quadrupled their income in real terms whilst the bottom 90 per cent of households experienced no income gains at all. They highlight the role of financial and real estate income as the driver of this inequality and conclude that the neoliberal promise of a share-owning democracy for all is inherently ideological. The connection between financialization and growing inequality is also made by Cutler and Waine (2001), Epstein and Jayadev (2005), Phillips (2002a), and Wade (2004) who in different ways highlight the regressive, distributive tendencies of finance-oriented capitalism. Political economy has not met its own ambitious aims of theoretically defining and measuring financialization but it has very effectively highlighted financial innovation and growing inequality.

NOTES 1

2

3

4

5 6

7

As the introduction to this volume outlined, the extracts in this section cover political economy approaches to financialization as a link between the first two sections, which provide historic context, and those that come later in the book, especially section 5 on financialized management. International political economy (IPE), which brings together international relations with political economy, has made a very important contribution to understanding financialization through its focus on the role of states and key institutions and actors in the development of international finance and this section includes several important references from this field. See also the arguments by Sweezy (1997) and Magdoff and Sweezy (1972, 1987) about the growth of the financial sector and its relation with economic stagnation; in a review essay which covers this area of work, Foster (2007) outlines the rise of what he terms ‘monopoly finance capital’, where ‘financialization has become a permanent structural necessity of the stagnation-prone economy’. Readers should note that Greta Krippner, whose paper from the Socio-Economic Review has been widely cited, is an economic sociologist. Her work is included in this section because her analysis of financialization both draws on and contributes to the political economy tradition. There are also all kinds of difficulties in measuring financial sources of income in some nonfinancial companies, like manufacturers of autos or capital equipment which sell finance packages as well as products. Because of complex accounting relations between the industrial and financial parts of such companies, as well as internal political decisions about where to ‘show’ the profit, it is often difficult to get any objective measure of the profitability of finance operations. See also Bryan and Rafferty (2006) on derivatives and Langley (2006) on mortgage backed securities. Phillips is a non-academic commentator – a former Republican party adviser turned political journalist – who has written prolifically on the causes and consequences of financialization since the early 1990s. See, for example, Phillips 1993, 1994 and 2002a. Stockhammer’s analysis is particularly useful because, unlike much political economy, it is not solely concerned with the US economy. In considering other countries, Stockhammer reminds us that financialization may have varying logics and outcomes in different country contexts.

REFERENCES Aglietta, M. (2000) ‘Shareholder value and corporate governance: some tricky questions’, Economy and Society, 29(1): 146–59

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Aglietta, M. and Regis Breton, R. (2001) ‘Financial systems, corporate control and capital accumulation’, Economy and Society, 30 (1), 433–66 Arrighi, G. (1994) The Long Twentieth Century: Money, Power and the Origins of Our Time, London: Verso. Best, J. (2003) ‘From the top-down: the new financial architecture and the re-embedding of global finance’, New Political Economy, 8(3): 363–84. Blackburn, R. (2006) ‘Finance and the fourth dimension’, New Left Review, 39: 39–70. Boyer, R. (2000) ‘Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis’, Economy and Society, 29(1): 111–45. Bryan, D. and Rafferty, M. (2006) ‘Financial derivatives: the new gold’, Competition and Change, 10(3): 265–82. Cerny, P. (1999) ‘Globalization and the erosion of democracy’, European Journal of Political Research, 36: 1–26. Crotty, J. (2005) ‘The neoliberal paradox: the impact of destructive product market competition and “modern” financial markets on nonfinancial corporation performance in the neoliberal era’, in G. A. Epstein in (ed.), Financialization and the World Economy, Cheltenham: Edward Elgar. Cutler, T. and Waine, B. (2001) ‘Social insecurity and the retreat from social democracy: occupational welfare in the long boom and financialization’, Review of International Political Economy, 8(1): 96–118. Duménil, G. and Lévy, D. (2004) ‘Neoliberal income trends: wealth, class and ownership in the USA’, New Left Review, 30 (Nov.–Dec.): 105–33. Duménil, G. and Lévy, D. (2005) ‘Costs and benefits of neoliberalism’, in G. A. Epstein, (Ed.), Financialization and the World Economy, Cheltenham: Edward Elgar, 17–45. Epstein, G. A. (2005) ‘Introduction: financialization and the world economy’, in G. A. Epstein, (ed.), Financialization and the World Economy, Cheltenham: Edward Elgar, 3–16. Epstein, G. and Jayadev, A. (2005) ‘The rise of rentier incomes in OECD countries: financialization, central bank policy and labor solidarity’, in G. A. Epstein (ed.), Financialization and the World Economy, Cheltenham: Edward Elgar, 46–74. Foster, J. B. (2007) ‘The financialization of capitalism’, Monthly Review, 58(11). Grahl, J. and Teague, P. (2000) ‘The regulation school, the employment relation and financialization’, Economy and Society, 29(1): 160–78. Harvey, D. (1999) The Limits to Capital, London: Verso. Johal, S. and Leaver, A. (2007) ‘Is the stock market a disciplinary institution? French giant firms and the regime of accumulation’, New Political Economy, 12(3). Krippner, G. R. (2005) ‘The financialization of the American economy’, Socio-Economic Review, 3(2): 173–208. Langley, P. (2006) ‘Securitising suburbia: the transformation of Anglo-American mortgage finance’, Competition and Change, 10(3): 283–99. Lowenstein, R. (2000) When Genius Failed. The Rise and Fall of Long-term Capital Management, New York: Random House. Magdoff, H. and Sweezy, P. M. (1972) The Dynamics of US Capitalism, New York: Monthly Review Press.

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Magdoff, H. and Sweezy, P. M. (1987) Stagnation and the Financial Explosion, New York: Monthly Review Press. Montgomerie, J. (2006) ‘The financialization of the American credit card industry’, Competition and Change, 10(3): 301–19. Morin, F. (2000) ‘A transformation in the French model of shareholding and management’, Economy and Society, 29(1): 36–53. Nitzan, J. (1998) ‘Differential accumulation: towards a new political economy of capital’, Review of International Political Economy, 5(2): 169–216. Panitch, L. and Gindin, S. (2005) ‘Finance and American empire’, Socialist Register 2005, 46–81. Phillips, K. (1993) Boiling Point: Democrats, Republicans and the Decline of Middle-class Prosperity, New York: Random House. Phillips, K. (1994) Arrogant Capital. Washington, Wall Street and the Frustration of American Politics, Boston, MA: Little, Brown and Company. Phillips, K. (2002a) Wealth and Democracy: A Political History of the American Rich, New York: Broadway Books. Phillips, K. (2002b) ‘Wealth and democracy: A political history of the American rich’, Speech to Commonwealth Club, 2002, http://www.commonwealthclub.org/archive/ 02/02–06phillips-speech.html. Sassen, S. (2001) The Global City: New York, London, Tokyo, Princeton, NJ: Princeton University Press. Scholte, J. A. (2002) ‘Civil society and democracy in global governance’, GlobalGovernance, 8(3): 281–304. Soederberg, S., Menz, G., and Cerny, P. (2005) Internalizing Globalization: The Rise of Neoliberalism and the Decline of National Varieties of Capitalism, London: Palgrave. Stockhammer, E. (2004) ‘Financialization and the slowdown of accumulation’, Cambridge Journal of Economics, 28(5): 719–41. Strange, S. (1986) Casino Capitalism, New York: Basil Blackwell. Strange, S. (1998) Mad Money: When Markets Outgrow Governments, Manchester: Manchester University Press. Sweezy, P. M. (1997) ‘More (or less) on globalization’, Monthly Review, 49(4): 3–4. Tickell, A. (1999) ‘Unsustainable futures: controlling and creating risks in international money?’, in L. Panitch and C. Leys (Eds), Socialist Register, New York: Monthly Review, 248–77. Veblen, T. (1904) The Theory of Business Enterprise, New York: New American Library. Wade, R. (2004) ‘Is globalization reducing poverty and inequality?’, World Development, 32(4): 567–89.

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Chapter 9

Robert Boyer

A FINANCE-LED GROWTH REGIME?

Introduction to extract from Robert Boyer (2000), ‘Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis’, Economy and Society, vol.29(1): 111–45

EDITORS’ COMMENTARY The french regulation school’s work tackled the general question of how capitalism could achieve long periods of stability and growth that could be sustained for ten years or more.1 Their answer was through a growth regime with an appropriate mode of regulation, as in the case of Fordism which had specific institutional foundations. Since the breakdown of Fordism in the 1970s, the Regulationists have been waiting for the restoration of coherence and, from this point of view, the question is whether financialization represents a new growth regime. The work of the Regulation School has led to subsequent interest in notions like post-Fordism which has been analysed using other approaches such as cultural economy (see, for example, Amin 1994). The principals of regulationism, like Michel Aglietta and Robert Boyer, are nearing retirement but they retain their ability to engage with current developments and to produce imaginative work. Thus Aglietta and Reberioux (2005) have taken the lead in responding to Hansmann and Kraakman’s (2001) triumphalism about governance for shareholders; and Boyer has produced a virtuoso theoretical essay on the possibility of a finance-led growth regime which imaginatively explores the dynamics of a financialized economy. Within a Regulationist frame, Boyer’s concern is not with financialization per se but with the possibility and desirability of a ‘finance-led accumulation regime’. In non-regulationist terms, this is probably best thought of as a kind of ideal-type construct which specifies quasi-institutional complementarities in areas such as labour

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robert boyer

market organization, forms of industrial competition, the role of the state and monetary policy. Boyer starts with a note of caution on ‘the fad about finance’ (p. 117) because many other socio-technical developments such as Toyotist manufacturing or the ‘knowledge based economy’ have not generated functioning regimes. Boyer’s initial contribution is made in table 1 where he characterizes the key features and complementarities which would define a finance-led regime where ‘the financial system would now occupy the central place previously held by wage compromise’ (p. 118) by organized labour under Fordism. Three salient features include: first, labourmarket flexibility and dual sources of income and wealth for workers who also hold securities; second, corporate competition oriented towards higher returns on the capital market, not price, quality, or innovation for the product market; and, third, monetary policy geared not towards price stability but towards controlling asset price bubbles. The unresolved question is whether all this could fit together in a regime to generate growth and stability in a putative new order where finance is pervasive because ‘all the elements of demand bear the consequences of the dominance of finance’ (p. 121). This question is answered by constructing an econometric growth model whose basic relations are given in Table 2. We have omitted Boyer’s brief and inconclusive discussion of empirics so that our extract can focus on the theoretical results. Results 1–5 suggest that financialization is not so much a singular process but multiple possibilities and different scenarios, which take us well beyond Keynesian expectations because a higher profitability norm at the expense of wages could still boost growth if wealth effects for wage earners boost consumption. Result 7 suggests the dynamics also depend on the success of monetary authorities in preventing or at least managing asset price bubbles. The explicit implication is that ‘some financialized systems are instable’ (p. 127). Boyer’s commentary written after the Asian crisis but before the US tech stock crash of spring 2000 presciently highlights US problems in managing bubbles and it is no doubt still true that ‘the next act of the financial drama may well start on Wall Street’ (p. 142). Robert Boyer is an economist at CEPREMAP (Paris), Senior researcher at the French National Centre for Scientific Research (CNRS) and Professor (Directeur d’Etudes) at EHESS. He is one of the founding figures in the French Regulation School and has published widely in books and journals on a range of economic matters. Apart from his 1990 book, The Regulation School: a Critical Introduction, other well-known books in English include States Against Markets (1996, with Danny Drache) and Regulation Theory: the State of the Art, (2000, with Yves Saillard).

NOTE 1

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For an introduction to the work of the Regulation School (in English) see, for example, Aglietta (1979), Boyer (1990) and Jessop (1990).

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REFERENCES Aglietta, M. (1979) A Theory of Capitalist Regulation: The US Experience, London: New Left Books. Aglietta, M. and Reberioux, A. (2005) Corporate Governance Adrift: A Critique of Shareholder Value, Cheltenham: Edward Elgar. Amin, A. (ed.) (1994) Post-Fordism: A Reader, Blackwell: Oxford. Boyer, R. (1990) The Regulation School: A Critical Introduction, New York: Columbia University Press (translated version of La Théorie de Régulation: une Analyse Critique, published in 1986). Hansmann, H. and Kraakman, R. (2001) ‘The end of history for corporate law’, Georgetown Law Journal, 89: 438–68. Jessop, B. (1990) ‘Regulation theories in retrospect and prospect’, Economy and Society, 19 (2): 153–216.

Introduction 1, 2

S

the Fordist accumulation regime in the US (Aglietta 1976), much research has been devoted to investigation of possible successors to this unprecedented synchronization of mass production and consumption. Many structural and multifaceted transformations have occurred and stimulated various proposals about the nature and properties of alternative accumulation regimes. It is important to emphasize that the 1990s have seen the emergence of a totally new candidate for the succession to Fordism, as a financeled regime has captured and fascinated many observers including regulationist researchers (Aglietta 1998). This is the starting point of the present article. . . . INCE THE DEMISE OF

Muddling through the Fordist crisis: many growth regimes that did not materialize 3 Since the American crisis, initiated by productivity slow-down and accelerating inflation at the end of the 1960s, economists, specialists in technical change, sociologists and even more so politicians have contemplated many ways out of the crisis. A short retrospective analysis in Table 1 may help with understanding the points of similarity and difference between these earlier visions and contemporary hopes and fears about a restructuring of accumulation which is dominated by finance. Each of the visions calls for a specific institutional architecture, accepting it is unlikely that each country will be part of the related growth regime (Table 1). [. . . .] One important alternative vision of the future of capitalist growth, is becoming increasingly influential in the second half of 1990s. Many giant mergers,

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Dualism according to Governed by the Credit, finance Schumpeterian New international schooling and speed of and even welfare state and division of labour cognitive skills. innovation. monetary State. according to KBE. policy pulled by innovation.

External market flexibility and competitive wage.

Knowledge-based economy (KBE)

Competition led Privatization, deregulation, liberalization.

Dualism according to Linked to a Role of risk the ability to master dominant capital and ICT. position in ICT. credit.

Stability of monetary policy.

Coherence and Typical case dynamic of the growth regime

Difficult to implement in countries with few academic resources.

Difficult to achieve for lagging countries

Proactive and Wider opening to Risk of overmarket-enhancing international trade, capacity and state. investment and deflation. finance.

Building of public New International infrastructure for division of labour ICT. according to the mastering of ICT.

Internationalization Extensive of modern business growth with services. rising inequality.

Most OECD countries (since 1985).

US (1990s)

Silicon Valley (since mid1980s)

US (1980s)

Phase of export-led A follower of Japan until growth. typical Fordist 1990 growth regime.

Information/ communication technologies led (ICT)

Developmentist State.

Trade-off Strictly limited between State, promoting inflation and flexibility. unemployment.

Active central bank, promoting growth.

Strong heterogeneity/ Local and inequality across oligopolistic for industries. traditional services.

Insertion into the international regime

Service led

State–society relations

Employment stability By quality and against work product malleability. differentiation of mass products.

Monetary regime

Toyotism

Form of competition

Wage–labour nexus

Growth regimes

Institutional forms

Table 1 Alternative emerging growth regimes and redesign of institutional forms

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Frequently competitive.

Employment flexibility, profit sharing and pension funds.

Export led

Finance led

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Mainly on financial markets, but trend towards oligopoly.

Prevent the emergence of financial bubbles.

By price and/or Targeted by quality. towards price and exchange rate stability.

Key institutional form.

Under scrutiny of Trend towards financial markets: global finance. search for credibility.

New mercantilist strategy.

Risk of systemic financial instability.

Strong exposure to external disturbances.

US and UK (1990s)

East Asian NICs (before 1997)

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capital mobility between countries, pressures on corporate governance, diffusion of equity among a larger fraction of population; all these transformations have suggested the emergence of a finance-led accumulation regime. This would lead to a totally novel regulation mode, currently labelled ‘the new economy’: this regime would combine labour-market flexibility, price stability, developing high tech sectors, booming stock market and credit to sustain the rapid growth of consumption, and permanent optimism of expectations in firms. The capacity of each country to adopt and implement such a model would be a key factor in macroeconomic performance and would determine that country’s place in a hierarchical world economy governed by the diffusion of a financialized growth regime (Aglietta 1998). Two major lessons can be drawn from the brief survey in Table 1. On the one hand, all these potential regimes are not equivalent from a class analysis point of view, since they are built upon various, or completely different, institutionalized compromises. Consequently, the institutional configurations and emerging regulation modes are indeed diverse. On the other hand, the current fad about finance has to be put into historical perspective and under close scrutiny, since almost all the previous scenarios have failed fully to materialize in the pure form. Therefore, it is likely that a form of hybridization between these pure systems will take place, with a different mix in each country according to political and social legacy, economic specialization and, of course, the strategic choices of key collective actors. Nevertheless, it would be intellectually interesting to make a prospective analysis of the operating conditions of a finance-led growth regime which would be poles apart from the post-war Fordist regime, in that the financial system would now occupy the central place previously held by wage compromise. For this purpose, we can derive some basic hypotheses from the American economy, which has long been committed to finding a system of growth which breaks with Fordism, if only because accumulation has become mainly extensive and based on the differentiation of modes of consumption and increasing inequalities (Boyer and Juillard 1995). It is therefore a question of finding the equivalent of what were the formalizations of Fordism (Bertrand 1983; Boyer 1988; Aglietta and Mendelek 1987), for this new regime. . . .

How financialization affects all institutional forms 4 The American example, like the tendencies in the British and European economies (Froud et al. 1998) and quite unlike the problems of Japan and the Asian financial crisis, makes it possible to diagnose the nature of the emerging economic system. Our aim is to define its properties and the possibilities of long term reproduction quite apart from the transitional period when, for example, pension funds develop, leading to increased market prices and the appearance of a financial bubble. Financial history suggests such speculative bubbles will not disappear (Kindleberger 1978), but, if they did, what would be the dominant characteristics of an economy where finance has imposed its logic? The impact would a priori bear on at least five elements (Figure 3).

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•

•

•

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The privileging of shareholder value primarily affects firm governance. Many large groups must increase the internal rate of return to levels which are compatible with the requirements of large international investors. But the transformation is more profound than this and does not affect only the volume, direction and mode of financing investment (arrow A in Figure 3). Indeed, managers are forced to review most of their management techniques, whether these concern the response to economic cycles, the degree of specialization or even the nature of the capital–labour compromise. . . . Thus, forms of competition and the nature of the employment relationship are directly affected. On the one hand, the financial markets will adjudicate between activities with similar rates of return so that competition shifts from the product market to the financial market. On the other hand, the need for flexibility is reflected in the use of new forms of employment contract (arrow B, Figure 3). Household behaviour is undergoing a striking transformation in relation to the Fordist post-1945 norm. Admittedly wages and salaries continue to be an essential component of reward, but two new mechanisms are emerging. On one side, under the pressure for shareholder value, the wage bill has to react quickly to any discrepancy between actual and expected returns. . . . But, on the other side, wage earners have access to financial gains, via direct equity holdings or, more likely, by the inter-mediation of pension funds. Consequently, the prospect of gains on the financial markets has a direct influence on the decision to save or spend. . . . This is why this system can be described as equity based (‘patrimonial’) because wealth, as measured by the financial markets, tends to become an important influence on the consumption of durable goods and also in-house purchase and indebtedness to banks. If they are sufficiently developed, these new behavioural elements can inject an unprecedented dynamic into consumption, on the model observed in the United States between 1992 and 1998 (arrow C, Figure 3). Relations between the State and the economy have themselves changed considerably in a great many ways. First, unsuccessful attempts to reduce public borrowing throughout the 1980s and then the 1990s have bequeathed a high level of public indebtedness, so that government expenditure is becoming increasingly sensitive to the actual rates of interest on state bonds. Next, and consequently, the financial markets attach great importance to restraint of public borrowing within strict limits (arrow F, Figure 3). Moreover, as the fiscal base no longer enjoys the same level of growth as it did in the thirty years of the long boom, there is increasingly strong pressure to rationalize public expenditure. The fact that capital has become extremely mobile causes the tax burden to fall on the less mobile factors, namely labour and possibly fixed assets (arrow E, Figure 3). According to this argument, taxation would become more pro-cyclical and no longer anti-cyclical as in a Keynesian system. Finally, and most importantly, monetary policy no longer has the sole function of ensuring the best ‘policy mix’ between growth and inflation. The careful scrutiny of the international financial community and substantial openness to external competition deliver low inflation or even a

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deflation prone economy where the central bank can much more easily defend price stability. These structural transformations grant a new degree of freedom just as the recurrence of financial bubbles gives the central bank a new role: monetary policy should now guide the development of the financial markets in the best possible way. These are quickly carried away by speculations which the central bank endeavours to contain. Ideally, it is the stability of the financial markets and no longer price stability which should be the key criterion when a fully financialized system has imposed its logic (arrow G, Figure 3). The difficulties of financing national insurance systems by redistribution, the concerns arising from an ageing population and the fragility of existing pension systems are among the factors which have encouraged the growth of private insurance and saving via the capital market, as well as retirement pensions more geared to individual needs. This change affects the employment relationship just as much as the nature of the financial markets, since a large part of savings is then professionally managed with the aim of optimizing the medium-term return. The dynamics of market prices, for example, can be affected, with long-termists setting the trend and compensating to some extent for the impatience of the short-termists (arrow D).

This being the case, all the elements of final demand bear the consequences of the dominance of finance. Productive investment becomes more cautious since it has to guarantee a sustained higher rate of profit than in the past, but this development is offset by much easier access to the financial markets for large groups and by an increasingly favourable tax system. For its part, household consumption becomes more volatile. On the one hand, income from employment is more uncertain because of trends relating to hiring and firing employees, changes in working hours and the fact that pay is more sensitive both to the general climate and to the financial situation of the firm. On the other hand, credit is more readily available, but collateral (such as fixed assets or stock portfolio) is often a prerequisite. Consequently, speculative bubbles can move from financial to product markets much more directly than in the past. These developments are even more striking when account is taken of the dynamics of house purchase and the much stricter management of public borrowing and the corresponding expenditure. A final consequence is that financial markets ensure that capital is used effectively so that, in comparison with the Fordist period, productive capacities and the choice between rationalization or increases in capacity are transformed. The whole macro-economic dynamic is thus driven by the compatibility between the expectations emanating from the financial markets, the reality of firms’ profit growth and interest-rate dynamics, which the central bank is trying to direct. Even supposing that expectations are never disappointed, under what conditions is this new system viable, that is, likely to last for a period of one or more decades? Hence the interest of a very simple modelling exercise with a system that retains only the first three mechanisms (A, B, C), with an extension into monetary policy (G).

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Figure 3 The components of a finance-led growth regime

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A model describing the determinants of macro-economic activity for a fully financialized economy 5 The above description leads to a very simple, basically linear model which takes into account the specific characteristics of this system. We shall comment briefly on the formalization choices made, the aim being to simplify as far as possible the features of a model that can subsequently be enriched by adding more financial variables, a dynamic analysis or even various non-linearities (Table 2). Table 2 A finance-led growth model: the basic relations

(2) I = α • K−1 • (r − ρ) + b • (D − D−1) + i0

Investment determined by the difference between profitability and the financial norm and by a term for increasing demand.

(3) C = α • MSR + β • W + c0

Consumption is set according to aggregate real wages and household wealth.

(4) K = K−1 • (1 − δ) + I

Capital stock develops according to the rate of obsolescence and of new investment.

(5) Q¯ = v • K

Production capacity is determined by capital stock.

(6) Q = Inf (Q¯ , D)

The level of production is fixed, in the short term, either by capacity or effective demand.

Q − MSR K−1

(8) W = q •

The profit rate is defined as the gross surplus in relation to capital stock.

Q − MSR i

Wealth is calculated on the basis of profit, taking into account the interest rate and Tobin’s q.

(9) MSR = f • Q − e • ρ + w0

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Aggregate real wages of employees increase with demand but decrease with the financial norm.

Income distribution

(7) r =

Supply/demand interaction

Closed economy without State or foreign trade.

Formation of demand

(1) D = C + I

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a finance-led growth regime? The financial markets fix the profitability norm.

(11) q = q¯

Tobin’s q is assumed to be exogenous

(12) i = j0 + φ

冢

W Q

− r*

冣

The central bank sets the interest rate to avoid the formation of financial bubbles.

(13) r* = r(Q, ψ)

Endogenous variables: 1 D, C, I, r, MSR, W, K, Q¯ , Q, i, r*

Financial and monetary variables

(10) ρ = ρ

185

The wealth/income ratio depends on the level of development and on the discretionary judgement of the central bank. Exogenous variables: 2 ρ, q

Note: All the parameters a, b, α, β, v, δ, f, e, φ are positive or nil.

Consumption and the demand regime are directly affected by financialization 6 The wealth behaviour of households has an important consequence. It has a direct effect on the propensity to spend income from employment: if employees fully integrated the choice between income from employment and wealth-based enrichment, the propensity to consume could even become negative, which shows the novelty of consumption behaviour in this system. [. . . .] Two results follow from this: Result 1: When equity effects are well developed and if the financial markets lead to a generalization of investment behaviour determined largely by profitability, then a virtuous system of financial growth can be said to exist. In this system, raising the profitability norm does have a favourable effect on demand even if the accelerator effects are still considerable. Result 2: If, on the other hand, financialization occurs in an economy which is still dominated by wage-earning social relations, where the wage is the essential determinant of the mode of consumption, raising the profitability norm has a contrary negative effect. Thus, the effects of financialization cannot be determined a priori, because the impact on the demand system depends on the configuration specific to each economy, so that (a priori) countries where the financial system exerts favourable effects can coexist with others where a Fordist logic continues to prevail.

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Some financialized systems are unstable: a discussion of the model’s solutions 7 For the sake of simplicity, let us suppose that it is demand which limits the level of activity . . . since we are interested in short-term equilibrium. If, on the other hand, we were interested in dynamics, we would have to discuss the case where it is production capacity . . . which limits the level of activity. It is thus convenient to resolve the model by supposing that equilibrium results from two intersecting determinations. On the one hand, what is the effective demand for an actual, given aggregate wage? . . . On the other hand, what is the level of aggregate wages for a given level of demand and a profitability requirement by the financial markets? . . . Four configurations appear, created by the demand system, since the wage determination system is assumed to be constant.

• •

A financialized Fordist configuration: where raising the profitability norm has a negative impact both for employees and for the economy as a whole. Both the demand system and the remuneration system suffer the unfavourable consequences of this rise. . . . A fully financialized system: where a rise in the profit required has a generally favourable effect on the level of activity, but not necessarily on earned income.

In the second case, demand changes favourably, but the rationalization implied by the increase in the profitability requirement has to be taken into account. As a result, employees do indeed benefit from the growth in demand, but can be penalized if the effects of reductions within the wage-earning sector prevail. Contrary to what is implied in a single demand system, employees can be losers in the financialization game, while the economy as a whole can attain a higher equilibrium. . . .

• •

A third configuration describes a ‘hybrid’ financial system in which the accelerator effects are not sufficient to bring about any growth in demand, but (in contrast) financialization plays a full role with regard to consumption behaviour. Thus an increase in the profitability norm leads to a reduction in the aggregate wages of employees and has ambiguous effects on the level of activity . . . A final possibility is a paradoxical wage system. The force of the accelerator effects allows the increase in the profitability norm to have a positive effect on demand but an ambiguous one on wages. . . .

However, beyond these variable configurations, one general and essential result holds for all the systems. Contemporary political programmes often connect the development of employee savings in shares and bonds with a necessary increased flexibility of employees’ remuneration. This is, moreover, often due to the weak bargaining power of the employees and their representatives. . . .

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Result 3: The various configurations are valid only if the wage relation is not too competitive, that is to say, the employees’ real wages are not strongly determined by the trend of demand. This result also applies to the wealthbased financial system. However, analysis of the four configurations produces three more results. Result 4: In each case, there is a threshold for the profitability demanded by the financial markets: a higher limit if the accelerator effects of the investment are weak and, conversely, a lower limit if they are strong. Thus a limit on the power of the financial markets is apparent; a limit which, if not respected, will introduce a series of unhealthy macro-economic effects (disequilibrium or instability, see below). Result 5: A wage claim which raises remuneration exogenously has a positive effect on macro-economic activity only if, provided the requirement for stability is met, there is either a characteristically Fordist or a paradoxical wage configuration. A final lesson concerns the development of the various configurations and their stability if we vary the parameters characterizing financialization, increased β and Tobin ratio with low interest rates. . . . Result 6: The development of the financial markets mechanically extends the wealth-based zone but at the same time takes the economy closer to the zone of structural instability. There is thus a threshold above which financialization destabilizes macro-economic equilibrium. This result is especially important for interpreting the contemporary situation. The South Asian crises have focused the attention on the mismanagement and bad supervision of the banking and financial system of Korea, Indonesia and Thailand (Krugman 1998), but not of Taiwan or Hong Kong. By way of contrast, the American system displays sophisticated management techniques and supervision and this may give a false feeling of security, especially after a one year ‘flight of quality’ to the Wall Street market. But the model suggests that there is a strong potential for a major financial crisis within the US, precisely because they are at the forefront of a financialized economy. And it has to be remembered that any effective financial regulatory system tends to divert innovation into new forms of risk taking with the potential for generating unexpected new forms of financial crisis (Caprio 1999). This is the issue of systemic risk (Aglietta et al. 1995).

What kind of monetary policies can stabilize a wealth-based system? 8 The assumption that the interest rate is exogenous can now be relaxed and we can then consider the stabilizing or destabilizing effects of a monetary policy

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whose sole objective would be to stabilize the value of financial assets related to income. . . . It would seem that monetary policy is a stabilizing factor only if the Central Bank has suitable reaction speed values when a speculative bubble appears . . . which produces a final result: Result 7: To stabilize a financial system, it is important for the Central Bank to react sufficiently quickly to prevent financial bubbles from bursting. [. . . .] The question now is: under what conditions can Alan Greenspan get on with, what the financial press perceives as, the difficult but necessary task of preventing the financialized economy from being trapped by a financial bubble (The Economist 1999: 15–16)? If, during the Golden Age, the central bankers tended to be captured by governments in charge of managing the Fordist capital labour compromise, in the 1990s and probably the first decade of the twenty-first century, central bankers may become the hostage of big internationalized finance as they cope with the risk of financial systemic crises. Each institutional configuration calls for a definite economic policy style, a rather useful teaching from ‘régulation’ theory (Lordon 1999). A finance-led regime is not at all a minor variant on a Fordist regime and the management of the central bank must be very different. [. . . .]

Conclusion 9 For the time being, the model sketched in this article aims only to provide a cognitive map and a simple representation of a highly complex process. The reader is offered three provisional conclusions:

•

•

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Contrary to a widely diffused belief, the main source of major financial crises may not be NICs that suffer from bad financial and banking supervision and weak surveillance from international organizations. . . . Thus, a major lesson of the model is that the major current risks seem to be observed in the US. The more extended the impact of finance over corporate governance, household behaviour, labour-market management and economic policy, the more likely is an equity-based regime to cross the zone of structural stability. The next act of the financial drama may well start on Wall Street! Outside the US, many governments may be tempted to import quickly the core institution of an equity-based economy, which in turn requires the adoption of the range of institutions that are typical of a market-led capitalism. If they hope that their economy will earn the same returns as the US or UK, this may involve a fallacy of composition. Of course, both these national economies are market led and strongly specialized in international financial intermediation, but the asymmetric role which the US and UK play in such a process of intermediation cannot be easily reproduced

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by simply importing labour-market flexibility, a slimming down of public expenditure and welfare. . . . The process of institutional hybridization seems much more promising. Finally, there are strong differences between the theory of an ideal and hypothetical equity-based regime and the historical evidence about the socalled American ‘new economy’. . . . The equity-based economy is the last and more recent stage of this process which took nearly a quarter of a century to affect the industrial, social and political structures of the US drastically. Consequently, it may be erroneous to attribute exclusively to finance all the interdependent and complementary transformations which took place in the hierarchy of institutional forms. The new economy is simultaneously more reactive to competition and product differentiation, based both on high tech and the extension of services to consumers, and, last but necessarily least, governed by the impact of the shareholder’s power and objectives.

It is especially difficult to combine theory and history. In the 1970s, early regulationist research took up this challenge when it tried to understand the emergence, rise and demise of the Fordist growth regime. For the first decade of the twenty-first century, the equity-based regime poses a similar challenge: when its success will unfold into a major structural crisis and that will be the starting point, form and diffusion of crisis.

References Aglietta, M. (1976) Régulation et Crises du Capitalisme, Paris: Calmann-Lévy. —— (1998) ‘Le capitalisme de demain’, Note de la fondation Saint-Simon 101 (November). —— and Mendelek, N. (1987) ‘Pourquoi et comment renouveler les objectifs et les règles du SME’, Économie et Prospective Internationale 32(4): 43–73. —— , Coudert, V. and Mojon, B. (1995) ‘Actifs patrimoniaux, crédits et économie réelle’, Cahiers économiques et monétaires, Paris: Banque de France. —— (1998) ‘Le capitalisme de demain’, Note de la fondation Saint-Simon 101 (November). Bertrand, H. (1983) ‘Accumulation, régulation, crise: un modèle sectionnel théorique et appliqué’, Revue Économique 34(6): 305–43. Boyer, R. (1988) ‘D’un krach boursier à l’autre: Irving FISHER revisité’, Revue Française d’Economie 3(3): 183–216. —— and Juillard, M. (1995) ‘Les États-Unis, adieu au fordisme!’, in R. Boyer and Y. Saillard (eds) Théorie de la régulation: L’état des savoirs, Paris: La Découverte. Caprio, G. (1999) ‘Beyond the capital ideals: restoring banking stability’, Washington, DC: World Bank mimeograph. The Economist (1999) ‘Trapped by the bubble’, 25 September: 15–16. Froud, J., Haslam, C., Johal, S., Leaver, A., Williams, J. and Williams, K. (1998) ‘Accumulation based on inequality: a Keynesian analysis of investment for shareholder value’, paper presented at the twentieth Conference of the International Working Party on Labour Market Segmentation, Arco/University of Trento, July.

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Kindleberger, C. (1978) Manias, Panics, and Crashes: A History of Financial Crises, New York: Basic Books. Krugman, P. (1998) ‘What happened to Asia?’, www.mit.edu/people/krugman/ index.html, January. Lordon, F. (1999) ‘Croyances économiques et pouvoir symbolique’, L’Année de la Régulation 3: 169–210. EDITORS’ NOTES 1 2

3

4 5 6

7 8 9

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Reprinted by permission of the publisher, Routledge, © 2000 Taylor and Francis. This extract of Boyer’s article excludes three sections in full: ‘What stylized facts can this model explain?’, ‘From theory to the empirical: is a financialized/equitybased economy plausible?’ and ‘Some theoretical requisites for a more satisfactory model’. These three sections are before the conclusion and discuss the empirical validity of Boyer’s macro-economic model of financialization and further theoretical adjustments to it. Other sections are abridged and the parts that are not included are mostly formal demonstrations of various aspects of the macroeconomic model. This section excludes a detailed survey on pages 113 and 116 of the contesting growth regimes after Fordism that are introduced in Table 1. Figures 1 and 2 (which present flow diagrams of the institutional conditions for Fordist and finance-led growth) are also excluded. This key section, which includes figure 3 with graphic illustration of the components of finance-led growth regime and their interrelationships, is included in its entirety. This extract of the section excludes pp. 123 and 124. Readers are referred to these pages for detailed explanations of the macro-economic model presented in table 2. The extract moves from p. 121 to p. 124 here. Pages 125 and 126, including Table 3, showing four possible scenarios of aggregate demand under different combinations of investment and wage behaviour and the accompanying formulaic demonstrations, are excluded. The extract of this section excludes Figures 4–7 on pp. 129–30 which show the equilibrium levels at four configurations considered in this section. Formulaic expression of the arguments of this section and Figure 8 (where the graphic illustration of the equilibrium levels in an IS-LM analysis) are excluded. The extract moves from p. 134 to p. 142. Readers are referred to the original article for the excluded sections entitled ‘What stylized facts can this model explain?’ and ‘From theory to the empirical: is a financialized/equity-based economy plausible?’ The latter section provides an econometric test of the macroeconomic model presented in the article by using data from the USA, UK, Canada, Japan, Germany and France. The econometric findings give paradoxical results like Japan coming out as a fully financialized economy. The following section entitled ‘Some theoretical requisites for a more satisfactory model’ then discusses theoretical improvements to the model. This section which is on pp. 140–2 is excluded from the extract.

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Chapter 10

Greta R. Krippner

ACCUMULATION AND THE PROFITS OF FINANCE

Introduction to extract from Greta R. Krippner (2005), ‘The financialization of the American economy’, Socio-Economic Review, 3(2): 173–208

EDITORS’ COMMENTARY Greta Krippner is an economic sociologist who has heeded Merton’s (1959) warning about the danger of developing elaborate explanations for imagined ‘pseudo facts’. Her aim is to offer a definition and measurement of financialization which will clarify the question of whether the US economy is financialized and when did it become so. She follows Arrighi (1994) in two key respects: first, she defines financialization as ‘a pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production’ (p. 174); second, she accepts the argument that the driver is declining profits in the non-financial sector which, under pressure of increased competition and labour militancy, ‘withdraws capital from production and diverts it to financial markets’ (p. 182). Krippner’s restatement of what could be considered as neo-Marxist orthodoxy is interesting because she carefully and explicitly justifies the definitional lens and then puts effort into constructing and presenting long-run time-series measures to produce empirics on the US economy which suggest financialization can be traced back for at least thirty years. As Krippner admits in her final call for more research, this aggregated macro evidence establishes little about corporate control mechanisms and drivers of finance. The first fundamental issue in Krippner’s article is the question of how to measure structural shifts in the US economy. Here she contrasts activity-based measures of employment using output and employment measures with accumulation-based measures from profit. The different metrics construct different fields of the visible: so

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that activity measures suggest a post-industrial world because they highlight the decline of manufacturing and growth of services; whereas profit measures suggest a financialized world because they highlight the dominance of finance and real estate (FIRE) income. Krippner prefers accumulation measures because she argues the goal of capitalist societies is to return a surplus to the owners of capital. This is coherent with classical political economy assumptions about the underlying logics of a capitalist system; but does not really engage with ideas about multiple logics and complex, interrelated developments in an economy where finance generates profit because it is not encumbered with labour costs. And as for the imperative requirement for profit, all capitalist enterprises must recover their costs but their apparent success or failure in doing so depends partly on accounting conventions. As Krippner recognizes, the changing and conventional basis for depreciation allowances or the calculations of corporate returns with or without cost of capital makes it possible to construct many different profit figures. But what are Krippner’s metrics and then what do the time series show? Krippner is concerned with two discrete measures from national income accounts. The first is the growing importance of portfolio income (interest, dividends, and capital gains) relative to corporate cash flow (profits plus depreciation allowances) for non-financial firms. The second is the growing importance of the financial sector as a source of profits for the economy, which she derives from national income and product accounts. The empirics then show that ratio of portfolio income to cash flow for non-financial firms was increasing from the early 1970s and that the increase was larger in the manufacturing sectors. The driver is not asset price bubbles or inflation in asset prices from the late 1980s onward, because the significant component of portfolio income was interest (not capital gains which merely held steady). In terms of the increasing weight and significance of the financial sector itself, Krippner highlights the growing importance of financial relative to that of non-financial profits and cash flow in the US since 1950, marking the beginning of the 1970s as the first wave, which then becomes more pronounced in the middle of the 1980s. Again objections are forestalled by arguing that such changes do not reflect reorganization and the changing boundaries of the firm after outsourcing, offshoring, or subsidiarization. The empirics about the growing weight of finance are striking and establish that many non-financial businesses have become corporate rentiers in our time. But that only raises questions about how this would appear in a broader historical perspective and, specifically, whether the weight of finance was unusually low in the 1950s and 1960s. Krippner herself cautions us not to see financialization as an entirely novel phase of capitalism, nor to assume the trends identified are permanent. Greta R. Krippner is currently Associate Professor of Sociology at the University of Michigan. She was selected for an award from the American Sociological Association (ASA) in 2004 for her PhD thesis The Fictitious Economy: Financialization, the State, and Contemporary Capitalism; a book based on this thesis will be published in 2008.

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REFERENCES Arrighi, G. (1994) The Long Twentieth Century: Money, Power and the Origins of Our Time, London: Verso. Merton, R. K. (1959) ‘Notes on problem-finding in sociology’, in R. Merton, L. Broom, and L. S. Cottrell, (eds), Sociology Today: Problems and Prospects, New York: Basic Books.

Two views of economic change 1, 2

T

H E P R I M A RY P U R P O S E O F this paper is to evaluate the evidence for the financialization of the American economy. Before turning to that task, I first want to motivate this endeavor by contrasting two views on economic change. The standard way of tracking long-term structural shifts in the basic composition of the economy has been to examine changes in employment or in the ‘contribution’ of different sectors to gross domestic product (GDP). This activity-centered view of economic change spans several generations of research, from early work on the rise of the service sector (Clark 1940), to Daniel Bell’s (1973) famous thesis on post-industrialism, to recent theorizations of the information economy (Castells 1996). By contrast, in this paper, I propose an accumulation-centered view of economic change, in which the focus is on where profits are generated in the economy. My objective in this section is to show how dramatically these two views diverge in terms of what they signal about the fundamental shifts that characterize the contemporary U.S. economy. I do so through a simple comparison of the picture of structural change in the economy that emerges from employment, GDP, and profit data. [. . . .] Employment data are the type of evidence most commonly marshaled in debates about how to characterize the nature of contemporary economic change. Because just three industries – manufacturing, FIRE,i and servicesii – account for most of the change in the sectoral composition of the economy over the last fifty years, I report only these three industries here. Figure 1 shows relative industry shares of total employment between 1950 and 2001.iii The steep decline of manufacturing is evident in this figure. Evident too is the stratospheric ascent of employment in services. But note that viewed through the lens of employment, finance is not particularly significant. FIRE is neither very large relative to other industries, nor does it register significant growth over the period. Thus, this evidence is consistent with an interpretation of recent developments in the economy as reflecting the rise of the service sector, post-industrialism, or (a little more tenuously) the information economy. These data do not point to financialization as an apt way of understanding economic change in recent decades. Another kind of evidence – less common than employment data – mobilized in debates about how to characterize the evolution of the economy in recent

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Figure 1 Relative industry shares of employment in US economy, 1950–2001

decades relies on shifts in the contribution of different sectors to GDP (e.g., Bell 1973). GDP is both a measure of what is produced and a measure of national income. . . . Thus, for purposes of this paper, GDP is a hybrid measure, reflecting both economic activity (output) and accumulation (the profit component of national income). Figure 2 shows relative industry shares of current-dollar GDP between 1950 and 2001.iv I again report data for only those three industries that account for most of the change in the sectoral composition of the economy. Like Figure 1, Figure 2 shows the decline in manufacturing over the postwar period. Similarly, the figure shows the dramatic growth of services, the largest industry in the economy on this measure. But now FIRE also appears as an industry in which significant growth has taken place over the postwar period. These data could be interpreted as supporting the rise of the service sector, post-industrialism, the information economy, and financialization. A third type of evidence for structural change in the economy is presented in Figure 3, which shows data on relative industry shares of corporate profits between 1950 and 2001 for manufacturing, FIRE, and services.v Profit data are considerably more volatile than employment data. Nevertheless, the picture of structural change in the economy that emerges is nearly the mirror image of the data presented in Figure 1, with the relative position of services and FIRE inverted. Again, the decline of manufacturing is dramatic in this figure. But now FIRE is the dominant sector of the economy, with services accounting for a relatively small share of total profits. This result is not in itself inconsistent with standard characterizations of economic change—finance is, after all, a service, and a rather information-intensive one at that. But it does suggest a different

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Figure 2 Relative industry shares of current-dollar GDP in US economy, 1950–2001

Figure 3 Relative industry shares of corporate profits in US economy, 1950–2001

emphasis. Rather than the rise of the service sector, post-industrialism, or the information economy, it is financialization that comes sharply into view when profit data rather than employment or GDP are the focus of analysis.

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Evidence for financialization In this section, I turn to a more systematic evaluation of the evidence for the financialization of the U.S. economy. It is first necessary to distinguish the concept of financialization as I use it here from various ways that the concept is deployed in related literatures. Numerous researchers have used the term in exploring various aspects of the rise of finance, but the literature on financialization is at present a bit of a free-for-all, lacking a cohesive view of what is to be explained. Some writers, for example, use the concept of financialization to refer to the ascendancy of ‘shareholder value’ as a mode of corporate governance (Froud et al. 2000; Lazonick and O’Sullivan 2000; Williams 2000). For other scholars, the concept references the growing dominance of the capital markets over systems of bank-based finance (Phillips 2002). A third view in the literature—harkening back to the beginning of the twentieth century (e.g., Hobson [1902] 1971; Hilferding [1910] 1981; Lenin [1916] 1988) – is that financialization reflects the increasing political and economic power of a rentier class (Duménil and Lévy 2002; Epstein and Jayadev forthcoming; Greider 1997). Finally, the term is sometimes used to describe the explosion of financial trading associated with the proliferation of new financial instruments (Phillips 1996). Here, I follow Arrighi (1994) in defining financialization as a pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production. One advantage of such a definition is that it is capable of encompassing alternative usages of the term: in a world where accumulation occurs predominantly through financial activities, one would expect systems of corporate governance to reflect the imperatives of financial markets. Similarly, one would expect that social actors occupying strategic positions vis-à-vis privileged sites of accumulation would accrue political and economic power. Finally, one would also expect a rapid pace of financial innovation, as well as financial flows that dwarf real economic activity. A related strength of this definition is that it lends itself to systematic empirical evaluation using some of the best data on the U.S. economy we have available—in particular, that provided by the National Income and Product Accounts, among other data sources.vi While long-term structural shifts in the economy are typically conceptualized in sectoral terms, an adequate understanding of financialization requires both a sectoral and an extra-sectoral perspective. The growing weight of finance in the economy is reflected in the expansion of banks, brokerage houses, finance companies, and the like, but equally it is reflected in the behavior of nonfinancial firms. In this regard, a number of researchers suggest that the origins of the current turn to finance can be found in the crisis of profitability that beset U.S. firms in the 1970s (e.g., Arrighi 1994; Fligstein 2001; Magdoff and Sweezy 1987). Confronted with labor militancy at home and increased international competition abroad, nonfinancial firms responded to falling returns on investment by withdrawing capital from production and diverting it to financial markets. Thus, an adequate conception of financialization must track the activities of both financial and nonfinancial firms. A purely sectoral approach that focuses only

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on the financial industry misses much of what is important in an account of the financialization of the U.S. economy. This paper uses two distinct measures to gauge financialization. First, I examine sources of revenue for nonfinancial firms, demonstrating the growing importance of ‘portfolio income’ (comprising income from interest payments, dividends, and capital gains on investments) relative to revenue generated by productive activities. Second, turning to a more traditional sectoral analysis, I examine the growing importance of the financial sector as a source of profits for the economy, comparing financial to nonfinancial profits. It should be noted that each of these measures has its own limitations, but taken together they provide what I will argue is persuasive evidence of the financialization of the American economy. Portfolio income One indication of financialization is the extent to which nonfinancial firms derive revenues from financial investments as opposed to productive activities. In the following analysis, I gauge the significance of financial revenues for nonfinancial firms by constructing a ratio comparing portfolio income to corporate cash flow. Portfolio income measures the total earnings accruing to nonfinancial firms from interest, dividends, and realized capital gains on investments. Corporate cash flow is comprised of profits plus depreciation allowances.vii Thus, the ratio of portfolio income to corporate cash flow reflects the relationship, for nonfinancial firms, between the return generated from financial versus productive activities.viii [Why use corporate cash flow rather than profits as a point of comparison to portfolio income? While it is a less intuitive measure, corporate cash flow unlike profit data effectively controls for the progressive liberalization of depreciation allowances over the postwar period.ix]3 Understanding why this is important requires a brief explanation of the concept of depreciation. Depreciation is based on the idea that capital is constantly being used up in the process of production. If a manufacturing firm uses a given piece of machinery for ten years, for example, then each year some of the value represented by the machine is depleted. The Internal Revenue Service (IRS) compensates for the value of the capital used up in production by allowing firms to subtract a depreciation allowance from their total earnings in order to calculate taxable profits. Yet while capital depreciates continually over the lifetime of capital, firms do not ‘pay’ the cost of depreciation continually, but only as capital is retired and replaced. Thus, in any given year, the total capital available to the firm consists of profits subject to tax plus depreciation allowances (which can be thought of as profits not subject to tax). . . . [In recent decades,] Congress has repeatedly mandated that the IRS shorten expected service lives—the length of time over which capital is assumed to wear out—as a means of encouraging business investment. This allows firms to depreciate investments more quickly and hence take larger deductions from earnings in order to calculate taxable profits.x The result is that, relative to the immediate postwar period, profits in more recent years are significantly understated in these data. Thus, in order to eliminate the possibility that an

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Figure 4 Ratio of portfolio income to cash flow for US non-financial corporations, 1950–2001

increasing ratio of portfolio income to profits could be an artifact of changes in the tax treatment of depreciation, I add depreciation allowances into profits to calculate corporate cash flow. Figure 4 shows the ratio of portfolio income to corporate cash flow among nonfinancial firms between 1950 and 2001.xi A five-year moving average is shown with the annual data. An increasing trend indicates a higher share of revenues coming from financial relative to nonfinancial sources of income and hence is consistent with a greater degree of financialization. The ratio is remarkably stable in the 1950s and 1960s, but begins to climb upward in the 1970s, and then increases sharply over the course of the 1980s. In the late 1980s, the ratio peaks at a level that is approximately five times the levels typical of the immediate postwar decades. The ratio retreats somewhat from the high levels obtained during the 1980s in the first half of the 1990s before recovering in the second half of the 1990s. While there is considerable volatility in the measure, what is most striking about the graph is the dramatic divergence in the structure of the economy between the immediate postwar period and the period beginning in the 1970s. Figure 5 presents these data disaggregated by manufacturing and nonmanufacturing sectors of the economy.xii For purposes of comparison, the data for all nonfinancial firms are also reported in Figure 5. The graph indicates that, beginning in the 1970s, manufacturing leads the trend in this measure for the nonfinancial economy as a whole. Given that increased labor militancy, intensified international competition, and declining profitability were especially

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Figure 5 Ratio of portfolio income to cash flow for US manufacturing and nonmanufacturing industries, 1950–2001

serious problems in the manufacturing sector during the 1970s (see Marglin and Schor 1990), we would expect to observe manufacturing firms relying on financial sources of income to a greater extent than nonfinancial firms as a whole in this period (cf., Arrighi 1994; Fligstein 2001; Magdoff and Sweezy 1987). While manufacturing subsequently staged something of a recovery from its dismal performance in the 1970s and the first half of the 1980s (Brenner 2002), the sector continues to lead the trend in the portfolio income measure through 2001, the last year for which data are available. This may reflect the extent to which firms in highly cyclical manufacturing industries increasingly depend on financial revenues to subsidize profits from productive enterprise.xiii Finally, Figure 6 breaks out the components of portfolio income, reporting the share of the total accounted for by each. It reveals that the upward surge in portfolio income in the last three decades was largely accounted for by increases in the interest component, rather than by capital gains, which merely held steady over the period, or dividends, which lost share relative to the other two components. Importantly, this result cautions against reducing financialization to developments in the stock market. While there clearly is a relationship between financialization and the bull market of the 1980s and 1990s, it is a more indirect one than is commonly assumed, at least as reflected by this measure.

