The corporate fallacy
By July 2009
A few prescient people – too few of them economists – are entitled to say of the current economic crisis, “I told you so.” One is Ian Macfarlane, the former governor of the Reserve Bank of Australia, who warned in October 1998, at an economic summit in Singapore, that “more and more people are asking whether the international financial system as it has operated for most of the 1990s is basically unstable. By now, I think the majority of observers have come to the conclusion that it is.”
In the same month, Macfarlane told an international conference of banking supervisors in Sydney that it was “simplistic to insist on the totally free movement of capital in all countries and in all circumstances” and said, “We need to devise a system for maximising the benefits to be gained from international capital while limiting the risks.” A month later, he told the Committee for the Economic Development of Australia that “the intellectual underpinning of the free market position in relation to asset price determination – the Efficient Markets Hypothesis – is very weak. In all the exchange-rate tests of which I am aware, the hypothesis has been contradicted by the facts.”
Yet, notwithstanding the worries of iconoclastic bankers such as Macfarlane, the world continued to dance to the tune of the financial engineers even as many of the dancers felt a rising sense of foreboding. Chuck Prince, the former chairman and CEO of Citigroup, said in July 2007: “When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Things will get complicated. Nothing illustrates more saliently the condition of modern managerial elites: power without responsibility. With his statement, Prince was making a pre-emptive case for being excused from responsibility, on the grounds that the financial system in which his bank was a participant gave it no option, if it wanted to maintain its market share, but to continue contributing to the inflation of a bubble that would inevitably burst. No matter that this perverse system was one that Citigroup had helped to create, and boosted and defended. Or that Citigroup’s managers were by no means powerless to behave responsibly, not only towards their customers and those with whom they did business, who would be harmed by what they did, but in relation to the viability of their own institution.
In all of this, no one has suffered a reversal in credibility to equal that of Alan Greenspan, the former chairman of the US Federal Reserve. Nevertheless, it is from the intense perspectives of key protagonists, such as Prince and Greenspan, that some of the sharpest insights into the economic crisis are to be gleaned. In his testimony to the Congressional Committee of Government Oversight and Reform, given last October, Greenspan expressed dismay at the failure of what he called “counter-party surveillance”:
those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counter-party surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined. What went wrong with global economic policies that had worked so effectively for nearly four decades?
Greenspan’s faith in the financial markets rested on this concept of counter-party surveillance: the self-interested monitoring by market participants of one another. Participants would automatically and naturally protect their own positions and manage their exposure to risk when dealing with counter-parties. This, he believed, was a stronger mechanism for preserving the balance of the financial system than any form of external regulation.
Belief in counter-party surveillance is justified, however, only if the self-interest of participants is indeed driving risk management. Yet it wasn’t. In the financial crisis, a clear breakdown in such surveillance occurred, which left Greenspan utterly confounded, as he elaborated following his Congressional testimony:
I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and the equity in the firms. And it’s been my experience having worked both as a regulator for 18 years and similar quantities in the private sector, especially ten years at a major international bank, that the loan officers of those institutions knew far more about the risks involved and the people to whom they lent money than I saw even our best regulators at the Fed capable of doing. So the problem here is something which looked to be a very solid edifice and indeed a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and obviously to the extent that I figure out where it happened and why I will change my views. If the facts change, I will change.
The cause of Greenspan’s bewilderment is so obvious that he, the most brilliant of rationalists, cannot see it: he had assigned self-interest to corporations, but self-interest can only be held by people.
What Greenspan calls “the self-interest of organizations” is merely the expression of the range of human interests contained within an organisation. Greenspan’s mistake I propose to call the anthropomorphic fallacy: the fallacy of ascribing human traits to a non-human entity – including that most fundamental of human drives, self-interest. In fact, the artificial creature called the corporation only superficially exhibits a collective self-interest. The collective interest apparently represented by a corporation may be aligned with the self-interests of the individuals who make it up, or it may not. Indeed, the interests of the individuals and groups that compose the corporation may be at odds in crucial ways.
In the modern corporation, the interests of the various parties – managers, talented and profitable risk-takers, staff and stockholders – are not unitary. Some pursue their interest in speculation on stock prices, some in dividends from profits. Some interests are long-term, others short. Some see themselves in a capitalist marketplace, while others see themselves in a casino.
The question, therefore, is who gets to determine the interest of the institution. In the modern corporation, it is the management. But the self-interest of managers, who have no significant ownership of the corporation, is disconnected from the interests of the other parties with a stake in the corporation’s fortune and fate.
Compare giant publicly listed corporations, with their numerous anonymous stockholders, including the superannuation fund managers responsible for the investments of millions on behalf of their policyholders, to privately owned corporations or listed corporations with powerful individual shareholders. There is no way that a Rupert Murdoch would allow the fate of News Corporation to be determined by the self-interest of a manager like Chuck Prince.
When you accept that corporations do not have a unitary self-interest, it is plain that fundamental reform of the structure of corporations – both in their governance and the relationship between owners and management – is imperative.
In an earlier era of capitalist corporations, the alignment of the interests of owners and managers was closer; corporate interest was assumed to be unitary. But the rise of large, multi-shareholder corporations and the decline of dominant individual shareholders, together with greater deregulation of financial institutions, created incentives for managers to lean towards short-term considerations and take greater risks. Fewer and fewer incentives supported the long-term. Just because many of the financial instruments that were traded involved long-run returns, those responsible for creating and trading these instruments got their rewards in the short run. Liabilities could be shoved into the future, while profit(eering) could be brought forward.
It was for good reason that collapse was averted following the Panic of 1907 by the actions of the financier JP Morgan, in the absence of any governmental mechanism to rescue the financial system. It was Morgan’s self-interest in his own organisation and the wealth that was tied up in it that drove him to provide a guarantee to the banks – in the form of a $100 million gold loan – in order to avert a general collapse. (It is said that during this period the four words that most terrified the banking community were: What if he dies?) In those days, owner-oligarchs concerned themselves with the long-term survival of their organisations, whereas today the manager-oligarchs’ self-interest is short-term. And so we have a long list of venerable institutions that have fallen over (or should have fallen over, had they not been heavily transfused with the blood of taxpayers) like so many ten-pins.
And yet Greenspan could not see the answer to his conundrum. Instead, reliant as he is on the mathematical models of risk management, he went on to say:
It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk-management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk-management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.
Greenspan claims it was not the mathematical model that was wrong, it was the numbers they plugged into it.
Professor Lucian Bebchuk from the Harvard Law School reinforces the importance of distinguishing between “controlled companies”, which have a controlling shareholder, and “widely held companies”, which lack such a figure. In controlled companies, the problem of governance centres on opportunism by the controlling shareholder. In widely held companies, it centres on opportunism by managers, who exercise de facto control. Bebchuk argues that reforms to improve corporate governance and protect investors must take into account the fundamental differences between controlled and widely held companies – that “one size fits both” reforms will not work.
Since the nineteenth century, when corporations were first anthropomorphised and granted the legal personality of human beings, we have come to assume that they possess the kind of self-interest that Alan Greenspan was banking on, the kind that would ensure they would not risk their own extinction as corporate entities. But a corporation is merely a collection of contracts between humans, whose individual interests are the true self-interests within the corporation. And in recent times, the decisive interests of the managers have become disconnected from the interests of the company and its shareholders.