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Figure 6 Share of total portfolio income accounted for by individual components for US non-financial corporations, 1950–2001

Financial and nonfinancial profits I have examined one measure of financialization that gauges the behavior of nonfinancial firms. Yet financialization should be reflected both in the behavior of nonfinancial firms and in the overall growth of profits in the financial sector. Thus, a second perspective on the process of financialization is sectoral in nature, comparing the profits generated in financial and nonfinancial sectors of the economy. This section argues that, above and beyond the increasing weight of financial activities in generating income streams for nonfinancial firms, the financial sector itself has become an increasingly privileged site of accumulation in the economy. I previewed the sectoral composition of profits for purposes of illustration earlier in the paper, but here it is necessary to be considerably more careful in how measures of profitability are constructed and interpreted. In particular, it is important to take into account some of the problems associated with depreciation already discussed in conjunction with the portfolio income measure. As noted, the liberalization of depreciation allowances in recent years results in profit figures that are artificially low relative to figures from the 1950s and 1960s. Even more troubling, depreciation allowances are not evenly distributed across firms, but will be highest for firms in capital-intensive industries, like manufacturing. Thus, these problems will bias a comparison of the financial and nonfinancial sectors, overstating the growth of financial relative to nonfinancial profits, especially in recent years. In short, corporate profit data present too favorable an estimate of financialization.

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One possible solution is to rely on corporate cash flow instead of profits, as I did when examining the portfolio income of nonfinancial firms. By adding depreciation allowances back into profit figures, such a measure eliminates the risk that financial profits appear high relative to nonfinancial profits solely as an artifact of the differential tax treatment of financial and nonfinancial firms. . . . [But] as proxy for accumulation, corporate cash flow data suffer from the opposite bias as that of corporate profit data. In particular, while liberalized depreciation allowances overstate true depreciation, true depreciation is not zero, and represents a cost borne by firms against profits. As before, this cost is not evenly distributed across firms, but will be highest in capital-intensive industries. Thus, corporate cash flow data produce an inflated estimate of profits in industries such as manufacturing, understating financial profits relative to nonfinancial profits. In sum, then, corporate cash flow data present too conservative an estimate of financialization. Since the flaws of these two measures are symmetrical and offsetting, we can be confident that the true, unobserved ratio of financial to nonfinancial profits lies somewhere in between the two measures. In Figure 7, I report both corporate profits and corporate cash flow as upper and lower bounds for financialization, respectively.xiv A five-year moving average is shown with the annual data; an upward trend in the ratio is consistent with greater degrees of financialization. On either measure, the ratio is relatively stable in the 1950s and 1960s but

Figure 7 Ratio of financial to non-financial profits and cash flow in US economy, 1950–2001

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becomes more volatile beginning in the 1970s. The ratio increases gradually in the 1970s, followed by a sharp upward surge during the ‘deal decade’ of the 1980s. The ratio then retreats somewhat in the first half of the 1990s, but subsequently recovers and supersedes even the soaring levels of the previous decade by the end of the 1990s. At its highest point at the end of the period, the ratio ranges (depending on which measure one follows) from approximately three to five times the levels typical of the 1950s and 1960s. [. . . .]

Discussion 4 The aim of this paper has been to suggest an alternative way of characterizing recent developments in the U.S. economy by substituting an accumulationcentered perspective for the more standard activity-centered view of economic change. The result of shifting our ‘lens’ in this way is that financialization— rather than the rise of the service economy or post-industrialism—emerges as the most important ‘fact’ about the economy. Such characterizations tend to be freely coined and even more freely used. Indeed, there is no shortage of labels to describe the nature of recent economic change: globalization, neo-liberalism, post-fordism, flexible specialization, the new economy and information age – among many others. Is it prudent to add financialization to a long list of such neologisms? In this regard, two features of this research program rescue it from mere label-mongering: 1) the exercise is grounded firmly (as firmly, I believe, as is possible, given data limitations) in empirical evidence; and 2) financialization proves to be a useful concept for working through a number of difficult theoretical problems. [. . . .] I now want to illustrate [this latter point] by providing two examples of longstanding debates in the social sciences where a view of economic change centered on accumulation suggests novel approaches to persistent questions. For the better part of a century, researchers have concerned themselves with the problem of who controls the modern corporation. Berle and Means’s (1932) famous thesis was that with the wide diffusion of stockownership, managers displaced owners at the helm of the economy. Such a development was considered progressive because managers were insulated from the most vicious social consequences of profit maximization—hence economic development assumed a more benign, if technocratic (e.g., Galbraith 1967), character. While early interventions in this debate were directed at discerning the continued presence of a unified capitalist class in control of the core functions of the modern economy (Domhoff 1967; Useem 1984; Zeitlin 1974), the implications of different forms of control for various aspects of corporate behavior quickly became a central focus of research. This literature rejected the simple distinction between owners and managers posed by Berle and Means (1932) to examine the control of nonfinancial corporations by banks and other financial institutions. . . . Methodological difficulties in establishing both control and its consequences

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are legion (see Zeitlin 1974), [however, with the result that the findings of] this research program have been somewhat inconclusive.xv One finding that is not inconclusive is that financial institutions sit at the center of the corporate network. An examination of interlock data reveals that banks are the most highly interlocked firms in the economy, meaning that shared directorships most often involve bank executives (see Mintz and Schwartz 1985). But, as Mizruchi (1996) acknowledges, it is not clear what these interlocks ‘do.’ Do nonfinancial corporations place financial directors on their boards in order to secure access to loan capital, as resource dependency theory suggests (Burt 1983; Pfeffer and Salancik 1978)? Or do bank directors sit on nonfinancial boards in order to monitor— and shape—the behavior of nonfinancial clients (Kotz 1978; Mintz and Schwartz 1985; Mizruchi and Sterns 1994a)? In short, who is controlling whom? Put differently, are interlocks cause or consequence of corporate strategy? Disagreement over such issues has continued without clear resolution (Mizruchi 1996). More recently, related questions have been posed in the literature on the rise of the ‘shareholder value’ model of the firm: has this strategy come from ‘inside’ nonfinancial corporations, initiated by management, or has it been imposed on nonfinancial firms by financial sector ‘outsiders’ (cf., Davis and Thompson 1994; Fligstein 2001; Zorn et al. 2004)? Part of the difficulty here reflects the fact that even where it is possible to detect relationships between financial and nonfinancial firms, instances of ‘control’ are often not directly observable (Mintz and Schwartz 1985). But the perspective on financialization outlined in this paper suggests that there may be other ways of making sense of corporate behavior. Indeed, one of the virtues of the financialization perspective is precisely that it attempts to transcend a purely sectoral understanding of the firm. In this sense, the position articulated here harkens back to the early twentieth-century literature on finance capital (Hobson [1902] 1971; Hilferding [1910] 1981; Lenin [1916] 1988). Rather than asserting bank dominance over industrial firms—as in much of the contemporary bank control literature—these early theorists of financialization emphasized the ‘union’ of industrial and financial capital in a ‘new social type’ [(see Zeitlin 1976: 900).]. . . . While evidence of financial control of nonfinancial corporations remains elusive, the increasing dependence of nonfinancial firms on financial activities as a source of revenue is critical for understanding the behavior of these firms. Indeed, the very elusiveness of the control debate reflects the fact that the distinction between forces operating ‘inside’ and ‘outside’ nonfinancial corporations is becoming increasingly arbitrary. Nonfinancial corporations are beginning to resemble financial corporations—in some cases, closely—and we need to take this insight to our studies of corporate behavior. While the data presented here indicate the broad relevance of this approach, aggregate-level data undoubtedly mask significant variation. Thus, firm-level research exploring how the financialization of nonfinancial corporations has changed corporate behavior is an important area for future work.xvi A second area of current research where financialization has important implications concerns the relationship between globalization and [transformations occurring in contemporary welfare states.]. . . .

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There is now a voluminous literature [exploring the implications of increased international economic integration for] welfare state retrenchment.xvii [Early contributions to this literature followed the wider debate on globalization by arguing either for an unequivocal loss of state power in the face of increased capital mobility or suggesting that such a development was pure hyperbole. In recent years, however, researchers associated with one or the other ‘side’ of this debate have tempered their views by conceding that international economic integration has occurred, but that it is more limited than is typically implied, and that its effects are often quite complex.]5 Swank (2002), [for example], argues that international capital mobility has the potential to exert pressure on the welfare state, but such pressure is mediated in [a variety of] ways through domestic political institutions . . . Huber and Stephens (2001) suggest that international capital mobility [weakens the welfare state but that this effect is indirect; by undermining the effectiveness of state economic management, globalization produces strains on the revenue base that funds social provision.] Hicks (1999) finds that the relationship between globalization and welfare state retrenchment is nonlinear in nature: increases in foreign direct investment are associated with an acceleration of welfare state spending up to a certain threshold, and beyond that threshold a deceleration. Hicks (1999: 212) explains this result by suggesting that increased openness generates demands from citizens for ‘protection’ from the vicissitudes of international markets (cf., Garrett 1998), but too much openness may embolden business interests, constraining the ability of the state to respond to such demands. This research represents a welcome attempt to soften the terms of a polarizing debate, but these researchers still must deal with [a basic problem]. . . . How do these scholars square what they acknowledge to be a modest degree of international economic integration with such significant, albeit indirect, effects on state structure? In this regard, another way around the impasse in the globalization literature is to examine contemporary welfare state transformations through the lens of financialization (see Arrighi and Silver 1999). For although only a relatively small share of U.S. firms participate to any significant degree in the global economy, the growing importance for nonfinancial firms of financial sources of revenue documented in this paper extends very broadly across the economy, and may be the functional equivalent of international capital mobility. That is, because financialization has lessened the dependence of nonfinancial firms on productive activities, it may have also reduced the dependence of these firms on their (domestic) workforces, in much the same way as is supposed to have occurred via placements of capital offshore. The point should not be overstated—production is of course still occurring in the American economy and to imply that it is somehow unimportant to nonfinancial firms would represent a gross exaggeration. But, at the same time, it is not hard to envision how processes associated with financialization might have eroded the ‘social pact’ between capital and labor that provided crucial support for the welfare state during much of the postwar period—even, perhaps, more effectively than capital mobility per se (Silver 2003; Silver and Arrighi 2001). Whether or not detailed empirical research actually bears out this thesis, we must conclude that, alongside investigations of its role in shifting centers of corporate control,

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financialization also promises new insights into the relationship between globalization and the state. Why not proceed directly to such topics – of obvious social and political interest – rather than labor over the data on corporate profits, an exercise that at first glance seems somewhat removed from more pressing tasks? In closing, it is worth recalling Merton’s (1959) famous observation that before social facts can explained it is important to establish that they are indeed ‘facts.’ As Merton wrote, ‘In sociology as in other disciplines, pseudofacts have a way of inducing pseudoproblems, which cannot be resolved because matters are not as they purport to be’ (1959, p. xv). If financialization is to make an appearance in the major social science debates of the day—as is already occurring, and will no doubt continue to occur—we must first establish its existence, as well as develop more precise knowledge of its timing and magnitude, through careful empirical work. In such an endeavor rests the principal contribution of this paper.

Author’s notes i ii

iii iv v vi vii

viii

ix x xi

xii xiii xiv xv

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FIRE is the industry group comprised by finance, insurance, and real estate. To avoid confusion, here and throughout I refer to the broader category of industries comprising the service sector (public utilities, transport, communications, wholesale, retail, FIRE, and services) as the service sector, the service economy, or service industries, while referring to the narrower industry simply as services. Data on full-time equivalent employees are from the National Income and Product Accounts, Table 6.5. Data on industry contributions to current-dollar GDP are from the BEA’s Gross Product Originating series. Data on corporate profits by industry are from the BEA’s Gross Product Originating series. Here and throughout the paper, profits are reported before taxes and dividends are paid. See Krippner (2005) for a detailed discussion of the data sources used in this paper. Typically, accountants report corporate cash flow net of dividends and income taxes (i.e., cash flow = retained earnings + depreciation allowances). Since I am primarily interested in the generation of surplus rather than its distribution, I report cash flow before taxes and dividends have been paid. One important adjustment made to the profit data in constructing this measure should be noted. While interest income is a component of corporate profits in the National Income and Product Accounts, I remove interest income from the profit concept used here so that the corporate cash flow measure exclusively reflects nonfinancial sources of income. The argument here closely follows Fred Block’s (1990) unpublished investigation of depreciation and national income accounting. See Krippner (2005) for details. Data on portfolio income are from the IRS, Statistics of Income, Corporation Income Tax Returns. Data on corporate profits are from the National Income and Product Accounts, Table 6.16. Data on depreciation allowances are from the National Income and Product Accounts, Table 6.22. Data sources are the same as for Figure 4. This phenomenon is well documented with respect to the auto industry. See Froud et al. (2002; cf., Hakim 2004). Data on corporate profits and depreciation allowances are from the BEA’s Gross Product Originating series. See Fligstein (2001), Mizruchi (1996), Mizruchi and Stearns (1994b), and Stinchcombe (1990) for sharply contrasting views of what this literature has accomplished.

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3 4

5

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Reprinted by permission of the publisher, Oxford University Press. © Oxford University Press and the Society for the Advancement of Socio-Economics 2005. This extract is the author’s own edited version and excludes section 1, ‘Introduction’, and sections 4 and 5, entitled ‘Financialization and the reorganization of corporate activity’ and ‘Financialization and the globalization of production’ respectively. Section 4 considers the effects of outsourcing and subsidiary formation on the measurement of financialization. Section 5 discusses whether it is possible to interpret the findings of the paper as globalization of production in the US economy rather than financialization. In the extract, the author’s own notes are presented as endnotes. This paragraph in the author’s shorter version for this book replaces the original paragraph on p. 183. The extract here moves from p. 188 to p. 198, leaving out sections 4 and 5, entitled ‘Financialization and the reorganization of corporate activity’ and ‘Financialization and the globalization of production’ respectively. In the original paper this section is entitled ‘Conclusion’. Here the author’s shorter version differs in expression from the original on p. 203.

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Chapter 11

Engelbert Stockhammer

FINANCIALIZATION AND THE SLOWDOWN OF ACCUMULATION

Introduction to extract from Engelbert Stockhammer (2004), ‘Financialization and the slowdown of accumulation’, Cambridge Journal of Economics, 28 (5): 719–41

EDITORS’ COMMENTARY In this extract the focus is on whether and how the rise in investment in financial assets has adverse effects on the accumulation of physical capital and hence an impact on growth rates. The question of accumulation is here posed not in a Marxist but a post-Keynesian framework. In general terms, the post-Keynesians reject the mainstream assimilation of Keynes into economics which retains neoclassical maximizing and general equilibrium assumptions; instead post-Keynesians point to the complications introduced by uncertainty, historical time, and money which lead to a continuing interest in macro-economics. Hence Engelbert Stockhammer’s interest in macro-economic modelling and empirical tests of changes, which are defined by reference to managerial theories of the firm. Unlike much of the current generation of economists, Stockhammer reads widely outside economics and knows there is no agreed definition of financialization, but brings his knowledge from the ‘shareholder value’ debates of the 1990s into the construction of econometric models and empirical testing. Stockhammer’s micro-economic starting point is the managerial theory of the firm by authors like Galbraith (1967), which he represents as part of a post-Keynesian attack on the (profit) maximizing postulates of mainstream theory. As he notes, managerial theorists of the firm had hypothesized that management control led to a preference for growth of the firm. But, in his view, the managerial theory of the firm is not a universal ahistoric theory, but, rather, is specific to the particular period of

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engelbert stockhammer

the long post-war boom and, therefore, in need of updating so as to take account of the changed ‘growth–profit trade-off’ (p. 725) of managers who have been pressed to deliver shareholder value since the 1980s. While the idea of a historically-sensitive and context-specific theory of the firm is attractive, it does of course pose problems about the choice of hypothesis for testing, because scholars operating outside economics disagree about what is going on in present-day capitalism. For example, in the late 1990s debate about shareholder value, Lazonoick and O’Sullivan (2000) emphasized how US management had ‘downsized and distributed’ while others such as Froud et al. (2000) emphasized that higher profitability was generally an unrealizable and utopian objective. Stockhammer’s macro-economic response is to clarify management’s behavioural shift by constructing an econometric model whose equations formally specify the relations between variables; the model is then run using OECD data on four countries (France, Germany, UK, and USA), so that Stockhammer can finally produce regressions which provide empirically-based evidence on whether and how the growth–profit tradeoff has changed. The model requires Stockhammer to estimate an investment function and control for other relevant variables. This investment function includes as an indicator of financialization, ‘the rentiers share of non financial business’ (p. 729) or the interest and dividend incomes of the non-financial sector divided by its value added. The construction and adjustment of the model is then a technical task which can only be appreciated and criticized by other economists, though outsiders can understand the empirical results obtained. As we have already noted in the introduction to this section, the regressions show there is a statistically significant positive correlation at the general level between more financialization and less growth but, if we consider country cases, the results are mixed and untidy. For example, financialization (defined as a rise in the rentiers’ share) explains the slowdown in accumulation in France and the USA but not in the UK or Germany. This raises an important question of whether financialization is a historical process with invariant results in all capitalist countries. Much of the discussion of financialization in the political economy literature has a US-focus and Stockhammer’s empirical analysis is interesting and relevant not least because it explicitly identifies national trajectories and variation and encourages further work from a variety of approaches that recognizes and explores such differences. Engelbert Stockhammer is Assistant Professor in the Department of Economics at the Vienna University of Economics and Business Administration. He has published a number of papers in journals (see, for example, Stockhammer 2005, 2007) and a book, The Rise of Unemployment in Europe. A Keynesian Approach (2004).

REFERENCES Froud, J., Haslam, C., Johal, S. and Williams, K. (2000) ‘Shareholder value and financialisation: consultancy promises, management moves’, Economy and Society, 29 (1): 80–120.

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Galbraith, J. K. (1967) The New Industrial State, New York: New American Library. Lazonick, W. and O’Sullivan, M. (2000) ‘Maximising shareholder value: a new ideology for corporate governance’, Economy and Society, 29 (1): 13–35. Stockhammer, E. (2005) ‘Shareholder value-orientation and the investment-profit puzzle’, Journal of Post-Keynesian Economics, 28 (2): 193–216. Stockhammer, E. (2007) ‘Uncertainty, class and power’, International Journal of Political Economy, 35 (4): 29–45.

1. Financialization 1, 2

F

term to capture transformations within the financial sector as well as in the relation between the financial sector and other economic sectors. There is no agreed upon definition since it includes phenomena ranging from the globalization of financial markets, the shareholder revolution and the rise of incomes from financial investment. Moreover, there are various disciplines that have made contributions to the debate. In this section no exhaustive overview of the literature is given, or indeed possible, but three core areas of debate around financialization are identified to situate the argument developed below. Finally, some stylized facts on the countries under investigation in the empirical part will be summarized. [. . . .] In what follows a theory of the effect of financialization on the investment behavior of non-financial businesses will be proposed. Financialization will be defined as the engagement of non-financial businesses on financial markets. These financial activities are interpreted as reflecting a shift in the firm’s objectives and a rising influence of shareholder interests in the firm. Thus a narrow concept of financialization is used that has the advantage of allowing us to derive a testable hypothesis. The argument is based on the post-Keynesian theory of investment, which for our purposes has to be developed further. To do so we draw on all three of the above discussions. We take qualitative changes highlighted in the corporate governance literature as our starting point and derive a specific quantitative hypothesis on investment behavior. Thus we complement the macroeconomic discussion that so far did not have much to say on investment. In constructing our indicator for financialization we draw on the literature on corporate finance. To conclude the discussion on the notion of financialization some stylized findings on the extent to which the phenomenon has occurred in the USA, UK, France and Germany will be given. . . . I N A N C I A L I Z AT I O N I S A R E C E N T

2. Class analysis Classes, or preferably class positions, can be defined with respect to the type of income received, the role in the production process and the political process. We

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will focus on the first dimension and merely note the other two dimensions briefly. With respect to types of income, we distinguish three income classes: recipients of wages, recipients of profits and recipients of interest payments, dividends and rents. To these income categories three social categories correspond: workers, (industrial) capitalists and rentiers. In the production process capitalists wield power, as they control and organize production, whereas workers perform the work. Rentiers, as absentee owners, play no role in the production process, but provide the initial finance to start the business and receive part of the surplus as distributed profits. [. . . .] Note that we have defined class with respect to a type of income received. Therefore, any individual and even groups of individuals will occupy multiple class positions if they receive different types of income (as most people in fact do) (this fact is well known and debated among Marxists, e.g. Resnick and Wolff 1987, Wright 1985). Moreover, the ‘industrial capitalist’ is an abstract category that, at least in modern capitalism, does not exist as such. The capitalist is defined by virtue of receiving profit income, part of which will be distributed as dividends or interest payments to rentiers. Any real life capitalist will therefore have a double position: as the capitalist during the day making decisions concerning the firm, and as a rentier in the evening and on weekends living off the income distributed to the owner of the firm. The classification becomes even more complex for modern day managers, who take the role of capitalists in terms of exerting power in the firm and making decisions e.g. concerning investment expenditures, but typically receive wage income and, more importantly now, receive rentiers income, often in the form of stock options. Managers therefore have multiple, at times even contradictory, class positions. Their interests and preferences hence depend strongly on the institutional setting of the economy, or more specifically the firm. The classification of present day rentiers has become seemingly easier as pension funds and investment funds have become institutional representations of previously decentralized savings. However, this simplicity is deceptive. First, in the above outline of class theory the income streams corresponding to classes were emphasized. Today’s rentiers however may be as much concerned about the valuation of existing assets (and consequently capital gains) as they are about income. Second, while pension and investment funds may constitute the most conspicuous form of rentiers, they are not the only form and there is no reason to presume that other actors may not pursue rentiers activities. Indeed, rentier activities and interests of non-financial businesses are at the core of the argument developed below.

3. The post-Keynesian theory of the firm What distinguishes the post-Keynesian approach to the firm from the simple version of the neo-classical approach is that the goal of the firm is not simply taken to be profit maximization. This is a difference that may disappear in more sophisticated neo-classical models. The entire argument presented here

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can be reformulated in a neo-classical model, i.e. assuming utility maximizing individuals. Our presentation will proceed along these lines. Post-Keynesians are readily willing to accept that there are more goals to a capitalist firm than the maximization of profits: the growth of the firm, the expansion of its market share, exerting power over its workers or suppliers and so on. The specific goal, or the weight of these goals, will depend on the specific institutional setting of the firm and the economy. In contemporary capitalism the pursuit of growth is regarded as the major aim of firms, which stems from the analysis of managerial capitalism. Developed by Galbraith (1967) and Eichner (1976), and summarized neatly by Lavoie (1992), post-Keynesians have a well elaborated theory of the firm in the age of managerial capitalism, but have done little to adapt this theory to contemporary changes in corporate governance. We will propose a way to do so in the next section. . . . Let us now formalize the argument. We assume that the only two variables, growth and profits, enter management’s and the owners’ utility functions. Further we assume that management only cares about growth and owners only care about profits. Thus we get the following utility functions UM and UO, for mangers and owners respectively. UM = U (g) UO = U (r) where g is the investment or growth of the firm and r the profit rate. Obviously this crude simplification is made for the sake of clarity of the argument rather than for realism. What is needed for the argument developed is that management cares more about growth than owners. Two points need clarification. Firstly, it is frequently argued that financial markets, here equivalent to owners, have a shorter time horizon than society or even banks (e.g. Schaberg 1999). They are interested in short-run returns and thus underinvest in long-run projects, thus harming the growth perspectives of the economy. In particular it has been argued that bank-based financial systems will exhibit higher growth rates than market-based financial systems. Such an argument about different time horizons is complementary to our story, and indeed strengthens it. However, our model does not rely on the assumption of different time horizons, and emphasizes differences in interests rather than in time horizons. Secondly, there may be many more things that management and owners could care about. One of them has gained prominence during the stock market boom of the 1980s and 90s: capital gains. Asset prices though not a decision variable of the fim have become a target for firms’ behaviour in their quest to create shareholder value. It will be argued in section 4 that the pursuit of shareholder value is equivalent to giving a higher weight to profits in the simple objective function of the firms to be discussed. To analyze the actual levels of growth and profits chosen, one has to take into account the constraints the firm faces. The two constraints discussed by post-Keynesians are: the finance constraint and the profit–growth trade-off. . . .

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For simplicity assume that banks give loans as a multiple of the profit earned last year. From this it follows that we can write the amount of investment feasible for a firm as a function of profits. finance constraint:

gFC ≤ g(r)

with g' > 0

Finance is limited by profits minus dividends paid, i.e. retained earnings, and outside finance which is a positive function of profits. Note that this constraint need not be binding. It tells how much the firm can possibly invest, not necessarily how much it will invest. The second fundamental constraint is the growth–profit trade-off. It is assumed that there is some relevant region where an increase in investment does harm future profits (the fact that current distributed profits and current investment expenditures are inversely related is trivial). This can be argued by start up costs of investment or by increasing managerial costs of fast growth (known as Penrose effect). Though it may not be obvious that growth harms profits, postKeynesians and recent literature on shareholder value agree . . . To be fair, this is not the only manifestation given, but the existence such a trade-off is obviously implied. More formally, with standard cost functions profitability will be concave in investment. Thus, above the profit-maximizing level of investment, a trade-off will exist. The assertion here is that management will choose a point in this region, thus the trade-off exists. Accepting the trade-off, we get profits as a function of investment: profit-growth trade-off:

rRG = r (g)

with r' < 0

Again this is a constraint that need not be binding, but if the only variables that matter to management are growth and profits, as we assume below, then the firm will choose a point inside the constraint only by mistake. In Figure 1 management’s indifference curve is horizontal (UM), whereas that of owners’ is vertical (UO). Taking the finance constraint and the growth profittrade off, the growth rate desired by management will in general not be feasible.

Figure 1 Preferences and constraints in a managerial firm (MF)

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Thus the finance constraint is binding. The actual growth and profit combination chosen will thus be what we designated as rMF and gMF. The post-Keynesian model has been taken as an ahistoric model of the firm by some authors. While Eichner and Galbraith emphasize the separation of ownership and control, Lavoie argues that ‘that there is no need to emphasize that divorce. Whether the owners are still in control or not is irrelevant: those individuals taking decisions within the firm are in search of power; and their behavior and motivations will reflect that fundamental fact.’ (Lavoie 1992, 101). This pursuit of power can only be successful if the firm is big, thus the unambiguous goal of growth. We disagree with this position, emphasizing the need to regard this model of the firm as the result of specific historic circumstances. The class perspective outlined above indicates that managers occupy a complex position with potentially contradictory interests. Therefore it is impossible to define their interests without reference to institutions. Furthermore, rentiers are underestimated in the managerial model. Rentiers are easily satisfied in this model: . . . Again, we insist that rentiers are unlikely to content themselves to such a passive role voluntarily. Rather it is specific historic circumstances of the Golden Age regime where an interventionist state purposefully restricted the role of finance.

4. Financialization and management priorities In the course of the 1970s two institutional changes occurred that helped to align management’s interests with shareholders’ interests: the development of new financial instruments that allowed hostile take-overs and changes in the pay structure of managers. Among the former were tender offers and junk bonds (Baker and Smith 1998), among the latter were performance related pay schemes and stock options (Lazonick and O’Sullivan 2000). The former play the role of the stick, the latter is the carrot. Both have proven fairly effective in making management adopt shareholders’ priorities and ‘profoundly altered patterns of managerial power and behavior’ (Baker and Smith 1998, 3). [. . . .] While there may be little disagreement that changes in corporate governance have occurred, it may be less clear what modern owners want. In their present institutional incarnation as pension or investment funds rentiers may well care more about capital gains, i.e. asset prices, than about profits. Though obviously not a choice variable of the firm, asset prices have indeed become a target of firms, which engage in activities ranging from installing departments of investor relations to share buy backs in order to influence stock prices. However, it has become painfully clear over the past two years that asset prices are notoriously hard to predict let alone influence. Overall, it is clear that in the simple model proposed asset prices as a target side with profits. First, if valued by fundamentals an asset price equals the discounted expected profit (or dividend) stream. Second, there is a clear correlation between asset prices and profits as witnessed by the shivers profit warnings send thorough stock markets. Third, the

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bias against growth is testified by the positive correlation of asset prices and reduction in force, i.e. firing, announcements (Farber and Hallock 1999). In the model proposed an increase in the shareholder power translates into the following: Management has an ambiguous class position and its interests are therefore sensitive to institutional changes. Changes in the pay structure as well as the threat of hostile take-overs will make it adopt shareholders’ preferences. In the figure above management’s utility function will rotate (U’ instead of U, see Figure 2) The new growth–profit combination chosen by the shareholder dominated firm will exhibit higher profits and lower growth (rSDF and gSDF in Figure 2). In the extreme case of perfect assimilation of managers by shareholders, they will adopt a vertical indifference curve and chose the profit maximizing point. In the new optimal point the finance constraint is not binding. Firms could grow faster, given their access to finance, but they choose not to because that would reduce profitability. If our story were true, one would expect that managers and consequently non-financial businesses identify increasingly as rentiers and hence will also behave as such. We would expect higher dividend payout, lower growth and more financial investment of non-financial businesses. Note that our story avoids assigning the active role exclusively to rentiers and financial markets. Given the ambiguous class positions of management they may, after initial changes, actively promote and further the shareholder value orientation, as noticed by Lazonick and O’Sullivan (2000) and Jürgens, Naumann and Rupp (2000). It is of course difficult to operationalize the concept of financialization for quantitative research. The interest and dividend income, for short: rentiers’ income, of non-financial businesses will be used as a proxy for financialization. This measure does correspond to the income related definition of class. It measures to what extent non-financial businesses have acquired rentier status, and, as has been argued, the hypothesis is that this corresponds to a change in management priorities. This measure obviously also has shortcomings. First, it is an indirect measure, a proxy, because we cannot measure the changes in man-

Figure 2 Preferences and constraints in the shareholder dominated firm (SDF)

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agement priorities directly, instead we look at a measure that, in our hypothesis, is itself a result of the change in attitudes. Second, rentiers’ income may rise because interest rates or dividend payout ratios have risen or because more financial investment has been undertaken. Thus we cannot distinguish between additional income due to changes in management priorities or due to changes in rates of return. In the econometric analysis this problem is countered by including interest rates in the regression, thus controlling for one important measure of financial rates of return.

5. The regression specification The hypothesis of this paper is that financialization contributed to the slowdown in accumulation since the Golden Age. As we have argued above, management adopted the preferences of rentiers in the process of institutional changes of financialization. The consequence of this is that management and thus nonfinancial business should become more rentiers-like, which among other things, means that they have less growth oriented priorities and invest in financial markets. [. . . .] To get from the microeconomic theory proposed to a macroeconomic test the implicit assumption of a representative firm is made. Since this assumption is debatable, two comments are in place. First, while the assumption of a representative firm is used, the model fundamentally differs from representative agent models because the assumption of homogenous firms is essentially used to highlight the role of different actors and their contradicting interests. Second, empirically the question is how good an approximation this assumption is with respect to the problem at hand. Since the argument presented is centered around the adoption of shareholder value and the corresponding changes in corporate governance, it refers to listed companies, i.e. large corporations. A huge number of firms are, or course, small and medium enterprises that are not listed and to which our argument has little relevance. Thus in the empirical test we really test a dual hypothesis: first, that the behavioral changes took place as suggested in the corporate sector; second, that the corporate sector is big enough to make a difference in the macroeconomic data. Thus we estimate an investment function controlling for standard variables and include a proxy for financialization. The theory part provides the analytical basis for adding the financialization variable. As an indicator for financialization we will use the interest and dividend income of the non-financial business sector divided by its value added, or, as we will henceforth say, the ‘rentiers’ share of non-financial businesses’ (RSNF). The numerator of this expression captures the rentiers’ income. Note that the ‘rentiers’ share of the non-financial business sectors’ measures the receipts from financial investment rather than financial investment itself. It is derived from the National Accounts and thus a flow magnitude that does not include revaluation of assets. To isolate the effect of financialization on investment we control for other variables that effect investment decisions. Thus we include an accelerator term, a

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profit term and a term for the relative cost of capital as the standard variables in the literature (see Meyer and Kuh 1957; Jorgenson 1971; and Chirinko 1993, as surveys). Our investment equation thus is: ACCU = f(CAPUT, PS, CC; RSNF )

(1)

with the expected signs being: fCAPUT > 0, fPS > 0, fCC < 0, fRSNF < 0 where ACCU CAPUT PS CC RSNF

accumulation capacity utilization profit share relative cost of capital rentiers’ share of non-financial businesses

[. . . .] We expect higher rentiers’ income of non-financial businesses to have a negative effect on their accumulation. Note that this is in contrast to the argument of firms being finance constrained as well as to the argument that financial investment by firms will overall increase efficiency. According to the first argument the effect should be positive, rentiers’ income is still income, after all. According to the second argument we expect a positive effect (if firms that previously had no finance now have access to finance) or no effect (if only the allocation of investment is effected). However, we argue that this type of income is an expression of the financialization and thus has a negative effect on the desired rate of growth.

6. Data sources and econometric issues The rate of growth of the capital stock (ACCU) is the growth rate of gross business capital stock. The profit share (PS) is gross profit share in the business sector and capacity utilization (CAPUT) is the detrended capital productivity in the business sector. The data are from the OECD Economic Outlook data set. The cost of capital measure is the (short-term) interest rate times the price index of investment goods divided by the wage costs per worker (all from the OECD Economic Outlook data set). The ‘rentiers’ share of the non-financial business sector’ (RSNF) is the interest and dividend income received by non-financial businesses divided by their value added. The data were extracted from the Detailed Tables of the OECD National Accounts. Unfortunately the calculation of these series is possible only for a few countries. Furthermore, the time periods for which we were able to compile the data, differ across countries. Plots of ACCU and RSNF can be found in Figure 3. [. . . .]

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Figure 3 Accumulation (ACCU) rentiers’ share of non-financial businesses (RSNF) Note: Suffixes D, F, UK and US denote Germany, France, UK and USA respectively.

8. Interpretation and comparisons with other investment studies 3 We note the following pattern regarding countries: Germany conforms to the standard model of investment: capacity, profits and the cost of capital are statistically significant, our variable of financialization is not. In France the profit share and the rentiers’ share of non-financial businesses are consistently significant. In the UK capacity utilization is significant, and depending on the specification, the RSNF is too. In particular, including CC in differences rather than levels has an adverse effect on the significance of RSNF. In the USA, RSNF is the only consistently significant variable, the profit share is sometimes. Are these findings consistent with our story on financialization? The lack of significance for Germany certainly is, since the literature regards Germany as a late comer in the development of shareholder value and our time series for Germany ends in 1990 (to avoid the statistical problems of unification). Our tests can hardly be conclusive of our hypothesis that financialization has caused a reduction in accumulation rates, but they certainly provide strong initial support. . . .

9. The economic significance of financialization . . . To what extent can we explain the slowdown in accumulation from the late 1960s to the early 1990s as the result of financialization? To answer this question Table 5 summarizes the coefficient estimates for the autoregression of ACCU and the coefficient estimates for RSNF. Taking the mean from the values above, we can calculate the long-run effect of the change in the rentiers share of non-financial businesses on capital

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Table 5 Summary of the coefficients on the lagged dependent variable and RSNF from various specifications France Autoregressive terms of ACCU ADL PAM With growth Mean Coefficient on RSNF ADL PAM With growth Mean

Germany

UK

USA

0.64 0.7 0.67 0.67

0.25 0.35 0.77 0.46

0.85 0.73 0.9 0.83

0.34 0.41 0.53 0.44

−0.31 −0.21 −0.32 −0.32

0.36 0.13 −0.22 0.09

−0.16 −0.22 −0.04 −0.12

−0.3 −0.37 −0.22 −0.27

Table 6 Explaining the slowdown in accumulation

Germany France UK USA Mean

Reg coeff βRSNF

Autoreg coeff βACCU

∆ RSNF

Long effect βRSNF

Run explained ∆ACCU

Actual ∆ACCU

0.09 −0.28 −0.14 −0.3 −0.24

0.5 0.65 0.84 0.44 0.64

0.015 0.026 0.034 0.015 0.025

0.18 −0.8 −0.88 −0.54 −0.67

0.003 −0.021 −0.030 −0.008 −0.017

−0.021 −0.027 0.005 −0.023 −0.015

Note. ∆ RSNF and ∆ACCU are the difference between average rates 65–74 and 85–94.

accumulation. The long-run effect of a change in the rentiers share is the regression coefficient divided by one minus the autoregressive coefficients. Multiplying this by the change in the rentiers share (column ‘∆RSNF’), we get the explained change in accumulation (column ‘explained ∆ACCU’), which we contrast with the actual change in accumulation (column ‘actual ∆ACCU’) in Table 6. The changes refer to the differences between the average of the period 1964–74 and of the period 1985–94 (or the closest value we had). Unsurprisingly, this value varies greatly between countries. For Germany, where most coefficient estimates for RSNF were positive, we calculate a positive contribution to accumulation. For France we explain almost the entire slowdown in accumulation. The UK is the only country where there was no slowdown in accumulation. Note that our ‘explained ∆ACCU’ for the UK is about as high as for France. Thus even though the coefficient estimates for UK were not statistically significant, they are economically significant, i.e. if the point estimates were correct, RSNF would have a strong impact on accumulation. In the USA we roughly explain a third of the reduction in accumulation. Taking the mean of the various coefficients for individual countries, we explain the entire slowdown of

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accumulation from the late 1960s to the late 1980s (as can be seen by comparing the columns explained and actual ∆ACCU). Thus while on the average, the story that increased financial investment caused the slowdown in accumulation can be substantiated, our calculations for individual countries vary in plausibility. The calculations certainly do confirm that financialization potentially played an important role in reducing investment.

10. Conclusion . . . We found strong support for our hypothesis in the USA and France, some support in the UK, but none in Germany. Financialization occurred in the UK, but there was no general slowdown in accumulation because the UK already had very low accumulation rates in the Golden Age. The insignificant findings for Germany are consistent with our story, since the literature indicates that shareholder value orientation is a very new phenomenon in Germany. We did perform tests for robustness and experimented with the lag structure, which showed that the results are robust. We conclude that financialization is likely to have the effects implied by our theory, but further research is needed to confirm the findings. On a macroeconomic level, a systems approach would be desirable to endogenize capacity utilization and on a microeconomic level it would be fruitful to test our underlying model, e.g. one could control for factors like the pay scheme of managers. Nonetheless, if our parameter estimates come close the actual effects this has strong implications. For France financialization explains the entire slowdown in accumulation, for the USA about one-third of the slowdown. Financialization therefore can potentially explain an economically significant part of the slowdown in accumulation. Our analysis does not lend itself to straightforward policy conclusions, rather it suggests that changes on financial markets and organizational structures in the firm have to be discussed simultaneously. Regulation of financial markets and the empowerment of growth interested groups within the firm should go hand in hand. But organizational changes will take time. Therefore, if investment is to be increased in the short run, public investment may be a more effective way to do so.

References Baker, George and Smith, George, 1998. The new financial capitalists: Kohlberg Kravis Roberts and the creation of corporate value. New York: Cambridge University Press Chandler, Alfred, 1977. The visible hand: the managerial revolution in American business. Cambridge, MA: Harvard University Press Chirinko, Robert, 1993. Business fixed investment spending: modeling strategies, empirical results and policy implications. Journal of Economic Literature 31: 1875–1911 Eichner, A., 1976. Megacorp and oligopoly: micro foundations of macro dynamics. Cambridge: Cambridge University Press Farber, H. and Hallock, K., 1999. Have employment reduction become good news for

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shareholders? The effect of job loss announcements on stock prices 1970–97. NBER Working Paper no. W7295 Fazzari, S. and Mott, T., 1986. The investment theories of Kalecki and Keynes: an empirical study of firm data, 1970–1982. Journal of Post Keynesian Economics 9, 2: 171–187 Froud, J., Haslam, C., Johal, S. and Williams, K., 2000. Shareholder value and financialization: consultancy promises, management moves. Economy and Society 29, 1: 80–110 Galbraith, John, 1967. The New Industrial State. New York: New American Library Grabel, Ilene, 1997. Savings, investment, and functional efficiency: a comparative examination of national financial complexes. In R. Pollin (ed.), The macroeconomics of savings, finance and investment. Ann Arbor: University of Michigan Press Hubbard, R., 1998. Capital market imperfections and investment. Journal of Economic Literature 36: 193–225 Jorgenson, D., 1971. Econometric studies of investment behaviour: a survey. Journal of Economic Literature 19799, 4: 1111–47 Jürgens, U., Naumann, K. and Rupp, J., 2000. Shareholder value in an adverse environment: the German case. Economy and Society 29, 1: 54–79 Keynes, John, 1971. A tract on monetary reform: the collected writings of John Maynard Keynes, Vol. IV. London: Macmillan Lavoie, Marc, 1992. Foundations of post-Keynesian economic analysis. Aldershot: Edward Elgar Lazonick, W. and O’Sullivan, M., 2000. Maximising shareholder value: a new ideology for corporate governance. Economy and Society 29, 1: 13–35 Meyer, J. and Kuh, E., 1957. The investment decision. Cambridge, MA: Harvard University Press Resnick, S. and Wolff, R., 1987. Knowledge and Class. A Marxian Critique of Political Economy. University of Chicago Press Robinson, Joan, 1956. The accumulation of capital. London: Macmillan Schaberg, Marc, 1999. Globalization and the erosion of national financial systems. Cheltenham: Edward Elgar Wright, Erik, 1985. Classes. London: Verso EDITORS’ NOTES 1 2

3

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Reprinted by permission of the publisher, Oxford University Press. © Cambridge Political Economy Society 2004. This extract of Stockhammer’s paper excludes the ‘Introduction’ (pp. 719–20) and section 7 ‘Regression results’ (pp. 731–5). The introduction observes the recent negative correlation in the OECD countries between profit and investment, and describes the paper’s objective to introduce the shareholder value perspective into the post-Keynesian literature. Readers are referred to section 7 for a comprehensive evaluation of the significance and robustness tests on the investment function which is presented in section 5 and is used to test the impact of financialization on capital accumulation. Readers can find the data sources for the econometric tests in the appendix on p. 741 of the original paper. The extract moves from p. 731 to p. 736, excluding section 7, ‘Regression results’.

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Chapter 12

Gérard Duménil and Dominique Lévy

FINANCIALIZATION, NEOLIBERALISM AND INCOME INEQUALITY IN THE USA

Introduction to extract from Gérard Duménil and Dominique Lévy (2004), ‘Neoliberal income trends: wealth, class and ownership in the USA’, New Left Review, 30 (November–December): 105–33

EDITORS’ COMMENTARY Duménil and Lévy’s article builds on the pioneering work of two economists, Piketty and Saez (2003), who used tax returns to construct a continuous series on household income shares in the USA from 1913 to 1998. Whereas Piketty and Saez operated under the sober interpretative conventions of mainstream applied economics, as Marxist commentators on ‘neoliberalism’ writing in the New Left Review, Duménil and Lévy could add argument about new class alliances between the capitalist and ‘upper salaried classes’ as well as a trenchant, empirically-grounded commentary on income inequality. In general terms, this paper argues that the USA represents ‘two tier capitalism’ where the upper salariat of the working rich have done very well out of the changes since the 1980s, while the downward diffusion of wealth has been much more limited. Our extract concentrates on the empirics and commentary because these are solidly grounded and of interest to a broad audience. The first observation that arises in this extract is about the share of households in the top groups of wage earners, who account for 2 per cent or less of all households. Since 1980, these groups have sharply increased their share of all incomes so that, by 2000, the 14,000 US households in the top 0.1 per cent fractile received 2.8 per cent of household income. If we set these gains in historical perspective, the thirty years after World War Two were an egalitarian interlude when the shares of high-income households were dramatically reduced from the pre-1914 levels of

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gérard duménil and dominique lévy

inequality which have now returned. There is, however, one significant difference. The pre-1914 high-income households were recognizably part of a rentier class because they were heavily dependent on income from capital and capital gains; whereas the high-income households in our own time are the ‘working rich’ in a neoliberal world. Duménil and Lévy unpack these trends by noting not only the increase in CEO pay in giant corporations but also the rise of partnership income driven by the expansion of finance and real estate. The implication is that high salaries, supplemented by stock options ‘have functioned not as a commensurate reward for toil but as a privileged means of appropriating the social surplus’ (p. 131). If income is one story, then wealth is another: high-income households have made large share gains since 1980 but the wealthiest households have not. At the same time, the diffusion of wealth via share ownership into lower-income groups has been much more limited than claimed or assumed by the ideologues of a shareowning democracy. Duménil and Lévy find that, although many US households now own mutual funds, for the majority of such households the holding is not large enough to generate a substantial share of income. Thus, amongst those earning under $200,000 p.a., capital income and gains represent little over 6 per cent of total income on average. They therefore refute the idea that a new class of ‘share-owning workers’ is reaping the rewards of capitalist owners and reports of a ‘new mass layer of shareholders’ (pp. 105–6) are greatly exaggerated because two-tier capitalism works not through diffusion of wealth downwards but by setting the masses and the upper salariat on different trajectories of income growth In real terms, the bottom 90 per cent of earners have had no increase in pre-tax income since 1970, whereas the income of the top 0.01 per cent have seen theirs quadruple, although wealth trends have not followed this pattern. Gérard Duménil is an economist and Research Director at the Centre National de la Recherche Scientifique (MODEM, University of Paris X, Nanterre). He is the author of Le concept de loi 'economique dans ‘Le Capital’ (foreword by Louis Althusser), Maspero, 1978. Dominique Lévy is an economist and Research Director at the Centre National de la Recherche Scientifique (CEPREMAP, Paris). Duménil and Lévy have written several books and papers together on the themes of capitalism, neoliberalism and inequality. See, for example: The Economics of the Profit Rate. Competition, Crises and Historical Tendencies in Capitalism (1993) and Capital Resurgent. Roots of the Neoliberal Revolution (2004) and the Duménil and Lévy articles (2004, 2006).

REFERENCES Duménil, G. and Lévy, D. (2004) ‘The economics of US imperialism at the turn of the twenty-first century’, Review of International Political Economy, 11(4): 657–76. Duménil, G. and Lévy, D. (2006) ‘Imperialism in the neoliberal era: Argentina’s reprieve and crisis’, Review of Radical Political Economy, 38(3): 388–96.

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Piketty, T. and Saez, E. (2003) ‘Income inequality in the United States, 1913–1998’, Quarterly Journal of Economics, 118(1): 1–39.

I

N M A N Y R E S P E C T S , the emergence of neoliberalism since the mid1970s has enhanced the legibility of capitalist social relationships.1, 2 New disciplines have been imposed on both workers and management. Capital incomes – dividends and interest – have dramatically increased. . . . A comparison with the postwar decades suggests that, after twenty years of neoliberalism, incomes originating in the ownership and control of the means of production sky-rocketed, and capitalist relations of production rule the world even more rigorously than before. However, other developments in contemporary capitalism, it has been argued, may serve to blur class frontiers. In this account, neoliberalism has seen the emergence of a new layer of the ‘working rich’, capitalists who now receive much of their income in the form of wages, as other workers do. If they also get a large ‘partnership’ income, the same can be said of doctors and lawyers. Of course, they also benefit from capital income and capital gains – but so, too, do many other wage-earners. Capital ownership itself has been increasingly diffused downwards, both directly and indirectly, through devices such as mutual and pension funds. This in turn is said to have created a new mass layer of shareholders, salaried workers who now share, to a significant extent, the interests of the owners of the means of production. . . . Neoliberalism has been the vector for the emergence of this ‘twotier capitalism’ as a new framework for social relations, the institutional expression of the compact between capitalist and upper-salaried classes versus the rest.

Patterns of income inequality What, first of all, is the actual composition of household income in the US, from top to bottom of the social pyramid? Table 1 presents a breakdown of incomes for 2001, with and without capital gains. For the great mass of the population— 98 per cent, around 125 million households—with an annual gross income of less than $200,000, wages, including pensions, account for 90.7 per cent of income; this figure is barely altered (to 89.6 per cent) when capital gains are included. Turning to the remaining 2 per cent—just over 2 million households—whose tax return is above $200,000 dollars, wages still account for nearly two-thirds of annual income, or 64.1 per cent, although this now falls to 52.8 per cent with capital gains included. Even at the very apex of the pyramid—the top 0.005 per cent (6,836 households) with incomes of over $10 million—wages still account for 50.1 per cent, excluding capital gains; the figure drops to 25.3 per cent when they are included. Placing this breakdown of top-level income in historical perspective allows

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Table 1 Composition of income, 2001 (%) A. Income without capital gains Gross income ($ thousands)

% of returns

Wages

Capital income

P-ship. income

S. prop. income

Under 200 200 or more 200–500 500–1,000 1,000–1,500 1,500–2,000 2,000–5,000 5,000–10,000 10,000+ All returns

98.01 1.99 1.57 0.276 0.066 0.028 0.040 0.010 0.005 100.00

90.7 64.1 73.1 62.2 55.2 52.7 52.8 52.2 50.1 85.6

4.8 13.6 9.7 13.1 15.6 17.4 18.4 20.3 24.1 6.5

1.0 16.7 10.2 19.6 24.4 26.2 25.5 23.9 21.5 4.0

3.3 4.5 6.2 4.2 3.3 2.6 2.0 1.7 2.3 3.5

Other

0.2 1.1 0.8 0.9 1.5 1.2 1.3 1.9 2.1 0.4

B. Income with capital gains Gross income ($ thousands)

% of returns

Wages

Capital Capital income gains

P-ship. income

S. prop. income

Other

Under 200 200 or more 0–5 5–10 10–15 15–20 20–25 25–30 30–40 40–50 50–75 75–100 100–200 200–500 500–1,000 1,000–1,500 1,500–2,000 2,000–5,000 5,000–10,000 10,000+ All returns

98.01 1.99 9.78 9.59 9.24 8.91 7.74 6.65 10.75 8.24 13.63 6.91 6.57 1.57 0.276 0.066 0.028 0.040 0.010 0.005 100.0

89.6 52.8 95.2 85.8 87.5 89.5 91.3 92.9 92.5 92.5 91.7 90.4 84.1 67.9 54.4 46.3 42.1 40.1 36.1 25.3 81.4

4.7 11.2 8.1 6.4 6.6 6.0 4.4 3.7 3.8 4.0 4.0 4.4 6.0 9.1 11.5 13.0 13.9 14.0 14.0 12.1 6.2

1.0 13.7 −1.3 −0.3 −0.1 0.1 0.2 0.2 0.2 0.4 0.7 1.0 2.7 9.4 17.1 20.4 20.9 19.3 16.5 10.8 3.8

3.3 3.7 4.5 8.5 5.5 3.8 3.6 2.7 2.8 2.4 2.6 2.8 3.9 5.8 3.6 2.7 2.1 1.5 1.2 1.2 3.4

0.2 0.9 −6.2 −0.5 0.0 0.1 0.1 0.1 0.1 0.2 0.3 0.4 0.4 0.7 0.8 1.3 0.9 1.0 1.3 1.1 0.3

1.2 17.6 −0.3 0.1 0.4 0.6 0.5 0.4 0.5 0.5 0.8 1.1 2.9 7.1 12.5 16.2 20.1 24.1 31.0 49.5 4.8

Note: P-ship: partnership: S-prop: sole proprietor. Wages: salaries and wages + pensions: capital income: interest + dividends + rent + royalties + estate and trust: partnership income: partnership and S. Corporation income (see footnote 9): income: netincome minus loss. The total number of returns was 128,817.050. Sources IRS Individual Tax Statistics, Data by Size of Income table 1.4.2001. Individual Income Tax. All Returns. www.irs.gov

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us to trace the variations in this income pattern over time (Piketty and Saez 2003).i Figure 2 shows both the share of total US household income received by the top 0.01 per cent since World War I, and its component parts.ii It suggests a periodization of three stages: 1

2

3

Before World War II, the concentration of income was very strong, with the top 0.01 per cent accruing some 2.2 per cent of total US household income. Most of this fractile’s income for this period consisted of capital income; on average, capital income and capital gains, taken together, accounted for 72 per cent of the group’s total income for 1918–40. During World War II, there was a spectacular reduction in the percentage of total US household income received by the top 0.01 per cent fractile, to ‘only’ 0.6 per cent—with no sign of recovery before the early 1980s. This was a consequence of the decline of capital income, slashed to a quarter of its pre-war level (i.e. from an average 1.51 per cent before 1940 to 0.42 per cent for 1950–79), and of wages, which were halved during World War II. In the postwar decades, the concentration of capital income continued to unravel. Inequality was re-established during the last two decades of the 20th century, with the top 0.01 per cent fractile receiving 2.8 per cent of total US household income by 2000, but this restoration of privileges for households with the highest incomes took a completely new form. Abstracting from the ephemeral rise of capital income in the late 1980s, the concentration of wages and entrepreneurship income increased tremendously. By 1999, the top 0.01 per cent received 11.3 per cent of total us household entrepreneurship income, and 1.6 per cent of total us wages. ‘Wages’ skyrocketed during the second half of the 1990s, reflecting both their upward trend and the large distribution of stock options.

How does this pattern compare to historical shares of income for broader layers of the US population? Figure 3 shows the trajectories for various fractiles within the top 90–100 per cent of us households. Here, a clear distinction emerges, first, between the lower two fractiles, 90–95 and 95–99, and the top 1 per cent (99–99.9, 99.9–99.99 and 99.99–100). In contrast to the continuing slow decline experienced by the top 1 per cent in the postwar decades, the share of income accruing to the 90–95 and 95–99 fractiles grew steadily from 1945 (in spite of the limited divergence from the beginning of the 1980s). The common profile of the three fractiles composing the top 1 per cent is striking and can be explained by their similar income composition. In 2000, the average income of the top 1 per cent, including capital gains, was $833,140.5 Between 1917 and 1940, this fractile had received on average 16.9 per cent of total us household income; this fell to an average 10.9 per cent during the first postwar decade, 1946–55, and to 8.4 per cent in 1973; it then soared to reach 19.6 per cent in 2001.

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Figure 2 The top 0.01 per cent income share in total household income: total income (excluding capital gains) and three components, 1918–2000 Source: Kopczuk and Saez, ‘Top wealth shares in the United States’.

Figure 3 Shares in total household income, including capital gains, received by various sections of the top decile, 1917–2002 Source: Piketty and Saez, ‘Income inequality’, Table A2.

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Unpacking ‘partnership’ The importance of partnership income for the top fractions of the US population, documented in Table 1 above, requires some explanation. In 2001, the income of the top 1.99 per cent, including capital gains, consisted of 13.7 per cent partnership income, compared to 11.2 per cent for capital income.iii Here, it is useful to break down partnership income by industry, using IRS data (see Table 2). A first observation is that ‘partnership’ predominantly relates to ownership and financial activity. Of the $8,428 billion total assets, only $2,085 billion correspond to industries other than fire; of the $3,593 billion of partners’ capital accounts, only $884 billion relate to industries other than fire—in both instances, around 25 per cent. Core finance alone represents 59.2 per cent of total partners’ capital accounts. This industry comprises 33.7 per cent of the total net income, and 57.8 per cent of total portfolio income distributed to partners. The scale of this sector should be emphasized: the $2,126 billion of partners’ capital accounts amounts to 23 per cent of the total net worth of us non-farm, non-financial corporations, and just over the total net worth (104 per cent) of financial corporations (Duménil and Lévy 2004).iv Secondly, the importance of this (largely finance-based) partnership income needs to be set in historical perspective. Figure 4 shows the dramatic transformation of the content and distribution of partnership income that occurred in 1987, with the rush of the top fractiles into partnership. Three separated income fractiles are considered: 0–90, 90–99.5 and 99.5–100, or the top half per cent. The variable is the percentage of total partnership income received by each Table 2 Partnership income and composition by industry, 2001 ($ billion) All industries

No. of partners (thousands) Total assets Partners’ capital accounts Total net income Net income from trade/ business Portfolio income dist. to partners Rental real estate income

All indust. except FIRE

FIRE Real estate

Core finance

Other finance

14,232 8,428 3,593 310 114

4,657 2,085 884 129 93

6,444 2,069 522 70 0

3,019 4,114 2,126 105 16

112 161 60 7 5

153

34

29

88

2

43

1

41

1

0

Note: FIRE: finance, insurance and real estate, or real estate, core finance, and other finance. ‘Core’ partnership finance (engaged in contracts such as ‘hedging’, transactions on securities on various markets, and the management of portfolios of securities) is made up of two industries: (1) securities, commodity contracts and other financial investment and related activity and (2) funds, trusts and other financial vehicles. Totals may not equal sum of components due to rounding.

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Figure 4 Percentage of total household partnership income received by each fractile (deviation from 1986), 1929–99 Source: Piketty and Saez, ‘Income inequality’, Table A7. Notes: Each series has been normalized to 0 in 1986. The percentages in 1986 were 45.4 per cent for the fractile 0–90; 38.3 per cent for 90–99.5; and 16.3 per cent for 99.5–100. The sudden fall of the curve (—) means, for example, that the share of partnership income accruing to the 0–90 fractile fell from 45.4 per cent in 1986 to 12.0 per cent in 1988.

fractile, but each series has been normalized to 0 in 1986. The figure clearly outlines the contours of the break between 1986 and 1987. Between 1986 and 1999 the 0–90 fractile lost 31 per cent, while the top 0.5 per cent fractile gained 29 per cent of the total partnership income.v Note that the earlier pattern remained stable from 1929 to 1986. The mid-1980s transfer of wealth by the top fractions of the population into the ‘partnership’ sector contributed extensively to the restoration of income inequality. . . .

Secular wealth equalization? 3 If the top percentile’s share of total US household income fell substantially during the postwar decades, only to be restored from 1980 on, the same percentile’s share of total US household wealth displays a different pattern. Figure 5 shows the percentage of total us household wealth held by the 0.01 per cent and 1 per cent richest fractions.vi It illustrates the dramatic decline of the concentration of wealth during the Great Depression (instead of World War II, as in the case of income), for both the top 0.01 per cent and 1 per cent. This fall continued, more gradually, up to the end of World War II. From an average

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Figure 5 The top 0.01 and 1 per cent shares of total household wealth, 1916–2000 Source: Kopczuk and Saez, ‘Top wealth shares in the United States’, Table B1.

37 per cent of total US household wealth held by the richest 1 per cent for 1916–30, the figure fell to 24.7 per cent in 1945 (and, respectively, from 8.9 per cent to 3.7 per cent for the richest 0.01 per cent). A new diminution occurred in the 1970s, compounded by the effects of inflation which, it should be noted, are not considered here. This was followed by a partial recovery from the mid-1980s—although the percentages of total wealth held still remained below the level of the 1960s. In other words, the top percentiles’ comparative share of income was restored in the last two decades of the 20th century, but not their comparative share of wealth. [. . .]

Top salaries Among the most publicized of the new trends in top income distribution has been the soaring rates of Chief Executive Officers’ pay. Figure 7 illustrates the rise in pay of the top 100 CEOs, as a ratio to the average us salary. The pay of the various CEO rankings grew at more or less the same rate. In 1971, the pay of the tenth CEO amounted to 47 times the average salary; by 1999 it was 2,381 times as great. A crucial component of these soaring rates of remuneration has, of course, been stock options. Again, this development needs to be historicized. A very clear break occurred towards the end of the 1970s. In 1977, the distribution of shares (as stock options or under other forms) still amounted to ‘only’ 20% of CEOs’ total pay. In 1979, this percentage suddenly rose to 40.5% (while the rise of salaries was in no way slowed down). By 1999, salaries represented

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Figure 7 Pay of CEOs of various rankings (ratio to the average salary of all wage earners), 1970–2002 Source: Piketty and Saez, ‘Income inequality’, Table B4. Notes: The first three curves show the rise of the pay of CEOs according to their rank in the hierarchy of remunerations: 10th, 50th and 100th. The fourth curve corresponds to the average pay of the 100 CEOs with the highest remunerations. Note that 1,000 means 1,000 times the average salary.

only 9.7 per cent of the total pay of CEOs (although note that the salary of the tenth CEO was over $10 million); stock options accounted for 58.5 per cent, and other shares for 31.8 per cent, of the total pay (Piketty and Saez 2003, table B4). This rise of top ‘remunerations’ was so concentrated at the apex of the hierarchy, and so accentuated, that it can hardly be interpreted as a reward for improved managerial skills—or for rising ‘marginal productivity’, in the neoclassical jargon, measured by the hike of stock prices. Rather, what is at stake is a privileged device to channel surplus towards a fraction of the ruling elite.

Bulk of the income pyramid 4 Turning now to the vast majority of the population, what further trends can be distinguished? . . . Real income figures [indicate] . . . stark trends. Figure 10 shows average real income, pre-tax, during the period 1970–2002 for the four fractiles 0–90, 90–99, 99–99.99 and 99.99–100, with no overlaps, giving the average income in constant dollars for each fractile, normalized to 1 in 1979. This reveals that the real income of the fractile 0–90, that is 90 per cent of the US population, actually stagnated since 1979, while for the top 0.01 per cent, real income

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Figure 10 Average real income for four fractiles, including capital gains, 1970–2002 Source: Piketty and Saez, ‘Income inequality’, Table A5. Notes: All series are in 2001 dollars and have been normalized to 1 in 1979; series are deflated using the Consumer Price Index. In 1979 the values were $27,532 for the fractile 0–90; $100,579 for 90–99; $308,290 for 99–99.99; and $3,387,913 for 99.99–100.

quadrupled. It is unfortunately impossible to use series consistent with the above to discuss the transformation over time of income distribution for the components of the 0–90 fractiles. A comparison with figures from the US Census Bureau, however, would suggest that the main burden of this growing income inequality fell on the lower half of the wage spectrum.

Everyone a capitalist? 5 What of the diffusion of financial assets that occurred during the last decades of the 20th century? It is well known that the percentage of us households holding stock shares, directly or indirectly, grew from about 32 per cent to 52 per cent between 1989 and 2001. This phenomenon extended to the poorest quintile of us households, although the percentage of shareholders in this layer remained a low 12 per cent in 2001, compared to nearly 90 per cent for the upper decile (Aizcorbe et al. 2003). Nevertheless, it is important to keep in mind the limited size of these holdings. For 2001, the average portfolio of shares amounted to $7,000 for the bottom quintile, while that of the top decile was $247,700. [. . .] The accumulation of wealth within pension funds or other retirement accounts has been widely documented in recent years. As a percentage of the disposable income of us households, these assets have grown from 13 per cent

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in 1952 to over 140 per cent in 2003, with some acceleration from the mid1980s. . . . In 2003, the financial assets of US households held within pension funds and retirement accounts represented 36 per cent of their total financial assets, whereas they were negligible after World War II. Besides pensions and retirement accounts, gradually broader fractions of the population held securities indirectly within other funds. In 1980, 5.7 per cent of us households owned mutual funds; by 2003, the percentage was 47.9 per cent (Investment Company Institute: www.financialservicesfacts.org) . . . The fraction of stock shares held indirectly—that is, within financial institutions—rose steadily from World War II and, in the early 2000s, reached about half of the total. Those held in pension funds amount to around half of all shares indirectly held, or one quarter of the total. Again, however, as noted for the total financial assets of households, there is no trend in the total amount of stock shares held relative to households’ disposable income. The fluctuations observed are merely those of the stock market, with a dramatic devaluation of households’ portfolios after the bursting of the late 1990s bubble. The value of stock shares indirectly held by households culminated above 100 per cent of their disposable income in 1999, and then fell to 67 per cent in 2002; in 2003, it stood at 86 per cent.

Capital income below the top 6 Capital income, including capital gains, accounts for a quite limited share of the total income of most households. As shown in Table 1 above, this share does not reach 6 per cent for the bottom 98 per cent income fractile. . . . Beginning with the bracket $200,000–$500,000, the composition of income changes considerably. . . . Capital income and capital gains account for 16.2 per cent of total income. Partnership income leaps to 9.4 per cent. But one must notice that we are now entering into the top 2 per cent of the income hierarchy. Although the frontiers apparent for distinct variables in each data source are not exactly identical, coherent patterns are revealed. Capital income and gains still account for a quite limited fraction of the income of wage-earners that compose, for example, the 90–99 fractile of the income pyramid. Given the significant amounts of securities accumulated in pension funds and other retirement accounts, and the limited share of capital income that uppersalaried classes receive, it seems obvious that most of what they do get must come from these sources. It is first important to emphasize that, in spite of the sums accumulated in pension funds and retirement accounts, these assets have, at least to date, contributed only to a limited extent to the income of retired households. . . . Thus, it must be emphasized that, in 2000, pension funds (government and private) accounted for only 18 per cent of the income of people aged 65 and older. Social Security, at 38 per cent, amounted to twice as much—a proportion that has remained stable since 1976. Predictably, upper-income fractiles benefit more than the rest of the population from the pensions paid by pension funds:

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instead of the total 18 per cent of income received on average by over-65s, the poorest quintile receives 3 per cent, the 20–40 quintile 7 per cent, the middle quintile 17 per cent, the 60–80 quintile 28 per cent and the top quintile 29 per cent. In other words the proportion never reaches 30 per cent, even for the upper quintile. It is interesting, however, that such pensions account for 17 per cent of the income of the 40–60 quintile. This clearly shows that pension funds extend the benefit of capital accumulation, income and gains to fractions of the population who, when active, received very little from it. [. . .]

Two-tier capitalism? 7 An analysis of US capital ownership and income trends would thus refute any notion of a society in which ‘share-owning workers’ reap the rewards of capitalist owners, and the ‘working rich’ are rewarded for their toil. For the ultra-rich, very high salaries, supplemented by stock options which reached astronomical proportions during the neoliberal decades, have functioned not as a commensurate reward for toil but as a privileged means of appropriating the social surplus. In global terms, these outstanding incomes can be unambiguously linked to the ownership of capital. Similarly, ‘partnership income’ largely refers to purely capitalist types of financial activities. Huge amounts of capital are invested there, its ownership concentrated in the hands of a tiny minority of high-income households. In addition, ‘partnerships’ allow for the transformation of capital income into capital gains, taxed at a much lower rate. The diffusion of this bonanza remains quite limited. . . . Two ‘levels’ of capital ownership can now be distinguished: 1 2

Capital ownership by a capitalist class. This form of ownership retains all the characteristics that have persisted since the separation of ownership and management at the turn of the 20th century. . . . The access given to broader salaried classes, primarily through pension funds, to a quite distinct form of passive and subordinate ownership—but in which the ownership of capital is still at issue. This is the configuration of what we call ‘two-tier capitalism’.

These relations, however, are historical and dynamic. The upper fractions of the salaried classes, involved in the second tier, are not just dominated mestizos in this capitalist reproduction process, but also actors. The broad social compromise imposed by the large masses of workers after World War II—in the context of the weakness of the capitalist order and the growing power of Soviet-style socialism—was gradually eroded by rising wage inequality . . . In the context of the social and economic conditions obtaining in the 1970s, the capitalist class was able to use this widening polarization among wage-earners to its own advantage and, after decades of continuous effort, to restore its prerogatives within neoliberalism. The Keynesian compromise yielded to the new neoliberal compact, a shift from the lower strata of the income pyramid toward the top.

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In the adherence of upper salaried classes to the neoliberal creed, pension funds played a crucial role. In the longer term, did these classes make the wrong choice? As we have seen, neoliberalism has not delivered much in real purchasing power to this layer. High interest rates, and the stock market and housing bubbles, created the illusion of an autonomous and automatic prosperity. But what is the future of the stock market when all profits are already distributed as dividends, and returns on stocks are still very low? What is the future of an economy which paradoxically lost its capability to save (when pension funds were supposed to stimulate savings), and has built itself on the accumulation of external disequilibria?

Authors’ notes i

ii iii iv v vi

In what follows, we draw extensively on the path-breaking work of Thomas Piketty and Emmanuel Saez (2003), which uses IRS tax returns to construct, for the first time, a homogenous series of us household income shares for 1913–98. See also Wojcieck Kopczuk and Emmanuel Saez (2004). In 2000, the average annual income (excluding capital gains) of the 13,447 individuals who composed this 0.01 per cent was $12,984,220. The income of the top 0.426 per cent, i.e., those receiving over $500,000, consisted of 22.6 per cent partnership income and 17.0 per cent capital income. Financial corporations here exclude government institutions and mutual and pension funds. The top 0.01 per cent income fractile garnered 1 per cent of total partnership income in the 1970s, and 5.3 per cent in 1986; in 1999 this figure reached 11.2 per cent. In 2000, the wealth of the individual at the bottom of the richest 1 per cent amounted to $1,172,896. The wealth of the individual at the bottom of the 0.01 per cent was $24,415,150, while the average wealth of the 20,187 individuals that compose the top 0.01 per cent was $63,564,151.

References Aizcorbe, A., Kennickell, A., and Moore, K. (2003) ‘Recent Changes in US Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances’, Federal Reserve Bulletin, vol. 89, pp. 1–32. Duménil, G. and Lévy, D. (2004) ‘The Real and Financial Components of Profitability (USA 1948–2000)’, Review of Radical Political Economy, vol. 36, no. 1: pp. 86–110. Kopczuk, W. and Saez, E. (2004) ‘Top Wealth Shares in the United States, 1916–2000: Evidence from Estate Tax Returns’, NBER Working Paper no. 10399. Piketty, T. and Saez, E. (2003) ‘Income Inequality in the United States, 1913–1998’, Quarterly Journal of Economics, vol. 118, no. 1: pp. 1–39. EDITOR’S NOTES 1 2

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129–31). Readers are referred to the original paper for these two sections where, in the former, the authors present their historical account of how class and income have evolved in US capitalism after World War II and argue, in the latter, that a class bond is formed between increasingly better remunerated upper-salaried managers and capital. Readers are referred to the original paper for the graph (Figure 6 on p. 16) showing the dramatic increase in the shares of total household wealth held by the 400 and 100 richest households in the US between 1982 and 2002. Readers are referred to Figures 8 and 9 on pp. 118–9 in the original paper, which show how the shares of the fractiles 0–90 per cent, 90–99 per cent and 99–100 per cent in total household income and total wage income deviated from the 1950 levels between 1920 and 2000, highlighting the top decile’s gains since the late 1970s. Readers are referred to the original paper for the US households’ comparative shareholding (Table 3 on p. 122) by income fractiles between 1992–2001; total financial assets, pension funds and retirement accounts; and stock shares as a percentage of the disposable income of households between 1952 and 2003 (figures 11 and 12 on pp. 122–3). The statistics on income sources of the retired households in this section are presented in Table 4 (p. 125) in the original paper, which is excluded from the extract. The extract moves from p. 126 to p. 131 here, leaving out the sections entitled ‘Neoliberalism in historical perspective’ and ‘A new class settlement?’.

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SECTION FOUR

Cultural economy: narrative and perfomative discrepancies EDITORS’ INTRODUCTION

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H E N E W T E R M ‘ C U LT U R A L economy’ is part of a claim about the

importance of culture, both to understanding what is happening to economic life and to effective practical interventions in areas of production and consumption. The range of work published in two recent readers by Amin and Thrift (2004) or du Gay and Pryke (2002) illustrate how this claim has been variably developed. Thus cultural economy narrowly includes work on the cultural industries and claims about the role of knowledge in a new kind of economy as well as the realization that culture is not limited to a particular set or sphere of activities and that, therefore, cultural economy provides a way of analysing many different areas of economy and society. There is, for example, a rapidly expanding body of work from different perspectives that develops cultural understandings of finance in terms of its actors, markets, and processes. For example, Caitlin Zaloom’s (2006) fascinating anthropological account of trading on the Chicago Board of Trade, or Jocelyn Pixley’s (2004) economic sociology analysis of how financial market actors deal with uncertainty. Marieke de Goede’s (2005) book provides a compelling cultural history of financial markets, while collections of work edited by Adler and Adler (1984) in the 1980s and by Knorr-Cetina and Preda (2004) in the 2000s showcase a diverse range of sociological and cultural approaches to the financial world. If the cultural economy of finance has already made an important, broadranging intellectual contribution, we can ask, more narrowly, what can cultural economy contribute to the study of financialization? To answer the question within the framework of this volume, it seems reasonable to begin not with a general definition but a specific contrast between the a priori of political economy and cultural economy about financialization. For political economy concerned with accumulation, growth, and stability, the financialized economy is a new mechanism of quantities and relations; the task of political economy is then to add empirics and descriptively model the relations around which economic subjects and institutions make choices and broker compromises. As we have seen, in the extracts from Boyer, Krippner, Stockhammer, and Duménil and Lévy in the last section, the empirics and conjecture are rich but the causal logic of capitalism proves elusive or remains disputed in a world where it is usually easier to find correlation than prove causality. After the socalled cultural turn of the 1990s, the new concerns of cultural economy are driven by the idea of an economy formatted by discourse(s) which introduces a different

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concept of the economy. Older Marxisant ideas about ideology emphasized how knowledge was a grid which limited the field of the visible, but formatting discourses do more and are different in two related ways. First, discourses can interpellate subjects, like the prudent savers or financially illiterate consumers of a financialized economy who do not have a pre-discursive identity. Second, formatting discourses drive behaviour because, in Donald MacKenzie’s (2006) phrase, a model is ‘an engine not a camera’1 so that, for example, the acceptance of a financial model like Black– Scholes changes valuations and option prices in the market. For cultural economy, the financialized economy runs on new stories and performances and, as we shall see in the extracts from Martin, Thrift, MacKenzie and Millo, and Langley, various authors place the accent and emphasis variably on either the narrative or the performative2. Causal issues are generally sidestepped but the results of discursive formatting are ambiguous because of new problems inherent in the way that human subjects both use and are used by discourse. Thus, subjects can use the authority of a discourse like economics cynically and instrumentally to justify behaviours, outcomes, and policy regimes which subjects maintain for other reasons and on the basis of knowledge which is not in the model. Equally, the same subjects may find it difficult to think or act outside the model’s box so that their reform projects are ones of making the world more like economic theory. The issues here have been focused by the response to Michel Callon’s strong statement of the case for discursive formatting of behaviour by economics. Callon focuses on the relationship between the discourse of (mainstream) economics and its ostensible object, the economy, in ways which should certainly provoke (nonmainstream) political economists who pride themselves on their ability to relativize homo economicus by setting him in historical and social context. Callon’s contention is that economics does not merely describe the economy, it performs it by bringing into being that which it claims merely to observe so that, ‘the economy is embedded not in society but in economics’ (Callon 1998: 30). Callon illustrates his approach and argument using Garcia’s example of strawberry markets in the Sologne, where the micro-economics textbook becomes the perfectly functioning market. Callon’s work alongside that of Bruno Latour and John Law institutes Actor Network Theory whose positions are derived from Science and Technology Studies but have since been widely used to structure case study research in other areas3. But there has also been stiff resistance to what some criticize as the exaggerations of French Cartesian rationalism. Thus the anthropologist Danny Miller (2002), shares Callon’s interest in the power of economics as a discursive frame, but proposes his own theory of ‘virtualism’ instead of Callon’s ‘performativity’ and argues that Callon mistakes an account of how exchange ought to be carried out for how it is carried out, as the representation and practice of economic life are conflated in ways which flatter economics. From within the cultural economy of finance, Davis (2006, p. 6) asks why Callon privileges economics as the only performative discourse and observes that ‘economic’ action could also be performed by accountancy, marketing, advertising, or, some combination of them all. Or again, Froud et al. (2006) shift attention onto corporate strategy (rather than economic action) and, as we shall see in the next section, observe discrepancies between corporate narratives, performative initiatives

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and the undisclosed business model of a company like GE. As in political economy, the different factions in cultural economy do not always agree, but they are all arguing about the narrative and performative in a debate which increasingly discusses performativity in ways which highlight infelicity and discrepancy. Some cultural economy of finance avoids the disputes about performativity by concentrating on what might be called the mobilizing narratives in the financialized economy of the 1990s and 2000s. Critical analysis of such narratives was intellectually and politically important in the period of the New Economy during the second half of the 1990s. Within a decade-long US bull market, the initial public offering of a company like Netscape with no profits record and no business model (Lewis 1999) opened the way to the dotcom boom and much nonsense about a ‘weightless economy’ which was largely inexplicable in orthodox economic terms. Enter Thomas Frank (2002) with his splendidly vigorous book about 1990s US ‘market populism’ or the mobilizing delusion that ‘markets were a popular system, a far more democratic form of organization than democratically elected governments’ (p.xiv). Randy Martin’s (2002) book on the Financialization of Daily Life takes much the same critical line as he analyses the ‘present invitation to live by finance’ and the promise that ‘money management is a means for the acquisition of self’ (p. 3). The issue is interpellation or ‘how individuals come to think of themselves’ when financialization ‘offers a highly elastic mode of self mastery that channels doubt over uncertain identity into fruitful activity’ (pp. 9–10). The practical effect is the ‘routinization of risk’ (p. 33) which plays differently for masses and elite. Even poor households are increasingly encouraged to think like capitalists and believe that all can gain if they practice financial self-management wisely and make money ‘work for them’. For Martin this promise of reward clashes with the outcome that wealth and power is concentrated in a small corporate stratum whose members live by finance alone. Frank and Martin can avoid debates about performativity because the mobilizing ideologies of the 1990s and 2000s are self-evidently absurd, but many other writers on the cultural economy of financialization put performativity at the centre of their work so that, for them, financialization is about discourse in action. Just like MacKenzie and Millo or Langley in their papers, Thrift’s article on the New Economy explicitly uses a concept of performativity as a framing device, and significantly all three articles emphasize empirical limits, discrepancies, and infelicities. This sample of three articles is necessarily small, but not misleading, because English-speaking researchers at the leading edge of cultural economy are characteristically theoretically literate but empirically curious and open minded about what they find; so these researchers are not so much elaborating an orthodoxy as exploring a space.4 As the limits of performativity are advertised, the need for a separate cultural economy could be called into question. Thus Langley (2004) uses the term ‘cultural political economy’ to denote a new hybrid discourse which combines the cultural sensitivity to narrative and performance with traditional political economy thematics about distributive inequality and macro instability. This rapprochement may be particularly fruitful for the study of financialization, which can hardly become mainstream cultural studies if financialization is intricated in the hard operating systems

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of present-day capitalism which generate income and wealth. It is also true that earlier separatist views of cultural economy envisaged a very curious division of labour whereby cultural economy was a kind of secondary commentary discourse while the quants in mainstream economics carried on with what they were previously doing. Thrift (2001) produced the ‘must read’ article on the New Economy as Boyer (2000) produced the ‘must read’ article on the shareholder value phase earlier in the 1990s. And in both cases for much the same reason: here was an author who was familiar with the established position on performativity (or the economy of high wages) and then imaginatively took up the question of how this played out in a financialized economy. Thrift is therefore concerned with the invention of the new economy which was, in Callon’s phrase, a matter of ‘trying to forge facts to which everyone would agree to submit’ (p. 413). A key initiating force was ‘the cultural circuit of capital’ or a machine for producing and disseminating knowledge to business elites’ involving business school, management consultants and management gurus’ which assembled a taken for granted world which ‘assumes the new economy’s assumptions’ (pp. 414–15). There was also a ‘performative politics of incarnation’ (p. 418) via the notion of management as a ‘passion’ and the idea of a new style of business. But, and this is the crucial qualification, the new economy was also ‘a ramp for the financial markets’ (p. 422) and a means of reinforcing inequalities in the era of booming tech stock prices and venture capital activity which mainly benefited senior managers with stock options and financial speculators. As Thrift points out, the language of novelty, inclusion and benefits for all obscured growing income inequalities and material benefits for some so the new economy is finally ‘a new received economic doctrine of the elite masquerading as a democratic even aesthetic impulse’ (p. 428). Thrift’s conclusion is that the cultural circuit’s new economy narrative may have been performed through new ideas about management but this did not format an economy which then ran on these principles. There is a huge chasm between Thrift and, say, Duménil and Lévy in terms of how they argue their case but maybe surprisingly little disagreement about the outcome of the 1990s which was increased inequality. This theme of performativity and discrepancy is given a different twist in MacKenzie and Millo’s extract, which has a much narrower focus in its examination of the influence of option pricing theory on trading behaviour and prices in the financial derivatives market. Like Thrift, this paper starts from the Callonesque assumption that economics performs the economy and ends by highlighting discrepancy and infelicity. The general issue here is the effect of the widespread adoption of a theory or model on its verisimilitude and the case is of the Black–Scholes model (used extensively for option pricing). The insight of MacKenzie and Millo is that the effects of adoption can be tracked empirically and verisimilitude can be measured by finding whether market price deviates from the theoretical prescription. Their empirics show the expected pattern whereby prices increasingly correspond with theoretical prediction but then interestingly diverge through renewed and explicable discrepancy. In this two-stage development, initial adoption of Black–Scholes by traders shifted futures market prices closer towards those predicted by the model through the

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1976–87 period; but, after the 1987 stock market crash, a new empirical discrepancy opened up because, ‘the market has come to expect crashes’ (p. 131) which are not in the model. If futures are a performance, it is divided into different acts with dramatically different values and no end in sight. The case of options pricing is an important one but it remains one case and Black–Scholes is about the algebra of financial engineering which can be largely detached from any larger capitalist context of inequality and instability, except insofar as an exogenously-determined stock market crash intrudes on the traders buying and selling on the futures market. In contrast, the issue of pensions has much more social reach because it is relevant to millions of contributors and pensioners, as well as to the statements of profit and loss in giant companies, so perhaps it is not surprising that, in analyzing pensions, Langley takes a different approach. Langley’s ‘cultural political economy’ analysis of pensions connects the author’s intellectual preferences with an appropriately scaled and scoped problem. Like the other authors, Langley includes the obligatory quotation from Callon about how economics formats the economy and then promises an account of how ‘specific discourses of the economy (are) . . . constituting the ongoing financialisation of Anglo American capitalism’ (p. 540). Significantly, Langley puts much of the emphasis on ‘ongoing’. His problem is a historical political economy problem about finding an alternative explanation for the widespread jettisoning of defined benefit private pension schemes after 2000, which is generally attributed to the happenstance of a ‘perfect storm’ caused by the fortuitous combination of low interest rates and collapsing stock prices. His concept is then of an economy which is historically path dependent with choices framed and set along that trajectory by discourses of the economy. Langley shows how the discourse of asset management had real financial effects as pension funds moved into ordinary shares from the 1960s onwards and the discourse then encouraged the subsequent shift into riskier assets not back into bonds. The flows of funds led to an asset price bubble whose legacy, after stock prices fell after spring 2000, was deficits in the occupational pension funds of many firms. The result was not any kind of fundamental reappraisal but a shift from defined benefit to defined contribution schemes which saved firms money and were also coherent with a ‘neo liberal welfare discourse’ (p. 540) of individualized saving for retirement. In Langley’s paper, the end result is performativity as an alternative historical explanation with history understood as the way narrative and performance frame choices along the pathway. All this may seem very esoteric to those readers unfamiliar with cultural economy, but it is worth emphasizing that the new cultural economy concerns with narrative and performance in many ways echo the understanding of some market participants. Thus, Tony Golding’s (2001) book The City: Inside the Great Expectation Machine provided an insider’s account of the investment management business and the interaction between giant FTSE companies and fund managers. Although the account is non-academic and untheorized, Golding highlighted the importance of ‘stories in boxes’ for the stock market several years before Froud et al. (2006) developed their arguments about giant firm strategy for the capital market as narratives of purpose and achievement. Equally, George Soros’ (2003) The Alchemy of Finance is a pertinent reminder that many practitioners are considerably more culturalist than their

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academic counterparts in mainstream economics and finance. Soros uses culturalist arguments about the reflexivity of stock markets to argue that markets are more prone to excess than to equilibrium, while his conclusion that ‘markets can influence the events they anticipate’ (p. 52) introduces the concept of performativity before the word passed into general usage. The achievements of cultural economy need to be read in this context as a kind of enrichment of political economy and catching up with the more reflective practitioners. Three of the four extracts in this section demonstrate a pragmatic (British) approach to the cultural economy of financialization whose empirical results hardly conform to Michel Callon’s assumptions. But Callon should take the credit as the initiator whose positions on performativity have stimulated new kinds of work on financialization which must in consequence be partly defined as the study of how economics and other discourses shape rather than observe processes of financialization. As performativity with discrepancy and infelicity is rapidly becoming the new orthodoxy, maybe it is time to return to neglected questions about what is narrative and how does it work, questions for which none of our cultural economists have yet theorized answers. Whether or not cultural economy is or can be a new autonomous discourse, it will almost certainly continue to provide us with a new toolkit for understanding the financialized economy.

NOTES 1 2

3 4

This phrase comes from the title of MacKenzie’s 2006 book which considers how modern finance theory has affected financial markets. For other example of the application of ideas of narrative and performative in the area of finance, see Aitken (2005), Clark et al. (2004), de Goede (2004) and MacKenzie (2004). See, for instance, Latour (1987, 2005), Law and Hassard (1999). Callon is highlighted here, not least because of the influence of his ideas on the extracts in this section. However, the cultural economy of finance draws on a range of theoretical perspectives, including Foucault (see, for example, de Goede 2005 and Langley 2007). See also Ball and Woytiuk’s (2007) introduction to the special issue on ‘Cultures of finance’ in Cultural Critique.

REFERENCES Adler, P. A. and Adler, P. (eds) (1984) The Social Dynamics of Financial Markets, Greenwich, CT: JAI Press. Aitken, R. (2005) ‘ “A direct personal stake”: cultural economy, mass investment and the New York stock exchange’, Review of International Political Economy, 12 (2): 334–63. Amin, A. and Thrift, N. (2004) The Blackwell Cultural Economy Reader, Oxford: Blackwell.

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Ball, K. and Woytiuk, M. (2007) ‘Introduction: cultures of finance’, Cultural Critique, 65: 1–5. Boyer, R. (2000) ‘Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis’, Economy and Society, 29 (1): 111–45. Callon, M. (1998) The Laws of the Markets, Oxford: Blackwell. Clark, G. L., Thrift, N. and Tickell, A. (2004) ‘Performing finance: the industry, the media and its image’, Review of International Political Economy, 11 (2): 289–310. Davis, A. G. (2006) ‘The limits of metrological performativity: valuing equities in the London Stock Exchange’, Competition and Change, 10 (1): 3–21. de Goede, M. (2004) ‘Repoliticizing financial risk’, Economy and Society, 33(2): 197–217. de Goede, M. (2005) Virtue, Fortune and Faith. A Genealogy of Finance, Minneapolis, MN: University of Minnesota Press. du Gay, P. and Pryke, M. (eds) (2002) Cultural Economy: Cultural Analysis and Commercial Life, London: Sage. Frank, T. (2002) One Market under God. Extreme Capitalism, Economic Populism and the End of Economic Democracy, London: Vintage. Froud, J., Johal, S., Leaver, A. and Williams, K. (2006) Financialization and Strategy: Narrative and Numbers, London: Routledge. Golding, T. (2001) The City: Inside the Great Expectations Machine, Harlow: Pearson Education. Knorr-Cetina, K. and Preda, A. (eds) (2004) The Sociology of Financial Markets, Oxford: Oxford University Press. Langley, P. (2004) ‘In the eye of the “perfect storm”: the final salary pensions crisis and the financialisation of Anglo-American capitalism’, New Political Economy, 9 (4): 539–58. Langley, P. (2007) ‘Uncertain subjects of Anglo-American financialization’, Cultural Critique, 65: 67–91. Latour, B. (1987). Science in Action: How to Follow Scientists and Engineers Through Society, Milton Keynes: Open University Press. Latour, B. (2005). Reassembling the Social: An Introduction to Actor-network-theory, Oxford: Oxford University Press. Law, J. and Hassard, J. (eds) (1999). Actor Network Theory and After, Oxford and Keele: Blackwell and the Sociological Review. Lewis, M. (1999) The New, New Thing: A Silicon Valley Story, London: Hodder & Stoughton. MacKenzie, D. (2004) ‘The big, bad wolf and the rational market: portfolio insurance, the 1987 crash and the performativity of economics, Economy and Society, 33 (3): 303–34. MacKenzie, D. (2006) An Engine, Not a Camera: How Financial Models Shape Markets, Cambridge, MA: MIT Press. MacKenzie, D. and Millo, Y. (2003) ‘Constructing a market, performing theory: the historical sociology of a financial derivatives exchange’, American Journal of Sociology, 109: 107–45. Martin, R. (2002) The Financialization of Daily Life, Philadelphia: Temple University Press.

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Miller, D. (2002) ‘Turning Callon the right way up’, Economy and Society, 31(1): 218–33. Pixley, J. (2004) Emotions in Finance, Cambridge: Cambridge University Press. Soros, G. (2003) The Alchemy of Finance, 2nd edn, Hoboken, NJ: John Wiley & Sons. Thrift, N. (2001) ‘ “It’s the romance not the finance that makes the business worth pursuing”: disclosing a new market culture’, Economy and Society, 30 (4): pp. 412–32. Zaloom, C. (2006) Out of the Pits: Traders and Technology from Chicago to London, Chicago, IL: University of Chicago Press.

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Chapter 13

Randy Martin

FINANCIALIZATION OF DAILY LIFE

Introduction to extract from Randy Martin (2002), The Financialization of Daily Life, Philadelphia: Temple University Press

EDITORS’ COMMENTARY If cultural economy explores narrative and performance, it includes several different styles of work. The extracts in this section by Thrift, MacKenzie and Millo and Langley avoid positivist language about hypotheses, testing and proof which hardly fits with social constructivism but they conserve the traditional mainstream style of academic discourse with clear beginning, middle and end. This starts from some kind of reference proposition which is often taken from an earlier academic text, as in this case where the reference proposition is Callon’s claim about economics formatting the economy. The body of the article than adds argument and empirics which either vindicate or more usually qualify the reference proposition. Most lived experience does not present this way and so it is perhaps not surprising that some cultural economy rejects the mainstream style of article and prefers a looser, less sequential and more obviously rhetorical style of discourse where several themes intertwine with pop-up empirics and observations about other peoples’ assumptions, arguments and conclusions. This is how Randy Martin writes his book about The Financialization of Daily Life and consequently this introduction outlines his themes rather than explains the structure of his argument; this aim is reflected in the way our extract is an editors’ choice which brings together several short passages from different sections of the book. In the terminology of other cultural economists, Martin views financialization through the lens of experience as the interpellation of subjects with narrative promises which induce performative action. Thus financialization is the current ‘incarnation of

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the good life’ (p. 6) and the ‘present invitation to live by finance’ (p. 3) implies that money management is ‘a way of working that money over and, ultimately, a way of working over oneself’ (pp. 16–17). Financialization as ‘a means for the acquisition of self’ is about how individuals come to think of themselves because ordinary house buyers or low income savers are ‘being asked to think like capitalists’ (pp. 9–10) as the family home is an object of speculation and credit. Finance offers ‘an elastic mode of self mastery’ through purchasing the products of the finance industry which reassembles the ‘possessive relations between persons and things’ (pp. 10, 11). For Martin, the combined effects may paradoxically increase financial precariousness through the dispersal of ownership and the detachment of individuals from the goods that they own; this could undermine the promise of individual liberty and financial gain that were always part of financialization’s seduction. As such his object, like that of other cultural economy authors in this section, is both the constitutive effect of discourse insofar as it constructs new economic subjectivities and the discrepancy between the discursive promise and actual outcomes. The new subjectivities are concomitants of a new economy-wide ‘routinization of risk’, where the mass of citizenry must put aside their attachment to security which means management by others and embrace risk which is actualization of self (p. 33). He quotes the journalist Michael Mandel who as an early adopter of the word financialization in 1996 wrote that ‘in the high risk society, workers, businesses and countries must start thinking like investors in the financial markets, where the only way to consistently achieve success is to accept risk’. The two key innovations are (mass) stockholding and securitization which Martin presciently sees (long before the liquidity crunch of 2007) spreads risk in ways which may also concentrate it and certainly means that ‘strangers come to control each other’s fate’ (p. 143). Through the financialization of everyday life, ‘risk become the world’ with indeterminate consequences, although the ‘proximate effect’ is to ‘concentrate wealth and the authority to dispose of it in a corporate stratum that lives by finance’ (pp. 191–2). Randy Martin is Associate Dean and Professor of art and public policy at the New York University Tisch School of the Arts. He combines interests in cultural and political theory and the arts with labour and social movements. Other books by Martin include: On Your Marx: Rethinking Socialism and the Left (2002) and An Empire of Indifference: American War and the Financial Logic of Risk Management (2007).

Introduction 1, 2 What in the world is financialization?

...M

the attention of all who would be forced to survive its whimsy or to profit by its movement. In a market economy, money is both the means and ends of life. But

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the present invitation to live by finance . . . is . . . being extended to players beyond the corporate world. A financially leavened existence asks for different measures of participation in shaping the values of polity and economy than did earlier challenges posed by market life. Finance, the management of money’s ebbs and flows, is not simply in the service of accessible wealth, but presents itself as a merger of business and life cycles, as a means for the acquisition of self. The financialization of daily life is a proposal for how to get ahead, but also a medium for the expansive movements of body and soul . . . (and) once all the features are unpacked, the nature of this self-in-the-making may turn out to be far from secure. Before assuming the integrity of a new market syndrome, it pays to look closely at the symptoms. . . .3 Advertising a new dream Like every prior incarnation of the good life [financialization] rests as much upon exclusion as inclusion. . . . Capitalism prides itself on wealth making. The social question is what to make of that wealth. Beyond making a slim percentage fat, what did the financially driven expansion have on what are taken as typical habits of life? We can judge capital’s reign not only by the riches and misery it produces, but also by its own promise to enrich the way we are together. True the US economy [recently] blasted through prior records of sustained expansion, but only after years of growth did wages for the least affluent begin to creep up and reverse a twenty-five year period decline. A stingy result to such unprecedented wealth creation. When the expansion sprang a leak just after the new millennium dawned and wage growth fizzled whole unemployment began to rise, it was easy to speculate that even this modest wealth sharing was considered excessive by the architects of the new economy. . . . [It is important therefore] to assess the social impact of such wealth creation – what changes in the theory and practice of the good life did all that money buy? Understanding financialization entails more than tracking new disequalities and distributions; it entails probing the new logics by which strange customs are made to feel normal. The coin of a realm To [understand these logics], financialization must refer to many different processes at once. The different dynamics would seem to operate apart from each other, but the burden of a useful analysis is to show how they work together (and we can see this at the level of subjectivity, government policy and political economy): How individuals come to think about themselves, take stock of how they are doing and what they have accomplished and how they know themselves to be moving forward through the measured paces of finance, yields a particular subjectivity. . . . Financialization promises a way to develop the self when even the noblest of professions cannot emit a call that one can answer with a lifetime. It offers a highly elastic mode of self-mastery that channels doubt over uncertain

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identity into fruitful activity. . . . This is not to say that financialization occupies all the room of the self or monopolizes the ethical domain, but that its medium and its message make themselves known and heard above the din. When financialization is examined as official policy, the rhetoric that invites us to embrace the new gets tangled up with an assassination of the older sets of expectation for how citizens should relate to society and what they should demand of their government. In this regard it suggests a new or revised social contract both for the corporate welfare states that once fit the moniker ‘First World’ and a model of developmental decorum for those nations grouped as ‘Third World’. [And] as people around the world can attest, refusal or inability to take up the new social contract has punishing effects no less violent than the coercive forces that made and sustained colonies and empires As a new package of principles of political economy, financialization may not have been given due time to ripen intellectually before it was taken out of its box. Here too however confusion is invited by the myriad of referents. A use of money, extension of credit, or state of indebtedness can make it possible to purchase or produce something not currently in one’s means. But finance is also the industry that organizes these activities and introduces its own innovations in product lines and services so that the possessive relations between persons and things are dissolved and reassembled. The connections forged when pieces of ownership are reassigned, such as the bundling of individual deeds to homes into mortgage-backed securities, transcend the immediacies of place and physically bounded community. Financialization integrates markets that were separate, like banking for business and consumers, or marketers for insurance and real estate. It asked people from all walks of life to accept risks onto their homes that were hitherto the province of professionals. Without significant capital, people are being asked to think like capitalists. Diversified interests may wind up soliciting curious forms of self-interest, particularly if individuals need to begin thinking though so many other selves. Ironically just when life seemed to be tailored so that rational actors could make decisions with perfect access to information, the rules for how to conduct one’s business, for what could count as information, and for ways of addressing oneself to it became so complex as to mess up the equation all over again.

Too much of a good thing? 4 The ascent of finance cannot be explained simply in terms of an accumulation of wealth, from which perspective it is by no means novel (those with money always seem to gain the upper hand). The present predominance of finance needs to be seen as something that brings people together only to seem to take away what they thought they possessed. Hence while seeming to operate with no hands at all, the magic of finance is its ability to take by giving, to spread growth while denying to those who might partake of it the very wealth it puts in view. This too is a familiar tale of society where the concentration of wealth passes as a spectacle for all to enjoy, even as most suffer being dispossessed of it. . . . [Yet] the current financial mode is not simply spectacle, an eye-catching

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economic view, but an invitation to participate in what is on display as a fundamental part of oneself. Finance is not only the question of what to do with the money one has worked for, but a way of working that money over, and ultimately, a way of working over oneself. With the new model of financial self-management, making money does not stop with wages garnered from employment. Money must be spent to live, certainly, but now daily life embraces an aspiration to make money as well. These are opportunities that quickly have obligations to invest wisely, speculate sagely, and deploy resources strategically. . . . When personal finance becomes the way in which ordinary people are invited to participate in that larger abstraction called the economy, a new set of signals are introduced as to how life is to be lived and what it is for5 . . . One consequence is a historic high of home ownership – two thirds of households in the US by the end of the twentieth century, an increase of almost 50 percent over what the rate had been a hundred years earlier. And certainly more consumables clutter these homes than ever before . . . More hours need to be put in by more people to pay these debts. It would seem less that consumerism had come to an end as a practice, than that it has been realized for so many as a way of life that it can no longer serve as a vision of what might be. While the improvements associated with acquisition of these material goods cannot be discounted, it is impossible to return to the past to enjoy the difference. . . . [Similarly] what it means to own something, just like what it means to be possessed of oneself, undergoes significant modulation under financialization. The securitization of consumer debt, the bundling of individual bills into bonds that can be traded in specialized markets, spreads ownership around in vexing ways. . . . It is in this area that the emergence of rather droll monetary policy, specifically the priority to control inflation through regulation of interest rates by the Federal Reserve Board, can be associated with far more extensive experiential consequences. It is in the intimate but highly mediated links between what amounts to a different governmental disposition towards its own regulatory activity and those it governs that the ascent of finance must be traced.6 Whither progress? The newly declared dependence on financial markets . . . has been the source of great controversy. What started in the 1980s as a concern over the decline of the middle class and erosion of the American Dream became, as measured prosperity took hold in the mid-1990s, a debate over the costs of success. The stronger claim that emerged is that the economy is not simply dependent on the financial sector, but modelled upon it. As one sympathetic observer put it: We are seeing the financialization of the American economy . . . Historically, . . . people worked for years at jobs, and businesses built up expertise producing real things such as cars and shirts, meanwhile financial investors merely traded pieces of paper in pursuit of high returns . . . This distinction is quickly disappearing, as the high risk society becomes as fluid and as competitive as the financial markets

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. . . The combination of high uncertainty and unrestricted competition is reducing the difference between the real economy of factories and offices on the one hand and the financial markets on the other . . . In the high risk society workers, businesses and countries must start thinking like investors in the financial markets, where the only way to consistently achieve success is to accept risk. (Mandel 1996, p. 8) To ameliorate the volatility that comes with risk, income averaging, layoff insurance and stock-market-like income markets are proposed. Notice that in this reckoning financialization has as much to do with treating all economic activities in the same way as it does on seeing an equivalence between individual workers, businesses and governments: all become agents subject to the same structures of opportunity and decision. These interchangeable entities share four characteristics: 1. uncertainty of rewards 2. ease of entry 3. widespread availability of information and 4. rapid reaction to profit opportunities. . . . [As such] financialization aims to make life like an approach to business, and thereby return the protocols of work to daily life with a vengeance. Here, risk will replace labor as something taken rather than given, as a venture rather than an appropriation of one’s effort. . . . Negative effects are not the return on unwanted bosses, but something one accepts as a consequence of seeking prosperity. Yet achieving wealth is also blended with the necessities of survival, since the older protections have already been removed and we have no choice but to embrace the new economy.7

Risking the world Finance offers a word to the wise and foolish alike: Risk. Those averse to it should seek professional help. Those willing to cuddle in its embrace can power themselves . . . The suffusion of the world with risk appears unavoidable. . . . Financialization . . . establishes the routinization of risk. Risk becomes normative not so much because it rewards its adepts with success, but more because the embrace of risk means one is embedded in the reality of the present. A risk taker is one who lives for the moment – the historical moment in which risk management ascends o the status of common sense. To be risk averse is to have one’s life management by others, to be subject to their miscalculations, and therefore to be unaccountable to oneself. . . . Routinization of risk makes a particular historical and economic arrangement appear to be natural. Socializing finance 8 Securitization, in general, claims to democratize access to investments that may once have required high minimums or limited partnerships. It also promises to increase returns over independent ownership (REITs averaged double what the appreciation for a single family home was) and to reduce capital costs through

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competition over interest rates. Securitization is meant to control risk by spreading it around and, like all market transactions, to increase efficiency . . . [However the] socialization of risk through securitization of property not only ties people together, but makes life more volatile as well. Not only is property bundled together to control its fate, but it is parcelized and decomposed to isolate its constituent uncertainties . . . [As such] by flinging ownership far and wide, strangers come to control each other’s fate and the immediate conditions for responding to risk vary greatly. That the investment instrument provides no resistance to liquidation means that suddenly what was meant to spread risk around can extravagantly concentrate it. There are two processes . . . through which risk become the world. The first is the common sociological meaning whereby people are brought into conformity with the assumptions of a given society. Although no grammar book for social codes is handed out at birth, the rules of the game are to be learned by playing. . . . But much eludes this consciousness . . . Much in the way that people are connected to each other is immeasurable. The cycles of dispossession and ownership brought into being by stockholding and securitization do not themselves engender an awareness of the massive interconnection that has taken place. The reliance on strangers operates unseen for the most part, but it also forces people to come to a reckoning with what they share. The commonality is not readily given by a term like ‘interest’, which assumes that people know what they need from each other or from a situation before they are able to act together. The way in which risk distributes association among people is not, by design, directly or immediately accessible. This other socialization of risk shadows the other. One can own shares, but their value is realized only when they depart. . . . Risk management in terms of finance is the willingness to let capital decide one’s fate but, given this delusion, to place that future in the hands of others in the present. Financialization, the elaboration of capital’s movement within the integuments of daily life, makes of the future, not an individual’s uncertainty, but a present obligation to embrace a risk of what can be made of a promised return. [And thus] the future can be seen as feeling the weight or burden of others in the present.

The new divisions: a geography reconfigured 9 Girdling the middle [However] the financialization of daily life turns out not to be for everyone, or more precisely, it becomes the means through which people are measurably different . . . During the 1900s, records were broken for the longest period of continuous economic expansion and the longest and largest bull market. . . . What is there to show for it?

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Summing up Any conclusion to the financialization of daily life would, necessarily be speculative. Increased risk tolerance means greater indeterminacy for what may come. [But more concretely] financialization is a way of rethinking the Trinitarian approach to the social sciences that would partition culture, economics and politics. The language of economics and concern with its movements have entered daily experience and political consideration to such a degree that it is difficult to say where the three terms part company. . . . Financialization is animated by the freeing of capital from its prior places of residence, and it is in the frenzied movement of currencies and other instruments of exchange that the mass of money available as investment outstrips the amount invested in industrial capacity. Through stock markets and their ilk, money seems to be made out of thin air . . . but the social effects of this accelerating circulation are quite tangible. Most saliently, the creation of new wealth forges the medium through which capital and risk are socialized, in which ownership is detached from individuals and assigned to far-flung nets of investors. The proximate effect of this process is to concentrate wealth and the authority to dispose of it in a corporate stratum that lives by finance. At the same time, however, financial self-management becomes a general feature of life for millions linked indirectly through their investments, in turn enlarging the scale of capital. This expansion in finance comes with a shift in orientation for managing national economies; no longer is maximizing growth the key recipe for prosperity. Just as the material entailments of progress hove into view for the bulk of the world’s population, the lights on the stage of universal human advance dimmed . . . Where growth and progress once reigned, inflation and transparency are now the watch-words to measure the human condition. . . . Shifting the fable of humanity’s march from progress to finance invites different ways in which those not directly in command of socials wealth can imagine that there is room for them too. Participation by the many in a particular way of life arranged for the benefit of the few is a simple definition of hegemony. Financialization aspires to such elegance. . . . Financial self-management leaves no corner of the home untouched. . . . By their own reports, people are busier than they have ever been, but business does not translate readily into participation. There remains a yawning gap between the socialized ownership of property that securitization has offered up and either the dreamscape or the political mobilization appropriate to such expanding interconnections. The redefinition of the family home as an object of speculation and credit [means] . . . the home is no longer an entertainment centre, but a medium of age-appropriate financial management whose authority may try to insist that father knows best, but he has to show the math. The financialized self embraces risk. . . . Just as the home is being fully rationalized for investment decision, all the information gathered there is somatized into what sleeping bodies can bear. At the same time, all these decisions are made through others, mainly strangers who reveal themselves in chat rooms or

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remain the anonymous holders of various securities. The socialization of ownership dispersed the self around the world, tying its fate with the most general movements of money. All finance is advertised on the basis of individual gain, but its means are wholly deindividualizing.

References Mandel, M. (1996) The High Risk Society: Peril and Promise in the New Economy, New York: Random House. EDITORS’ NOTES 1 2

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Reprinted by permission of the publishers, Temple University Press. © 2002 Temple University Press. This extract is a summary of the key arguments of Randy Martin’s 230-page book. To do this we used sections and in some cases individual paragraphs from the introduction and chapters 1, 3 and 4 to try to present to the reader a highly condensed version of the book. We decided against the inclusion of any text from Chapter 2 titled ‘When finance becomes you’, which explores the socialization or naturalization of modes of financial calculation and behaviour within the household. This was excluded because of space limitations (though the key main point is summarized in the introduction which is included in this chapter); interested readers are encouraged to read the original text. In all cases the headings and subheadings are faithful to the original, and the prose is reproduced verbatim and in its original order. There are a few exceptions where new words or phrases had to be inserted to make sense of the sentence after sections were cut. These words are included in square brackets. At this point we jump from p. 3 to p. 6 in the original, cutting an extended discussion of Wingspan’s ‘new corporate culture’. The rest of the introductory section of this chapter is taken from pp. 7 to 12 of the original book. At this point we cut the first three and a half pages of Chapter 1 which explores the relationship between growth and standards of living. This point is picked up from p. 16 onwards of Martin’s book. Several paragraphs between p. 17 and p. 19 of the original are cut at this point. These paragraphs explore in more detail the impact of personal finance on ordinary people’s lives. At this point 13 pages are cut from the original; these discuss the governance of finance and the institutional management of debt. The rest of this section comprises excerpts from pp. 33 to 35. At this point we exclude the remainder of Chapter 1, which discusses activities like day trading, the prominence of conspicuous consumption and its relation to household debt, and the whole of chapter 2 on the social construction of new financial subjects. The next section, ‘Risking the world’, presents excerpts from pp. 103–7 and pp. 140–6 of the original.

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randy martin Here we cut 33 pages which explore the routinization of risk and the socialization of finance in more detail. This section ‘The new divisions’ provides excerpts from pp. 140–6, pp. 170–3 and pp. 191–5 in the original. This section begins on p. 170 and presents a condensed summary of Martin’s key arguments, in particular drawing out the themes of growing inequality and the personalization of risk. We also tried to focus Martin’s argument about the paradox of financialization which promises individual freedom and autonomy, but places an individual’s financial fate in the hands of dispersed anonymous investors whose decisions affect the incomes and livelihoods of ordinary households. The omitted sections develop these ideas in more depth.

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Chapter 14

Nigel Thrift

THE NEW ECONOMY AND A NEW MARKET CULTURE

Introduction to extract from Nigel Thrift (2001), ‘ “It’s the romance not the finance that makes the business worth pursuing”: disclosing a new market culture’, Economy and Society, 30(4): 412–32

EDITORS’ COMMENTARY Nigel Thrift’s focus is the so-called ‘New Economy’ of the second half of the 1990s, which manifested as the collective vision that digital technologies, falling costs of information, and the internet were undermining all the old economic rules and business models. This vision appeared to be validated by a boom in new issues on the stock market (especially the NASDAQ) and by establishment of numerous dotcom companies. In retrospect, this was a collective delusion that was decisively discredited by the tech stock crash in spring 2000 after which it was clear that we were living in the same old economy. This extract is the first of three which explicitly takes Callon as its theoretical starting point because for Thrift the new economy was, in Callon’s phrase, a classical case of ‘trying to forge facts to which everyone would agree to submit’ and Thrift’s article is an exploration of performativity. But, given the choice of New Economy as object, it is perhaps not surprising that Thrift’s version of performativity plays rather differently from Callon’s. While the strawberry market in Sologne or Beveridge’s Labour Exchanges after 1909 may represent micro instances of the performative power of economic discourse, the New Economy presents as something different given that it could exist powerfully as half-baked grand narrative but was performatively unrealizable. Hence the quality of this article is defined by how Thrift handles discrepancy: the lesson of Thrift’s story is that discourse may indeed ‘format the economy’ but the world that it animates will usually run on different principles in large, complex cases.

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Thrift argues that the New Economy ‘concept or brand’ was driven by five sets of stakeholders who established a frame of action and expectation which ushered both a new set of market rules and commensurabilities based on entrepreneurialism and innovation, and defined the ‘old economy’ as its bureaucratic opposite. The most important stakeholder was an institution which Thrift calls the ‘cultural circuit of capital’ whereby business schools, management consultants and management gurus produce knowledge for business elites. But this became an effective social movement through a ‘performative politics of incarnation’ whereby the worlds assumed the new economy’s assumptions. Hence the need for embodying the New Economy in new management practices which reconfigured the manager-subject as a participative change agent with a passion for management. The story so far is Callonist but the twist comes with Thrift’s treatment of the ‘finance’. Thrift recognizes that the New Economy was also a ‘ramp for the financial markets’ with an asset price bubble in tech stocks which was not part of the story about the new economic paradigm or the performance of management with passion. This was wider share ownership for the masses who were left holding their losses after the tech stock crash; and share price gains for the business elite with stock options and new opportunities for venture capitalists. So the historical process flips the assumptions of management with passion when ‘it’s the romance that produces the finance that makes the business worth pursuing’. And Thrift’s overall verdict on the New Economy is that it was an ‘economic doctrine of the elite masquerading as a democratic or even aesthetic impulse’. The article that gets to this sharp conclusion is a virtuoso piece which shows how leading-edge intellectualism can be used in a free-hand way to produce a complex yet intelligible historical story. Nigel Thrift is Vice-Chancellor at the University of Warwick, UK and is also a Visiting Professor of Geography at Oxford University. As a human geographer he has made a major contribution to research into several areas, including finance. Thrift is the author of many books and papers, including The Blackwell Cultural Economy Reader with Ash Amin (2004), Knowing Capitalism (2005) and Money/Space: Geographies of Monetary Transformation (with A. Leyshon) (Routledge, 1997).

Introduction 1, 2

I

I want to consider the invention of a new economic form, the so-called ‘new economy’. This form was invented by a series of stakeholders as a means of providing new behaviours which confirmed its existence. It was a canonical case of trying to forge facts to which everyone would agree to submit (Callon 1998). Forging this new economic form was a Herculean task, involving vast expenditures without any necessary return. And it worked – partly because of the power the various stakeholders had to define what the facts consisted of, partly because of the ability a number of stakeholders had to train up bodies whose stance assumed this world and partly because of the N T H I S PA P E R ,

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provision of measures of behaviour that offered confirmation. Act as if it is the case and new regularities are produced which ‘have the obduracy of the real’ (Callon 1998: 47). . . . To summarize my argument, rhetorics and frames produced practices and knowledges which have consequences. But this was not a mechanical causality. Rather, the new economy was a performative legitimation, a realignment of knowledge and power which could take in and work with middle-class management bodies and desires by shifting ‘between different evaluation grids, switching back and forth between divergent challenges to perform – or else’ (McKenzie 2001: 19). This new kind of free-associating management narrativity clearly could not last, since, as we shall see, it depended for its existence on extraordinary levels of financial subsidy. But it has laid down a new style of doing business which cannot just be reduced to its time. Elements of this style will continue, as new forms of property, as new kinds of ‘expressive organisation’ (Schulz et al. 2000) and as a legacy of new technologies, some of whose most important impacts have yet to be felt. These thoughts provide an agenda for this paper . . . In the first part of the paper, I will outline how the concept (or better, perhaps, brand) of ‘the new economy’ was constructed by stakeholders, like the cultural circuit of capital, as a new institutional-cum-ideological calculus. The second part of the paper then considers the means by which the new economy was incarnated into business. I will suggest that, above all, this involved the romantic notion of a kind of passion for business – thus Komisar’s best-selling injunction that ‘it’s the romance, not the finance that makes business worth pursuing’ (2000: 93). In other words, the new economy was an attempt at mass motivation, which, if successful, could result in a new kind of market culture – or a spiritual renewal of an old one. Then in the third section, I will argue that we should be careful about this attempt to build a conviction capitalism. In very specific ways, the new economy was framed by finance – in terms of venture capital, the prevalence of shareholders and the distribution of wealth. I will argue that the new market culture was therefore better interpreted as a material-rhetorical flourish intended to produce continuous asset price inflation. . . .

The new economy [T]he idea of the new economy has been stabilized; it consists of strong noninflationary growth arising out of the increasing influence of information and communications technology and the associated restructuring of economic activity. All kinds of other features can be . . . associated with this core definition – for example, the growth of small high-tech firms, the increasing importance of mobile and highly skilled talent, the rise of entrepreneurship and the centrality of venture capital. . . . The ‘new economy’ as a description was first used in the 1980s. . . . It was made durable in the media, in academia and, most importantly of all, in people’s own houses through the advent of the personal computer and subsequently the internet and the world-wide web. . . . [B]y the mid-1990s, the new economy

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had already become a stable rhetorical form, in common usage in business and government, and seeping into popular culture. In effect the new economy had become a kind of brand, compounding in one phrase the attractions and rewards of a new version of capitalism. So, how had an innocuous phrase become the chief watchword of capitalism, so that, by the late 1990s, even the Financial Times had declared itself the ‘newspaper of the new economy’. I want to argue that its strength and speed of diffusion was the result of the existence of five stakeholders willing to give it push. Of them, undoubtedly the most important was an institution I have else-where called the ‘cultural circuit of capital’. This circuit, which has chiefly come into existence since the 1960s, is a machine for producing and disseminating knowledge to business elites (Thrift 1997a, b, 1999a, b). The three chief producers of this knowledge are business schools, management consultants and management gurus. . . . [B]usiness schools are the jewels in the crown of a vast global executive education market, calculated to be worth in excess of $12 billion per annum, of which they generate about one quarter of the value (Crainer and Dearlove 1998) . . . Management consultants . . . date from the later nineteenth and early twentieth centuries. . . . [M]anagement consultants offer advice to business on such a large scale that a case could be made that they have simply become an extension of firms. Whatever the case, it is clear that they are important producers and disseminators of business knowledge, able to take up ideas and translate them in to practice and to feed practice back into ideas (Micklethwait and Wooldridge 1996; Clark and Fincham 2001). . . . Finally, [there are] management gurus, . . . consisting of various well-known academics, consultants and business managers who have been able to package their ideas as aspects of themselves. . . . Gurus tend to develop formulaic approaches to management, which play down context for the sake of rhetorical force. . . . These three producers could not exist in their modern form without a symbiotic relationship with the media which both publicize and distribute their wares. In particular, we can consider three main ways in which the media intervene. First, through the production of standard media like books, magazines, newspapers, internet sites and television. The importance of journalists as translators of business ideas, coupled with the way in which the media provide outlets for writing for the knowledge producers to display their wares, is underlined by these media (Furusten 1999). A second element is the increasing scale of specialized business media. These range all the way from industry-specific magazines to the new breed of consultancy-sponsored magazine (such as Strategy and Business) which emulates The Harvard Business Review. Since the mid-1990s a whole set of new economy magazines have come into existence, either in print or on the web (e.g. The Standard). The model provided by Fast Company, first published in 1995, has proved particularly influential, leading to a large number of copycat magazines (e.g. in the United Kingdom alone Business 2.0, Red Herring, e-Business, Revolution, The International Standard). In turn, parts of Fast Company’s format have been copied back into the mainstream business journals like Fortune. A third element is the growth of media intermediaries – press officers, publicity consultants, design consultants, advertising agencies and so on – which have

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become more important as business ideas have increasingly come to resemble brands. Then, a fourth element has been the re-engineering of the face-to-face meeting through the continual production of conferences, seminars, workshops and the like. These events serve both as disseminators of new business knowledge and as motivational fuel. The new economy could not have taken off without this cultural circuit. But it was not the only stakeholder. There were others. To begin with, there was government. By the mid-1990s governments around the world were latching onto the idea of a new economy and were attempting to make it their own through a series of reports (e.g. Report to the President 1997). Particularly active in all of this were intergovernmental bodies like the OECD and the EU for whom the new economy provided both a means of justifying their existence and a new means of authentication (e.g. EU 1997; Anderson 2000). . . . Another set of stakeholders was non-business school academics, and especially economists. Initially economists were slow to take up the new economy, although their ideas (e.g. on endogenous growth) were sometimes drawn upon by new economy gurus (e.g. Romer 1990). But, in the late 1990s, many economists began to take serious note, and acted as key legitimators by providing validation through empirical studies as well as elaboration (e.g. Quah’s (1997) weightless economy). Economists, in other words, began to produce a formal body of knowledge which could act as serious confirmation of more general (and rather flighty) business knowledge. In their hands the new economy took on weight. Then, another group of stakeholders: the managers themselves. Managers provided a growing audience for the new economy for a series of different reasons. For older managers the new economy was something to keep in touch with. For younger managers it was something to be part of. It was talking the talk and walking the walk. It was both a rhetorical frame for producing business effects and a source of ideas about how business (and the management self) should be conducted. There was one final stakeholder, and that was information and communication technology itself. ICT has now reached the point where it can be counted as having its own agency, of a sort. That agency comes from four separate directions. First, there is the simple matter of sunk costs. Massive amounts of expenditure have been laid down on ICT, which means that it has to be used, even if at first its use is highly inefficient. Many of the results of ICT come from massive, even excessive, expenditures which force the world in a particular direction. Second, it produces an expectation of usage, complete with its own morality where ‘good’ companies have and use ICT. Third, it provides new means of apprehending the world, although often not in the ways originally expected (see Brown et al. 2001 on Groupware). Fourth, through software, rules of conduct are laid down which are the informational equivalent of walls and barriers, roads and tolls, junctions, and crossroads, and which have a similar effect. The push provided by these five stakeholders set up a frame of action and expectation, a new set of market rules and commensurabilities. Just as importantly, the institution of the frame also depended upon a vision of what was

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outside it. In this case, it was the ‘old economy’ of heavy industry, bureaucratic ways, a deficit of entrepreneurial spirit and general lack of economic sparkle. This othering was crucial since it provided an economic negative, a mirror world of all the things that cannot and must not be.

Management body: it’s the romance This is all very well, but it suggests a level of engagement with the new economy which is merely . . . gestural. But effective social movements need to create background, a taken-for-granted world which, if you like, assumes the new economy’s assumptions. In this section, I will argue that this necessarily meant providing a performative politics of incarnation. Management had to become convincingly embodied in new ways. So what kind of management body was required by the new economy? On this the cultural circuit of capital was clear and its ideas are still being played out in businesses around the world. There were four ways in which the management body was to be shaped. To begin with, at a number of levels the management body had to do more. ‘All of us can do more, and be more, and contribute more, and help each other more’ (Lewin and Regine 1999: 268). The management body had to make more of itself. That meant working harder but it also meant spreading the body around more. So, second, the major body had to be passionate. Managers had to be continuously active in pursuit of visions and goals, continuously wary of ‘spinning the wheels’. But that required being able to engage the emotions, not just cognitive skills, in order to design the moment so that it would engage others. Third, the management body had to become more adaptable. Bodies had to be involved in continuous learning so that these firms could learn faster, on the ground that learning faster than their competitors was now the main competitive advantage that firms had (de Geus 1997; Senge et al. 1999). But this was a particular kind of learning based on the production of emergence rather than the reproduction of routines. Therefore it was necessarily open-ended: ‘if we believe that people in organizations contribute to organizational goals by participating inventively in practices that can never be fully captured by institutionalized processes then we will minimize prescription, suggesting that too much of it discourages the very inventiveness that makes practices effective’ (Wenger 1999: 10). The learning had to be carried out in a new way which would maximize invention, sort for creativity. . . . Finally, the management body had to be participative. Management bodies had to work through persuasion as well as command. They had to engage the ‘soul’ (Lewin and Regine 1999). This means investing the community with a sense of purpose and common ownership through deliberate working on relationships. The idea was that the management body would be sensitized to the social dynamics of the organization and could achieve continuous modulation rather than bureaucratic control (Deleuze 1990). The management body could go with the flow, providing smaller but more effective interventions as and when

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necessary. The heavy bureaucratic hand was replaced by the light touch of the ‘change agent’.3. . . .

It’s the finance Many of those who worked in the new economy . . . [believed that it was not] primarily a financial institution . . . [but a] creative institution (Komisar 2000: 55). . . . But there is another way of understanding the new economy and its rhetorical claims, one that reintroduces finance not just as inimical to passion but as the central passion of the new economy. Business missionary becomes financial mercenary. For another way of understanding the new economy is as a ramp for the financial markets, providing the narrative raw material to fuel a speculative asset price bubble which was also founded on an extension of the financial audience. On this interpretation, the real genesis of the new economy was probably the initial public offering made on 9 August 1995 by Netscape, the internet browser company which is now part of AOL. Initially set at $28 a share, the price of its stake doubled during the day and then kept on going up, so setting off the internet feeding frenzy which was to last five years. And this interpretation of finance as the ruling passion of the new economy has much to commend it. After all, many of the key innovations of the new economy were clearly financial. Most particularly, there was the growth of venture capital companies, able to specialize in funding technological innovations; the growth of the initial public offering (which provided powerful necessities for managers and members who generally held stock options, produced funds for expansion and allowed investors to cash out without waiting ten or twenty years); the increased use of stock options as compensation; and the creation of a labour market of entrepreneurial workers willing and able to take the risks, which formed a ‘mobile attack force’, constantly on the move to the projects most likely to be successful (Mandel 2000). This financial interpretation, therefore, produced a frame around the frame of the new economy; the new economy became a command performance whose script (aided by extravagant props and acting) played so well to financial audiences that they were willing to pay the ever-increasing costs of admission. In other words, the new economy became a theatre which could be used both to push share prices up and to extend share ownership. . . . [I]n the last two decades of the twentieth century, the demand [for shares] began to become more general, the result of the increase in the number of those who have investments, either directly or indirectly. This growth resulted from four sources. First, and most importantly, there was the growth of pension funds and other institutional investors (Clark and Fincham 2001). Pension funds now own many of the key sectors of the US economy and nearly half of the British and Dutch economies. In effect, pension funds (which themselves account for more than 40 per cent of investments in venture capital funds) dramatically multiplied those who had indirect investments in the shareholder economy. Then, second, there was the growth of new aggregate investment vehicles. Of these, the most important must be the mutual funds (unit trusts in the UK),

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which grew strongly, in the United States since the early 1980s to the point where by 1998 there were nearly two shareholder accounts per family (Shiller 2000). In part, the reason for the proliferation of these funds can be linked to a third source, the growth of individual shareholder choice (Martin and Turner 2000). In the United States this was given an enormous boost by the growth of defined contribution (401(k)) pension plans which allowed employees the opportunity to have their pension contributions paid into a tax-deferred retirement account. They then controlled the investments in these accounts and must allocate them among stocks, bonds and money market accounts. Elsewhere, individual shareholders were growing in number even without this boost. Finally, there was the growth of employee stock options, shares issued through privatizations and other means of boosting share ownership. Through the 1980s and 1990s these became more general. This growth in the number of shareholders (both directly and indirectly) and in shareholder choice was buttressed by the increasing mediation of finance, which meant that narratives like the new economy could travel further and more forcefully than before. This mediation came about through four processes of authority. The first was the constitutive role of the media which now acted as the main conduit of market information for most shareholders. . . . The second, related process of authority was the growth of financial literacy. This has been remarkable. . . . A third process of authority was the general growth of financial advice, ranging from the kind of advice that was being doled out by the star media analysts like Mary Meeker through brokerage services to personal financial advisers. Such advice produced a kind of proxy financial literacy which is heavily oriented to the promotion of share ownership. And, finally, there was the fact that business interest increasingly ran to the dictates of shareholder sentiment (Williams 2000). Through the advent of measures of performance like shareholder value, the share price of a company has become a crucial determinant of what is regarded as business success. In turn, these new processes of authority led to a continuation of stories like the new economy day-by-day to the point where public relations became a crucial element of many aspects of economic life – from the IPO to managing shareholder sentiment – and increasingly, therefore, economic life came to resemble the media industry with fashions, stars and favourite stocks. . . . [F]inancial journalists no longer just reported. They were players (but with no real penalty for being wrong). . . . Running the new economy story through this financial machine had enormous benefits for a number of actors: it added value to particular shares (so, for example, benefiting managers whose salaries are attached to share value), it proved analysts’ worth and made media stars of some of them, it demonstrated the worth of the system as a whole and so on. In particular, a new story will have grip on this machine if it can change the investment categories through which the economy is thought. And in the 1990s the new economy became an investment category of its own, as an obsession with high-technology shares, with markets like NASDAQ and so on. In other words, telling the new economy story worked, and worked to the extent that it began to re-describe market fundamentals. So great was the demand for shares in this category that, for a time, the new economy became an irresistible force. For example, in the UK, fund management

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firms, like Foreign and Colonial and Philips and Drew, which tried not to get sucked into the technology bubble fared poorly. Pension funds gave them the cold shoulder. And the growth of indexing added to the whole effect, making it well nigh impossible to ignore technology stocks (Economist, 21 October 2000:145). Indeed, as Mandel (2000) has argued, one way of interpreting the new economy story was as a means of persuading investors of all kinds to take on riskier investments. In this sense, it might be seen as . . . a means of drawing investors into taking on debt. It is worth remembering that in the five years to 2000 business and consumers took on $4 trillion in debt (Mandel 2000) and the US savings rate in 2000 was only 0.8 per cent, a sixty-seven-year low. Seen in this way, the new economy comes to resemble a financial instrument like junk bonds. The strength of the story was only added to by the growth of the technology which most symbolized the new economy, the internet. . . . Spectacular US corporate earnings growth in 1994, up 36% in real terms as measured by the S and P composite real earnings, followed by real earnings growth of 8% in 1995 and 10% in 1996, coincided roughly with the Internet’s birth but in fact had little to do with the Internet. Instead the earnings growth was attributed by analysts to a continuation of slow recovery from the 1990–91 recession, coupled with a weak dollar and strong foreign demand for US capital and technology exports, as well as cost-cutting initiatives by US companies. It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet, and indeed they still are not. But the occurrence of profit growth coinciding with the appearance of a new technology as dramatic as the Internet can easily create an impression among the general public that these two events were somehow linked. . . . What matters for a stock market broker is not, however, the reality of the Internet revolution, which is hard to discern, but rather the public impressions that the revolution creates. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind easily. (Shiller 2000: 20–1) In turn, such impressions had knock-ons. For example, managers started to consider how they could insert their companies into the high-valuation categories, often with little concern for longer-term consequences. The consequences were clear. By one estimate, about $150bn was raised for venture capital and public stock offerings in the five years from 1995 to 2000 to finance the new economy story. In turn, this led to major income and profit for certain sectors, precisely those addressed in this paper (Tomkins 2000). In particular, very large amounts of money went into the cultural circuit in the form of consultancy fees (especially to specialist consultancy firms like the Gartner Group, Forrester Research and Jupiter Communications) and public relations company fees and the like. Most spectacular of all were the benefits that

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accrued to the media from publicity: advertising agencies, television, network, radio stations, billboards, newspapers and magazines. Others who benefited included the financial sector, investment banks, venture capitalists, and their investors (especially institutional investors like pension funds). Those who lost were the investors who acquired shares and failed to sell them in time: mutual funds, pension funds, some corporate investors and, inevitably, large numbers of ordinary investors (especially young first-time investors). So by disclosing a new world – ‘the new economy’ – money was made and spent – and it was made – and invested to be made and spent again, in large quantities. Little wonder that Lewis (1999: 254) has argued that, for a time, Silicon Valley was a ‘little experiment of capitalism with too much capital’. But what was being described was not so much new knowledge as new business impressions and sensitivities, a new mood of engaging activity (Spinosa et al. 1997; Flores 2000; Flores and Gray 2000), a new style of doing capitalism. In turn, the new economy share boom had enormous effects on wealth distribution, and these should not be gainsaid. It is worth remarking that, in the United States, for example, since the beginning of the 1980s, Americans’ financial wealth has grown from $7 trillion to $32 trillion, but this growth has been unevenly spread. In 2000, for example, the richest 2.7 million Americans, comprising the top 1 per cent of the population, had as many after-tax dollars to spend as the bottom 100 million put together. (Meanwhile, the poorest one-fifth of households had an average income of $8,800, a decline from the 1970s.) More to the point, since the beginning of the Clinton administration (roughly paralleling the growth of the new economy) the incomes of the richest one-fifth rose twice as fast as those of the middle fifth (Reich 2000). . . . Thus, the new economy story has had great purchase on the world. But, to slightly rephrase Komisar, it’s the romance that produces the finance that makes the business worth pursuing. The romantic journey ends here. For stories of economies have usually proved to be about ownership and this story was no exception. As the figures above show, the youthful countenance of the new economy masked social relationships which were still regressive. The new economy built new connections but at the same old cost. To this extent, it was simply a new received economic doctrine of the elite masquerading as a democratic or even aesthetic impulse (Gregory 1997).4

Creating a new market culture . . . To summarize the argument so far, the success of the new economy arose from its ability to disclose, to bring out, a new kind of market culture as a frame in which technology could be constantly modulated and so constantly redefined – to the advantage of many stakeholders. In other words, the triumph of this new culture resulted from an act of redescription, which provided a peculiarly open means of framing the world as a set of becomings which kept the possible possible and thereby initiated a new style of doing business. In a certain sense this was simply a successful commercial restatement of Euro-American culture’s fundamental tenet that everything is possible given the technology (Strathern

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1999), but, if that was so, then it was also about producing more effective means of making this restatement effective, new holdings that could create a new view-point.5

References Anderson, T. (2000) Seizing the Opportunities of a new Economy: Challenges for the European Union, Paris: OECD. Brown, S., Middleton, D. and Lightfoot, G. (2001) ‘Performing the past in electronic archives: interdependence in the discursive and non-discursive ordering of institutional remembering’, Culture and Psychology 7 (2): 123–4. Callon, M. (ed.) (1998) The Laws of the Market, Oxford: Blackwell. Clark, T. and Fincham, R. (eds) (2001) Critical Consulting, Oxford: Blackwell. Crainer, S. and Dearlove, D. (1998) Gravy Training: Inside the Shadowy World of Business Schools, London: Capstone. De Geus, A. (1997) The Living Company, London: Nicholas Brealey. Deleuze, G. (1992) ‘Postscript to societies of control’, October 59 (Winter): 3–7. European Union (1997) The Globalising Learning Economy: Implications for Innovation Policy, Brussels, DG XII, EUR 18307 EN. Flores, F. (2000) ‘Heideggerian thinking and the transformation of business practice’, in M. Wrathall and J. Malpas (eds), Heidegger, Coping and Cognitive Science: Essays in Honour of Herbert L Dreyfus, Vol. 2, Cambridge, MA: MIT Press, pp. 271–91. —— and Gray, J. (2000) Entrepreneurship and the Wired Life: Work in the Wake of Careers, London: Demos. Furusten, S. (1999) Popular Management Books: How They Are Made and What They Mean for Organisations, London: Routledge. Gregory, C. (1997) Savage Money, Oxford: Berg. Komisar, R. (2000) The Monk and the Riddle: The Education of a Silicon Valley Entrepreneur, Boston, MA: Harvard Business School Press. Lewin, R. and Regine, B. (1999) The Soul at Work: Unleashing the Power of Complexity for Business Success, London: Orion Books. Lewis, M. (1999) The New, New Thing: A Silicon Valey Story, London: Hodder & Stoughton. McKenzie, J. (2001) Perform – Or Else: From Discipline to Performance, New York: Routledge. Mandel, M. (2000) The Coming Internet Depression, New York: Perseus Books. Martin, R. and Turner, D. (2000) ‘Demutualization and the remapping of FInancial landscapes’, Transactions of the Institute of British Geographers, NS, 25: 221–42. Mickelthwait, J. and Wooldridge, A. (1996) The Witch Doctors: What the Management Gurus Are Saying and How to Make Sense of It, London: Heinemann. Quah, D. (1997) ‘The weightless economy’, Bank of England Quarterly Bulletin 37 (1): 49–56. Reich, R. (2000) ‘It’s the year 2000 economy, stupid’, The American Prospect Online, 29 November. Romer, P. (1990) ‘Endogenous technological change’, Journal of Political Economy, 98: S71–S102. Schulz, R., Hatch, M. and Larsen, M. (eds) (2000) The Expressive Organization, Oxford: Oxford University Press. Senge, P., Kleiner, A., Roberts, C., Rose, R., Roth, G. and Smith, B. (1999) The Dance of

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Change: The Challenges of Sustaining Momentum in Learning Organisations, London: Nicholas Brealey. Shiller, R. (2000) Irrational Exuberance, Princeton, NJ: Princeton University Press. Spinosa, C., Flores, F. and Dreyfuss, H. (1997) Disclosing New Worlds: Entrepreneurship, Democratic Action, and the Cultivation of Solidarity, Cambridge, MA: MIT Press. Strathern, M. (1999) Property, Substance and Effect, London: Athlone. Thrift, N. (1997a) ‘The rise of soft capitalism’, Cultural Values 1: 29–57. —— (1997b) ‘The rise of soft capitalism (long version)’, in A. Herod, S. Roberts and G. Toal (eds), An Unruly World?, London: Routledge, pp. 25–71. —— (1999a) ‘Virtual capitalism: some proposals’, in J. Carrier and D. Miller (eds), Virtualism: A New Political Economy, Oxford: Berg, pp. 161–86. —— (1999b) ‘The place of complexity’, Theory, Culture and Society 16:41–70. Tomkins, R. (2000) ‘A virtual investment’, Financial Times, 5 December 26. Wenger, E. (1999) Communities of Practice: Learning, Meaning and Identity, Cambridge: Cambridge University Press. Williams, K. (2000) ‘From shareholder value to present-day capitalism’, Economy and Society 29 (1): 1–12. EDITORS’ NOTES 1 2

3

4

5

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Reprinted by permission of the publisher, Routledge. © 2001 Taylor and Francis Ltd. The extract retains the original structure and much of the text in the first and third sections (‘The new economy’ and ‘Its the finance’), with more significant abridgement of the third section ‘Management body: it’s the romance’, where readers are referred to the original for the full argument about the shaping of the management body for the new eceonomy. Due to space constraints, the extract excludes ten paragraphs of the original, which discuss the production of the management body through a series of technologies of government of the self. The extract excludes the first long paragraph of the section ‘Creating a new market culture’ on p. 428, which considers the role of ICT (information and communications technology). The extract excludes the final short section ‘Screaming uncle’, which includes reflections on the new economy after it is ‘all over’ (p. 429).

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Chapter 15

Donald MacKenzie and Yuval Millo

PERFORMATIVITY AND THE BLACK–SCHOLES MODEL

Introduction to extract from Donald MacKenzie and Yuval Millo (2003), ‘Constructing a market, performing theory: the historical sociology of a financial derivatives exchange’, American Journal of Sociology, 109: 107–45

EDITORS’ COMMENTARY Donald MacKenzie and Yuval Millo’s approach is to observe how performativity plays in a discrete and important case of financial innovation when they consider the impact of the Black–Scholes model on the pricing of options on the Chicago Board Options Exchange (CBOE). The case matters because the Black–Scholes theory of options pricing (or more precisely the Black–Scholes–Merton equation of 1973) is prestigious theory which won a Nobel prize for its authors; and because derivatives trading expanded hugely in the ensuing thirty years to become a $100 trillion business, as the traditional activity of commodity futures was dwarfed by the growth of options trading on equities, bonds, interest, and exchange rates. Again Callon and performativity are foregrounded at the beginning of this article, with Callon acknowledged for his ‘challenging recent theoretical contribution’. MacKenzie and Millo conclude that their ‘answer is broadly compatible with Callon’s analysis’ which, as the authors note is notoriously short of empirical corroboration. This verdict about ‘compatibility’ is perhaps too kind because readers of the extract will discover that the empirics show first price convergence and then price divergence from Black–Scholes predictions so that performativity operates within strict limits. The elegance of this demonstration of the limits of performativity owes much to the way in which the empirical fit between market prices and theoretical predictions can be used as a simple, conclusive measure of what’s going on and the result is a history in three stages. In the first stage, in the first half of the 1970s, there are

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discrepancies between market prices and Black–Scholes predictions so the theory is not a discovery of pre-existing relations. In the second stage, from about 1976 to summer 1987, prices increasingly fit theoretical predictions because the veracity of theoretical assumptions increases with market change, Black–Scholes is incorporated into the CBOE screen display systems and, simplest of all, traders use Black– Scholes to value options. This then appears to be a classic case of performativity which demonstrates the power of finance theory to make itself true. But then events intervene in the form of an (unexplained and exogenously determined) stock market crash in 1987 of when the S&P 500 index fell 20 per cent in one day. In a third stage from fall 1987 to the present day, the fit between market prices and Black–Scholes is persistently poor, especially in the case of puts with low strike prices ‘which will be exercised only if the underlying index falls considerably’. The trauma of fall 1987 severely stressed the options market and led to the near collapse of the CBOE. This had a permanent legacy in that the options market has learnt to expect stock market crashes, a class of event which is not in the Black– Scholes model. So performativity operates within strict limits subject to interference by other knowledges. These knowledges are part of a practice of valuation that seems to imply reflexive subjects who fit neatly with George Soros’ view of the market and challenge Callon’s concept of performativity, which denies the scope for the ‘contested, historically contingent outcome’. Donald MacKenzie is a professor of sociology at the University of Edinburgh. In 2003, he was awarded an ESRC professorial fellowship to research ‘social studies of finance’. His two most recent books are An Engine, Not a Camera: How Financial Models Shape Markets (2006), and Do Economists Make Markets? On the Performativity of Economics, co-edited with Fabian Muniesa and Lucia Siu (2007). Yuval Millo is a lecturer in accounting at the London School of Economics. His recent publications include Market Devices, co-edited with Michel Callon and Fabien Muniesa (2007) and ‘From risks to second-order dangers in financial markets: unintended consequences of risk management systems’ (New Political Economy, 2005, with Boris Holzer).

Introduction 1, 2

T

theoretical contribution to economic sociology is Callon’s (1998) assertion of the performativity of economics. The economy, Callon (1998, p. 30) writes, ‘is embedded not in society but in economics’. Economics does not describe an existing external ‘economy’, but brings that economy into being: economics performs the economy, creating the phenomena it describes. Sociology, Callon argues, is wrong to try to enrich economics’s calculative, self-interested agents. Such agents do exist, he suggests; sociology’s goal should be to understand how they are produced, and he claims that economics is key to their production. . . .

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Empirical material for examination of these issues is less rich than might be wished. Most of the studies collected in Callon (1998) are not informed directly by performativity, and they and subsequent discussions such as Slater (2002) focus largely on accountancy and marketing. That these ‘economic’ practices play a constitutive role in modern economies is easy to establish but not a novel assertion. The contributions of economists such as Faulhaber and Baumol (1988) to discussion of performativity have been missed in the sociological debate. The central case study of the performativity of economics in the narrower sense is the examination of the creation of a computerized strawberry market in the Loire by Garcia (1986), who demonstrates how a reasonable approximation to a ‘perfect market’ was consciously constructed, in good part by the efforts of a functionary trained in neoclassical economics. Though a delightful study, it is limited in its scope and has not, for example, persuaded Miller (2002, p. 232) of the case for performativity. In this article, we explore performativity by examining one of high modernity’s central markets, the Chicago Board Options Exchange (CBOE). The CBOE opened in April 1973; it was one of the first two modern financial derivatives exchanges. . . . In 1970, financial derivatives were unimportant (no reliable figures for market size exist). By June 2000, the total notional amount of derivatives contracts outstanding worldwide was $108 trillion, the equivalent of $18,000 for every human being on earth (http://www.bis.org). The CBOE is an appropriate site at which to look for performativity because it trades options, which have a special place in modern economics. The theory of option pricing developed by Black and Scholes (1973) and Merton (1973) was a crucial breakthrough that won the 1997 Nobel Prize for Scholes and Merton (Black died in 1995). This theory allowed reformulation of a host of issues such as business decisions and the valuation of corporate debt, and it became the central paradigm – in the full Kuhnian sense – of financial economics: ‘Most everything that has been developed in modern finance since 1973 is but a footnote on the BSM [Black–Scholes–Merton] equation’ (Taleb 1998, p. 35). Above all, option pricing theory enjoyed empirical success: ‘When judged by its ability to explain the empirical data, option pricing theory is the most successful theory not only in finance, but in all of economics’ (Ross 1987, p. 332). The study of the CBOE thus allows the question of performativity to be given a precise formulation. Why was option pricing theory so successful empirically? Was it because of the discovery of preexisting price regularities? Or did the theory succeed empirically because participants used it to set option prices? Did it make itself true? As will be seen, the answer is broadly compatible with Callon’s analysis. . . . We shall argue that to theorize how performativity articulates with these themes requires that conventional economic notions of the rational actor both be impoverished (in the sense of the acknowledgement of human cognitive limitations) and enriched. To study the articulation empirically demands, we claim, a historical understanding of markets. If the CBOE were examined at any one point in time, quite mistaken conclusions about performativity could be reached. This has determined our methodology, which is that of historical sociology, in particular use of oral-history interviewing. We have tracked the CBOE from its

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origins to the present, taking advantage of the fact that interviewees can be found who have been active in the market throughout, or almost throughout; we have also interviewed the leading option theorists3. . . .

Option pricing theory [Early] academic work on options (e.g., Malkiel and Quandt 1968, 1969) . . . involved either empirical, econometric analyses or elaborate theoretical models that contained parameters whose values could not be measured in any straightforward way. In contrast, Black, Scholes (1973), and Merton’s (1973) arguments were at their core simple and elegant. If the price of a stock followed the standard model of a log-normal random walk in continuous time, and other simplifying assumptions held . . . it was possible to hedge any option transaction perfectly. In other words, it was possible to construct a continuously adjusted portfolio of the underlying stock and government bonds or cash that would ‘replicate’ the option: that would have the same return as it under all possible states of the world. Black, Scholes, and Merton then reasoned that the price of the option must equal the cost of the replicating portfolio: if their prices diverged, arbitrageurs would buy the cheaper and short sell the dearer, and this would drive their prices together. This reasoning led to the famous Black–Scholes equation, where w is the price of the option, x the price of the stock, t time, σ the volatility of the stock, and r the riskless rate of interest: ∂w ∂w 1 2 2 ∂2w + σ x 2 + rx − rw = 0. ∂t 2 ∂x ∂x

(1)

. . . Black, Scholes, and Merton’s fellow economists quickly recognized their work as a tour de force. It was more than a solution of a difficult technical problem: it showed how to approach a host of situations that had ‘optionlike’ features; and it linked options to the heartland theoretical portrayal of capital markets as efficient and permitting no arbitrage opportunities. . . . Black, Scholes, and Merton’s work was, however, theoretical rather than empirical. In 1972, Black and Scholes tested their formula against prices in the pre-Chicago Board Options Exchange (CBOE) ad hoc options market and found only approximate agreement. For example, as against the model, ‘contracts on high variance securities tend to be underpriced, and . . . contracts on low variance securities tend to be overpriced’ (Black and Scholes 1972, pp. 4 14–15). Nor did the opening of the CBOE immediately improve the fit. Mathew L. Gladstein of Donaldson, Lufkin and Jenrette Securities Corporation contracted with Scholes and Merton to provide theoretical prices ready for its opening: The first day that the Exchange opened . . . I looked at the prices of calls and I looked at the model and the calls were maybe 30–40% overvalued! And I called Myron [Scholes] in a panic and said, “Your

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model is a joke,” and he said, “Give me the prices,” and he went back and he huddled with Merton and he came back. He says, “The model’s right.” And I ran down the hall . . . and I said, “Give me more money and we’re going to have a killing ground here.” (Gladstein interview) Measuring how long this situation persisted is problematic. Black–Scholes prices are extremely sensitive to the value chosen for σ. Calculating previous ‘historical’ stock price volatility is straightforward, but ‘the [future] volatility of the stock must be estimated. The past volatility . . . is not an infallible guide’ (Black 1975, p. 36). However, the empirical validity of the Black–Scholes formula can be tested indirectly by investigating whether investment strategies are available that yield excess profits: if they are, either the formula or one of its assumptions (for example, of an efficient market) has failed. When Scholes’s student Dan Galai applied such tests to the first seven months of the CBOE, he found that ‘some above-normal profits could have been made’ (Galai 1977, p. 195). These profits ‘were even greater than those found in our original tests’ (Scholes 1998, p. 486), indicating a poorer fit of the model to the CBOE than to the earlier ad hoc market. Soon, however, the fit began to improve. The most thorough tests of fit were conducted by Rubinstein (1985), using a data set of all CBOE price quotations and transactions between August 1976 and August 1978 for the 30 stocks on which options were most heavily traded. Rubinstein judged the fit of the model without independently estimating σ, by constructing from sets of matched pairs of observed option prices the estimate of volatility that minimized deviations from Black–Scholes values. He then calculated the largest deviation from the Black–Scholes prices implied by that volatility, finding typical deviations of around 2%. He later repeated the exercise for the index options that the CBOE began to trade in 1983, finding that by 1986 typical deviations had fallen to less than 1% (Rubinstein 1994, p. 774). By any social science standards it was an excellent fit. This empirical success was not due to the model describing a preexisting reality: as noted, the initial fit between reality and model was fairly poor. Instead, two interrelated processes took place. First, the markets gradually altered so that many of the model’s assumptions, wildly unrealistic when published in 1973, became more accurate. Consider, for example, the assumptions made by Black, Scholes, and Merton about the construction of a portfolio of stock and cash to replicate an option: that it could be constructed using entirely borrowed funds and/or stock; that it could be adjusted instantaneously; and that its construction and adjustment en-tailed no transaction costs. In the mid-1970s, stock could not be bought entirely on credit: the Federal Reserve’s Regulation T limited credit to 75% of the stock price. Borrowing stock was often difficult and always expensive: stock lenders retained the proceeds of short sales as security and typically refused to pass on any of the interest earned. If an options trader did not belong to a member firm of the New York Stock Exchange, stock transactions incurred significant commissions. The information on stock price changes needed to adjust a replicating portfolio was often not available quickly (the

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electronic feed from New York to the CBOE was slow), adjustments took time, and ‘to place a stock order, a marketmaker must leave the options trading crowd (or at least momentarily divert his attention from options trading activity), and, as a result, may lose the opportunity to make an advantageous options trade’ (SEC 1979, pp. 139–40). Gradually, though, many of the model’s assumptions gained greater verisimilitude. Regulation T was waived for bona fide hedging by options market makers, with the model used, performatively, to determine the quantity of stock purchases that constituted a bona fide hedge (Millo 2003). Stock borrowing became more respectable (short sellers had in the past often been blamed for price declines), and the balance of market power began to shift, with borrowers obtaining increasing proportions of the interest on the proceeds of short sales (Thorp interview). Fixed commissions on the New York Stock Exchange were abolished in May 1975. The data feed to Chicago was improved, and better communications and growing automation made it quicker and easier to adjust the replicating portfolio. To the increasing veracity of the Black–Scholes–Merton model’s assumptions was added the second process: the model’s growing use as a guide to trading. . . . Calculating a theoretical price involved taking natural logarithms, finding values of the distribution function of a normal distribution, and exponentiation. It could not plausibly be done by hand in the hurly-burly of trading. Implementing the model on a mainframe computer and making the results available via terminals were straightforward. But such terminals could not be used on the trading floor. Electronic calculators programmed with Black– Scholes solutions did quickly become available, but, despite what others have written (e.g. Passell 1997), they were used only very occasionally on the CBOE floor: even the few seconds it would take to input parameters and wait for a result made them unattractive in fast-moving trading. More attractive was to print theoretical prices on sheets of paper that could be carried on the floor, often tightly wound cylindrically with only immediately relevant parts visible. Particularly widely used was a subscription service of Black–Scholes price sheets that Fischer Black began in 1975. . . . Interlocked economic and cultural processes gradually reduced the various barriers to the use of models. A sudden surge in stock prices in April 1978 caused huge losses to market makers who had sold large numbers of insufficiently hedged calls, and some were forced out of the market. . . . Gradually, the CBOE market makers began to develop a distinct self-identity in which careful pricing and hedging were important. . . . As the CBOE prospered, individual market makers and small firms were gradually displaced by larger firms, such as O’Connor and Associates. . . . Seat-of-the-pants trading or simple heuristics could not suffice when implementing a position across several markets and carrying dozens or hundreds of such positions. Pricing models were necessary for risk management and, crucially, offered a way of communicating and coordinating activities, of talking about options. . . . As the options markets grew, and the SEC relaxed, options were traded on more stocks, some no longer ‘blue chip’ corporations but high volatility

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newcomers. More expensive errors made pricing models seem indispensable: . . . ‘when you get to multiple expirations, strike prices, higher volatility stocks . . . well, volatility changes by 10%, Arco goes from a 15 to a 13.5 [annualized percentage implied volatility], I can do that math in my head. [With a high volatility stock] 150 to 135 seems like it ought to be similar but . . . I’ve got too much money at risk if I’m wrong in my mental calculations’ (Carusillo and Struve interview 1). [. . . .] Gradually, models became not just private resources for some traders but the public property of the whole floor. This began with the start of trading of options on stocks on the National Association of Securities Dealers Automated Quotation system, or NASDAQ, which has no trading floor: transactions are dispersed among large numbers of NASDAQ dealers buying and selling via computer screens and telephones. CBOE market makers soon learned that stock prices on NASDAQ screens were, in practice, indicative only. One could not be sure of a genuine price for a large transaction until one telephoned a dealer, and there were suspicions that at crucial moments telephones were left unanswered for critical seconds. Black, Scholes, and other options theorists had implicitly (the matter was never expressly discussed) assumed that the price of the underlying stock was known. With NASDAQ, that pervasive assumption failed. So, in 1986, the CBOE launched its first ‘Autoquote’ system. In the crowds within which NASDAQ options were traded, CBOE employees would feed in the prices of the most liquid options, those with strike price close to the current stock price. Autoquote software implementing the Black–Scholes equation would then generate the price of a ‘synthetic underlying,’ in other words, calculate the stock price compatible with those option prices. From that it would generate and make public to traders the Black–Scholes prices of the full range of options being traded, including the less liquid ones for which preceding market prices might be a poor guide (Knorring interview).

The volatility skew By the late 1970s, then, Black–Scholes was widely used by CBOE traders, and in the 1980s it began to be incorporated into the CBOE’s informational infrastructure. Gradually, ‘reality’ (in this case, empirical prices) was performatively reshaped in conformance with the theory. However, perhaps the Black–Scholes formula came to be adopted, and came to describe prices accurately, simply because it was ‘right,’ because it gave the correct way to price options? Perhaps the poor early fit of the formula was just a passing consequence of an inefficient market, fated to diminish as the CBOE reached efficiency? If that were so, a claim of performativity would be an empty gloss on a process better understood in conventional economic terms. Here a historical perspective becomes crucial. Let us fast-forward to our most recent observations of the CBOE in November 2000. . . . A crucial aspect of the Black–Scholes–Merton model . . . is now almost never present. [In the Black–Scholes–Merton model] . . . the relationship between strike price and

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implied volatility is a flat line. In the fall of 1987, however, the flat-line relationship, empirically manifest in the late 1970s and early 1980s, disappeared and was replaced by a distinct ‘smile’ or ‘skew.’ . . . The earlier flat line has not returned subsequently (see, e.g., Jackwerth 2000): indeed, the skew continued to grow at least until 1992 (Rubinstein 1994, pp. 772–4). The direction of the skew has been stable: puts with strike prices well below current stock index levels have higher implied volatilities – are relatively more expensive – than puts with higher strike prices, and put-call parity relations imply that the same is true of calls. Similar, if less intense, skews are also to be found in options on individual equities (Toft and Prucyk 1997, p. 1177). The empirical history of option pricing, therefore, falls into three distinct phases. First is the phase prior to the opening of the CBOE and in its first year or so, when there were substantial differences between the observed prices and Black–Scholes values. The second is a phase that had begun by 1976 and lasted until summer 1987, in which the Black–Scholes–Merton model was an excellent fit to observed prices. Third is a phase from autumn 1987 to the present, when the model’s fit has again been poor, especially for index options, in the crucial matter of the relationship between strike price and implied volatility. There is little doubt which event separates the second and third phases: the stock market crash of October 1987, particularly Monday, October 19, 1987, when American stocks suffered their largest ever one-day fall. That day, the Standard and Poor’s (S&P) 500 index fell 20%, and the S&P 500 two-month future on the Chicago Mercantile Exchange – probably a better indicator because of trading disruptions in New York – fell 29% (Jackwerth and Rubinstein 1996, p. 1611). . . . To put it simply, the options market does not (now) expect changes in the S&P 500 index to be log-normally distributed, and large downward movements have implied probabilities far greater than on log normality. After October 1987, the market has come to expect crashes, and it prices options accordingly: puts with low strike prices, which will be exercised only if the underlying index falls considerably, are relatively much more expensive than if the market believed that price changes followed the log-normal assumption of Black– Scholes pricing. What is now performed on the CBOE, therefore, is no longer classic option pricing theory. . . .

The skew and the memory of the market The volatility skew described is qualitatively consistent with standard models of rational learning, but quantitatively the options market has overlearned. For a prolonged period, excess risk-adjusted profits have been available from selling index puts at the market prices that have prevailed since 1988. Remarkably, this is the case even when artificial crashes of 20% in a month are introduced into the computation with probabilities as high as one every four years (Jackwerth 2000). . . . To explain observed index option prices since 1988 requires artificial addition of crashes of almost 1987 severity more frequent than one every four years, when ‘even a 20% [one-month] crash every 8 years seems to be a rather

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pessimistic outlook’ (Jackwerth 2000, p. 447). ‘The most likely explanation,’ Jackwerth concludes (p. 450), ‘is mispricing of options in the market.’ If true, this is a striking finding: participants in one of high modernity’s most efficient, sophisticated markets have been behaving irrationally. Such a conclusion, however, seems to us to involve too narrow a view of rationality. Because the 1987 crash had remarkably little direct effect on the wider economy, and because many investors lost only what they considered to be ‘paper’ gains (the result of earlier stock price rises), it is hard now to recapture just how traumatic 1987 was to those most directly involved. On October 28, 1929, the worst day of the Great Crash, the Dow fell 12.8% (Brady Commission 1988, p. 1). A collapse in a single day of twice that severity lay almost outside the bounds of the conceivable. . . . Nowhere was the trauma more sharply felt than in the CBOE and the Merc. The unprecedented market movements called for huge sums of collateral to change hands, and there was a very real fear that major participants would be unable to meet their obligations. Clearers inherited the obligations of those for whom they cleared; if one clearer failed, the others became responsible for its debts; if they could not honor them, the entire clearing system, and thus the exchange, would collapse. As the Merc (by 1987 tightly linked to the CBOE by the use of its index futures to hedge index options) closed on Monday, October 19, Leo Melamed ‘said a silent prayer. I didn’t know whether we had survived.’ After a prearranged dinner meeting, he returned to the exchange just before midnight and learned that ‘the longs owed the shorts some $2.5 billion,’ more than 20 times the normal settlement sum. In the middle of the night, ‘with sweating hands,’ Melamed began to return the telephone calls that his secretary had received, beginning with the chair of the Federal Reserve, Alan Greenspan. Melamed could not promise Greenspan that the exchange would be able to open the following morning. Frantic activity by Melamed and his colleagues throughout the night (including a call to the home of the chief executive of Morgan Stanley at 3 a.m.) achieved the transfer of $2.1 billion, but as morning approached $400 million was still owed by a customer of Continental Illinois Bank. Around 7 a.m., Melamed called Wilma J. Smelcer, the bank executive who ran its account with the exchange: “Wilma . . . you’re not going to let a stinking couple of hundred million dollars cause the Merc [Mercantile Exchange] to go down the tubes, are you?” “Leo, my hands are tied.” “Please listen, Wilma; you have to take it upon yourself to guarantee the balance because if you don’t, I’ve got to call Alan Greenspan, and we’re going to cause the next depression.” There was silence on the other end of the phone. . . . Suddenly, fate intervened. “Hold it a minute, Leo,” she shouted into my earpiece, “Tom Theobald just walked in.” Theobald was then the chairman of Continental Bank. A couple of minutes later, but what seemed to me like an eternity, Smelcer was back on the phone. “Leo, we’re okay. Tom said to go ahead. You’ve got your money.” I looked at the

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time, it was 7:17 a.m. We had three full minutes to spare before the opening of our currency markets. (Melamed and Tamarkin 1996, pp. 358–9 and 362–3) . . . What was learned in October 1987, therefore, was more than that stock markets could suddenly fall by previously unthinkable amounts: it was also that the consequences of such a fall could threaten the very existence of derivatives markets. Nor were all the effects of the crash short-lived: it was 1995 before stock options trading on the CBOE recovered to pre-crash volumes (CBOE/ OCC 1998a, p. 12). It is this collective trauma, we conjecture, that sustains the skew.4 . . .

Conclusion . . . The development of the CBOE and (in a different way) of the Merc is a small but significant thread in the emergence of high modernity. . . . The development of the CBOE . . . is of importance in its own right as one of the transformative processes of our times. Its chief theoretical interest is as a study in the performativity of economics. . . . Black, Scholes, and Merton’s model did not describe an already existing world: when first formulated, its assumptions were quite unrealistic, and empirical prices differed systematically from the model. Gradually, though, the financial markets changed in a way that fitted the model. In part, this was the result of technological improvements to price dissemination and transaction processing. In part, it was the general liberalizing effect of free market economics. In part, however, it was the effect of option pricing theory itself. Pricing models came to shape the very way participants thought and talked about options, in particular via the key, entirely model-dependent, notion of ‘implied volatility’. The use of the Black–Scholes–Merton model in arbitrage – particularly in ‘spreading’ – had the effect of reducing discrepancies between empirical prices and the model, especially in the econometrically crucial matter of the flat-line relationship between implied volatility and strike price. Gradually, then, the CBOE participants began to price options as economists suggested homo œconomicus should. In the ad hoc New York market, and in the early months of the CBOE, prices were often set following simple rules of thumb. Participants then were more like the heuristic followers, with bounded rationality, posited by Herbert Simon (e.g., Simon 1955) than fully rational neoclassical homines œconomici. But even those participants who were not convinced by, or entirely ignorant of, Black, Scholes, and Merton’s elegant reasoning were pushed toward Black–Scholes–Merton pricing as increasing numbers of other participants used the model. As far as pricing is concerned, the process, at least until 1987, nicely fits Callon’s formulation: ‘Yes, homo economicus does exist, but is not an a-historical reality; he does not describe the hidden nature of the human being. He is the result of a process of configuration. . . . Of course it mobilizes material and metrological investments, property rights and money, but we should not forget the essential

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contribution of economics in the performing of the economy’ (Callon 1998, pp. 22–3). . . . The performativity of classic option pricing theory was, however, not a matter of simple self-fulfilling prophecy (see Merton 1949) or of the discovery of the correct way to price options. It was a contested, historically contingent outcome, ended by a historical event, the 1987 crash. No feedback loop of performativity stabilized the assumption of log-normal stock price movements. The crash was a grotesquely unlikely event on such an assumption and thus undermined its credibility. Nor, as we have seen, was the market reaction to 1987 a simple matter of rational learning from the rejection of the null hypothesis of log-normality. The strength and persistence of the skew becomes understandable only once 1987’s threat to the very existence of derivatives markets is grasped. No economist – indeed no identifiable person – invented the skew; economists have yet to reach any consensus on how best to theorize it. It was, we have argued, the upshot of a collective trauma, held in place subsequently in part by a concern that has an edge of morality to it. . . . A mature, efficient market (which the CBOE had certainly become by the mid-1970s) priced options one way until 1987 and differently thereafter, and the change was driven by a historical event. ‘Performativity’ is a helpful addition to economic sociology’s conceptual tool kit, and Callon has usefully shown the insights that can be gained by reversing the field’s normal approach: instead of showing how market participants are more complex and more embedded than economics assumes, show how economics and its associated practices simplify and disembed them to the extent that economics becomes applicable.5

References Black, Fischer. 1975. ‘Fact and Fantasy in the Use of Options.’ Financial Analysts Journal 31:36–41, 61–72. Black, Fischer and Myron Scholes. 1972. ‘The Valuation of Option Contracts and a Test of Market Efficiency.’ Journal of Finance 27:399–417. —— . 1973. ‘The Pricing of Options and Corporate Liabilities.’ Journal of Political Economy 81:637–54. Brady Commission. 1988. Report of the Presidential Task Force on Market Mechanisms. Washington, DC: Government Printing Office. Callon, Michel, ed. 1998. The Laws of the Markets. Oxford: Blackwell. Faulhaber, Gerald L. and William J. Baumol. 1988. ‘Economists as Innovators: Practical Products of Theoretical Research.’ Journal of Economic Literature 26: 577–600. Galai, Dan. 1977. ‘Tests of Market Efficiency of the Chicago Board Options Exchange.’ Journal of Business 50:167–97. Garcia, Marie-France. 1986. ‘La construction sociale d’un marche' parfait: Le marche' au cadran de Fontaines-en-Sologne.’ Actes de la Recherche en Sciences Sociales 65: 2–13. Jackwerth, Jens Carsten. 2000. ‘Recovering Risk Aversion from Option Prices and Realized Returns.’ Review of Financial Studies 13:433–51. Jackwerth, Jens Carsten and Mark Rubinstein. 1996. ‘Recovering Probability Distributions from Option Prices.’ Journal of Finance 51:1611–21.

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Malkiel, Burton G. and Richard E. Quandt. 1968. ‘Can Options Improve an Institution’s Performance?’ Institutional Investor November, 55–56, 101. —— . 1969. Strategies and Rational Decisions in the Securities Options Market. Cambridge, Mass.: MIT Press. Melamed, Leo and Bob Tamarkin. 1996. Leo Melamed: Escape to the Futures. New York: Wiley. Merton, Robert K. 1949. ‘The Self-fulfilling prophecy’. Pp. 179–95 in Social Theory and Social structure, by Merton. New York: Free Press. Merton, Robert C. 1973. ‘Theory of Rational Option Pricing.’ Bell Journal of Economics and Management Science 4:141–83. Miller, Daniel. 2002. ‘Turning Callon the Right Way Up.’ Economy and Society 31: 218–33. Millo, Yuval. 2003. ‘How to Finance the Floor? The Chicago Commodities Markets Ethos and the Black–Scholes Model.’ Manuscript. Passell, Peter. 1997. ‘2 get Nobel for a Formula at the Heart of Options Trading.’ New York Times, October 15, D1 and D4. Ross, Stephen A. 1987. ‘Finance.’ Pp. 322–36 in The New Palgrave Dictionary of Economics, vol. 2. Edited by John Eatwell, Murray Milgate, and Peter Newman. London: Macmillan. Rubinstein, Mark. 1985. ‘Nonparametric Tests of Alternative Option Pricing Models Using All Reported Trades and Quotes on the 30 Most Active CBOE Option Classes from August 23, 1976 through August 31, 1978.’ Journal of Finance 40:455–80. —— . 1994. ‘Implied Binomial Trees.’ Journal of Finance 49:771–818. Scholes, Myron, S. 1998. ‘Derivatives in a Dynamic Environment’, Pp. 475–502 in Les Pix Nobel 1997. Stockholder: Alanquist and Wiksell. SEC (Securities and Exchange Commission). 1979. Report of the Special Study of the Options Markets to the Securities and Exchange Commission. Washington, DC: Government Printing Office. Simon, Herbert. 1955. ‘A Behavioral Model of Rational Choice.’ Quarterly Journal of Economics 69:99–118. Slater, Don. 2002. ‘From Calculation to Alienation: Disentangling Economic Abstractions.’ Economy and Society 31:234–49. Taleb, Nassim. 1998. ‘How the Ought Became the Is.’ Futures and OTC World Black– Scholes–Merton suppl., pp. 35–6. Toft, K. B., and B. Prucyk. 1997. ‘Options on Leveraged Equity: Theory and Empirical Tests.’ Journal of Finance 52:1151–80. EDITORS’ NOTES 1 2

3

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Reprinted by permission of the publisher, University of Chicago Press. © 2003 by the University of Chicago. This extract focuses on the third, fourth and fifth sections of the paper. The original paper is nearly 40 pages long and, therefore, for reasons of space this extract also omits the authors’ notes, tables and figures. Readers are referred to the original, including for a list of interviewees given in the appendix to the paper. At this point we removed the remainder of this section which outlined the structure

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of the article, the next section on ‘Derivatives, morals and economics’, which provides a history of the construction of the CBOE, and the section after that on ‘Culture, structure, and collective action’, which considers the sociology of the CBOE, including the particular norms, habits and socialities on and off the trading floor. Interested readers are referred to the original. At this point we removed four paragraphs which discuss in more detail the reasons for the persistence of the skew, drawing on interviews with key financial actors. The conclusion also includes a further six paragraphs which return to a discussion of Callon’s work.

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Chapter 16

Paul Langley

THE FINAL SALARY PENSIONS ‘CRISIS’

Introduction to extract from Paul Langley (2004), ‘In the eye of the “perfect storm”: the final salary pensions crisis and the financialisation of AngloAmerican capitalism’, New Political Economy, 9(4): 539–58

EDITORS’ COMMENTARY In the period since 2000, many large employers in the USA and UK have closed their defined benefit (DB) pension schemes (at least to new employees) but have continued to offer defined contribution (DC) schemes. The difference is important to employees because DB schemes offer a pension which is usually guaranteed in relation to final salary whereas DC schemes offer only the money purchase value of contributions made which depends on the performance of financial markets and interest rates by or at a particular point in time. Callon figures quite explicitly in Paul Langley’s introduction via the quotation about how ‘economics formats the economy’ and Langley is concerned with how ‘discourses of economy’ constitute the ‘ongoing financialisation of Anglo American capitalism’. But Langley’s distinctive aim is to combine traditional political economy concerns about power and distributive outcomes with culturally-inflected understandings of the construction of new economic subjectivities. The result is a hybrid discourse which Langley defines as ‘cultural political economy’. The starting point is a history of the development of occupational pensions since about 1970. Langley does not accept the standard account which explains the recent collapse of DB as happenstance caused by a ‘perfect storm’ of low interest rates and collapsing stock prices after 2000 which could not have been predicted. Instead he proposes an alternative performative explanation where ‘the discourse and institutions of asset management’ determine the portfolio choices of pension funds before

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and after they encountered the storm. It was this institutions/discourse couple which, from the 1960s and 1970s, encouraged pension funds to hold increasing amounts of ordinary shares whose value could go up and down and then to pursue trading strategies of active trading and short term profit maximization, which fed the ‘speculative mania’ of the new economy in the 1990s. The issue arising from this alternative history then becomes: how and why were DC schemes presented to workers as the natural and sustainable alternative to DB? The discourse and institutions of pension fund management meant that the intermediaries in the pension fund industry could not question the commitment to equities and were in Engelen’s (2003) phrase ‘prisoners of their own investments’. Langley argues that the choice was then determined by the material incentives for employers who, through DC schemes, capped any liability to top up fund deficits and reduced their employers’ contributions as a percent of employee salary costs. This outcome was also coherent with neoliberal welfare discourse which represented individual investment in personal pension provision as an inalienable right that would empower the individual. For Langley, the result is greater insecurity for the pension contributor since under DB schemes the risk that investments may underperform is borne by the firm, whereas under DC schemes the risk is held by the individual. This redistribution of risk from firms to households is, from Langley’s perspective, a defining characteristic of financialization which should be resisted. Hence the importance of a final section in his paper on alternatives to the present provision and antidotes to any nostalgia for DB. Langley’s has ‘serious doubts’ about stock market-based pension provision and hints at public provision and a new role for the state in ‘adequate and inclusive collective saving for retirement that eschews processes of financialization’. Paul Langley is a Senior lecturer in International Politics, Northumbria University He is currently serving as Convenor of the British International Studies Association’s (BISA) International Political Economy Group (IPEG). His published books include: World Financial Orders: An Historical International Political Economy (Routledge, 2002) and The Everyday Life of Global Finance: Saving and Borrowing in AngloAmerica’ (forthcoming).

REFERENCE Engelen, E. (2003) ‘The logic of funding European pension restructuring and the dangers of financialisation’, Environment and Planning A, 35(8): 1357–72.

A

N A P PA R E N T PA R A D O X M A R K S the current crisis of US and UK occupational pensions.1, 2 On the one hand, the customary explanation casts the crisis as akin to a ‘perfect storm’ . . . the unlikely coincidence . . . of low interest rates and the fall and stagnation of global stock market prices. . . . The

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crisis appears as something of an anomaly, a passing disaster that could not have been predicted, but will, like all storms, eventually blow itself out. It follows that the current difficulties experienced by occupational pension funds do not challenge the efficacy of investment in securities as a means of providing for income in retirement. . . . The crisis is [portrayed] as the ‘final salary pension crisis’ . . ., in the popular media. The majority of US and UK final salary schemes are now closed to new entrants who, for the most part, have been offered membership of a defined contribution (DC) scheme by way of alternative. . . . [Yet both] schemes invest the tax-favoured contributions of employees and sponsoring employers in equities, bonds and other financial instruments. . . . While the ‘perfect storm’ threatens to blow away the benefits paid by both DB and DC schemes, it is only the solvency and sustainability of DB schemes that has been called into question. The purpose of this article is to explore the two sides of this apparent paradox. How, in the midst of the crisis, is the death knell being sounded for final salary pension schemes at the same time as the privileged place of stock market investment in saving for retirement is retained? My central argument is that the course of the crisis can be fruitfully understood in terms of the financialisation of Anglo-American capitalism. . . . Taking inspiration from recent contributions that seek to renew political economy through an engagement with ‘cultural economy’, I focus on the significance of specific discourses of economy to constituting the ongoing financialisation of Anglo-American capitalism. . . . [I then] turn to reflect critically on the customary ‘perfect storm’ explanation of the crisis. I show how, far from an anomalous event temporarily interrupting the capacity of the stock market to provide for retirement, the roots of the crisis lie in the investment practices of occupational pension funds themselves. . . . [Thirdly, I examine] the manner in which the final salary crisis has progressed . . . [and conclude that] the reassertion of the primacy of DC schemes reflects a commitment to individualised responsibility for saving for retirement found in the neoliberal welfare discourse that advances financialisation as ‘both subjectivity and moral code’ (Martin 2002, p. 9).

The financialisation of Anglo-American capitalism . . . Recent contributions to new political economy provide an insightful starting point as we seek not to dilute the concept of financialisation, but to come to a more nuanced understanding of financialised practices, their construction and contradictions. Jessop and Sum’s timely call for ‘a Marxist-inflected ‘cultural political economy” reminds us that Marxist approaches tend to neglect ‘the discursive constitution of the economy’ (2001, pp. 92, 95). Marieke de Goede (2003) also warns of the weakness of approaches to political economy that are guilty of assuming ‘a prediscursive economic materiality’ (p. 80). Our attention is thereby drawn to those ‘cultural economists’, working in sociology and elsewhere, who maintain that culture, discourse and narratives are not, in Marxist terms, superstructural and secondary, but of central importance to the active making of the economic base itself (Amin and Thrift 2004; Callon 1998; du Gay

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and Pryke 2002; Ray and Sayer 1999). ‘Cultural economy’ should not be understood narrowly as an epochal concern with contemporary ‘cultural industries’ (e.g. leisure, tourism, arts), but analytically as a ‘far-reaching ambition to rework the economy as a cultural artifact’ (Amin and Thrift 2004, p.xii). It is in this sense, for instance, that Michel Callon asserts that ‘economics, in the broad sense of the term, performs, shapes and formats the economy, rather than observing how it functions’ (1998, p. 2). . . .

Situating the final salary pensions crisis The ‘perfect storm’? The customary explanation of the current difficulties of Anglo-American final salary pension schemes tends to cast the crisis as the outcome of a ‘perfect storm’ (The Economist 13 September 2003, pp. 84–5) . . . As such, the final salary pensions crisis appears as a consequence of a highly unlikely confluence of major downturns and stagnation in stock market prices since March 2000 and relatively low interest rates. As journalists at The New York Times put it, Company pension plans have been battered by more than three years of poor investment returns combined with low interest rates. . . . The last three years represents the longest period of combined declining stock values and low interest rates since company pensions became widespread after World War II. (21 June 2003) Similarly, for The Economist magazine, ‘falling stockmarkets have torn gaping holes in pension funds’ (22 March 2003, p. 34), as Anglo-American schemes have experienced a dramatic decline in their returns on investment and value of assets over the last three years. In the UK, the mean returns of pension funds with a typical portfolio (roughly 70 per cent equities, 20 per cent bonds and 10 per cent cash and property) were −0.9 per cent in 2000, −11.9 per cent in 2001, −18.1 per cent in 2002 and −4.4 per cent in the first three months of 2003 (Cicutti 2003, p. 20). The total market value of UK occupational pension scheme assets had reached a record high of £812.2 billion at the end of 1999. This fell to £765.2 billion at the end of 2000, £711.6 billion at the end of 2001, and is estimated to have fallen to £597.3 billion by the end of 2002 (UBS Global Asset Management 2003, p. 11). Falls in the value of assets have been sufficient to ensure that the majority of DB schemes are not currently able to meet their liabilities, that is, their current and future benefit payments to scheme members. The result is that the major companies pension funds are collectively in deficit to the tune of £65–100 billion (US$110–160 billion) according to a range of competing estimates (Economist, 5 July 2003, p. 5). In the US, meanwhile, the majority of DB schemes now find themselves firmly in deficit. According to calculations by the Pension Benefit Guaranty Corporation, the federal agency that insures US DB schemes, US companies’ schemes faced a total pension

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shortfall of about US$350 billion at the end of 2002 (New York Times, 28 July 2003). Certain sectors and companies have been particularly hard hit. For example, in the US the automotive and airline industries account for around US$90 billion of the total shortfall (New York Times, 1 May 2003). General Motors would appear to be the holder of the unwanted title of the largest single corporate pensions shortfall of roughly US$25 billion worldwide, a deficit that is greater than the total value of the company measured by market capitalisation at US$21.8 billion (New York Times, 22 June 2003). Important connotations are contained within the perfect storm explanation: the crisis constitutes the worst-case scenario for pension fund investment; and the nature of the crisis could not have been reasonably predicted, as downturns in stock market prices and falls in interest rates rarely coincide. . . . In contrast to the perfect storm explanation, I wish to argue that the roots of the final salary crisis can be found in the financialisation of Anglo-American capitalism and, specifically, in the financialised and contradictory investment practices of occupational pension funds. The crisis is, therefore, not an anomalous and exogenous development that temporarily interrupts the capacity of the stock market to provide for retirement, but arises endogenously from pension fund investment itself. Financialised pension fund investment . . . A cultural political economy reading suggests that we consider the (discursive) making of the financialised investment practices of pension funds. Here I argue that the discourse and institutions of asset management are constitutive in the financialisation of Anglo-American occupational pensions. As indicated, asset management portrays the obligations arising from the promises to pay of credit creation as assets that yield returns on investment. ‘Investment’ in this sense is only indirectly and marginally concerned with plant or production. As Gordon Clark has shown, the asset management techniques pioneered by Anglo-American pension funds, investment management firms and actuarial consultants have been ‘a crucial catalyst in the transformation of the theory and practice of financial management’ (2000, p.ix). . . . At the heart of the discourse and practice of asset management techniques is the use of investment models such as modern portfolio theory that start from the assumption that rates of return from assets are commensurate with the risks of investment. For example, government bonds are expected to yield relatively low returns as they are regarded as virtually risk-free investments, while the yield from the stocks of a new, innovative and unproven hi-tech company are potentially much greater. It follows that a larger and more diversified investment portfolio is likely both to generate returns that reflect trends across she whole financial market and reduce overall risk (Clark 2000, pp. 31–2). Anglo-American pension funds had already begun, during the 1960s and 1970s, to invest in corporate equities to a much greater extent than previously, as relatively high inflation rates undercut fixed returns from government and corporate bonds (Clowes 2000, pp. 12–13). The discourse of asset management

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brought new meaning to, and thereby further accelerated, this diversification of investment. Meanings attached to equity investment practices by pension funds that previously focused on avoiding the corrosive consequences of inflation for fixed-interest investments were jettisoned. Not only does the discourse of asset management suggest the need for a diversified portfolio of pension fund investment but, on the basis of comparative historical analysis of risk and return, also tends to assert the primacy of equity investment. Pension fund investment in equities at the expense of bonds continued to accelerate during the relatively low inflationary climate of the 1980s and 1990s. Schemes turned to designated asset management firms which – based upon their fee structures, product ranges, claims to expertise and past performance records – compete to be ‘mandated’ or contracted by trustees and their consultants to manage some or all of a scheme’s funds for a designated period of time. Such contracts reflect and perform particular positive assumptions about the expertise of asset managers as a certain type of service provider. By the early 1980s the discourse of asset management and utilising the services of asset management firms came to be the dominant ‘frame of reference’ in pension fund investment practices (Callon 1998, p. 22). The drive to diversify investment led to the financialisation of pension funds’ investment in the sense that, on a daily basis, attention came to focus on the rapid and ongoing opening and closing of opportunities for speculation in one type of asset or another. For example, pension funds became involved in so-called ‘momentum investment’, with stocks purchased as their prices rise and sold as prices fall.i Moreover, diversification also ensured that pension funds became embroiled in a succession of largely discrete speculative waves or fads as investment came to focus upon particular classes of assets. For example, pension funds were key participants in developed world corporate restructuring and downsizing during the 1980s and the so-called ‘emerging markets’ bubbles of the 1990s (Toporowski 2000; Harmes 2001, pp. 83–119). Today’s Anglo-American schemes typically undertake diversified investment strategies that are ‘contrived to be both conservative-in the sense of concentrating on well-known brands and blue chip companies – and speculative – in the sense that they . . . slavishly follow market fads’ (Blackburn 2002, p. 177). In the parlance of those who manage the assets of occupational pension schemes, investment and trading strategies must find the right balance between ‘core’ and ‘satellite’ holdings.ii The overtly speculative or ‘satellite’ side of the investment practices of Anglo-American pension schemes is compounded by two related dynamics. In the words of one asset manager, such dynamics ensure that the speculative practices of pension funds are ‘increasingly not just the froth on the head of the glass’. First, a gradual increase in the ratio of beneficiaries to contributors in mature DB schemes translates into an increased need for relatively short-term profit maximization. As Engelen (2003a, p. 1366) puts it, As soon as pension funds mature, their need to push the envelope of existing investment norms and practices grows, resulting in increasingly speculative behaviour and a frantic search for financial

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innovations. Subsequently, ever more specialized and sophisticated asset categories are demanded and constructed. Second, the nature of the contractual relations that prevail between pension funds and asset management firms are also significant in fostering the speculative side of investment practices. Financialisation is effectively institutionalized through the competitive process whereby the performance of the asset management firms that invest on behalf of pension schemes is measured. So-called ‘benchmarks’ for asset management performance typically contract these firms to outperform average market returns (usually measured in terms of the major stock market indices) by 1–1.5 per cent, and not to underperform by a similar amount. The result is ‘herd behaviour’ and greater use of so-called ‘index-linked funds’ as asset managers fear both missing out on the perceived investment opportunities offered by the next big thing and deviating from uniform investment practices. Debates over pension fund investment practices that have coincided with the final salary crisis are also illustrative of the financialisation carried forward through the asset management discourse. . . . Those who have sought to defend equity investment and the practices of asset management more broadly usually focus on historical rates of return and the capacity of investment techniques to hedge risks. For example, writing in the Financial Times, Kate Burgess argues that a mass shift into bonds in the style of Boots would take UK pension fund investment ‘back to the Victorian era’ at the expense of ‘modern investment tools that maximise returns and minimise risk’ (15–16 March 2003). The indications are that this position is currently winning out. As a recent report in the US media put it, If anything, corporate pension managers appear to be moving toward more risk, not less. The composition of pension portfolios is not generally disclosed, so trends are hard to track. But anecdotal evidence suggests that pension managers are turning to hedge funds, real estate investment trusts, emerging markets and other riskier investments, in an effort to recoup the stock losses of the past three years. (Mary Williams Walsh, New York Times, 28 July 2003) In the UK, meanwhile, a recent widely-read industry publication states: ‘increasingly, pension funds are willing to consider “alternative” investments . . . [that] include private equity, hedge funds, gold, commodities, timber, and art and collectables’ (UBS Global Asset Management 2003, p. 52). In short, constituted through the discourse of asset management, the financialisation of pension investment practices appears to be deepening at present. The use of the notion of ‘risk’ in the asset management discourse – that is, the category of ‘risk’ as the basis for the construction of the uncertain future as calculable, measurable and manageable – continues to obscure the very speculative practices that it licenses (de Goede 2002).

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Contradictions of financialised investment The financialised investment practices of Anglo-American schemes contributed to the largely discrete speculative wave of the so-called ‘new economy’ that built up during the late 1990s. Just as with the speculative fads of corporate mergers and acquisitions during the 1980s and of emerging markets during the 1990s, the perceived investment opportunities offered by the new economy rested upon the formation of collective beliefs in future prospects that verged on a mania (Thrift 2001, pp. 415–6). . . . There are . . . considerable grounds for viewing the collapse of the new economy bubble in 2000–2001 and the ensuing stagnation of stock market prices that has so strikingly ruptured Anglo-American pension schemes as a far from temporary problem. Put differently, the ‘perfect storm’ is not just a passing storm, a one-off and unpredictable event. Pension funds’ financialised investment practices are marked by significant contradictions that stem from the dialectical nature of speculation. Speculative manias such as that linked to the new economy are not simply episodes or moments in financial markets, as claims and obligations arising from investment and credit creation are often directly and indirectly claims and obligations on the ‘real’ economy. Financialised practices find expression ‘not only quantitatively as the ascendance of financial contracts over real economic turnover, but also as a qualitative effect of a subordination of real economic and social relations to the financial system’ (Altvater 1997, p. 59). While all promises to pay carry with them assumptions that contribute to shaping the context for the undertakings of those to whom obligations apply, then, under conditions of financialisation the representation of promises to pay as assets necessarily carries with it the assumption that socioeconomic relations are commodified. . . . It follows that a contradiction is present between investment practices that are subject or respond to speculative motivations, on the one hand, and the tensions generated by obligations that falsely assume the commodification of ‘real’ socioeconomic relations, on the other. Panics and severe asset price volatility break out as the (fictitious) assumptions of commodification cannot be consistently met. The ongoing contradictions of financialisation are particularly acute for occupational pension schemes. Pension funds are currently confronted by a dangerous set of circumstances that echo the position of Japanese banks’ crossshareholdings as the so-called ‘bubble economy’ of the 1980s began to burst. Falling and stagnating equity prices encourage pension funds to sell, but, given the sheer scale of their holdings in highly concentrated markets,iii the decision to sell in a market without buyers would be likely to produce a further fall in the value of the remainder of their assets. In Engelen’s terms, pension funds are ‘prisoners of their own investments’ (2003a, p. 1365). Whilst they attempt to avoid this potential ‘meltdown’ scenario by trading holdings in the most liquid markets, it is not certain that financialised occupational pension schemes can continue to have their cake and eat it.

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The crisis unfolds The argument made above is that the foundations of the final salary pension crisis lie within the financialisation of Anglo-American capitalism. Specifically, the contradictory financialised investment practices of pension funds, constituted through the discourse and institutions of asset management, are at the roots of the crisis. This section of the article carries the argument further. With particular reference to two sets of tactics – the closure of existing DB schemes to new entrants and the reassertion of the primacy of DC over DB – I show how the strategies employed by corporate sponsors of pension schemes and state managers in the course of the crisis have also been consistent with the discursive constitution of processes of financialisation. Closing final salary schemes The problems of Anglo-American final salary pensions schemes have engendered a range of tactics from their corporate sponsors. At their most draconian, a few corporations such as shipping group Maersk have taken the decision to wind up their pension schemes. While the benefits of Maersk’s retired UK workers are secure, current employees are likely to see their accrued benefits slashed by as much as half (The Economist, 22 March 2003, p. 34). At the other extreme, firms confronted by shortfalls have made significant contributions in order to maintain the solvency of their DB schemes. In a particularly staggering example, General Motors announced in June 2003 that it intended to borrow US$10 billion to be spent principally on reducing the deficits of its various pension funds (New York Times 21 June 2003). Major corporations and representatives of the pensions industry have also lobbied for significant changes to the standards used in the actuarial calculation of a pension scheme’s assets and liabilities. In the UK such campaigns have led to a delay in the implementation timetable of the Financial Reporting Standard (FRS) 17 which, once fully in place, will serve to minimise the surpluses and amplify the deficits of DB schemes. Meanwhile, in the US, special Congressional measures and new legislation supported by the Bush administration have enabled an increase in the discount rate which translates as a reduction in the liabilities of US DB schemes (New York Times, 11 April 2003).iv The tactics of the corporate sponsors of DB schemes have also included: increasing the retirement age at which members can begin to withdraw their benefits; cutting benefits earned through new service; preventing members from taking lump sum pay-outs on retirement; and requiring that employees either increase contributions or accept lower wage rises as a condition of their continued membership of DB schemes (Watson Wyatt 2003). The principal tactic of corporate sponsors has, however, been to close DB schemes to new entrants who, in most cases, are offered a DC alternative. Indeed, it is arguably only the closure of DB schemes in the name of the final salary crisis that has signalled the crisis itself. A survey of 338 DB schemes covering almost 2 million UK workers by the Association of Consultant Actuaries in March 2003 found that 63 per cent had been closed to new members in the

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previous five and a half years, with 17 per cent closing between October 2002 and March 2003 (Cicutti 2003, p. 17). A report in the Financial Times newspaper in the same month suggested that three-quarters of DB schemes in the UK are now closed to new entrants. It also warned that ‘some senior pension industry figures are predicting that a wave of closures to future contributions by existing members – and then a wave of wind ups – will follow’ (28 March 2003). With regard to the first stage of this prediction, Dixons, Ernst and Young and Iceland supermarkets have become somewhat notorious in the UK for closing their DB schemes to existing members. . . . In our terms, the significance of corporate decisions to close DB schemes provides further illustration of the ties that bind the final salary pension crisis with the processes of financialisation in Anglo-American capitalism. The discourse and practice of shareholder value is an important constitutive dynamic of financialisation. Indeed, critical theorists of contemporary corporate governance place shareholder value firmly at the centre of their accounts of financialisation. For Cutler and Waine, for example, financialisation is reducible to ‘the marginalization of non-financial criteria for evaluating corporate performance’ and ‘the promotion of a regulatory framework conducive to the pursuit of shareholder value’ (2001, p. 100). During the 1990s the search for share-holder value coincided with a long bull market in securities prices which ensured that pension costs for firms were minimized. So-called ‘contributions holidays’ were common. Rising markets combined with actuarial tinkering and (in the UK) regulatory restrictions on the size of a pension fund’s surplus to undercut the need for employer contributions to DB schemes. Around one-third of UK corporate sponsors of DB schemes enjoyed ‘holidays’ worth £18.57 billion between 1987–8 and 2000–1 (TUC 2002). However, the recent emergence of significant deficits in DB schemes in the midst of the ongoing attempt to squeeze more value from corporate operations has, in the words of a representative of UK pension schemes, ‘rapidly transformed pensions from a personnel issue to a financial issue affecting the bottom line’.v The practice of privileging financial transparency and accountability in the measurement of corporate performance that follows from the discourse of shareholder value now extends to the scrutiny of DB pension schemes. A decision to retain a DB scheme that is currently in deficit necessitates significant additional contributions from the profits of its corporate sponsor. This, in turn, leads to a fall in the productive investment necessary to generate future profits and dividend payments for shareholders. For example, in a recent letter sent to each member of the US Congress, Glen A. Barton, chairman and chief executive of Caterpillar, remarked that ‘companies cannot commit to building new plants, launching new research projects or hiring new employees if that cash is needed to fund pensions’ (New York Times, 22 June 2003). Similarly, in the UK, the Confederation of British Industry (CBI) has warned that companies addressing shortfalls in their DB schemes are likely to reduce investment, thereby undercutting the general economic recovery predicted by the UK Treasury amongst others (Financial Times, 28 July 2003). Investment and shareholder value is not only undercut as corporate profits are absorbed by the deficits of DB schemes, but deficits in corporate pension schemes also impact on the cost of

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credit for future investment. For instance, in March 2003 Standard and Poors warned that the credit rating of twelve major European companies might be cut because of their pension liabilities (Financial Times, 28 July 2003). A decision to close a DB scheme, meanwhile, eliminates the so-called ‘open chequebook problem’ of likely additional contributions in the future and facilitates attempts to provide value to investors. Reasserting the primacy of DC pensions For the corporate sponsors of those DB schemes that have recently been closed to new entrants, the provision of a DC alternative represents a significant cost saving. In the UK the most recent survey . . . clearly shows that on average employers contribute significantly less to DC than DB schemes (Government Actuary’s Department 2003, p. 42). For example, as a percentage of the earnings of active members in schemes with between 1000 and 4999 members, employers contributed 15.5 per cent to DB schemes and only 4.8 per cent to DC schemes in 2000. While part of this difference is accounted for by the maturity of many of the DB schemes in question, there is little doubt that the end of the final salary promise significantly reduces costs to schemes’ sponsors. Yet the overall shift from DB to DC occupational pension provision predates the final salary crisis, especially in the US where this trend was in full swing by the mid-to-late 1980s (Mitchell and Schieber 1998, pp. 1–14). In 1975 87 per cent of American workers that were members of an occupational pension scheme were part of a DB plan. By 1996 this figure had fallen to 50 per cent. The closure of DB schemes and their replacement by DC schemes in the course of the final salary pension crisis has, then, accelerated and intensified a previous trend. . . . By reasserting its preference for DC schemes in the midst of the final salary crisis, the UK government indicated that primary responsibility for saving for retirement lies not with the state or the employer, but with the individual. Pensions have been placed more firmly in the context of a ‘new moral economy of welfare’ that turns on the ‘axial principal’ of the ‘privatisation of responsibility’ (Rodger 2000, p. 3). In the opening words of a new pamphlet produced by the Department of Work and Pensions to guide members of the public: Everyone needs to plan ahead for retirement. As people live longer and healthier lives, it’s even more important to think about your retirement income. The basic State Pension will give you a start, but to have the lifestyle you want in retirement you need to think about a second pension, and the sooner you can start the better. (2003, p. 1) There is, then, an ‘atomizing of retirement risk’ that has been reinforced during the final salary crisis (Harmes 2001, p. 105–8). The risk that investments underperform – and that savings are insufficient to provide for ‘the lifestyle you want in retirement’ – are held under DC schemes by the individual and not the corporation. . . . Under DC schemes, individuals are responsible for deciding

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whether to join a pension plan, how much of their pay to contribute, which investment options they should take, and what to do with vested account balances when changing jobs. It is, in short, the making of the subjectivity of ‘the investor’ that most characteristically marks Anglo-American pension reform strategies that reassert the primacy of DC schemes (Langley, forthcoming). In the US initiatives led by the Department of Labor under the auspices of the Savings Are Vital to Everyone’s Retirement (SAVER) Act are currently exploring further possibilities for deepening this financialisation of the subject. The most recent SAVER summit in 2002 considered, for instance, the effectiveness of educational and marketing techniques designed to enhance personal investment as the favoured form of saving for retirement.vi In the UK the newly formed Pensions Commission, under the leadership of former CBI boss Adair Turner, is monitoring the success or otherwise of the government’s so-called ‘voluntarist’ approach (as opposed to Australian-style mandatory arrangements) to encourage individual responsibility for saving for retirement (Turner 2003). Success is felt likely to hinge on what is termed the ‘financial literacy’ of individuals who choose and then manage the financial market investments that are deemed necessary for their retirement.

Concluding remarks In a speech delivered to the SAVER summit in 2002, US President George W. Bush remarked in his own inimitable style that: Every American deserves to be an owner in the American Dream. That Dream includes a sound pension plan, and adequate private savings . . . There’s nothing better than providing the incentive to say ‘this is my asset base, I own it, I will live on it in retirement’. (See http://www.saversummit.dol.gov/bush.html) This statement reveals much about the course of the Anglo-American final salary crisis. The crisis has broken out in a period in which US and UK state managers are committed to furthering the individualisation of responsibility and risk in saving for retirement. This is an issue of ‘ownership’ in Bush’s terms. Prevalent discourses of economy that are constitutive of processes of financialisation in Anglo-American capitalism both frame this individualisation and call up a particular subjectivity. The neoliberal economics of welfare and the drive for shareholder value in corporate governance give rise to an economy in which responsibility for pensions does not lie primarily with the state or firm, but instead resides firmly at the door of the individual. Faith in returns from financial market investment and the discourse of asset management specifically brings form to this financial self-discipline. ‘Private savings’ become ‘a sound pension plan’ that, through appropriate institutional channels and expertise, is transformed into the investments that comprise an ‘asset base’. In the light of Bush’s remarks, then, it is perhaps not that surprising that the final salary crisis has been marked by the seemingly paradoxical closure of DB schemes, on the one hand,

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and the continued promotion of saving for retirement through stock market investment, on the other. Whilst firms can no longer be expected to tolerate the risk that anomalous storm conditions may undercut returns on investment, individuals are best placed to shelter from the same storms by ensuring that their savings are ‘adequate’ to ‘live on . . . in retirement’. . . . Politically, the contradictions of the financialised practices of pension funds raise serious doubts as to the continued promotion of stock market investment in saving for retirement. Rather then reducing overall risk through diversification, the pooling of contributions in funds and their collective investment shaped by the discourse and institutions of asset management serves to promote speculation. Dangerous contradictions are present as the speculative representation of promises to pay as ‘assets’ to be bought and sold effectively (but falsely) commodifies social relations. Current campaigns by the likes of the UK Trades Union Congress to defend DB schemes against the threat of closure, maximise corporate contributions to schemes and maintain the final salary pension promise somewhat miss the point. The current crisis is not simply a crisis of DB schemes, but a crisis of the place of stock market investment in saving for retirement. Similarly, technical tinkering with markets by US and UK state managers in order to ‘regulate the integrity of pension and retirement income institutions’ will not suffice (Clark 2003, p. 1367).vii Rather, as some enlightened activists have noted (Murphy et al. 2003), what is needed is a fresh and innovative approach to adequate and inclusive collective saving for retirement that eschews processes of financialisation.

Author’s notes i ii iii

iv

v vi vii

Confidential interview with a representative of the Investment Management Association, London, 1 September 2003. Confidential interview with a representative of a US-owned asset management firm, London, 4 September 2003. For example, based on LSE figures, pension funds hold around 28 per cent of LSE equities, with insurance companies holding around 22 per cent. Unit trusts and other investment vehicles (including personal pensions) hold an additional 10 per cent. See Minns 2001, p. 170. The discount rate is the rate used in the measurement of the value, in current terms, of a plan’s future obligations to members. The discount rate reflects, therefore, expectations about the rate at which a scheme’s assets can be expected to increase before its beneficiaries retire. Confidential interview with representatives of the National Association of Pension Funds, London, 4 September 2003. See http://www.saversummit.dol.gov/bush.html. For a thorough critique of Clark’s position, see Engelen (2003b) pp. 1377–80 and Tickell (2003) pp. 1381.

References Altvater, E. (1997) ‘Financial crises on the threshold of the 21st century’, in Leo Panitch (ed.), Socialist Register: Ruthless Criticism of All That Exists, London: Merlin.

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Amin, A. and Thrift, N. (eds) (2004) The Blackwell Cultural Economy Reader, Oxford: Blackwell. Blackburn, R. (2002) Banking on Death, or Investing in Life: The History and Future of Pensions, London: Verso. Callon, M. (1998) ‘Introduction: the embeddedness of economic markets in economies’, in Michel Callon (ed.), The Laws of Markets, Oxford: Blackwell. Cicutti, N. (2003) ‘Everything you ever wanted to know about pensions but were afraid to ask’, Bloomberg Money, no. 66, July. Clark, G. L. (2000) Pension Eund Capitalism, Oxford: Oxford University Press. Clowes, M. J. (2000) The Money Flood: How Pension Funds Revolutionized Investing, London: John Wiley and Sons. Cutler, T. and Waine, B. (2001) ‘Social insecurity and the retreat from social democracy: occupational welfare in the long boom and financialisation’, Review of International Political Economy, vol. 8, no.1: 96–118. de Goede, M. (2002) ‘Repoliticising financial risk’, unpublished paper presented to the British International Studies Association 27th Annual Conference, London School of Economics, 17 December. de Goede, M. (2003) ‘Beyond economism in international political economy’, Review of International Studies, vol. 29, no.1: 79–97. Department of Work and Pensions (2003) A Guide to Your Pension Options, London: The Pension Service. du Gay, P. and Pryke, M. (2002) ‘Cultural economy: an introduction’, in Paul du Gay and Michael Pryke (eds), Cultural Economy, London: Sage. Engelen, E. (2003a) ‘The logic of funding european pension restructuring and the dangers of financialisation’, Environment and Planning A, vol. 35, no.8: 1357–72. Engelen, E. (2003b) ‘The false necessities of state retreat’, Environment and Planning A, vol. 35, no.8: 1377–80. Government Actuary’s Department (2003), Occupational Pension Schemes 2000: Eleventh Survey by the Government Actuary, London: Government Actuary’s Department. Harmes, A. (2001) Unseen Power: How Mutual Funds Threaten the Political and Economic Wealth of Nations, Toronto: Stoddart. Jessop, B. and Sum, N.-L. (2001) ‘Pre-disciplinary and post-disciplinary perspectives’, New Political Economy, vol. 6, no.1: 89–101. Langley, P. (forthcoming) in ‘The Everyday Life of Global Finance: Saving and Borrowing in America and Britain’, unpublished manuscript. Martin, R. (2002) Financialisation of Daily Life, Philadelphia: Temple University Press. Minns, R. (2001) The Cold War in Welfare: Stock Markets versus Pensions, London: Verso. Mitchell, O. S. and Schieber, S. J. (1998) ‘Defined contribution pensions: new opportunities, new risks’, in Olivia S. Mitchell and Sylvester J. Schieber (eds), Living With Defined Contribution Pensions: Remaking Responsibility for Retirement, Philadelphia: University of Pennsylvania Press. Murphy, R., Hines, C. and Simpson, A. (2003) People’s Pensions: New Thinking for the 21st Century, London: New Economics Foundation. Ray, L. and Sayer, A. (1999) ‘Introduction’, in Larry Ray and Andrew Sayer (eds), Culture and Economy after the Cultural Turn, London: Sage. Rodger, J. J. (2000) From a Welfare State to a Welfare Society: The Changing Context of Social Policy in a Postmodern Era, London: Macmillan. Thrift, N. (2001) ‘It’s the romance, not the finance, that makes the business worth

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pursuing’: disclosing a new market culture’, Economy and Society, Vol.30, no.4: 412–32. Tickell, A. (2003) ‘Pensions and Polities’, Environment and Planning A, vol.35, no. 8: 1381–4. Toporowski, J. (2000) The End of Finance: Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism, London: Routledge. Trades Union Congress (TUC) (2002), Pensions in Peril: The Decline of the Final Salary Pension Scheme, available at http://www.tuc.org/pensions/. Tumer, A. (2003) ‘The Macroeconomics of Pensions: A Lecture to the Actuarial Profession’, London, 2 September 2003, available at http://www.actuaries.org.uk/ Display_Page.cgi?url=/pensions/AdairTumerlecture.html. UBS Global Asset Management (2003) Pension Fund Indicators 2003: A Long-term Perspective on Pension Fund Investment, UBS Global Asset Management. Watson Wyatt (2003) Pension Plan Design Survey: 2003 Update, available at http:// www.watsonwyatt.com. EDITORS’ NOTES 1 2

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Reprinted by permission of the publisher, Carfax Publishing. © 2004 Taylor and Francis Group. This extract follows the strucure of the original paper. The introduction is followed by a first section on financialization, a second section (with three subsections) on pension fund investment, a third section (with two subsections) on the final salary crisis and a fourth section which concludes. The author’s notes are given at the end of the extract and indicated by roman numerals.

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SECTION FIVE

Current debates: questioning financialized management EDITORS’ INTRODUCTION

T

H E C U R R E N T F O R M S O F financialization are associated with social disap-

pointment and panics as much as with economic inequality and insecurity. The disappointment is typically about the conduct of whole classes of subjects who are not behaving as they should according to the scripts of corporate governance and democratized finance: thus, corporate governance reports and the media highlight the problem of ‘executive excess’ as ‘fat cat’ CEOs enrich themselves rather than create value for shareholders;1 while national reports and a book length OECD report highlight the problem of ‘financial literacy’ (OECD 2005) because the mass of the population lack the competence or commitment to make long-term savings decisions. Social panics about these issues rest on very blurred problem definitions. On financial literacy, as we have argued elsewhere (Erturk et al. 2007), the uncertainties about future life course, long-term returns, and product characteristics prevent rational decision-making; and, as the Wharton behavioural finance academics argue, it would be more socially sensible (but less privately profitable) to adapt the financial services product to the consumer rather than adapt the consumer to the product (Mitchell and Utkus 2004; see also Leyshon et al. 1998). Indignation about executive excess begs the question about whether pay-for-performance criteria can be specified ex ante and about what management could and should do to ‘create value’ when (without acquisitions) most giant firms predictably grow no faster than GDP and when many firms face problems about cyclicality and product-market competition. Matters are further complicated by our limited understanding of what used to be called ideology and false consciousness before critical academics recognized that such disparagement was unsustainable when science was a social construction, not a truth value. Thus, critical intellectuals encounter difficulties in understanding coupon pool capitalism without the old conceptual toolkit for deconstructing the multiple illusions about social behaviour and its outcomes within successive conjunctures. What we do have are some sharp insights such as Mauro Zilbovicius’ (1999) concept of ‘sincere lies’, which are, of course, told by the well meaning and believed by the good natured. Social disappointment and blurred intellectualism both frustrate incisive analysis and sustain lively debate. So it is in the case of the debates about financialized management by centre-left academic analysts of LBOs (leveraged or debt-based buyouts of public companies) in the USA in the 1980s and of value-based management and

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shareholder value in Europe and the USA in the 1990s. As we have seen in section 2, agency theorists had welcomed these developments in the hope that they would impose financial discipline on corporate managers and thereby deliver social benefits for shareholders. But centre-left critics feared that these developments would divert corporate managers from their productive responsibilities, with a resulting economic and social cost in terms of corporate capacity to innovate and compete.2 The centreleft of the 1990s had forgotten Tawney but was still operating with a basic opposition between finance and production and a lively suspicion about finance against production (see, for instance, Langley’s 2003 review of approaches to finance in international political economy). The question then was what did the prioritization of finance mean and require by way of management behaviour and corporate performance in the new context of the 1980s and the 1990s. Because the centre-left is theoretically diverse and empirically curious, their answers have increasingly discovered a world where management behaviour and its outcomes are both more complex and contrary to their simple expectations about the power of finance to impose new priorities on productive management. The centre-left debates of the 1990s and early 2000s (in economic and industrial sociology, economic history and elsewhere) took up a series of related questions as to whether the pressure for shareholder value is clear, well articulated and sustained, whether corporate managers respond predictably and mechanically to these pressures, and whether these pressures produce better financial results and/or worse social outcomes for labour, innovation, and competitiveness. These questions were posed in a variety of different disciplinary problematics. If we consider the four extracts brought together in this section, Fligstein is an economic sociologist latterly influenced by Bourdieu; Lazonick and O’Sullivan represent a post-Chandlerian institutionalist economics of innovation; Kädtler and Sperling are German industrial sociologists; Froud et al. (2006) represent a hybrid political cultural economy about narrative and numbers from CRESC, an interdisciplinary British institute. Their research questions were answered empirically in different national contexts amidst general recognition of the importance of national varieties of capitalism. In the typologies proposed by Hall and Soskice (2001) and elaborated by Amable (2003), the USA and UK were stock market (not bank based) systems and the question then was whether LBOs and the pursuit of shareholder value more generally represented an internal mutation in governance and control systems within and beyond the Anglo-Saxon systems. In countries like France and Germany, the rather different starting point was cross-shareholdings involving banks or other industrial companies (Morin 2000) and corporate managements concerned with market share and product technik (Lawrence 1980); so the intrusion of US consultants and fund managers in the 1990s was here represented as an assault on distinctive European national models. The one thing which unites these diverse specialists is their conviction that the company is in its own right a substantial object for empirical research and an organizational object whose properties and effects are not well understood. Of course, if we consider the importance of innovation in the wholesale money markets or new kinds of subjectivities in households, financialization includes much more than the

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public company. But, as Micklethwait and Wooldridge (2003) rightly observe, the nineteenth-century innovation of the public company has been a catalyst for subsequent economic development and the giant public company has inevitably been the institutional focus for many of the debates around financialization. Agency theory was effectively an attempt to devalue the company, which had no real substance if it was only a nexus of contracts between maximizing individuals. In understanding the company as a substantial organizational form, however, the centre left drew on a very different back story about the giant firm, which was derived from the pioneering economic history of the US giant firm by Alfred Chandler in the 1960s and 1970s; and from subsequent development of classical strategy by Michael Porter and Prahalad and Hamel in the 1980s and 1990s. Discussions of what was new and different about financialized companies in the 1990s need to be set in this frame about m-form organization and strategy for the product market. Alfred Chandler was writing at a time in the 1960s when US giant firms were quite explicitly an example to the rest of the world which, under the tutelage of consultants like McKinsey, was imitating the American way by adopting its corporate organizational forms. In Chandler’s story, the native genius of American business was manifest in its response to the unprecedented opportunity of a huge national market which required all kinds of innovation (Chandler 1977). By the 1920s, however, strategies of product diversification and international expansion were pressing against the limits of existing corporate organizational forms. Firms like du Pont, General Motors, Jersey Standard, and Sears then responded with the structural innovation of m form or divisional organization, which offered an optimal mix of centralized and devolved decision-making for diversified operations. The new m-form combines two elements: first, product based or geographic divisions which are quasifirms with all the functions to negotiate a specific market; and, second, a corporate head office freed of operating decisions so that head office can concentrate on higher-level strategy, control, and allocation of resources (Chandler 1969). This history from Chandler in the 1960s forms the backdrop to the classical idea of strategy in the product market as developed by Michael Porter in the 1980s and Prahalad and Hamel in the 1990s. With ideas about positioning and value chain Porter (1980 and 1985) provided a kind of toolkit for doing (or more exactly describing) divisional strategy; while corporate strategy was a matter of which markets to enter and how to manage the business units (Porter 1985, p. 225). After American firms had been unexpectedly defeated by upstart Japanese competitors, Prahalad and Hamel in the early 1990s offer a twist on earlier ideas about strategy in the product market (1990). In their view, the m-form is dysfunctional because it locks up competences which could spawn new products inside divisional silos. In Prahalad and Hamel, success comes to firms with distinctive and inimitable ‘core competences’ and the task of corporate management is then to mobilize competences and break down the barriers between divisional silos; their position subsequently licenses all kinds of ideas about new tasks such as the ‘management of change’ amidst hostility to bureaucratic organization. The comfortable assumption of classical strategy was that, if organization was fit for purpose, strategy in the product market would produce adequate financial

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returns; although Porter in the 1980s recognized some industries were more financially attractive, he was able to largely ignore questions about financial outcomes. But, the capital markets were about to become increasingly articulate and assertive in their demands for higher returns or, in the language of the 1990s ‘value creation’ through distribution and/or higher share prices; new metrics like EVA (economic value added) were financially derived in ways which challenged management excuses about difficult product markets or cyclical turndown; while proceduralized governance for the shareholder aimed to ensure non-executive directors (NEDs) acted in the financial interests of shareholders. By the late 1980s LBO boom, a new generation of financiers was able to take over and take private under-performing public companies, including the giant RJR Nabisco in 1988. That pressure was removed when the LBO boom self-destructed via excess leverage and insider trading. But, through the 1990s and afterwards, public company managements in the USA and UK had to deal increasingly with fund managers and analysts who asked for explanations, dismissed excuses, and extracted new promises from senior managers. CEOs spent more time on investor relations (Golding 2001; Davis 2006) and public company managements had to submit to disciplinary meetings with the intermediaries who represented the virtual shareholder (Roberts et al. 2006). The change of practice was even more marked in European countries like France as US funds bought French shares: as Morin (2000) observed, by the mid-1990s foreign funds owned 35 per cent of the French market, and French CEOs had to explain themselves in exactly the same way as their US counterparts. The subsequent excess liquidity and easy borrowing environment of the 2000s only intensified the pressures: LBOs came back as private equity in the 2000s using 70 per cent debt to fund the purchase of ever-larger companies all over the world (Froud and Williams 2007; Golding 2007). Size provided limited protection by the peak of the boom in 2007 when private equity bought Alliance–Boots, its first UK FTSE 100 company. The old US corporate raiders from the 1980s like Carl Icahn and Kirk Kerkorian were revitalized; while easy borrowing also empowered new actors in the form of hedge funds who were just as aggressive about demanding the next value creating moves. In 2004, the hedge funds blocked Deutsche Borse’s proposed takeover of London Stock Exchange because they had shorted LSE stock and stood to gain from a fall in stock price. Thus, the stock market’s power was publicly and ostentatiously displayed. The question of how corporate management reacted was first answered in a scholarly, historically sensitive way by Neil Fligstein, writing after the takeover and LBO boom of the 1980s. As an economic sociologist, interestingly Fligstein put the main emphasis not on external pressures but on internal drivers through changing management ‘conceptions of control’, which represent a complication not considered in Chandler’ mechanical schema of strategy and structure, challenge and response. In an earlier debate about US national competitiveness, Hayes and Abernathy (1980) had observed that financially controlled US firms were being trounced by Japanese competitors and pointedly asked whether financially controlled US corporations were ‘managing’ their way to decline. In Fligstein’s view, the medium of change was a new

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‘finance conception of the firm’ as a collection of assets that could be manipulated to increase short-run returns to shareholders; and, in turn that that resulted in a range of non-product market oriented strategies including M&A activity (Fligstein 1990).3 The social precondition for the finance conception included the limits of the earlier sales and marketing conception in managing diversification, corporate managers with backgrounds in finance (not sales or operations) and a changing institutional and legal framework which included anti-trust laws that indirectly encouraged crossproduct market M&A activity. The finance conception then dominated the conceptions of leading actors and resulted in both the conglomerate merger boom of the 1960s and the subsequent dismantling of the conglomerates in the 1980s. The finance concept survives and reasserts itself through these changes and Fligstein sees that the same conception which brings giant firms financial success in the 1980s also brings deindustrialization and manufacturing decline. It is this contrast between corporate financial success and national social welfare which Bill Lazonick and Mary O’Sullivan take up a decade later. Lazonick and O’Sullivan came up with a narrower story in their 2000 Economy and Society article included here.4 Their argument has been very influential partly because it has a strong line about consequences, with their hypothesis that giant US firms had shifted in the 1980s from traditional pro-innovation strategies of ‘retain and reinvest’ to pro-shareholder strategies of ‘downsize and distribute’. Again, this adds an unhappy ending to Chandler’s story because Lazonick and O’Sullivan and Chandler may have some theoretical differences but they are fundamentally agreed that the giant firm is (or should be) an engine of economic growth through innovation. As in Fligstein’s book, much emphasis is placed on earlier control failures and internal drivers. In Lazonick and O’Sullivan, over-centralized and under-performing divisionalized US firms are beaten by the ‘innovative’ Japanese. Agency theorists and institutional investors create a space in which a market in corporate control develops and the senior management of giant firms is suborned and given a vested interest in financial success, since a larger part of their remuneration takes the form of stock options. In Lazonick and O’Sullivan’s view, shareholder value is an ‘ideology of corporate governance’ not a structural outcome of the growing power of pension funds. Consequently, the precepts of ‘maximizing shareholder value’ are potentially resistible in other national economies which, by implication, could safeguard their productive competitiveness by not diverting onto new US-style financial priorities. Meanwhile, back in the USA under the influence of shareholder value, corporate attempts to boost the stock price through ‘downsize and distribute’ strategies result in job losses and under-investment that finances share buyback and higher dividend payouts. In Lazonick and O’Sullivan’s (2000) clear-cut account, capital is the winner and labour the loser. The centre-left’s suspicions about shareholder value encouraged further empirical research into the outcomes of shareholder value and more financially oriented corporate management. Accumulating evidence over the 2000s has complicated the story line and challenged preconceptions about finance against production: first, in US and UK giant firms, epochal stories about before and after are difficult to sustain

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because there is no straightforward step change in management behaviour or corporate performance in the 1990s or afterwards; second, in at least one mainland European case, the empirics suggest that the capital market did not constrain but facilitated discretionary management behaviour. The available empirics on the S&P 500 in the USA and the FTSE 100 in the UK are summarized in Froud et al. (2006) who also supply a commentary: management is responsible for the return on capital employed (ROCE) ratio but that fluctuates cyclically rather than showing any secular increase; giant firm distributions to capital (dividends and interest payments) increase in the UK but show no clear upward trend in the USA; and the largest source of value creation is the general rise in share prices in the bull market of the 1990s which owes nothing to efforts of management; the ultimate limit on value creation remains sales growth, when any group of large companies typically grows roughly as fast as GDP. As for outcomes in the mainland European national cases, the German case is ambiguous but the French case shows how the stock market can facilitate discretionary management policies. German researchers disagree about the effects of a shareholder value orientation and the unwinding of bank holdings with some researchers (e.g. Beyer and Hassel 2002; Beyer and Höpner 2003) arguing the national model is undermined while others (eg Jürgens et al. 2000; Vitols 2004) emphasize the adaptability and resilience of governance institutions, which have not so far been tested by major recession. The French case, as described in related articles by O’Sullivan (2007) and Johal and Leaver (2007) is, in some ways, much more interesting. In the 1990s, a relatively unprofitable French giant-firm sector was not disciplined by its encounters with fund managers from the secondary market. This was partly because fee-driven investment bankers from the primary markets were at the same time offering new issues of stocks and bonds to fund French management strategies of global expansion through acquisition, especially in the USA and UK. These empirical observations about the limits on the disciplinary power of the markets need to be set in the context of the more theorized position of Folkman et al. (2007) who argue that the different groups of intermediaries in the markets are not a class or an elite with a coherent agenda but a loose distributional coalition incentivized by fees which ensure the efforts of some sub-groups will frustrate others. If demands for shareholder value and disciplinary encounters with fund managers do not reliably increase the quantum of shareholder value, the practices of ‘value based management’ (VBM) may yet make a difference inside the giant firm where, according to Chandler’s history, operations are controlled inside the divisions and strategy is formulated in head office. Regrettably, there is still a shortage of empirical studies of decision-making inside the organization and at the lower levels under pressure for improved financial results.5 Jürgen Kädtler and Hans-Joachim Sperling’s article thus makes a valuable contribution because it is empirically based on fieldwork by two industrial sociologists inside German auto firms; and because it is theorized so that it presents a political concept of the firm and of management work as negotiation. Pressures for financial results and the imposition of financial criteria certainly increased in these German firms but Kädtler and Sperling argue that outcomes are uncertain. In their view, the workplace remains a site of contestation

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between the workforce and management which must mediate and balance the logic of low costs and target rates of return against different calculative logics of action. The overall interpretative line is that competences and organizational learning are important to these German firms and therefore ambiguous financial criteria will often be disputed and are often set aside when the outcome is settled by the exercise of power or discretionary decisions made when there is not clearly one best way. For example, should a premium auto manufacturer outsource engine production to a lowcost site or is engine production (like design) a core competence which sustains the brand? Here the German big three premium manufacturers have all made different decisions: Audi builds more than a million engines a year in Hungary; Mercedes builds only in Germany; and BMW produced the engine for the 2001–7 Mini in a Brazilian joint venture but then switched back to West European production. Here again empirical research complicates the story and suggests the interim conclusion that it is quite difficult to impose financial priorities and criteria outside the sphere of portfolio management. The question of strategy after financialization is discussed in the 2006 book by Froud et al. from which the final extract is taken, which includes argument and empirics about the US and UK giant firms in the S&P 500 and the FTSE 100, as well as extended case studies of Ford, GE and Glaxo. Froud et al. (2000a, 2000b) had, from the very beginning of the shareholder value debate, taken the position that the pursuit of higher financial returns was utopian given product-market limits but this utopian project could have real effects such as increased volumes of corporate restructuring. Their 2006 book develops this point by arguing that, after the demands for shareholder value, business strategy in the product market is complicated by corporate strategy for the capital market which takes new forms through narratives of corporate purpose and achievement plus supporting performative initiatives so that strategy involves both saying and doing. Matters are further complicated because the stock market makes diverse demands about rates of return and growth from different companies in various periods, while corporate management usually manages and always spins the presentation of financial numbers. But corporate management does not control the financial numbers, so that last year’s narrative is often discredited by this year’s numbers. In this context, successful management is about delivering narrative and performative reassurance with supporting numbers, though the numbers are not necessarily being driven by what is highlighted in narrative and performance. Thus GE in the 1980s and the 1990s had an undisclosed business model of running the industrial business for profit and the acquisitive finance arm for sales growth. The two businesses together generated the numbers that confirmed its story about management excellence and Jack Welch’s status as an icon. Consequently GE was not punished by the stock market for delivering a feeble ROCE and did not generally trade at a discount like other conglomerates in the S&P index. If we put all this together, our accumulating knowledge of management after the intrusion of the capital market since about 1980 has taken us away from earlier epochal understandings of capitalism in terms of a before and after which are antithetically different in every way. Rather, it has taken us towards an understanding of coupon pool capitalism as a succession of conjunctures whose multiple logics are

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wrapped in all kinds of narrative and performative justifications which should not be taken at face value. The practical lesson of the debates about financialized management is that financial power and management actions should never be accepted as they present themselves because actors and commentators often tell or believe sincere lies about what is going on.

NOTES 1

2

3

4 5

See, for example, the succession of industry-led reports and government consultations on corporate governance in general and executive pay in particular (Cadbury 1992; Greenbury 1995; Hampel 1998; DTI 2003) This debate follows on from a variety of concerns evident in the 1970s and 1980s, such as the extent to which financial corporations were controlling industrial firms via inter-company networks and positions on company boards of directors. See, for instance, the review in Scott (1997). Fligstein’s argument here provides an interesting contrast to that in the extract from Jensen (1993) in section 2 of this book. Jensen argues that internal control was weak in the late 1980s and early 1990s and that the absence of an effective market for exit meant that shareholder interests were not being pursued as effectively as they should. In contrast, Fligstein’s argument suggests that the finance conception was driving internal control in the 1980s and that many corporate decisions (including plant closure) were driven by financial objectives. For an extended argument see also O’Sullivan (2001). See also, for example, Vitols 2002, Ezzamel et al. 2004 and Pike 2006.

REFERENCES Amable, B. (2003) The Diversity of Modern Capitalism, Oxford: Oxford University Press. Beyer, J. and Hassel, A. (2002) ‘The effects of convergence: internationalisation and the changing distribution of net value added in large German firms’, Economy and Society, 31 (3): 309–32. Beyer, J. and Höpner, M. (2003) ‘The disintegration of organised capitalism: German corporate governance in the 1990s’, West European Politics, 26 (4): 179–201. Cadbury, A. (1992) Report of the Committee on the Financial Aspects of Corporate Governance, London: Gee & Co. Chandler, A. D. (1969) Strategy and Structure: Chapters in the History of the American Industrial Enterprise, Cambridge, MA: MIT Press. Chandler, A. D. (1977) The Visible Hand: The Managerial Revolution in American Business, Cambridge, MA: Harvard Belknap. Davis, A. G. (2006) ‘The limits of metrological performativity: valuing equities in the London Stock Exchange’, Competition and Change, 10 (1): 3–21. DTI (2003) ‘Rewards for Failure’: Directors’ Remuneration – Contracts, Performance and Severance, consultation paper, London: DTI.

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Erturk, I., Froud, J., Johal, S., Leaver, A., and Williams, K. (2007) ‘The democratisation of finance? Promises, outcomes and conditions’, Review of International Political Economy, 14 (4): 553–75. Ezzamel, M., Willmott, H. and Worthington, F. (2004) ‘Accounting and management– labour relations: the politics of production in the “factory with a problem” ’, Accounting, Organizations and Society, 29 (3/4): 269–302 Fligstein, N. (1990) The Transformation of Corporate Control, Cambridge, MA: Harvard University Press. Folkman, P., Froud, J., Johal, S., and Williams, K. (2007) ‘Working for themselves?: capital market intermediaries and present day capitalism’, Business History, 49 (4): 552–72. Froud, J. and Williams, K. (2007) ‘Private equity and the culture of value extraction’, New Political Economy, 12 (3): 405–20. Froud, J., Haslam, C., Johal, S., and Williams, K. (2000a) ‘Shareholder value and financialisation: consultancy promises, management moves’, Economy and Society, 29 (1): 80–120. Froud, J., Haslam, C., Johal, S., and Williams, K. (2000b) ‘Restructuring for shareholder value and its implications for labour’, Cambridge Journal of Economics, 24 (6): 771–98. Froud, J., Johal, S., Leaver, A., and Williams, K. (2006) Financialization and Strategy. Narrative and Numbers, London: Routledge. Golding, T. (2001) The City: Inside the Great Expectations Machine, Harlow: Pearson Education. Golding, T. (2007) ‘Private equity: myth and reality’, Competition and Change, 11 (4): 348–52. Greenbury, R. (1995) Directors’ Remuneration: Report by a Study Group Chaired by Sir Richard Greenbury, London: Gee Publishing. Hall, P. and Soskice, D. (2001) Varieties of Capitalism: The Institutional Foundation of Comparative Advantage, Oxford: Oxford University Press. Hampel, R. (1998) Committee on Corporate Governance: Final Report, London: Gee. Hayes, R. H. and Abernathy, S. (1980) ‘Managing our way to business decline’, Harvard Business Review, 58 (4): 67–77. Jensen, M.C. (1993) ‘The modern industrial revolution, exit and the failure of internal control systems’, Journal of Finance, 48 (3): 831–80. Johal, S. and Leaver, A. (2007) ‘Is the stock market a disciplinary institution? French giant firms and the regime of accumulation’, New Political Economy, 12 (3): 349–68. Jürgens, U., Naumann, K. and Rupp, J. (2000) ‘Shareholder value in an adverse environment: the German case’, Economy & Society, 29 (3): 54–80. Kädtler, J. and Sperling, H.-J. (2001) ‘After globalisation and financialisation: logics of bargaining in the German auto industry’, Competition and Change, 6 (2): 149–68. Langley, P. (2003) ‘The everyday life of global finance’, IPEG Papers in Global Political Economy, no. 5. Lawrence, P. A. (1980) Managers and Management in West Germany, New York: St Martin’s Press.

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Lazonick, W. and O’Sullivan, M. (2000) ‘Maximising shareholder value: a new ideology for corporate governance’, Economy and Society, 29 (1): 13–35. Leyshon, A., Thrift, N., and Pratt, J. (1998) ‘Reading financial services: texts, consumers and financial literacy’, Environment and Planning D: Society and Space, 16: 29–55. Micklethwait, J. and Wooldridge, A. (2003) The Company: A Short History of a Revolutionary Idea, London: Weidenfeld & Nicolson. Mitchell, O. S. and Utkus, S. (Eds) (2004) Pension Design and Structure: New Lessons from Behavioral Finance, Oxford: Oxford University Press. Morin, F. (2000) ‘A transformation in the French model of shareholding and management’, Economy and Society, 29 (1): 36–53. O’Sullivan, M. (2001) Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany, Oxford: Oxford University Press. O’Sullivan, M. (2007) ‘Acting out institutional change: understanding the recent transformation of the French financial system’, Socio-Economic Review, 5 (3): 389–436. OECD (2005) Improving Financial Literacy: Principles, Programmes, Good Practices, Paris: OECD. Pike, A. (2006) ‘Shareholder value versus the regions: the closure of the Vaux Brewery in Sunderland’, Journal of Economic Geography, 6: 201–22. Porter, M. E. (1980) Competitive Strategy: Techniques for Analysing Industries and Competitors, London: Collier Macmillan. Porter, M. E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance, New York: Free Press. Prahalad, C. K. and Hamel, G. (1990) ‘The core competencies of the corporation’, Harvard Business Review, 68 (3): 79–92. Roberts, J., Sanderson, P., Barker, R., and Hendry, J. (2006) ‘In the mirror of the market: the disciplinary effects of company/fund manager meetings’, Accounting, Organizations and Society, 31 (3): 277–94. Scott, J. (1997) Corporate Business and Capitalist Classes, Oxford: Oxford University Press. Tawney, R. H. (1923) The Acquisitive Society, London: G. Bell and Sons. Vitols, S. (2002) ‘Shareholder value, management culture and production regimes in the transformation of the German chemical-pharmaceutical industry’, Competition and Change, 6 (3): 309–25. Vitols, S. (2004) ‘Negotiated shareholder value: the German variant of an Anglo-American practice’, Competition and Change, 8 (4): 357–74. Zilbovicius, M. (1999) Modelos para a Produção, Produção de Modelos: Gênese, Lógica e Difusão do modelo Japonês de organização da Produção (tr.: Models for Production, Production of Models: Genesis, Logic and Diffusion of the Japanese Model of Production Organization), Fapesp, São Paulo: AnnaBlume.

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Chapter 17

Neil Fligstein

THE FINANCE CONCEPTION OF THE FIRM

Introduction to extract from Neil Fligstein (1990), The Transformation of Corporate Control, Cambridge, MA: Harvard University Press

EDITORS’ COMMENTARY Fligstein’s starting point in 1990 is US relative decline, as manifest in economic problems about deindustrialization and loss of manufacturing jobs and in the changed status of US business which had, by this time, lost world dominance. As an economic sociologist, Fligstein’s response is not to rush to judgment and blame but to stand back and take a longer-term sociological view of ‘the current conceptions’ of the actors dominating major institutions, which sets recent developments in the context of a hundred years of American history. His argument challenges both Chandler’s narrative, which attributes US success after 1920 to the heroic manager and the divisional organizational form, and the inversion of that account, which blames bad managers for problems after 1970. Instead, Fligstein broadens the organizational frame to consider, not the firm, but the ‘organizational field’ which includes other firms and state regulation. This also introduces an ideational element because leading managers share a conception about ‘how the largest firms should operate to preserve growth and profitability’. The problem of US relative decline is then set in a theorized context, not as an actor’s failure or an organizational deficiency but a logical corollary of the current US finance conception of the firm where ‘the purpose of the firm is to increase short-run profits by manipulating assets so as to produce growth through mergers and diversification’, as the example of US Steel in this extract illustrates. The control tools are financial measures of profit rates and the organisational field is not one of industries or products but of other financially controlled firms. The strong conclusion is that the finance concept of control enables the success of some

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giant firms in financial terms but drives the failure of America. Galbraith in the 1950s would have called all this ‘conventional wisdom’; we would now use the term discourse. This economic sociology then becomes outline economic history where the issues are periodization and the conditions of change. Without ever demonstrating empirically that the leaders of all or most giant firms do in each period share a common conception, Fligstein claims that there have been four successive conceptions of control, beginning in 1880 with direct control of competitors, which was replaced by a manufacturing conception of control at the turn of the century, followed by sales and marketing control in 1925 and finally finance control from the mid-1950s onwards. Moments of change come about when outsider managers change their understandings of the internal and external problems of control that confront them and then build successful firms. The conditions of change are diverse and in the post-1945 USA the conditions include the exhaustion of the earlier sales and marketing conception of the firm. Corporate managers with finance backgrounds and objectives like growth, but a permissive stock market alongside anti-trust policy which prohibited mergers that increased concentration in one industry resulted in diversified mergers. ‘By the mid1960s’ the finance concept was dominant and manifest in the growth of the giant conglomerate. Like many later writers, Fligstein accepts that ‘acquisitive conglomerates generally performed poorly in the 1970s’ and were then broken up for good financial reasons which, for Fligstein, represents not reversal but reassertion of financial control. Although his schematism would now be questioned by those who challenge epochal concepts, Fligstein’s work is insightful in seeing that the financialized firm predates the late 1980s and has developed through what could be considered as inversion phases, as when conglomerates are replaced by core focused firms. This makes careers for some managers and, of course, allows intermediary fees to be earned from undoing the previous generation’s work. Neil Fligstein is professor of economic sociology and director of the Center for Culture, Organizations and Politics at the University of California, Berkeley. His other books include: The Architecture of Markets: An Economic Sociology of Capitalist Societies (2001); and The Institutionalization of Europe, with Wayne Sandholtz and Alec Stone (2001). Recent papers include: ‘The sociology of markets’, Annual Review of Sociology (2007, 33: 105–28); ‘The transformation of the American economy, 1984–2001’ (with T-j. Shin), Sociological Focus (in press).

Finance as a concept of corporate control 1, 2

B

the American economy has become commonplace. Critics seek to explain how and why the dominance of American business in the world has decreased. Some have argued that American culture with its emphasis on the individual has raised expectation to such high E M O A N I N G T H E S TAT E O F

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levels that people are no longer self-sacrificing enough for the common good. Others blame workers, who they say lack a work ethic and demand more in wages and benefits than is justified by their productivity. Still others point to inadequate technological innovation and improvement in productive capital stock. Some view the federal government as the key problem with its intrusiveness into the workplace and high tax rates. And some have taken American executives to task for favouring policies that may raise short-term profits but ignore the long-term possibility of decline. While there appears to be little consensus as to the cause of this decline, the consequences are evident everywhere. The United States has rapidly moved from an exporter of goods and capital to an importer. The country’s industrial base has diminished and there are now fewer manufacturing jobs as a proportion of all jobs in absolute and relative terms. I propose a different way to understand how the American economy has been transformed in the past hundred years. Since the current tendencies are the product of long-run strategic interactions between key actors in the firms and the government, the causes of any decline must be located in that interaction. These actors have interpreted their environments, both inside and outside their organization and created new solutions to recurring problems. Their innovations have been adopted by other firms and become accepted business practices. American managers may pay inordinate attention to short-run policies, but this is the result of the implementation of a certain conception of the firm within a set of existing institutions. From this perspective, the actions of managers are explicable only in the context of a long-run structural view oriented towards discovering how, when and why changes have taken place. My central thesis is that the viability of the large industrial enterprise in the United States is most related to the long-term shifts in the conception of how the largest firms should operate to preserve growth and profitability. These shifts have occurred in response to a complex set of interactions between the largest firms, those who have risen to control those firms and the government. They originated with managers and entrepreneurs who sought more control over their internal and external environments. When one solution was blocked by the action of the government, new solutions were created and diffused. The result was a shift to a new conception of the large corporation and hence a new set of strategies and structures. These changes were not the product of profit-maximizing actors in efficient firms working to become more efficient. Managers and entrepreneurs were not optimizers or satisficers. Instead they constructed new courses of action based on their analyses of the problems of control they faced. The new conceptions and the strategies and structures that resulted were successful to the degree they allowed firms to survive and grow. Consider for example the finance conception of the firm: the purpose of the firm is to increase short-run profits by manipulating assets in order to produce growth through mergers and diversification. This conception has come to dominate the world of the largest firms and for these firms has generated a successful strategy for growth. Indeed, between 1947 and 1985, the asset concentration of the 500 largest manufacturing companies increased from 42 per cent to

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76 per cent. Most of this increase has had the ironic effect of promoting the health and growth of the largest firms, while impeding expansion of manufacturing facilities. For those who control the largest firms, their actions have been profitable and sensible. For the economy as a whole, the effects have been less positive. The current system has come about in a complex, yet explicable way. It emerged under a certain set of rules and as those rules changed, the system changed. These changes were driven by managers and entrepreneurs seeking tactics for survival in the face of economic crisis, instability in their relations with competitors and the restrictions of antitrust laws. The finance conception of the large corporation, consequently, is the historical product of a dynamic system. In the scholarly literature, there exist two opposing images of the large, modern corporation. The first stresses the success of the corporate form as a vehicle that deploys capital efficiently to maximize returns. The heroes of this version of the corporation are the top managers who maintain control through decentralized administration and detailed financial reporting. These tools allow top managers to assess problems and react quickly to shifts in markets, technology and consumer preferences. The second version focuses on the failure of the modern firm as inefficient with low quality production leading to an inability to compete in world markets. Managers, rather than being heroes, rule over bloated bureaucracies that do not produce sufficiently high returns on investment to stockholders. Instead, these managers concentrate on their personal aggrandizement by surrounding themselves with large staffs and perquisites. This poor performance is measured by the fall of a firm’s stock price below the book value of assets. These descriptions evaluate the firm primarily in financial terms. Both accounts place too much responsibility for the success or failure of the corporation on managers. While managers have played a central role in the transformation of the large corporation, they have done so in ways that are much more subtle and constrained than either point of view would acknowledge. Neither version theorises the context of production or allows for the interaction between mangers; ideas about appropriate corporate behaviour, how the forms actually work, and what is occurring in the organizations surrounding the firm. In any given moment, there exists a conventional wisdom that guides action and managers face pressures to confirm to that view, the internal strategy and structure of existing firms reflect organised power and interests. Managers, as part of those organized interests, behave to preserve what is. The organizations that surround the firm provide constant clues as to what is occurring in the firm’s product markets. This information is filtered and interpreted and greatly affects what actions are possible. . . . The primary question is how the conceptions of control in the largest US firms have been transformed in the past one hundred years. The strategies, structures and organizational fields that have emerged embody these different conceptions. Once in place as control perspectives they are widely shared ways of reducing the complexity of the world. They come into existence in a piecemeal fashion and are articulated by representatives of the largest most successful firms. They are propagated by the business press and informal links between organizations and then are supported by those organization and their organizational fields.

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Since 1880 there have been only four conceptions of control used by the leaders of the largest firms: direct control of competitors, manufacturing control, sales and marketing control and finance control. These conceptions are not disembodied, idealist constructs. They emerged from the interaction among leaders of large firms and are conditioned by the state. They become successful by helping create organizational fields and by being accepted as principles to guide action within those fields. Once they prove successful, they disseminate across organizational fields. Each conception of control makes use of a small number of consistent actions, or strategies. Strategy implies an explicit understanding of the goals of the organization and the construction of appropriate courses of action for reaching those goals. . . . The finance conception of the modern corporation, which currently dominates, emphasizes control through the use of financial tools which measure performance according to profit rates. Product lines are evaluated on their short-run profitability and important management decisions are based on the potential profitability of each line. Firms are viewed as collections of assets earning differing rates of return, not as producers of given goods. The firm is not seen as being a member of only one industry. Consequently if the prospect of an industry in which it participates declines, the firm disinvests. The problem for management from this perspective is to maximize short-run rates of return by altering produce mix, thereby increasing shareholder equity and keeping the stock price high. The key strategies are: diversification through mergers and divestments (as opposed to internal expansion); financial ploys to increase the stock price; indebtedness, and ability to absorb other firms, and the use of financial controls to make decisions about the internal allocation of capital. The product mix of firms is less important in the finance conception because each of the firm’s businesses are no longer product lines, but profit centres. Since the goal is to increase assets and profits, the organizational fields of the finance driven firms are no longer industrial based. Once large firms began to pay more attention to one another than to industries or products, strategic innovations that reflected the finance conception of control spread more rapidly across the population of the large firms. Currently leveraged buyouts, stock repurchases and corporate restructuring, which all reflect the finance conception, have disseminated throughout the largest firms as appropriate strategies for growth and profits. . . . The finance . . . conception of the firm developed for two reasons. In order to grow, large firms needed to diversify. The sales and marketing conception had continued to prove profitable, but lacked a way to direct diversification. Those who controlled the firm lacked the expertise to evaluate new products on their own merits. As a result, investments began to be made only on a financial basis. The implementation of financial controls and advanced accounting systems, therefore, shifted power in the large firms to those who could judge whether a product made money. Firms then paid more attention to short-run objectives. Instead of building a new plant which might take years to show a profit, it was easier to buy an existing company. The second impetus for the finance conception was the antitrust environment which was hostile toward large firms in general and horizontal and vertical

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mergers in particular. The first Supreme Court decision after the passing of the Celler–Kefauver Act made mergers illegal between relatively small firms with moderate market shares. The large firms quickly responded and stopped merging for market share. Instead, they turned their attention to product related and unrelated mergers as a strategy for growth. From 1945 to 1969 the largest firms rapidly diversified mostly through mergers. The business community had one important example of the pure financial strategy: the acquisitive conglomerate. The acquisitive conglomerates were built by people on the edges of the American corporate sector, often outside New York, where most of the large firms were located. Many of the original conglomerates had been in declining industries and then their founders removed them from their established organizational fields. Using financial ploys, these executives parlayed the smaller firms into larger firms through mergers and the floating of debt. By 1955 the conglomerate strategy of buying disparate firms and creating a large highly diversified corporation was already well known. The emergence of Textron, Ling–Temco–Vought (LTV), International Telephone and Telegraph (ITT), Litton Industries, and Gulf and Western in the early 1960s, encouraged other firms to try instant growth through mergers. The finance conception remade the organizational fields of the largest firms. Managers saw that the acquisitive conglomerates merged their way into the ranks of the largest industrial enterprises in a short period of time. This caused managers in otherwise stable organizational fields that were defined by industry to shift their attention from their position in the industry to their position in the hierarchy of large American corporations. While the acquisitive conglomerate garnered much attention, the most important phenomenon in the economy was the spread of product-related diversification strategies to firms such as Rockwell International, WR Grace, Thompson–Ramo–Wooldridge (TRW), and Minnesota Mining and manufacturing (3M). It eventually also spread to firms in the staid oil and steel industries. The finance conception rose to prominence and today still dominates the actions of the largest US firms. . . . By 1979 finance presidents were the single largest group of presidents of the 100 largest firms. Finance-oriented executives are not committed to any given industry and no longer identify their firms in market terms. Instead, the population of the largest firms is now the reference group for these managers. Nonetheless, because many of the firms are in one or two major industries, they must continue to monitor competition in those industries. The current vogue is to argue that the economy should be left alone. Investment decisions, merger decisions, and industrial policy should be placed in the hands of the largest firms who are most influential in the marketplace. But this argument ignores the fact that over time firms have operated under different conceptions which resulted from the dynamic interaction of the economic environment, and the internal organization of the firm. The structures that are in place now are not the products of some pure process of competition. Nor has competition been weakened by the actions of government. Instead, what has come into existence is the result of a social and political process that defines and redefines markets. If left to their own devices, managers in the largest firms would continue to do what they are doing. Eliminating government regulation

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and antitrust enforcement will not automatically produce a more competitive corporate world. The finance conception remains in effect and the incentives that produced it continue. To view the economy and its development outside of the current conceptions of the actors dominating major institutions means one will not understand the actions of those institutions. One is also not likely to be able to anticipate what any political action oriented toward the economy is going to have. To argue that current conceptions somehow reflect the best of all possible worlds is neither historically informed nor scientific, but ideological. Instead, what has emerged is the product of large-scale social organisation over a substantial period of time.

The finance conception takes over 3 [The finance conception of control] reflected both an extension of existing tendencies in the organisational fields of the large corporations as well as a clean break with the past. The pioneers of this new strategy were trained in finance and accounting. Their views were not shaped by the necessities of production or the desire to sell more products. Instead, they focused on the corporation as a collection of assets that could and should be manipulated to increase short-run profits. The spread of this point of view resulted from complex interactions within the organizational fields of the largest firms and the antitrust environment. These conditions provided the incentive for finance-oriented executives to experiment with a new conception of the corporation. Once that conception proved successful, that is, produced growth, it spread through the population of the largest firms. To understand the shift from a sales and marketing conception to a finance conception of control, we must consider which firms innovated the new conception and how it was passed to other firms until it dominated them all. Those who pioneered the finance conception of control often ran sizeable enterprises, but most frequently were outsiders whose examples were copied by the largest firms. A set of conditions made the finance conception of control possible. The diversification of American industry was well under way by the end of World War II. Actors in firms realized that in order to grow and be profitable, they needed to increase sales. The desire of managers to spread risks across product lines and to enter growing industries and leave stagnant ones was already firmly established. Indeed, the largest firms depended on new product lines for continued growth. Thus diversification was already a tactic of managers in large firms. The second condition for the new conception of control was an organizational structure that would allow a multi-product firm to be controlled by a central office. The multidivisional form pioneered by General Motors and DuPont became the blueprint for the reorganization of other large firms. Once managers chose to venture into industries where they had little production or marketing expertise, the only way to evaluate products was through financial

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performance. The financial controls that supported the multidivisional form became the chief source of power in the large corporation over the past thirty years. . . . The decision to grow through merger rather than through internal expansion required cash, stock or the capacity to borrow large sums of money. The generally prosperous periods, 1946 to 1969 and the 1980s, left firms with money and rising stock prices. where firms lacked money, innovative financial techniques such as the leveraged buyout were developed to borrow money for mergers. In this bullish economy high rates of growth through acquisitions were possible. Of course, to take advantage of these possibilities required people with a new view of the corporation. The final condition for the emergence of the finance conception of control was the antitrust policy of the federal government. . . . [T]he Celler-Kefauver Act discouraged firms from pursuing mergers that tended to increase intraindustry concentration. By the 1960s, it was an accepted fact that diversified mergers were legal and horizontal and vertical mergers problematic. These conditions allowed finance-oriented executives to create large organizations entirely through large-scale mergers. The relative success of their actions caused other firms to pay attention to these tactics and eventually adopt them. . . . The new conception of control was invented by and relied on actors with finance backgrounds who were willing to merge firms with disparate product lines into one decentralised administrative structure. Financial criteria alone were used to evaluate the performance of products. The industry of a firm did not matter. Firms had product lines with different rates of return and growth. The executives function, therefore, was to invest so that sales, assets, and profits would increase. If products or divisions did not meet expectations, they were divested and new ones purchased. The pioneers of the finance conception and its strategy of diversification through mergers provided a new model of the corporation. Their spectacular growth rates could not be ignored by the managers of other large firms. Many of them evaluated their strategies and opted to follow the finance conception. They reorganized their internal organization and adopted mergers as a growth strategy. Those who resisted the new conception of the firm often became merger targets. The organizational fields of the largest firms were thus restructured. Once a firm adopted the finance conception of control, the industry in which it operated mattered far less than its short run profitability. The stock market, stock prices, and the relative rates of return of firms in other industries became as important as the behaviour of a firm’s competitors. The largest firms for the first time formed an organizational field that serves as a reference group for other large firms. Although all firms did not participate equally in this field, and many continued to define themselves industrially, much more attention was given to the collective behaviour of large firms. The spread of these tactics has generally increased the power of finance executives. The result is the large, financially driven, multiproduct firm that dominates American business today. . . . From the finance perspective, the firm was a collection of assets earning

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varying rates of return. The firm’s central goal was to allocate capital across product lines in order to increase short-term rates of return. Managers pursued growth through mergers and, when product lines did not perform adequately, divestment. By the mid-1950s, the large firm was already producing multiple products and rapidly becoming organized into the multidivisional form. Managers had been pursuing mergers for diversification since the 1920s. So how was the finance conception different from the sales and marketing conception? What caused the new conception of control to emerge? The key difference revolved around how each point of view conceived of the firm and its purposes. The sales and marketing conception of control pursued growth by increasing sales. Diversification was one of the tactics utilised. The finance conception pursued growth by ruthlessly evaluating the contribution of each product line to overall profit and goals of the firm. The finance conception of control viewed the central office as a bank and treated the divisions as potential borrowers. The central office would invest in division that showed great potential and divest those in slow-growing markets. Profitable divisions supported mergers of new divisions. From this perspective, mergers were attractive because product lines could be purchased at a lower price than they could be produced internally. The managers of the firm were no longer constrained by major industry because the production of each unit was evaluated solely on its rate of return. This new conception was not invented by the managers of the largest firms. Indeed, they were generally restricted by their established organizational fields and the power structure of their firms. The new conception was instead the creation of finance-oriented executives who operated mostly outside the established channels. Their firms grew at spectacular rates and often entered stable organizational fields who followed either the manufacturing or sales and marketing conceptions of control had two choices. They could risk being targets of mergers, and thereby lose their corporate identity, or they could alter their tactics and adopt the finance conception of control. The overall result of this new conception of control was a shift in the construction of organizational fields. The reference group for the largest firms became the other large firms. Indeed the 1960s merger movement was a direct result of the spread of the finance conception and strategies to the population of the largest firms. Today the finance conception of control continues to dominate corporate discourse and the largest firms operate as an organizational field for one another. . . . By the mid-1960s, the finance conception of control and its major strategy of growth, diversified mergers, dominated the largest firms. This was because the tactics yielded high rates of growth. The business press was full of stories about firms that had begun to diversify, reorganize into divisions, and use mergers for growth. What held these tactics together was a conception of the firm that stressed close management of assets and strict financial evaluation of product lines. The importance of finance personnel and financial control was the subject of frequent articles. One argued, ‘Top financial officers now

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have a hand in everything from mergers to budgets to personnel and marketing. They also woo bankers and stock analysts. Because they know more about the company than anyone else, they often move, finally, right into the driver’s seat. (Fortune, January 1962, p. 85) The basis of this new power was their knowledge of the complex financial control systems put in place during the 1950s and 1960s. Financial expertise was necessary top identify merger candidates. . . . One indication of this development was that Ralph Cordiner, the president of General Electric and a sales and marketing executive, was followed by Gerard Phillipe, the chief financial officer of the corporation (Fortune, January 1962, p. 85) Today General Electric is one of the most diversified large corporations in America. . . . After the 1969–70 stock market crash some of the firms that had expanded most rapidly during the boom years of the 1960s lost their gleam. The 1970s were not good years for the stock market, not for the American economy in general, so the pace of mergers slowed until 1975. Mergers never fell below their active 1955 level however. Many of the firms that had actively pursued mergers in the 1960s divested themselves of their less profitable acquisitions. After 1975 merger activity increased until the 1980s witnessed a great resurgence under the Reagan Administration. The bull market, the lax antitrust environment, and the dominance of the finance conception of control promoted large scale mergers. . . . One might argue that the finance conception of control went from boom to bust as the acquisitive conglomerates generally performed poorly in the 1970s. This view, however, misunderstands the nature of the finance conception. While the conglomerates practiced the purest form of those tactics, they were only its most obvious advocates. Indeed, the finance strategy of operating corporations as a set of divisions each responsible for an adequate contribution to overall growth and profits of the firm remains the dominant one for the large corporation. Almost all of the largest firms are significantly diversified and set up in divisions. The divestment movement of the 1970s reflects the finance conception. If divisions did not meet the standards, then firms divested themselves of those lines. The decision to divest was usually made as a function of product mix and performance. A multi-product firm would decide to get rid of divisions that were too distant from its core businesses. Frequently, those divisions had been unprofitable from the beginning and management lacked the expertise to make them profitable. The price of a firm’s stock continued to be its most salient trait in the 1980s. If a firm’s worth exceeded its stock price, as was often the case, it was a merger target. The evaluation and selection of merger candidates fuelled the stock market throughout the decade. The corporate raiders of the 1980s used strategies developed in the 1950s and 1960s. Their tactics were financially motivated and their behavior, once they acquired firms, closely resembled that of the earlier conglomerate leaders. One excellent example of the finance conception of control in operation in the late 1970s and early 1980s is US Steel. The steel industry in the United States

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is mature; the product lines are established and demand is not growing. The industry’s problems are compounded by the need for large fixed investment in capital stock in the face of overcapacity and ageing plants with obsolete technology. Given the relatively high wage rates in the industry and foreign competition, the steel companies have drifted in and out of profitability for the past thirty years. U.S. Steel, since its emergence during the turn of the century merger movement, has continued to be one of the largest industrial organizations in the country. But the company’s management was always trained in steelmaking and, until 1979, the president was someone who had come up through manufacturing. Its switch to the finance conception of control required that the board of directors recognize the problems of the firm and industry, and act toward their resolution. The board chose David Roderick as chair and CEO in 1979. Roderick had no practical experience in the steel mills and had been finance vice-president in the organization. His point of view on the problems of US Steel was distinctly financial. Roderick made two moves to save the company. He closed all unprofitable facilities so that the steel company shrank in capacity by over 30% between 1979 and 1985 (Industry Week, February 4, 1985, pp. 34–38). He also embarked on a diversification effort to lessen U.S. Steel’s dependence on steel, which he perceived was a declining business (Fortune, June 1984, p. 23; Business Week, December 2, 1985, p. 82). . . . Under Roderick’s leadership, the company has divested itself of Universal Cement, its division that manufactures pails and drums, its housing division, real estate scattered all over the country, and a substantial amount of its coal properties (Wall Street Journal, July 9, 1986, p. 14). Cash from these sales has been used to purchase a number of companies. The first major purchase was Marathon Oil, one of the largest petrochemical companies in the world. The second was Texas Oil and Gas, a major producer of natural gas and owner of an extensive pipeline system. By 1986 only 30% of revenues came from the steel division (Wall Street Journal, July 9, 1986, p. 14). On July 9, 1986, the company officially changed its name from U.S. Steel to USX. . . . In six years U.S. Steel has been transformed from the largest American steel company, dominated by a manufacturing conception of control with a vertically integrated structure, to a finance-oriented, multidivisional, diversified energy, chemical and natural resource company. This shift was undertaken by the board of directors and CEO as a self-conscious response to the decline of steel, the firm’s basic industry. The original U.S. Steel merger in 1901 marked the new era of monopoly capitalism. U.S. Steel’s finance strategies may now cause the firm to abandon its once primary industry. The corporation endures but its identity and product lines have been altered drastically by the implementation of the finance conception of control.

EDITORS’ NOTES 1

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Reprinted by permission of the publisher, Harvard University Press. Copyright © 1990 by the President and Fellows of Harvard College. All rights reserved.

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neil fligstein This section of the extract is taken from The Transformation of Corporate Control, chapter 1, ‘Introduction’ (pp. 1–3, p. 12, pp. 15–16 and pp. 29–32), with the subheading added by the authors. This part of the extract is taken from Chapter 7, ‘The Finance Conception of Control’ (pp. 226–30, pp. 238–40, pp. 251–2 and pp. 256–8). The subheading is used by Fligstein on p. 238.

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Chapter 18

William Lazonick and Mary O’Sullivan

SHAREHOLDER VALUE AND CORPORATE GOVERNANCE

Introduction to extract from William Lazonick and Mary O’Sullivan (2000), ‘Maximizing shareholder value: a new ideology for corporate governance’, Economy and Society, 29(1): 13–35

EDITORS’ COMMENTARY Bill Lazonick and Mary O’Sullivan’s article is about the rise of governance and the lure of arguments for maximizing shareholder value in the USA in the 1980s, but it is also explicitly offered as a warning to Germany, France, Sweden, and Japan where shareholder value ‘is not yet an entrenched principle of corporate governance’. Lazonick and O’Sulllivan published this article in the year 2000 in a special issue of Economy and Society and they attracted considerable attention. Against a background of often confusing debate about the causes, extent, and consequences of change, Lazonick and O’Sullivan had a strong, simple story line about the consequences of ‘maximizing shareholder value’ in giant US firms. Thus, Lazonick and O’Sullivan state their basic argument about an epochal shift in corporate policy from which capital wins and labour loses. In the name of ‘creating shareholder value’, the past two decades have witnessed a marked shift in the strategic orientation of top corporate managers in the allocation of corporate resources and returns away from ‘retain and reinvest’ to towards ‘downsize and distribute’. Under the new regime, top managers downsize the corporations they control, with a particular emphasis on cutting the size of the labour forces they employ, in [an] attempt to increase the return on equity’ (p. 18).

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The extract includes their broader argument and supporting empirics. Lazonick and O’Sullivan’s story of the financialized firm begins in the 1980s, some twenty years later than in Fligstein’s history. Their argument is that in the 1980s, over diversified and centralized divisional firms were beaten by ‘innovative’ Japanese competitors who had harnessed the capabilities of their workforces for ‘organizational learning’. Instead of confronting these basics, US giant firms were diverted into shareholder value. A combination of agency theory justifications and institutional investment fed a takeover market where shareholder value was the measure; while senior corporate managers were enlisted for policies of ‘downsize and distribute’ partly because they were incentivized by stock options and encouraged to ‘align their own interests with external financial interests rather than with the interests of the productive organisations over which they exercised control’ (p. 27). As in Fligstein’s extract, Lazonick and O’Sullivan put the emphasis on management’s understandings of its role because, in their view, shareholder value is an ‘ideology’ not a structurally inevitable outcome of the growth of institutional investment or any other development. Unlike Fligstein, Lazonick and O’Sullivan support their argument about changes of corporate behaviour with corroborating empirics about more distribution and less employment. The empirics they cite are more inconclusive than they appear to be: with distributions, the issue is the measure and definition because the authors add together dividend payments and share buybacks but do not consider the impact of substitution of lower-cost debt for equity; on the downsizing of giant firm workforces, Lazonick and O’Sullivan marshal the available evidence but are handicapped by limited sources when, for example, US giant company annual financial accounts do not normally disclose numbers employed. William Lazonick is an economist specializing in industrial development and international competitiveness. He is a Professor at the University of Massachusetts Lowell and a Distinguished Research Professor at INSEAD. He has written or co-edited many books (see, for example, Business Organization and the Myth of Market Economy, 1991; Competitive Advantage on the Shop Floor, 1990; and American Corporate Economy, four volumes, Routledge, 2002) and numerous journal articles. Mary O’Sullivan is Associate Professor of Management at Wharton (University of Pennsylvania) with particular interest in corporate governance and comparative economic systems. Her books include: Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany (2000) and Corporate Governance and Sustainable Prosperity, co-edited with William Lazonick (2002).

Introduction1, 2

O

decades the ideology of shareholder value has become entrenched as a principle of corporate governance among

V E R T H E PA S T T W O

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companies based in the United States and Britain. Over the past two or three years, the rhetoric of shareholder value has become prominent in the corporate governance debates in European nations such as Germany, France and Sweden. Within the past year, the arguments for ‘maximizing shareholder value’ have even achieved prominence in Japan. In 1999 the OECD issued a document, The OECD Principles of Corporate Governance, that emphasizes that corporations should be run, first and foremost, in the interests of shareholders (OECD 1999). . . . In the so-called Anglo-Saxon economies of the United States and Britain, the exclusive focus of corporations on shareholder value is a relatively recent phenomenon, having risen to prominence in the 1980s as part and parcel of the Reaganite and Thatcherite revolutions. The decade-long boom in the US stock market and the more recent boom in the US economy have impressed European and Japanese corporate executives with the potential of shareholder value as a principle of corporate governance, while American institutional investors, investment bankers and management consultants have incessantly promoted the virtues of the approach in Europe and Japan. There is, however, in both Europe and Japan, considerable misinformation about why shareholder value has become so prominent in the governance of US corporations over the past two decades and the actual impact of its implementation on the performance of US corporations and the US economy. Therefore, as a precondition for considering the arguments for ‘maximizing shareholder value’ in those nations in which it is not yet an entrenched principle of corporate governance, it is imperative that we understand the evolution and impact of the quest for shareholder value in the United States over the past two decades. Such is the purpose of this paper.

The origins of ‘shareholder value’ The arguments in support of governing corporations to create shareholder value came into their own in the United States in the 1980s. As has been the case throughout the twentieth century, in the 1980s a relatively small number of giant corporations, employing tens or even hundreds of thousands of people dominated the economy of the United States. On the basis of capabilities that had been accumulated over decades, these corporations generated huge revenues. They allocated these revenues according to a corporate governance principle that we call ‘retain and reinvest’. These corporations tended to retain both the money that they earned and the people whom they employed, and they reinvested in physical capital and complementary human resources. Retentions in the forms of earnings and capital consumption allowances provided the financial foundations for corporate growth, while the building of managerial organizations to develop and utilize productive resources enabled investments in plant, equipment and personnel to succeed (Ciccolo and Baum 1985; Hall 1994; Corbett and Jenkinson 1996). In the 1960s and 1970s, however, the principle of retain and reinvest began running into problems for two reasons, one having to do with the growth of the corporation and the other having to do with the rise of new competitors.

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Through internal growth and through merger and acquisition, corporations grew too big with too many divisions in too many different types of businesses. The central offices of these corporations were too far from the actual processes that developed and utilized productive resources to make informed investment decisions about how corporate resources and returns should be allocated to enable strategies based on ‘retain and reinvest’ to succeed. The massive expansion of corporations that had occurred during the 1960s resulted in poor performance in the 1970s, an outcome that was exacerbated by an unstable macroeconomic environment and by the rise of new international competition, especially from Japan (Lazonick and O’Sullivan 1997; O’Sullivan 2000: ch. 4). . . . Compared with American practice, Japanese skill bases integrated the capabilities of people with a broader array of functional specialties and a deeper array of hierarchical responsibilities into processes of organizational learning. In particular, the hierarchical integration of Japanese skill bases extended from the managerial organization to shopfloor production workers and subsidiary firms that served as suppliers and distributors. In contrast, US companies tended to use their managerial organizations to develop and utilize technologies that would enable them to dispense with shop-floor skills so that ‘hourly’ production workers could not exercise control over the conditions of work and pay. US companies also tended to favour suppliers and distributors who would provide goods and services at the lowest price today, even if it meant that they were not engaged in innovation for tomorrow (Lazonick and O’Sullivan 1997). As, during the 1970s, major US manufacturing corporations struggled with these very real problems of excessive centralization and innovative competition, a group of American financial economists developed an approach to corporate governance known as agency theory. Trained, to believe that the market is always superior to organizations in the efficient allocation of resources, these economists were ideologically predisposed against corporate – that is, managerial – control over the allocation of resources and returns in the economy. Agency theorists posited that, in the governance of corporations, shareholders were the principals and managers were their agents. Agency theorists argued that, because corporate managers were undisciplined by the market mechanism, they would opportunistically use their control over the allocation of corporate resources and returns to line their own pockets, or at least to pursue objectives that were contrary to the interests of shareholders. Given the entrenchment of incumbent corporate managers and the relatively poor performance of their companies in the 1970s, agency theorists argued that there was a need for a takeover market that, functioning as a market for corporate control, could discipline managers whose companies performed poorly. The rate of return on corporate stock was their measure of superior performance, and the maximization of shareholder value became their creed (see, for example, Ross 1973; Jensen and Meckling 1976; Fama and Jensen 1983; Jensen 1986; Scharfstein 1988; Baker et al. 1988). In addition, during the 1970s, the quest for shareholder value in the US economy found support from a new source – the institutional investor. The transfer of stockholding from individual households to institutions such as mutual funds, pension funds and life insurance companies made possible the takeovers advocated by agency theorists and gave shareholders much more

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collective power to influence the yields and market values of the corporate stocks they held. During the 1950s and 1960s, there were legal restrictions on the extent to which life insurance companies and pension funds could include corporate equities in their investment portfolios, while mutual funds played only a limited, although growing, role in the mobilization of household savings. In the 1970s, however, a number of changes occurred in the financial sector that promoted the growth of equity-based institutional investing. Partly as a consequence of Wall Street’s role in the buying and selling of companies during the conglomeration mania of the 1960s, from the early 1970s there was a shift in the focus of Wall Street financial firms from supporting long-term investment activities of corporations (mainly through bond issues) to generating fees and capital gains through trading in corporate and government securities. To expand the market for securities trading, Wall Street firms convinced the Securities and Exchange Commission (SEC) to put an end to fixed commissions on stock exchange transactions. At the same time, developments in computer technology made it possible for these firms to handle much higher volumes of trade than had previously been the case. . . .

From ‘retain and reinvest’ to ‘downsize and distribute’ 3 The stage was now set for institutional investors and S&Ls [(savings and loans institutions)] to become central participants in the hostile takeover movement of the 1980s. An important instrument of the takeover movement was the junk bond – a corporate or government bond that the bond-rating agencies considered to be below ‘investment grade’. . . . The innovation of Michael Milken, an employee at the Wall Street investment bank of Drexel, Burnham, and Lambert, was to create a liquid market in junk bonds by convincing financial institutions to buy and sell them (Bruck 1989: ch. 1). . . . [F]inancial deregulation (in the late 1970s and early 1980s) brought, first, pension funds and insurance companies and, then, S&Ls into the junk-bond market. From the late 1970s, it became possible to issue new junk bonds, most of which were used at first to finance management buyouts of divisions of corporations, a mode of undoing the errors of the conglomerate movement of the 1960s that left the new independent companies with huge debt burdens. By the early 1980s, and especially after the Garn-St. Germain Act of 1982 enabled S&Ls to enter the market, it became possible to use junk bonds to launch hostile takeovers of even the largest corporations (Gaughan 1996: 302). Milken orchestrated most of these hostile takeovers by gaining commitments from institutional investors and S&Ls to sell their shareholdings in the target company to the corporate raider, when the target company was taken over, to buy newly issued junk bonds that enabled the company to buy the raider’s shares. The result was (until, beginning in late 1986, the arbitrageur Ivan Boesky and then Milken as well as others were indicted and eventually imprisoned for insider trading) the emergence of a powerful market for corporate control – something of which the agency theorists of the 1970s had only dreamed. The ideology of the market for corporate control lent powerful support to the claim

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that such takeover activity was beneficial to the corporations involved and indeed to the US economy as a whole. Takeovers, it was argued, were needed to ‘disgorge the free cashflow’ from companies (Jensen 1989). The exchange of corporate shares for high-yield debt forced liquidity on the acquired or merged companies. These takeovers also placed managers in control of these corporations who were predisposed towards shedding labour and selling off physical assets if that was what was needed to meet the corporation’s new financial obligations and, indeed, to push up the market value of the company’s stock. For those engaged in the market for corporate control, the sole measure of corporate performance became the enhanced market capitalization of the company after the takeover. . . . Increasingly during the 1980s, and even more so in the 1990s, support for corporate governance on the principle of creating shareholder value came from an even more powerful and enduring source than the takeover market. In the name of ‘creating shareholder value’, the past two decades have witnessed a marked shift in the strategic orientation of top corporate managers in the allocation of corporate resources and returns away from ‘retain and reinvest’ and towards ‘downsize and distribute’. Under the new regime, top managers downsize the corporations they control, with a particular emphasis on cutting the size of the labour forces they employ, in an attempt to increase the return on equity. Since 1980, most major US corporations have been engaged in a process of restructuring their labour forces in ways that have eroded the quantity of jobs that offer stable employment and good pay in the US economy. Hundreds of thousands of previously stable and well-paid blue-collar jobs that were lost in the recession of 1980–2 were never subsequently restored. Between 1979 and 1983, the number of people employed in the economy as a whole increased by 377,000 or 0.4 per cent, while employment in durable goods manufacturing – which supplied most of the well-paid and stable blue-collar jobs – declined by 2,023,000, or 15.9 per cent (U.S. Congress 1992: 344). Indeed, the ‘boom’ years of the mid-1980s saw hundreds of major plant closures. Between 1983 and 1987, 4.6 million workers lost their jobs, of which 40 per cent were from the manufacturing sector (Herz 1990: 23; more generally, see Staudohar and Brown 1987; Patch 1995). The elimination of well-paid and stable blue-collar jobs is reflected in the decline of the proportion of the manufacturing labour force that is unionized from 47.4 per cent in 1970 to 27.8 per cent in 1983 and to 18.2 per cent in 1994 (US Dept of Commerce 1975: 375; 1995: 444; US Bureau of the Census 1976: 137). Not only were blue-collar workers affected by the mounting predilection of US corporate managers towards downsizing during the 1980s and 1990s. The ‘white-collar’ recession of the early 1990s saw the elimination of the positions of tens of thousands of professional, administrative and technical employees – salaried white-collar workers who were considered to be members of ‘management’. Even in this recession, however, it was blue-collar workers who bore the brunt of displacement. Overall, the incidence of job loss in the first half of the 1990s stood at about 14 per cent, even higher than the quite substantial rates of about 10 per cent in the 1980s. The rate of job loss for 1981–3, a period with a slack labour market,

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was about 13 per cent. As the labour market tightened during the mid-1980s, the rate of job loss fell. As the economy went into recession from 1989, the jobloss rate increased again to a level similar to that in the recession of the early 1980s, notwithstanding the fact that the recession of the late 1980s was much milder. Moreover, even as the economy moved into a recovery from 1991, the job-loss rate rose to ever higher levels, a trend that continued through 1995, despite an acceleration of economic growth. Leading the downsizing of the 1980s and 1990s were many of America’s largest corporations. In the decades after World War II, the foundations of US economic development were the willingness and ability of the nation’s major industrial corporations to allocate their considerable financial resources to investment strategies that created the good jobs that many Americans began to take for granted. In 1969, the fifty largest US industrial corporations by sales directly employed 6.4 million people, equivalent to 7.5 per cent of the civilian labour force. In 1991, these companies directly employed 5.2 million people, equivalent to 4.2 per cent of the labour force (Lazonick and O’Sullivan 1997: 3). And since 1991 the downsizing of these companies has gone forward at a steady pace. By the early 1990s even US firms known for their no-lay-off commitments – IBM, DEC, Delta – had undergone significant downsizing and lay-offs of blue- and white-collar workers (Weinstein and Kochan 1995: 16). The American Management Association (AMA) conducts a survey every year of lay-offs by major US companies. A striking finding of this survey is that job elimination has continued to be pervasive among US corporate enterprises leading to substantial reductions in their workforce(s), notwithstanding the considerable improvement in the business cycle during the 1990s. Moreover, notwithstanding the downward trend since 1994–5 in the proportion of companies reporting job elimination, the most recent Challenger, Gray and Christmas estimates of announced staff cuts by major US corporations suggests that another upsurge in lay-offs by US corporations is in the offing. The AMA survey shows, moreover, that job cutting is much more prevalent among larger employers than smaller ones. Almost 60 per cent of companies that employed more than 10,000 people laid off some of their workforce in 1996–7 (American Management Association Surveys various years). In the boom year of 1998 the number of announced staff cuts by major US corporations was greater than for any other year in the 1990s. . . . While US corporate managers became focused on downsizing their labourforces in the 1980s and 1990s, they also became focused on distributing corporate revenues in ways that supported the price of their companies’ stocks. During the 1950s, 1960s and 1970s the pay-out ratio (the ratio of dividends to after-tax adjusted corporate profits) varied from a low of 37.2 per cent in 1966 (when increases in dividends lagged increased profits) to a high of 53 per cent in 1974 (when profits fell by 19 per cent while dividends went up by 8 per cent). But averaged over any five-year period during these three decades, the pay-out ratio stayed remarkably stable, never going above 45.9 per cent (1970–4) and never falling below 38.8 per cent (1975–9). The stability is even greater over ten-year periods – 47.9 per cent for the 1950s, 42.4 per cent for the 1960s and 42.3 per cent for the 1970s. These pay-out ratios were high by international

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standards, manifesting the extent to which US corporations returned value to stockholders even before the rise of the institutional investor. Compared with the 1960s and 1970s, an upward shift in corporate pay-out ratios occurred in the 1980s and 1990s. In 1980, when profits declined by 17 per cent (the largest profits decline since the 1930s), dividends rose by 13 per cent, and the pay-out ratio shot up 15 points to 57 per cent. Thereafter, from 1980 through 1998, the pay-out ratio fell below 44 per cent only twice, in 1984 and 1985, and even then not because dividends fell but because the increase in dividends did not keep up with the increase in profits. There was no five-year period within the period 1980 to 1998 during which the pay-out ratio did not average at least 44 per cent, and over the nineteen years it averaged over 49 per cent (O’Sullivan 2000: fig. 6.4; US Congress 1999: 431). Since the mid-1980s, moreover, increases in corporate dividends have not been the only way in which corporations have distributed earnings to stockholders. Prior to the 1980s, during a stock-market boom, companies would often sell shares on the market at inflated prices to pay off debt or to bolster the corporate treasury. In general, although equity issues have never been an important source of funds for investment in the development and utilization of the productive capabilities of US corporate enterprises, they tended to issue more equities than they repurchased. But, during the 1980s, the net equity issues for US corporations became negative in many years, largely as a result of stock repurchases. In 1985, when total corporate dividends were $84 billion, stock repurchases were $20 billion, boosting the effective pay-out ratio from under 40 per cent, based on dividends only, to 50 per cent with the addition of stock repurchases. In the quarter following the stock market crash of 1987, there were 777 announcements by US corporations of new or increased buybacks (‘The buyback monster’, Forbes, 17 November 1997). In 1989, when dividends had risen to $134.4 billion, stock repurchases had increased to over $60 billion, increasing the effective pay-out ratio to over 81 per cent. With close to $70 billion in stock repurchases in 1994, the effective pay-out ratio was about 66 per cent. In 1996, stock repurchases were $116 billion, for an effective pay-out ratio of 72 per cent (‘The hidden meaning of stock buybacks’, Fortune, September 1997). Although for any one year the announced buyback plans tend to be lower than actual repurchases, the continuing high levels of announced buyback plans since 1996 suggest that US corporate enterprises continue to favour buybacks as a respectable use for their cash; US corporations announced plans to buy back $177 billion of stock in 1996, $181 billion in 1997, and $207 billion in 1998. For many major US corporations stock repurchases have now become a systematic feature of the way in which they allocate revenues and a critically important one in terms of the amount of money involved. General Electric is a good example. From 1994 to 1998, its cumulative dividend growth was 84 per cent compared with 29 per cent for the population of S&P 500 firms. Moreover, during the same period, the cumulative amount of cash that GE spent on share repurchases at $14.6 billion rivaled the $15.6 billion paid out in cumulative dividends. Together these two outflows of cash amounted to an extraordinary 74.4 per cent of GE’s cumulative cash from operations from 1994

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to 1998. Notwithstanding the enormous amounts that the company has already spent on repurchases, in December 1997, GE’s Board of Directors increased the authorization to repurchase company stock to a massive $17 billion (GE 10K 1998). It is perhaps not coincidental that since 1981, when the current CEO, Jack Welch, took office, GE has set the tone for downsizing among corporations. Why and how did this shift in the orientation of top managers from retain and reinvest to downsize and distribute occur? Corporate governance for most US corporations from their emergence in the late nineteenth and early twentieth century through the 1970s was based on the strategy of retain and reinvest. Top managers tended to be integrated with the business organizations that employed them and governed the corporate enterprises that they controlled accordingly. One condition that supported this integration of top managers into the organization was the separation of share ownership and managerial control. In the absence of hereditary owners in top management positions, career employees who worked their way up and around the managerial hierarchy could realistically hope to rise to top management positions over the course of their careers. Into the 1970s the salaried compensation of top managers was largely deter-mined by pay structures within the managerial organization. Forces were at work from the 1950s that increasingly segmented top managers of US corporations from the rest of the managerial organization. Top managers of many US corporations began receiving stock options in 1950, after tax changes made this form of compensation attractive. During the 1950s and 1960s, with the stock market generally on the rise, gains from the exercise of these options and the holding of stock became increasingly important components of the incomes of top managers. When, in the early 1970s, the stock market turned down, many corporate boards transformed worthless stock options into increases in salaried remuneration, on the grounds that these managers could not be blamed for the general downturn in the stock market. In effect, the expectations of gains from stock options that had been formed during the general rise in the stock market in the 1950s and 1960s came to be considered, along with salaries, as part of the basic compensation of top managers. Thus began a trend that during the 1970s favoured the pay of top managers over the pay of everyone else in the corporation. During the 1980s and 1990s the explosion in top management pay has continued unabated, with stock-based rewards playing an ever more important role (Hall and Liebman 1997). On average, the pay packages of CEOs of US corporations were forty-four times those of factory workers in 1965, but 419 times in 1998 (Business Week 20 April 1998, 19 April 1999). From the 1950s, therefore, US corporate managers developed an evergrowing personal interest in boosting the market value of their companies’ stock. Yet even though US companies had relatively high pay-out ratios by international standards in the 1950s, 1960s, and 1970s, during these decades US top managers remained oriented towards a strategy of retain and reinvest rather than simply using corporate revenues to increase dividends or repurchase stock to boot stock prices. . . . It was this environment of corporate growth that spawned the belief among many top managers of US corporations that a good manager could manage

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anything – a belief that the major business schools of the time were happy to propound and that provided a rationale for the conglomeration movement of the 1960s. But in the much more difficult economic environment of the 1970s and early 1980s, this belief in the omnipotence of top management began to be shattered. Indeed, the over-extension of the corporate enterprises into too many different lines of business had helped to foster the strategic segmentation of top managers from their organizations. At the same time, the innovative capabilities of international competitors made it harder to sustain the employment of corporate labour-forces, unless the productive capabilities of many if not most of these employees could be radically transformed. Under these conditions, US corporate managers faced a strategic crossroads: they could find new ways to generate productivity gains on the basis of retain and reinvest or they could capitulate to the new competitive environment through corporate downsizing. If the changed competitive environment of the 1970s and 1980s made it more difficult for top managers of US corporations to be successful through a strategy of retain and reinvest, increased segmentation within their own organizations made it more difficult for them to understand what type of innovative strategies they should pursue and the capabilities of their organizations to implement these strategies. In addition, by the 1980s the deregulated financial environment and the rise of the institutional investor as a holder of corporate stocks encouraged top managers to align their own interests with external financial interests rather than with the interests of the productive organizations over which they exercised control. Manifesting this alignment was the explosion in top management pay, while the other side of the same paycheck was the shift in the strategic orientation of top management from retain and reinvest to downsize and distribute. With the co-operation of top corporate managers, shareholder value had by the 1990s become a firmly entrenched principle of US corporate governance.

References Baker, G., Jensen, M. and Murphy, K. (1988) ‘Compensation and incentives: practice vs. theory’, Journal of Finance 43: 593–616. Bruck, C. (1989) The Predators’ Ball, London: Penguin. Ciccolo, J. Jr. and Baum, C. (1985) ‘Changes in the balance sheet of the U.S. manufacturing sector, 1926–1977’, in B. Friedman (ed.), Corporate Capital Structures in the United States, Chicago: University of Chicago Press. Corbett, J. and Jenkinson, T. (1996) ‘The financing of industry, 1970–1989: an international comparison’, Journal of the Japanese and International Economies 10(1): 71–96. Fama, E. and Jensen, M. (1983) ‘Separation of ownership and control’, Journal of Law and Economics 26: 301–25. Gaughan, P. (1996) Mergers, Acquisitions, and Corporate Restructurings, New York: Wiley. Hall, B. (1994) ‘Corporate restructuring and investment horizons in the United States, 1976–1987’, Business History Review 68(1): 110–43. —— and Liebman, J. (1997) ‘Are CEOs really paid like bureaucrats?’, NBER Working Paper Series no. 6213. Herz, D. (1990) ‘Worker displacement in a period of rapid job expansion, 1983–1987’,

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Monthly Labor Review, May, http://findarticles.com/p/articles/mi_ml153/ is_n5_v113/ai_9209851. Jensen, M. (1986) ‘Agency cost of free cash flow, corporate finance, and takeovers’, American Economic Review 76: 3 23–9. —— (1989) ‘Eclipse of the public corporation’, Harvard Business Review 67(5): 61–74. —— and Meckling, W. (1976) ‘Theory of the firm: managerial behavior, agency costs, and ownership structure’, Journal of Financial Economics 3: 305–60. Lazonick, W. and O’Sullivan, M. (1997) ‘Investment in innovation, corporate governance, and corporate employment’, Jerome Levy Economics Institute Policy Brief no. 37. O’Sullivan, M. (2000) Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany, Oxford: Oxford University Press. OECD (1999) OECD Principles of Corporate Governance, Paris: OECD. Patch, E. (1995) Plant Closings and Employment Loss in Manufacturing: The Role of Local Conditions, New York: Garland. Ross, S. (1973) ‘The economic theory of agency: the principal’s problem’, American Economic Review 63: 134–9. Scharfstein, D. (1988) ‘The disciplinary role of takeovers’, Review of Economic Studies 55: 185–99. Staudohar, P. and Brown, H. (1987) Deindustrialization and Plant Closure, Lexington, MA: Lexington Books. US Bureau of the Census (1976) Historical Statistics of the United States from the Colonial Times to the Present, Washington, DC: US Government Printing Office. US Congress (various years) Economic Report of the President, Washington, DC: US Government Printing Office. US Department of Commerce (various years) Statistical Abstract of the United States, Washington, DC: US Government Printing Office. Weinstein, M. and Kochan, T. (1995) ‘The limits of diffusion: recent developments in industrial relations and human resource practices’, in R. Locke, T. Kochan, and M. Piore (eds), Employment Relations is a Changing World, Cambridge, MA: MIT Press. EDITORS’ NOTES 1 2

3

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Reprinted by permission of the publisher, Taylor and Francis Group. This extract from Lazonick and O’Sullivan’s paper includes the introduction and first two main sections of the paper: ‘The origins of shareholder value’ and ‘From “retain and reinvest” to “downsize and distribute” ’, which present the authors’ arguments about the origin and effects of the ideology of shareholder value in the US. Readers are referred to the original paper for the analysis and discussion of US economic performance and nature of ‘current prosperity’, which form the second half of the Economy and Society paper not included in this extract. This extract excludes six figures from the original, which the authors present as evidence for the trends analysed here. Interested readers are encouraged to consult the full paper in Economy and Society to view these exhibits, which cover job loss, US corporate payout ratios, US corporate share buybacks and CEO-factory wage comparisons.

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Chapter 19

Jürgen Kädtler and Hans Joachim Sperling LOGICS OF BARGAINING IN THE GERMAN AUTOMOTIVE INDUSTRY

Introduction to extract from Jürgen Kädtler and Hans Joachim Sperling (2002), ‘After globalisation and financialisation: logics of bargaining in the German automotive industry’, Competition and Change, 6(2): 149–68

EDITORS’ COMMENTARY Kädtler and Sperling are German industrial sociologists whose work in this article combines careful theoretical framing and close empirical case study of the workplace. Many readers would be most interested in their case studies, particularly of Daimler Chrysler’s ‘shareholder value with a productionist face’ (p. 161) because there are so few empirical studies of how financialization agendas play within organizations and at the lower levels. But we have chosen instead to extract their theorized discussion of firms ‘under pressure of markets and finance’ and their general arguments about bargained globalization and financialization in the German context. This material acts as an interesting counter to the concept of control articulated by Fligstein and Lazonick and O’Sullivan, for whom control is both a realizable conception in the heads of senior management and a lever that can be pulled to benefit shareholders at the expense of other stakeholders. Instead, Kädtler and Sperling build on Child’s (1972) idea of strategy as a political choice in a field of competing possibilities and bounded rationalities. Thus German managers have to negotiate complex choices with other players, especially organized labour. Complexity is introduced at the beginning in the literature review because Kädtler and Sperling are concerned with, not one, but at least two new and disruptive logics when German manufacturing now finds itself in a ‘globalising and financialising world’ (p. 151). Kädtler and Sperling accept that under this double pressure ‘the position of organised labour within the industrial relations systems of advanced

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capitalist economies in general has deteriorated’ (p. 153). But they fiercely resist the idea that the financial markets can impose an all powerful mono-logic and thereby ‘dissolve all sources of power on which workers representation could be based at the plant and company level’ (p. 155). There are good reasons for supposing that strategy necessarily involves more than managers ‘execut[ing] decisions made by shareholders or financial markets’ (p. 154). Management as execution is impossible because financial pressure fragments when there are a variety of competing financial measures and restrictions so that instructions are ambiguous. Other logics have to be respected in companies which must conciliate labour when they seek advantage through organizational learning. According to Kädtler and Sperling, ‘companies, like organisations in general, have to be analysed as systems of collective action’ (p. 155), where different interests and logics of action must be balanced. So German management is more realistically about negotiation, not execution, with the outcomes often uncertain, unexpected, and variable from one conflict or company to the next. Thus, Kädtler and Sperling note that in 1996 the German employers’ association in the metal industry picked a fight about sick pay, convinced senior Mercedes management to take on their workforce and lost within days in a way which gratified lower management levels who were unconvinced about the issue or the tactics. Furthermore, as Kädtler and Sperling point out, companies are shielded by a variety of bloc ownership arrangements by dominant families as at BMW or the regional government as at VW. Kädtler and Sperling’s research on German companies provides a useful point of contrast with the Fligstein and Lazonick and O’Sullivan extracts earlier in this section, which had a US focus. As Lazonick and O’Sullivan observed, German managers at the beginning of the twenty-first century, were not under the same degree of direct pressure for shareholder value as their US counterparts, nonetheless the value of Kädtler and Sperling’s case study is that it highlights a more complex notion of control, in an environment where shareholder-value pressures are acknowledged yet not dominant. In this way, their extract has broader relevance for understanding financialization in other country contexts. Jürgen Kädtler and Hans Joachim Sperling are industrial sociologists at the SOFI research institute at the Georg August University, Göttingen, where Kädtler is also a Director. Both authors have written extensively in German on industrial change and labour relations. Their English language publications include Kädtler (2001), Kädtler and Sperling (2001, 2002).

REFERENCES Child, J. (1972) ‘Organizational structure, environment and performance: the role of strategic choice’, Sociology, 6: 1–22. Kädtler, J. (2001) ‘Social movements and interest groups as triggers for organizational learning’, in M. Dierkes, A. Berthoin Antal, J. Child and I. Nonaka (eds), Handbook

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of Organizational Learning and Knowledge, Oxford and New York: Oxford University Press. Kädtler, J. and Sperling, H. J. (2001) ‘The transnationalization of companies and their industrial relations’, in L. Pries (ed.), New Transnational Social Spaces, London and New York: Routledge. Kädtler, J. and Sperling, H. J. (2002) ‘The power of financial markets and the resilience of operations: arguments and evidence from the German car industry’, Competition and Change, 8: 81–94.

Introduction 1, 2

...T

the bargaining aspect of industrial relations and discusses whether bargaining for compromise is now much less important or if and how bargaining still matters in times of globalisation and financialisation. . . . [W]hen companies and economic actors search for viable economic strategies, they always have to deal with a multitude of different or even competing possibilities and demands under the condition of bounded rationality (Simon 1949; 1995). Our conceptualisation of this problem draws on the current debates of ‘Globalisation’ and ‘Financialisation’. Globalisation has generally been considered to be a disruptive principle, which upsets local compromises. While several writers on financialisation emphasise the contradictions of this process: Froud et al. (2000) for example, emphasise the contradiction gap between the return on capital employed which the capital market requires and the competitive product market allows. In this paper, we will therefore set discussion of the automotive industry in the broader context of these debates about globalisation and financialisation: the question is about whether and how plant or company level interests and industrial relations in general still matter in a globalising and financialising world. . . . H I S PA P E R F O C U S E S O N

Under pressure of markets and finance: towards a concept of bargained globalisation This section develops two main strands of our argument. First, through a literature-based discussion of what globalisation and financialisation means, this section aims to reduce the ambiguity of these terms and develop our understanding of them as well as their inter-relation. Second, this section develops a general argument concerning the persisting influence of workers’ and employees’ interests and bargaining on the plant and company level after globalisation and financialisation. The important conclusion of this argument is that companies, like organisations in general, have to be analysed as systems of collective action, where different interests and logics of action must be balanced. Financialisation does not make this necessity obsolete, but raises the problem in a new way.

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As an analytic category, globalisation is ambiguous because it rests on a loose association between elements of reality and assumptions, which are not necessarily connected in reality. So some write of informational, ecological, economic, cultural globalisation, the globalisation of production etc. (Beck, 1997: 39–42; Giddens, 2000), where national limitations and restrictions are weakened in different spheres. Conversely, other proponents of globalisation present common labelling as indicator of a common basic principle that is the cause of specific effects. This last strategy is exemplified in the writings of Ulrich Beck who seeks to provide evidence for his sophisticated and multi-dimensional globalisation theory just by generalising ad-hoc observations (Beck, 1997; Kädtler, 1998). In consequence, the ‘productionist’ concept of globalisation, which Froud et al. (1998; 1999) identify as a late outcome of the ‘Japan debate’, may be prominent but is only one element in an ambiguous and foggy discourse. Robert Boyer’s essay on the ‘politics of the age of globalisation and finance’ (Boyer, 1999) is a promising attempt to bring more transparency into this conceptual twilight zone. Introducing the dimensions of ‘intensity’ and ‘range’ of internationalisation he counts 13 + 1 different meanings of ‘globalisation’. Hereby ‘range’ stands for five levels on a micro-macro-scale between the single firm and the whole world, whereas ‘intensity’ refers to the amount of functional internationalisation pursued or realised on these different fields. In our construction of this categorisation, which is not completely consistent with Boyer’s, the most important point is that all of those meanings of ‘globalisation’ can stand for themselves. They refer to different aspects of reality, that of course can be cumulative but they can also be the result of each other, or have common elements or be intertwined. However, they cannot be seen to result from a single and coherent causal relationship. Any such causal relationship could be produced by intermediate variables and cumulative effects that might have a lock-in, selecting or intensifying effect. This would confirm earlier findings by Piore and Sabel (1984) who argue that such effects are the reason for long spells of stability between historic turning points. . . . As Chesnais (1997) and other authors (Aglietta, 1998a,b; Boyer, 1999) argue, global financial markets or actors on such markets play a decisive role in this context. Their influence derives from the deregulation of US financial markets after the 1970s and especially from the lifting of restrictions on US pension fund and insurance company investment in ordinary shares as part of more aggressive investment strategies. In consequence, institutional investors became powerful actors on financial markets who were able to enforce a strategic shift by US corporate management from a productionist focus on ‘retain and reinvest’ to financialised policies of ‘downsize and distribute’ for shareholder value (Lazonick and O’Sullivan, 2000). This influence was spread worldwide by the deregulation of global financial markets, which at the same time became more disconnected to real economy. One of the results has been a growing debate on shareholder value and financialisation from a variety of different perspectives. The special issue of Economy and Society on the political economy of shareholder value illustrates this with contributions by Williams (2000), Lazonick and O’Sullivan (2000), Morin (2000), Jürgens et al. (2000), Froud et al. (2000), Boyer (2000) and Aglietta (2000).

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From this point of view it is important to be clear about the different definitions of financialisation which are on offer and to make an intelligent choice. In this respect we follow those authors who theorise a strong interrelation between the manifest pressures of financial markets on industrial management and major changes as the importance of different sources of income and new circuits of savings and investment in developed capitalist societies, with increasing pensions requirements of ageing middle class populations as crucial factor (Aglietta, 1998a; Boyer, 1999; 2000). We leave open the question, whether this social contents necessarily had to take this form or if – as we might assume – contingent institutional deregulation has to be seen as major cause, triggering important lock-in effects. The twofold increase of mobility for capital, which can easily change between different sites and between different spheres of investment, makes more fixed or localised actors fall behind. Conditions for capital investment are redefined according to the rules of financial investment. By taking short-time financial profits as targets for the profitability of real investment, the action scope of the real economy is more and more restricted to short-term opportunities. From this perspective it is consistent to predict that economic growth will either stagnate in the long run (Chesnais, 1997) or will depend on future political regulations at the macro-level, as on the national state or the European Union (EU) level (see Boyer, 1999; Aglietta, 1998a,b; Amable et al. 1997). The conventional wisdom is that in a globalising and financialising world, the interests of organised labour lose out and the importance of industrial relations is diminished. The relative bargaining power of organised labour supposedly deteriorates in line with the transformation of the basic conditions for production because actors at financial markets are now setting requirements for profitability. In an environment of freer trade, where financial markets have priority, manufacturing is, at best, a weak power base for organised labour. This new institutional setting, which Boyer describes as the result of the internationalisation of financial markets (see Boyer, 1999: 33–38), is shaped by a new and different hierarchy of institutional forms. In Fordism, the capital–labour accord was the cornerstone of the institutional architecture, more or less dominating the other institutional forms and securing the coherence of the system. By way of contrast, after financialisation, capital–labour relations are now supposedly reduced to simply executing the options determined through other elements of the configuration. Even in Boyer and Freyssenet’s concept of ‘productive models’, where the category of ‘enterprise government compromise’ is central, there is so far no systematic role for collective actors, collective interests and industrial relations (Boyer and Freyssenet, 2000). According to Michel Aglietta, workers or their unions are only able to change outcomes if they change their playing field and organised labour has to learn the lesson that ‘the control of corporate shareholding is the battle that has to be fought and won’ (Aglietta, 1997: 462). There is no doubt that the position of organised labour within the industrial relations systems of advanced capitalist economies in general has deteriorated, to a large extent as a result of the developments sketched above. And it is easy to agree that this deterioration could not be reversed unless labour’s field of activity changed fundamentally. However, we would argue against any analytical approach

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which ignores forms of interest representation at the plant or company level and dismisses them as irrelevant to the efficient representation of the collective interests of labour in the future. In practice, the old and new terrains are connected and there may well be a connection between the preservation of traditional bargaining positions and the probability of getting influence on new or for non-traditional fields of activity. In theory, excluding labour relations at the plant and company level would be justified only on two conditions: first, if market forces and the constraining powers of financial markets would quickly and without complications become the only determining factors within the corporation; and, second, if the conflicts and resistance which emerge from this hegemony could be ignored with respect to long-term economic development. The first condition represents an extreme assumption which could not easily be justified; and the second condition requires us to ignore the major findings of regulation theory as well as simple historical experience, a sacrifice we think is unnecessary and inappropriate. Against this, we hypothesise that companies will retain their crucial position as a site where economic strategies are developed and enacted. The most common strategies concern the production and marketing of goods and services. As Child argued, the process of finding and implementing a corporate strategy has to be analysed as a political process of ‘strategic choice’ that extends to the environment within which the organisation is operating, to the standards of performance against which the pressure of economic constraints has to be evaluated, and to the design of the organisation’s structure itself. (Child, 1972: 2) The implication for our theme is straightforward. Viable strategies for the automobile industry are being developed within companies which do more (and have to do more) than just execute decisions made by shareholders or financial markets. The globalisation of financial markets and the increasing power of global players which accompanies it, in fact creates new power relations, environmental constraints and strategic problems but does not pick the winner among alternative ‘best practices’ or abolish all the old games. This is true for two reasons. First, financial variables appear to be unambiguous at first glance but practically do not suspend alternative economic rationales. Plurality of economic rationales is an inevitable implication of the fact that economic actors have to act under condition of bounded rationality. New financial parameters or restrictions tend to make the entire picture even more complicated. Second, dealing with given and self-imposed environmental pressures, companies are pushed towards seeking advantage through organisational learning where complex procedures for interest balancing are a critical factor. In short, both these sets of considerations may provide workers and labour representatives with additional power sources because they either open up new spheres of uncertainty or keep old ones in place. . . . Our analysis does not reject the notion that existing industrial relations systems can be challenged even substantially. However, this would not prove that

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the pressure created by financial markets would dissolve all sources of power on which workers representation could be based at the plant and company level. Challenges for industrial relations systems are rather the result of a mismatch between at least potential sources of power at the one side and the ability of existing organisations and institutions of industrial relations to deal with them at the other. This ability depends on unions’ capacity to deal with the new economic environment as triggers for organisational learning. In the case of failure, they might even be challenged substantially. In this context organisational learning could have many implications including – among others – unions’ ability to enter new fields of activity, e.g. the development of labour-related funds management as suggested by Michel Aglietta (1997: 482). In our view however, such a field enlarging approach will stop short if organised labour is not able to provide new concepts for bargaining and pro-active intervention at the plant and company level.

Company strategies and labour’s bargaining power: German cases Although the proportion of the German workforce employed in the automotive industry continues to decline, there can be no doubt that the big automotive companies are the core, if not the hard core, of industrial relations in Germany. And, obviously it is worker and union bargaining power on the shop floor which is crucial in this respect. There was an exemplary demonstration of both of these aspects in autumn 1996, when the employers’ associations for the metal industries tried to change unilaterally the terms of sick pay that were part of collective agreements for all their industries. They chose Mercedes Benz as the company where they could make an exemplary breakthrough, but the end-result was exactly the opposite. Confronted with heavy and spontaneous workers’ resistance, the company management had to give in within a few days.i And this exemplary defeat had a strong influence on public sentiment, so that employers’ associations gave up their struggle to reduce sick pay not only in the metal industries but also in many other industries where unions and workers’ representatives were in a much weaker position. This outcome in 1996 raised the question of whether organised labour’s victory was a kind of last ditch stand, or whether it should be seen as harbinger of the persistence of labour’s power and influence in the future. For in some German industries, including the tyre industry which supplies the automotive sector, highly organised labour and a strong bargaining traditions was powerless against the forces of globalisation which dispersed production to low wage countries.ii . . . [We] [now] present some background information on the German automotive industry, which establishes the broader context of the automotive business in Germany and Europe. The German automotive industry is by far the most important and successful in Europe in terms of production and market share. One-third of all cars produced in Europe came from Germany in 1999, and nearly 50 percent from German based companies. The German share of world-wide production is 17 percent, with one-third of this volume being built at non-German sites. If the

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non-German brands of German companies are included, the German share rises to 23 percent, with more than half that output produced outside Europe (VDA, 2000). As a result of its success, the German automotive industry has an unusually large weight and significance in the national economy. The automotive industry share of German national industrial production in 1995 was 16.2 percent, a share which is higher than that in any other large industrial country. And, with 11.2 percent of the German work-force employed in the automotive industry, the German industry’s share of the total industrial workforce was larger than in any other country (ILO, 2000). These figures indicate the continuing leading role of the industry in German economy and society as well as its participation in globalisation. This important industry is characterised by a broad variety of different configurations, with regard to product and market portfolios, profiles of internationalisation, and ownership structures. This creates opportunities for analysing how financial logic is balanced with the logics of different product and market strategies for various configurations, as well as opportunities for appraising the respective role and influence of industrial relations. On the one hand, the leading firm is the Volkswagen Group (VW) which makes 5 million cars a year (in the year 2000) as a multi-brand volume manufacturer with strong internationalisation of production facilities. In Boyer and Freyssenet’s terms, VW follows a Sloanist strategy (Boyer and Freyssenet, 2000: 14). Then there are (former) Daimler Benz and BMW, the two traditional premium manufacturers. One of these firms, now DaimlerChrysler, pushes forward to global presence in all segments by an aggressive merger and acquisition strategy; whereas BMW, after the sale of Rover, has returned to a stand alone strategy, with cautious segment enlargement, but still focussing on a premium strategy. Finally there is Porsche, which has a highly exclusive niche strategy, very export oriented and very much focussed on a few German sites. The German based subsidiaries and headquarters of the European operations of the big American owned car producers Ford and General Motors (GM) complete the landscape of the strong German automotive industry. As traditional volume producers they both lost ground against the German competitors during the nineties in Germany as well as in Europe. Their declining market share and profitability was rooted in the poor design and quality performance of their products, which urged attempts for upgrading product strategy and adjusting it to distinct consumers’ preferences. All the German owned assemblers are publicly listed. However, in the case of BMW and Porsche, one family holds the majority of shares, whereas at Volkswagen, the State of Niedersachsen holds 20 percent of the shares and is the most important shareholder. Daimler Benz was only temporarily internationalised by the Chrysler merger because many American shareholders in the merged companies quickly sold out; and the Deutsche Bank still has a very strong position in this firm, based on a 12 percent share and significant blocks of proxy votes. In a nutshell, in the German owned assemblers, significant checks still limit the influence of financial actors and shareholder activism (cf. Beyer, 1998; D’Alessio and Oberbeck, 1999; O’Sullivan, 2000). However, it has to be said that this protection cannot be taken for granted, because the strategic reorientation

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of some significant shareholders could change things radically. The situation of the two major German subsidiaries of GM and Ford is completely different because, through their parent companies, these subsidiaries are tightly connected to the requirements of US-shareholders and US financial markets. Nevertheless, these firms have to be seen not only as US-subsidiaries in Germany, but also as German style firms within US-companies.3 . . .

Conclusion [Within these firms] industrial relations, based on shop-floor positions and influence at plant or company level, still matters. [They operate] under conditions of globalisation or, more precisely, under the influence of those economic evolutions, that are indicated by the term of globalisation. That argument is reinforced by the brief case studies in this paper. All three cases [Volkswagen, GM and DaimlerChrysler] represented situations of complex and open negotiations where actual results are not variations on one unique logic of globalisation, which has clearly defined consequences for industrial relations in general. Of course, corporate management can and does refer to the increasing pressure of shareholders and financial markets; and the opportunities for transnational relocation of industrial production are increasing, at least in principle. These developments do strengthen the bargaining position of management relative to plant work force in every single case as well as relative to labour in general. A symptomatic result is the emergence of company level ‘site-agreements’ on employment and competitiveness which define a new level and sphere of collective bargaining. Traditionally in Germany, basic wage systems and basic wage levels, working time, and other general working conditions are fixed by industry wide agreements that are periodically negotiated between unions and employer associations. At plant or company level, Works Councils and plant management deal with more specific problems through applying those collective agreements and legal regulation. With the new type of site agreements in the 1990s, a rapidly expanding grey zone developed between the two levels of institutionalised interest regulation that constitute the German ‘dual system’. Companies used benchmarking results and new investment projects as levers to start negotiations with Works Councils on subjects such as working times, which were previously considered to be the exclusive prerogative of industry level agreements. Industry wide collective agreements therefore provide a weaker support for workers’ representatives at plant or company level. According to this viewpoint, the local concessions weaken collective agreements or make them more flexible. Bob Hanké has argued that site agreements are primarily drivers of a downward spiral (Hanké, 2000). But, in our view, this is just one side of the story. For the agreements secure commitments to investment in new product developments, production volumes for manufacturing sites, employment maintenance and such like which bind management strategies at least in the short and medium term. Therefore, one can argue that the increasing imperatives of financialisation

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and the options of globalisation are at least partly counter-balanced by bargaining in complex relations of production. It is simply unclear, how and to what extent management brings its potential power to bear in every actual bargaining situation at plant or company level. On the one hand, the instructions given by shareholders and financial markets are ambiguous so that corporate management does not entirely depend on orders given by them. The merger of DaimlerChrysler, undertaken with strong reference to the logic of financial markets, has to be seen, at least for a large part, as a strategy to prevent the companies from being too strictly subordinated to the short-term interests of shareholders or financial actors. Although [the] share price for DaimlerChrysler declined sharply during the post-merger period, management escaped punishment from shareholders for the time being. Firstly, it can be argued, because the US shareholders have sold out: after the merger only 17 percent of the shares were held by US shareholders and 75 percent by Europeans. And, secondly, because the major shareholders, the Deutsche Bank and the State of Kuwait are still supporting management’s productionist strategy. But doubts remain, since the Deutsche Bank confirmed in early 2001, they are working together with J. P. Morgan on a plan for protecting DaimlerChrysler against a hostile takeover. As the protagonists of financial markets as well as industrial management act under conditions of bounded rationality, they are in fact partners in bargains where both sides have important assets. On the other hand, decisions concerning the location or relocation of plants are not made by simply applying financial parameters. They are in fact the outcome of complex negotiations, which bring together different economic logics, and diverging interests, as well as questions of power and aspects of concrete situations. In this context, even under conditions of globalisation, the institutions and organisations of industrial relations are not only restrictions but also useful instruments for dealing with problems raised by globalisation. The complex connection between product, product development, manufacturing process and employment continues to be essential in the world of automotive production. And, this ensures the continuing relevance of specific standards of quality and qualification, the particular human resource strategies of management and the corresponding structures and practices of employees’ interests representation. The extent of the influence of workers representation depends strongly on the conceptualisation of products and markets on which company strategy is based. . . . [And] the result [for labour] depends partly on organisational learning by unions, as they discover to what extent they can compensate for this predictable loss of immediate influence. Unions would have to find ways to connect existing bargaining positions with new emerging ones, and to apply these principles to worker representation in those parts of the industry, where the position of labour is weaker. In Germany, industry-wide or regional level collective agreements have carried out this task for many years in an efficient way. And, we think that such bargaining can be developed to meet these requirements in the future. However, out-sourcing, just-in-time-delivery, and local supplier networks result in heterogeneous but strongly integrated structures of production which do not dissolve this traditional mode of regulation. To gain power in

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these areas unions need to find new organisational solutions that go beyond the principle of ‘one plant, one industry, one union’. At best, there are some first steps that might perhaps lead further in this direction. The first steps to effective transnational labour relations are tentative and the results are fragile. But, this does provide a first experience of effective interest co-ordination and more stable structures could be built at this level in the long run. We do not want to speculate further on the prospects for dealing efficiently with problems of globalisation. Some points at least are by now clear. As long as automobile development and production is complex and relies on collective competence and systems of collective action, workers will find important resources of power at plant and company level, even if some positions get less important and others more. Industrial relations are about making these resources available for collective bargaining and interest representation, even under conditions of globalisation. That verdict does not challenge the importance of other fields of collective action, indicated, for example, by Michel Aglietta’s demand for the development of an active shareholder-policy by unions. But, those who invoke military metaphors should remember that important and far-reaching social conflicts were never resolved in one battle or fought on one battlefield.

Authors’ notes i

ii

The decision to go into this conflict was made by top management and found no sympathy at all on the levels below. It can be taken as an experiment in executing pure shareholder value management without taking into account the social requirements and the conventional foundations of collective action in the company. Other German automotive companies such as VW and BMW pulled out of the employers front from the beginning (Bispinck and WSI-Tarisfarchiv, 1997). The German tyre industry and Continental AG, which was the union’s traditional powerhouse in this industry, provides a striking example. By transferring standard production to low wage countries, management established concession bargaining at the traditional sites, which must now compete for the remaining high wage production volumes. Union membership of more than 90 per cent and a strong bargaining tradition were if little help in this situation.

References Aglietta, M. (1997). Regulation et crises du capitalisme. Editions Odile Jacob, Paris. Aglietta, M. (1998a). Le capitalisme de demain. Notes de Ia Fondation Saint-Simon, 101. Aglietta, M. (1998b). Macroéconomiefinanciere. La Découverte, Paris. Aglietta, M. (2000). Shareholder value and corporate governance: some tricky questions. Economy and Society, 29, 146–159. Amable, B., Barré, R. and Boyer, R. (1997). Les system ` es d’innovation a l’ère de Ia globalisation. Economica, Paris. Appel, H. and Hein, C. (1998). Der DaimlerChrysler-Deal. DVA, Stuttgart. Beck, U. (1997). Was ist Globalisierung? Suhrkamp, Frankfurt a. Main. Beyer, J. (1998). Managerherrschafi in Deutschland? Westdeutscher Verlag, Opladen. Bispinck, R. and WSI-Tarifarchiv (1997). Vom ‘Bündnis für Arbeit’ zum Streit um die Entgeltfortzahlung. WSI-Mitteilungen, 50, 69–89.

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Boyer, R. (1999). Le politique a l’ère de la mondialisation et de la finance. Le point sur quelques recherches regulationnistes. L’année de Ia regulation, 3, 13–76. Boyer, R. (2000). Is a finance-led growth regime a viable alternative to Fordism? A preliminary analysis. Economy and Society, 29, 111–145. Boyer, R. and Freyssenet, M. (2000). The World that Changed the Machine. Synthesis of GERPISA-Research-Programs 1993–1999, paper presented at the 8th GERPISA International Colloquium, 8–10 June, Paris. Chesnais, F. (1997). La mondialisation du capital. Syros, Paris. Child, J. (1972). Organizational structure, environment and performance: the role of strategic choice. Sociology, 6, 1–22. D’Alessio, N. and Oberbeck, H. (1999). Is the German model of corporate governance changing? In Morgan, G. and Engwall, L. (eds), Regulation and Organizations. Routledge, London and New York, 106–19. D’Alessio, N., Oberbeck, H. and Seitz, D. (2000). Rationaliierung in Eigenregi Ansatzpunldeflir den Bruch mit dem Taylorismu bei VJV. VSA, Hamburg. Froud, J., Haslam, C., Johal, S. and Williams, K. (1998). Breaking the chains? A sector matrix for motoring. Competition and Change, 3, 293–334. Froud, J., Haslam, C., Johal, S. and Williams, K. (1999). Car Companies and the Challenge of Financialisation, paper presented at the 7th GERPISA Colloquium, 18–20 June, Paris. Froud, J., Haslam, C., Johal, S. and Williams, K. (2000). Shareholder value and financialisation: consultancy promises, management moves. Economy and Society, 29, 80–110. Giddens, A. (2000). Runaway World. Profile Books, London. Haipeter, T. (2000). Mitbestimmung bei VJV. Westfälisches Dampfboot, Münster. Hanké, B. (2000). European works councils and industrial restructuring in the European motor industry. European Industrial Relations, 6, 35–59. International Labour Organization [ILO] (2000). The Social and Labour Impact of Globalization in the Manufacture of Transport Equipment. ILO, Geneva. Jürgens, U., Naumann, K. and Rupp, J. (2000). Shareholder value in an adverse environment: the German case. Economy and Society, 29, 54–79. Kädtler, J. (1998). Globalisierung und Arbeitnehmerinteressen-oder wie aus einfachen Antworten komplizierte Fragen entstehen. SOFI Mitteilungen, 26, 69–80. Lazonick, W. and O’Sullivan, M. (2000). Maximizing shareholder value: a new ideology for corporate governance. Economy and Society, 29, 13–35. Morin, F. (2000). A transformation in the French model of shareholding and management. Economy and Society, 29, 36–53. Sullivan, M. (2000). Contests for Corporate Control. University Press, Oxford. Piore, M. J. and Sabel, C. F. (1984). The Second Industrial Divide. Possibilities for Prosperity. Free Press, New York. Simon, H. (1949). Administrative Behavior: A Study of Decision-making Process in Administrative Organization. Macmillan, New York. Simon, H. (1995). Bounded rationality and organizational learning. In Cohen, M. S. and Sproull, L. S. (eds), Organizational Learning. Sage, Thousand Oaks/London/New Delhi. Verband der Automobilindustrie [VDA] (2000). Auto 2000. VDA, Frankfurt a. Main. Williams, K. (2000). From shareholder value to present-day capitalism. Economy and Society, 29, 1–12. Womack, J. P., Jones, D. T. and Roos, D. (1990). The Machine that Changed the World. Rawson Associates, New York.

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Reprinted by permission of the publisher, Maney Publishing, on behalf of the copyright holder. Kädtler and Sperling’s paper is in two halves. The first half, which is included in this extract, reviews the literature on globalization and financialization and their potential effects on corporations; this is then used to present possible arguments about the extent to which these two major trends may change firm priorities and managerial decision-making in German automotive companies. The second half of the paper contains detailed case studies of Volkswagen, General Motors and DaimlerChrysler, which are not included in this extract. Authors’ notes are given at the end of the extract and indicated by roman numerals. This extract does not, for reasons of space, contain the detailed case study analysis of Volkswagen (characterized by Kädtler and Sperling as ‘still stable collective regulation’), nor of General Motors (‘shareholder inspired vs region-based reorganisation’), nor finally of DaimlerChrysler (‘shareholder value with a “productionist” face’). Interested readers are referred to the original for details about to what extent and how globalization and financialization have changed management decision and workforce relations in these three auto firms. The conclusion in the extract provides an outline of the findings based on these three cases.

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Chapter 20

Julie Froud, Sukhdev Johal, Adam Leaver and Karel Williams GE UNDER JACK WELCH: NARRATIVE, PERFORMATIVE AND THE BUSINESS MODEL Introduction to extract from Julie Froud, Sukhdev Johal, Adam Leaver and Karel Williams (2006), ‘General Electric: the conditions of success’, in Financialization and Strategy: Narrative and Numbers, London: Routledge, 299–388

EDITORS’ COMMENTARY This case study of GE’s success under Jack Welch as chief executive in the 1980s and 1990s is taken from a recent book which explores what giant firm strategy has become when it is now produced for the capital market as much as executed in the product market. The book combines general argument and evidence about giant firms in the UK FTSE 100 and US S&P 500 with substantial 20-year case studies of three giant firms (Ford, GE, and Glaxo). Its subtitle ‘narrative and numbers’ indicates a political-cultural economy mixed method because financial numbers are used to interrogate corporate narratives of purpose and achievement and to question the role of performative initiatives in delivering financial results. The premise is that giant companies may be managing their financial numbers through income smoothing and such like but (if we exclude Enron-style fraud) they do not control the numbers so that last year’s narrative promise can be and often is discredited by this year’s results. This opens up a new world of financialization where, at individual company level, every company needs a story and in most cases there are discrepancies and infelicity between the different elements of corporate strategy; the implication is that narrative claims and performative assumptions should never be taken at face value as they present or are presented. This academic approach is not so different from that of stock market analysts and other practitioners engaged in investment analysis and stock picking, although these groups are more inclined to

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take the claims of successful management at face value than Froud et al., whose object here is deconstructing success. Jack Welch and GE were icons of success in the late stages of Welch’s 20-year tenure as chief executive of what was an unusually large conglomerate providing everything from light bulbs to aero engines and personal loans. As the first half of the extract explains, Jack Welch was a master of narrative who insisted that GE was a ‘business engine’ not a conglomerate and supported that line with performative intitiatives. In the 1980s, large-scale divestments and sackings went along with the mission of fix, close, sell, so that GE would be number one or number two by market share in each of its businesses. In the 1990s, softer initiatives about ‘boundarylessness’ and ‘work out’ allowed 1980s Neutron Jack to reinvent as People Jack. Froud et al. challenge Welch’s claim and the generally accepted assumption that GE’s sustained financial success can be attributed to the company’s initiatives. The Froud et al. argument is that the initiatives were ‘moves’ which projected corporate purpose and achievement, while the ‘levers’ of financial success were part of an (undisclosed) business model which combined earnings from industrial businesses in GE Industrial with sales growth from financial services in GE Capital, where Welch rapidly expanded financial services using the AAA credit rating of the blue chip industrial business to reduce the cost of borrowing to lend in financial services. In the language of value based management, the price of the strategy was large-scale ‘value destruction’. GE’s accounts were complex and made more opaque by acquisitions, but borrowing to lend in financial services certainly increased GE’s capital base and reduced the return on capital employed (ROCE) to around 5 per cent. Meanwhile, the rising share price shows how the stock market suspended disbelief as long as sales growth and earnings increased year by year. The shallow judgment of the stock market only become a problem under Welch’s successor, Jeffrey Immelt, who reached the limits of the undisclosed business model: if GE Capital was expanded much further, GE would be reclassified as a financial company, re-rated downwards and subject to more onerous regulatory requirements. Julie Froud, Adam Leaver and Karel Williams are at Manchester Business School and also members of the ESRC-funded Centre for Research in Socio-Cultural Change (CRESC) at the University of Manchester, where Williams is also co-director. Sukhdev Johal is at Royal Holloway Management School, University of London. As well as their 2006 book Financialization and Strategy: Narrative and Numbers (Routledge), they have also jointly written a number of journal articles on themes relevant to financialization, including Froud et al. 2000a, 2000b, 2004, Feng et al. 2001 and Erturk et al. (2004, 2007).

REFERENCES Erturk, I., Froud, J., Johal, S. and Williams, K. (2004) ‘Corporate governance and disappointment’, Review of International Political Economy, 11 (4): 677–713. Erturk, I., Froud, J., Johal, S., Leaver, A. and Williams, K. (2007) ‘The democratisation

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of finance? Promises, outcomes and conditions’, Review of International Political Economy, 14 (3): 553–75. Feng, H.-Y., Froud, J., Haslam, C., Johal, S., and Williams, K. (2001) ‘A new business model?’, Economy and Society, 30 (4): 467–503. Froud, J., Haslam, C., Johal, S., and Williams, K. (2000a) ‘Restructuring for shareholder value and its implications for labour’, Cambridge Journal of Economics, 24 (6): 771–98. Froud, J., Haslam, C. Johal, S. and Williams, K. (2000b) ‘Shareholder value and financialisation: consultancy promises, management moves’, Economy and Society, 29 (1): 80–110. Froud, J., Johal, S., Papazien, V. and Williams, K. (2004) ‘The temptation of Houston: a case study of financialisation’, Critical Perspectives on Accounting, 15 (6/7): 885–909.

Introduction 1, 2

B

Y T H E L AT E R 1 9 9 0 s , GE and its long serving CEO Jack Welch were icons of business success. In 2002, GE came top of Fortune’s most admired companies list for the fifth year in a row (19 February 2002) and, Fortune (22 November 1999) described Welch as ‘the most widely admired and imitated CEO of his time’. In 2004, several years after his retirement, Jack Welch still commands a top three position in the Financial Times’ list of most admired executives. It is easy to understand the basis for this hero worship. GE under Welch in the decades of the 1980s and 1990s was the only US giant firm from the glory days of the 1960s which could, despite increasingly difficult product markets, apparently meet the profit and growth requirements of a more demanding capital market. The Financial Times’ (20 January 2004) report on the ‘world’s most respected companies’ asked CEOs about the companies they most admired and one CEO then commented that GE had ‘survived the pitfalls of many blue chips, while others have fallen’. If GE and Welch appear as a brilliant success, this case study questions two widely believed assumptions or assertions about GE under Welch.3 The first assumption is that Jack Welch’s initiatives explain GE’s performance: this assumption originates with Welch himself who in his penultimate letter to shareholders argued ‘this performance has been driven this decade by three big Company – wide growth initiatives: Globalization, Services and Six Sigma quality’ (GE Annual Report 1999: 3–6). The second assumption is that GE under Welch offers transferable lessons which could improve performance in other giant companies: this is popularised in books by authors like Slater whose dust jacket for the ‘GE Way Fieldbook’ (2000) promises ‘an action-oriented blueprint for managing like Jack Welch – and achieving Welch-like results in your organisation’. These assumptions have been challenged in this case by arguing that the initiatives were part of a series of narrative and performative moves that

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projected corporate purpose and achievement; while the levers of financial success were part of an (undisclosed) business model about combining earnings from industrial businesses with sales growth from financial services. This argument implies limited transferability. It would be possible for other companies to buy the workbooks and copy some of the Welch initiatives, such as Number 1 or Number 2, Work Out, digitisation etc. Such imitation might achieve positional advantage or cost reduction; but such initiatives in other companies would not produce the sustained growth of sales revenue and earnings that apparently validates a corporate narrative of purpose and achievement. Management of giant firms is more complicated than authors like Slater make out or Welch would have us believe. This conclusion forces us to rethink what we mean by corporate success and good management. Of course GE was a brilliant success, but not quite of the emblematic and transferable type and kind supposed in the prevailing culturalist accounts. In our view such accounts of management should always be cross checked against the financial numbers in a different register. Of course, Jack Welch offered leadership of the highest calibre but his was a Machiavellian virtue which rested on his understanding that narrative and performative excellence was necessary but not sufficient when business model levers needed to be purposively pulled to achieve results.

Narrative and performative defence 4 By any standard, GE in 1980 or 2000 was (and is) a conglomerate because it sells a multiplicity of different products like aero engines, light bulbs, medical equipment and financial services into unrelated markets. This identity was a problem for GE from the early 1980s because conglomerates were unfashionable and regarded with suspicion by the capital market so that their shares generally traded at a conglomerate discount and there was often pressure for divestment and spin offs to increase value. GE under Welch used discursive attack as the best form of defence to enhance the GE share price and protect the combine from break up. The conventional narrative defence was that the different GE businesses were one way or another connected so that there was synergistic gain from combining the apparently unrelated businesses as a ‘business engine’. The innovative performative defence was that the company was unified under Welch’s leadership by a series of initiatives such as ‘Work Out’ and ‘Six Sigma’, which were widely discussed in the media and business press before being imitated by other giant firms. If GE wanted to displace ‘the “C” word’ (Slater 1993: 198–201), the first most obvious resource was narrative and Welch made the argument that, despite the apparent diversity, the different parts of GE did fit together in ways that added value. Welch’s early 1980s version of this argument was his so–called ‘business engine’ concept, whereby GE was described as a collection of businesses that make a strong whole, allowing participation in many markets and working together ‘like pistons’ so that slow growing businesses like lighting provide the cash fuel for the faster growing parts, like financial services (Tichy

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and Sherman 1993: 25). The engine metaphor was new but did little more than restate the BCG ‘product portfolio matrix’ and the box diagram about stars, dogs and cash cows which may still figure in strategy textbooks but does not much influence market judgements. Hence, the importance of adding a performative element through several company-wide initiatives which rationalised GE’s existence to outsiders and employees alike by identifying a unifying organisational focus within the business portfolio. The initiatives came in two successive phases: the ‘hard’ restructuring initiatives of the 1980s which met with a mixed reception but did help the share price; and the ‘soft’ restructuring of the 1990s which framed Welch and GE as brilliant successes and turned GE into a brand. The first and most controversial of Jack Welch’s initiatives was set in motion in the early 1980s by his declared mission to ‘become the most competitive enterprise in the world by being number one or number two in market share in every business we are in’ (GE Annual Report 1984: 2). Where this target could not be met, management should ‘fix, close or sell’. GE in the 1980s then enacted this ambition by dramatically restructuring its activity base and sacking a substantial part of the workforce When Welch took over, GE employed 420,000 and, according to Tichy and Sherman (p. 10) some 170,000 jobs were then lost through ‘lay offs, attrition and other means’ as part of a larger restructuring with divestment between 1980 and 1984 accounting for 20 per cent of the 1980 asset base. As is often the case with such management exercises, the number one or two rule was not consistently used and could not be rigorously applied. As Welch (2001: 237) admitted in his autobiography, the rule was ignored at GE Capital where ‘we didn’t have to be No 1 or No 2’; and in a 1999 interview he accepted GE managers’ claims that industrial managers were playing redefinition games as ‘everyone is defining their markets smaller so they can be number one or two’ (Slater 1999: 180). At the same time Welch’s detractors suspected that GE was, like many other giant firms, in retreat and avoiding Japanese competition. The business media were initially negative as the new CEO acquired an unflattering epithet as ‘Neutron Jack’, in a phrase supposedly coined in 1982 by Newsweek, which implied ruthless downsizing that was surely more about cost cutting management than about leadership. The market was more positive but also guarded as GE’s price/earnings ratio did no more than track the S&P 500. In performative terms, by the late 1980s Welch needed another big idea and some new initiatives that would accentuate the positive and eliminate the negative. This was supplied by some fresh thinking about how the CEO, head office and corporate infrastructure could add value to GE’s diverse operations by emphasising values, leadership and knowledge transfer across divisions. From this point of view, Welch’s next big idea at the end of the 1980s was ‘integrated diversity’. This allowed Welch to explain that GE was not a conglomerate because it demonstrated ‘integrated diversity’. It is this elimination of boundaries between businesses and the transferring of ideas from one place in the company to another that is at the heart of what we call integrated diversity. It is this concept that we believe sets us apart from both single product companies and from

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conglomerates . . . by sharing ideas, by finding multiple applications for technological advancements and by moving people across businesses to provide fresh perspectives and to develop broad-based experience. Integrated diversity gives us a Company that is considerably greater than the sum of its parts. (GE Annual Report 1990: 2) In due course this big idea segued into Welch’s early 1990s principle of ‘boundarylessness’ in a delayered organisation without ‘organisational silos’ which was, according to Welch the only way that GE would be able to achieve its productivity goals (GE Annual Report 1991: 2–3). The ‘Work-Out’ initiative was a further development of GE’s ‘software’ (GE Annual Report 1991: 1), introduced in 1989 as an enactment of GE values and a central element in the attempt to break through boundaries. It reflected frustration with the limited reach of the GE staff college at Crotonville, which could only involve a fraction of the workforce through traditional training methods (Welch 2001: 182). Under Work-Out, GE staff from all levels came together for sessions based on the idea of the town meeting, where employees were allowed to ask their managers awkward questions about why things were done in particular ways and to suggest improvements to processes that would save time and cash. The initiative was based on the principle of empowering the workforce, requiring middle managers to come out from their offices and making all employees responsible for GE’s continued success. By 1992, more than 200,000 employees, some 85 per cent of GE’s staff, had taken part in a Work-Out session (Welch 2001: 183). Increasingly, Welch who headed a giant firm hierarchy presented himself as a crusader against bureaucracy and for cultural change: my view of the 1990s is based on the liberation of the workplace, everybody a participant . . . In the new culture, the role of leader is to express a vision, get buy-in, and implement it. That calls for open, caring relations with every employee, and face-to-face communication. People who can’t convincingly articulate a vision won’t be successful. But those who can will become even more open – because success breeds self-confidence. (quoted in Tichy and Sherman 1993: 247) This was reflected in the development of Work-Out through successive phases, which put more emphasis on leaders as ‘professional change agents’. With the reduction of ‘management’ and the dismantling of bureaucracy, leaders have moved quickly to the front, creating a vision for each business and articulating their vision so clearly and compellingly that an entire organization can rally around it and turn it into reality. (GE Annual Report 1987: 4) As Welch wrote in 1991: ‘In the first half of the 1980s we restructured this

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Company and changed its physical make-up. That was the easy part. In the last several years, our challenge has been to change ourselves’ (GE Annual Report 1991: 4). Here, the touchy, feely stuff was interestingly combined with the hard edge of performance requirements. Work-Out was accompanied by Welch’s now famous annual review (GE Annual Report 1991: 4–5) which classified managers into the ranks of A, B and Cs, where the As got stock options and the Cs were encouraged to find new challenges outside GE. The next major new initiative from the mid-1990s was Six Sigma, which combined hard and soft management: Six Sigma was a set of generic statistical techniques which GE borrowed from AlliedSignal and Motorola, and used to improve product and process quality and thereby to reduce costs and improve relations with customers. Again, GE explains this initiative as involving and rewarding the workforce at all levels: ‘quality is the responsibility of every employee’ (GE undated: 2), while also delivering a bottom line impact as costs are lowered and customers are ‘delighted’. But the more important aspect of all this, according to Welch, is that it contributes to building GE as a ‘learning organization’ where ‘everyone in GE gets up in the morning and comes to work every day trying to find a better way’ (Collingwood and Coutu 2002: 94). Thus, in his final letter to shareholders in the 2000 annual report and accounts, Welch summarises his achievement: The most significant change in GE has been its transformation into a Learning Company. Our true ‘core competency’ today is not manufacturing or services, but the global recruiting and nurturing of the world’s best people and the cultivation in them of an insatiable desire to learn, to stretch and to do things better every day. (GE Annual Report 2000: 2) In a valedictory interview for the Harvard Business Review in 2002, Welch concludes by saying that he would like his gravestone to say ‘People Jack’ (rather than ‘Neutron Jack’ or some other epithet), because the single most important part of his job has been ‘spend(ing) time with people’ (Collingwood and Coutu 2002: 94).

GE’s undisclosed business model 5 Generically, business models are about how firms recover their costs, including a surplus that includes the cost of capital. Under the influence of finance theory and shareholder value ideology, consultants of the 1990s targeted rates of return of at least 11–13% (after tax) on capital employed; though most S&P 500 companies had difficulty in attaining that level of return from competitive product markets. The stock market also wanted growth of sales revenue which was just as difficult because the average giant company grows no faster than GDP. GE is the apparently effortless exception with a 20% return on equity capital, sustained double digit sales revenue growth and a 20 year unbroken run of quarterly sales increases which indicate cyclicality was never a major problem.

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These results are generally read as a validation of GE’s narrative and performance but we would refer them to an undisclosed business model. All firms that survive for any length of time must have a business model which could be either the consequence of accidental developments or purposive movement planned by management. Accident includes happenstance changes of circumstance such as unexpected success in a new product market segment while purpose includes actions such as deliberate labour cost reduction. Explicit business models are models that are disclosed in the company’s narrative of purpose and achievement and discussed by analysts as with the pharma business model of marketing blockbusters (Froud et al. 2006: 168–79). But it is also possible to have an implicit business model where the major sources of profit and cash do not figure prominently in the company narrative and their implications are not generally understood outside the company. The fascination of GE is that long run analysis of the financial numbers shows very clearly that GE had a purposive but undisclosed business model with management clearly pulling levers hard to get profits in ways which do not fit the narrative and performative account of moves under Jack Welch. By undisclosed business model we do not mean that this model was ever hidden or concealed; that cannot be so insofar as this case study develops its account of GE’s business model from publicly available accounting information. Rather, we use the term undisclosed to denote a business model which was not explicitly articulated by the company and its CEO who preferred to talk about other things and sometimes denied elements of the business model; just as outside analysts and commentators never brought the business model into focus. Our analysis of the undisclosed business model is relatively straightforward and focuses on how GE synergistically combined two large diversified businesses (GE Industrial and GE Capital Services). The division of labour was such that GE Industrial was run for profits and generated some two-thirds of the earnings that were distributed to shareholders over the twenty years of Welch’s tenure as CEO. GE Capital Services provided all the sales growth because sales were flat in GE Industrial despite a successful attempt to build up industrial services. The synergistic connection between Industrial and Capital was that Industrial generated the AAA credit rating which gave Capital Services an advantage over banks. Returns and growth were then boosted by buying and selling companies through large scale acquisition and divestment which both achieved returns and growth objectives and incidentally increased opacity and thus the power of narrative. These business model principles are analysed in turn below with some discussion of how the issue is represented in GE’s own discourse where the principles are never acknowledged and sometimes denied.

Principle 1: run GE Industrial for margins to cover the earnings requirement and build up industrial services to cover hollowing out Companies which explicitly run blue chip industrial businesses for margins, like Weinstock’s British GEC, seldom enjoy a positive reputation because there is

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something inherently unconstructive about management by financial hurdle which often results in hollowing out as the company sells businesses which do not meet the returns criteria. For GE, the narrative and performative deflects such criticism insofar as it suggests that brilliant numbers are not the objective of management but a result that drops out from initiatives. Equally interesting in GE from the mid-1980s onwards is the absence of a high profile discourse of cost reduction because productivity increase was used as coded GE management speak for cost reduction. Thus, the ‘change acceleration process coaches workshops’ at Crotonville started with an overview: ‘CAP has proven to be a valuable tool that is helping GE businesses achieve measurable growth and productivity improvements’ (Slater 2000: 162). GE also showed considerable narrative flair in the way it represented its commitment to services, where it elided financial and industrial services in a way that discouraged questions about either. Against this rather blurred background, the numbers suggest that GE Industrial is an operation that has been run for higher earnings when management has found it difficult to wring increasing margins out of GE Capital. RoS (return on sales) in GE Industrial grew fairly steadily from around 5–6 per cent to around 11–13 per cent, with some drop in 1991. For GE Capital, however, the RoS has been much more variable with some increase from 8 per cent in the early 1980s to 11–13 per cent by 1983–4, but this has since fallen back to around 6–9 per cent. In the company as whole, net (post-tax) income grew from $3bn to $15bn through the 1980s and 1990s and two-thirds of this increase depended on GE industrial extracting higher earnings from flat sales (while GE capital increased sales with flat margins). By far the largest element in GE’s service offering is financial services which generally have no connection with GE industrial products (GE Capital is definitely not a captive finance operation like Ford Credit). But GE has traditionally constructed a narrative of GE as a technology-based company that puts the emphasis on industrial services as support for the primary industrial product which is a jet engine, a turbine or a medical scanner. The development of services within GE Industrial was clearly an explicit objective in the 1990s; symbolically illustrated by the purchase of aero engine maintenance businesses from British Airways and Varig. The company accounts shows there was a successful push into services after the early 1990s which raised the share of services in GE Industrial sales from 21 per cent in 1992 to 29 per cent by 2003; and these services were consistently profitable with gross margins never below 23 per cent.

Principle 2: grow the financial services business, up to the limit of the company’s credit rating The growth of financial services does not register as GE’s central achievement in the Welch years because GE Capital does not fit the narrative and performative frame. As we have noted, the company prefers to talk about growing service businesses in a way that brackets financial and industrial services; while much of the performative element (like number one or two in every business) simply

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doesn’t apply in GE Capital. In this context, the general lack of interest in GE Capital in many management books on GE is symptomatic: if there is a discrepancy between what management says in its script of purpose and achievement and what the company does for growth and cost recovery, outsiders with a limited interest in the mechanics of cost recovery quickly become confused about cause and effect and prefer the narrative. GE has sold financial services since the 1930s, starting with domestic credit for refrigerators, a classic form of captive finance. However, through the 1980s and 1990s, GE Capital greatly expanded and increased its offering in everything from LBO finance to store cards. In Edgar Allen Poe’s (1845) story, when the apartment was searched, the purloined letter could not be found because it had been hidden in the letter rack. GE Capital is hidden in much the same way inside the GE accounts exactly where it should be and, though disclosure is limited, any undergraduate accounting student could calculate that real sales increased from $3bn to $58bn from 1980 to 2002 so that once negligible financial services now account for nearly half of turnover and all of GE’s sales growth. If the expansion of GE Capital rested on management judgement and controls, it also reflected the structural advantage of the triple AAA credit rating which was based on the industrial business and used by Capital as a source of competitive advantage. The solid industrial base is the basis for GE’s AAA credit rating, which allows GE Capital to borrow cheaply and this provides a considerable cost advantage over rivals including banks like Citigroup which enjoys only an AA rating, Citigroup’s rating is the highest of any US bank but implies an extra $400m a year in interest on its long term debt (Business Week, 8 April 2002).

Principle 3: deal, so that large scale acquisition and divestment of businesses assists with returns and growth objectives and incidentally increases opacity The role of acquisition and divestment could not be openly discussed by an incumbent CEO because, if Welch or Immelt admitted GE’s limited ability to generate organic growth, the market would immediately ask about where/when the next big deal was coming from and whether a company of GE’s size could do enough deals to maintain forward momentum. Thus, the company line has to be that it is not built on acquisitions. For example, Immelt in a 2002 interview claimed that: when you look at how GE has been put together, you’ll see that we are a long term player in every industry we’re in. We’ve really invented most of these industries. We haven’t acquired our way into specific businesses, except maybe for NBC; we’ve developed these businesses from the ground up. (Money, 1 September 2002) GE’s deal making is legendary yet it is difficult to obtain systematic information on the individual and total value of deals, let alone the effect on the company’s

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financial results. Various estimates can be cited. The 2000 Annual Report states that ‘the Company made over 100 acquisitions for the fourth consecutive year’ (GE Annual Report 2000: 1) but provides no systematic information on these. The fragmentary information in the company accounts yields one useable broad measure – cash flow applied to acquisitions. This is not a perfect indicator because it is a net figure, after the cash inflow from disposals has been offset, but it does nonetheless provide a useful guide to the scale of activity. Over the 1988–2003 period, a total of $144bn of cash (in 2003 prices) was applied to acquisitions and of this, the largest sum of $103bn was for GE Capital acquisitions, with some $40.4bn for industrial acquisitions. Opacity is important for a company like GE because it increases the creative power of the narrative and performative elements insofar as they cannot easily be checked against a numbers-based understanding of corporate achievement. Acquisition and divestment with limited accounting disclosure increase opacity because they make long run like-for-like comparisons very difficult so that it quickly becomes impossible to judge the achievement of continuing operations or the success of bolt on acquisitions. GE has to be a ‘trust me’ story for believers because the published accounts make it difficult for outsiders to probe the sources of GE’s growth or the capacity of GE managers either to run existing businesses or to implement acquisition. Several interrelated problems arise from GE’s limited disclosure of acquisition and divestment and the limited information on business segments. As we have noted, the cash flow statement after 1988 gives cash applied to acquisitions but it does not separate the cash flow that results from divestments, nor is there any comprehensive, systematic disclosure of what is bought (or sold), when, for how much and how was it financed. The GE business model was both brilliantly effective and had natural limits which had been reached by the late 1990s with GE Capital accounting for 40 per cent of turnover. By this point, GE had to curb further growth of GE Capital revenues because, if more than 50 per cent of GE’s revenues come from finance, GE would be reclassified as a financial company and the credit rating would probably be lowered in line with that for other finance houses. Thus, by the late 1990s if GE wanted to maintain growth, it had to find ways of bulking out the industrial part of the business and this partly explains the interest in large scale industrial acquisitions like those of Honeywell (which was blocked by EU regulators in 2001) and of Universal, which GE did acquire from Vivendi in 2004. As it was, the growth of financial services in the 1980s and 1990s completely wrecked the return on capital employed because GE Capital Services was not only a low return business but a voracious user of capital. GE was not a retail bank so that broadly speaking (and disregarding the complication of securitisation) the company had to borrow the money GE Capital Services lent on. The balance sheet was then quite radically restructured as a result of the expansion of the finance business. Most of the extra capital comes in the form of debt not equity and almost all of the liabilities are associated with GECS: while GECS has a little more than half of all the equity, it has around 75 per cent of the short term liabilities and more than 90 per cent of the total long term liabilities. The stock market can be kept happy because only a small part of GE’s Capital is now

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in the form of equity so ROCE may be poor but return on equity can be kept high. Thus GE consolidated achieves a return on equity (RoE) of well over 20 per cent in most years since 1990, while the return on capital employed (ROCE) has struggled to get much above 5 per cent, which is below any target based on the opportunity cost of capital. The brilliant success is, by this measure, a huge destroyer of value.

Conclusion Maybe it is sensible to turn the doxic question round and ask not ‘how did Jack do it?’, but ‘why can most other CEOs not do it?’. In the terminology of our Financialization and Strategy book, most of the Welch era initiatives that pre-occupy the popular business books were moves (e.g. programmes for reducing costs) not levers. These were important insofar as they helped generate narrative and performative purpose and incidentally deflected hard questions about the sources of growth and profit and the future trajectory. But the GE numbers were generated by pulling cost recovery levers which most managers do not have or cannot easily shift: for example, GE built financial services on a triple AAA credit rating where Ford had to do the job on a single A rating in the 1990s. Even the brightest and best of managers cannot escape structural constraint: in businesses like lighting or domestic appliances where GE returns performances that are what we would expect in mature, competitive activities. The only general lesson of Welch and GE is that high-level management in complex operations is an activity which is perhaps best understood through the classic Machiavellian categories of virtu, fortuna and occasione. The art of management here is to understand what is possible and necessary by holding the narrative and performative separate from the business model in internal calculation and then bringing them together by public association in media and market commentary. As for the CEO, (s)he then becomes the actor who first follows the script and then learns to improvise a public rhetoric and performance while operating an undisclosed business model. This is why all these interviews with great managers about the ‘secrets of management success’ offer the reader so little because their well chosen words for the Harvard Business Review spin the narrative as part of the performance without clarifying the relation between moves and levers. As for the rest of us outside GE, the main result of Jack Welch as exemplar is twofold. First, specific companies, especially in the late 1990s at the height of the cult, implemented copies of what they imagined Jack did: thus, Welch was an influence on the sector matrix strategy and the grading of managers in Ford under Jacques Nasser. Second, more generally, Welch’s example has encouraged the motivational and evangelical tone which makes the modern organisation into a place of obligatory enthusiasm for endless initiatives which often have very little connection with the levers of business performance. It was Jack Welch who encouraged GE managers to carry round statements of GE values on laminated plastic cards:

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All of us . . . Always with unyielding integrity Are passionately focused on driving customer success Live Six Sigma Quality . . . ensure that the customer is always its first beneficiary . . . and use it to accelerate growth Insist on excellence and are intolerant of bureaucracy Act in a boundaryless fashion . . . always search for and apply the best ideas regardless of their source Prize global intellectual capital and the people that provide it . . . build diverse teams to maximize it See change for the growth opportunities it brings . . . e.g. digitization Create a clear, simple, customer centred vision . . . and continually renew and refresh its execution Create an environment of ‘stretch’, excitement, informality and trust . . . reward improvements and celebrate results Demonstrate . . . always with infectious enthusiasm for the customer . . . the ‘4-Es’ of GE leadership: the personal Energy to welcome and deal with the speed of change . . . the ability to create an atmosphere that Energizes others . . . the Edge to make difficult decisions . . . and the ability to consistently Execute (Welch 2001: 190)

• • • • • • • • •

In private corporations and public sector organisations, management has become something which draws on the language and emotions of sales conference and religious revival as we must all now, through passion and works, attain a higher state for love of the customer. For that, Jack Welch is partly responsible.

References Collingwood, H. and Coutu, D. L. (2002) ‘Jack on Jack’, Harvard Business Review, February: 88–94. Froud, J., Johal, S., Leaver, A. and Williams, K. (2006) Financialization and Strategy: Narrative and Numbers, London: Routledge. GE (undated) What is Six Sigma. The Roadmap to Customer Impact. Online, http:// www.ge.com/sixsigma/SixSigma.pdf, accessed 12 March 2004. Slater, R. (1993) The New GE, New York: McGraw Hill. Slater, R. (1999) Jack Welch and the GE Way, New York: McGraw Hill. Slater, R. (2000) The GE Way Fieldbook, New York: McGraw Hill. Tichy, N. M. and Sherman, S. (1993) Control Your Destiny or Someone Else Will, New York: Harper Business; repr. (2001) New York: Harper Collins. Welch, J. (2001) Jack. What I’ve Learnt Leading a Great Company and Great People (with John A. Byrne), London: Headline.

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3

4

5

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Reprinted by permission of the publisher, Routledge. © 2006 Taylor and Francis Group. This extract is an abridgment of a long case study of GE under Jack Welch, which contains over twenty years of financial analysis. This extract included here draws on two sections: the first section, ‘Industry frame: not a conglomerate’; and the fourth section, ‘GE’s undisclosed business model’. Interested readers will find that the original GE case study published in Froud et al. also contains detailed analysis of GE’s narrative in the media and in business books and a deconstruction of the company’s long-run financial performance. The nature of the abridgment means that cuts in the original text are not shown. This and the two paragraphs that follow immediately are taken from the conclusion of the original book chapter (pp. 364–5) and are helpful in outlining the general argument of the original chapter. This section of the extract is taken from the section of the original chapter in Froud et al. titled ‘Industry frame: “not a conglomerate” ’ (pp. 303–11), with the subheading added by the editors. This section of the extract is an abridged version of the section of Froud et al.’s original GE case titled ‘GE’s undisclosed business model’ (pp. 336–58), with the subheading added by the editors. In this section, the original seven principles of GE’s cost recovery have been compressed into three with some editing of the original text for the purposes of fluency and conciseness.

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