23 Things They Don't Tell You About Capitalism

Some accepted the rise of the professional managers as an inevitable, if not totally welcome, phenomenon. Joseph Schumpeter, the Austrian-born American economist who is famous for his theory of entrepreneurship (see Thing 15), argued in the 1940s that, with the growing scale of companies and the introduction of scientific principles in corporate research and development, the heroic entrepreneurs of early capitalism would be replaced by bureaucratic professional managers. Schumpeter believed this would reduce the dynamism of capitalism, but thought it inevitable. Writing in the 1950s, John Kenneth Galbraith, the Canadian-born American economist, also argued that the rise of large corporations managed by professional managers was unavoidable and therefore that the only way to provide ‘countervailing forces’ to those enterprises was through increased government regulation and enhanced union power.

However, for decades after that, more pure-blooded advocates of private property have believed that managerial incentives need to be designed in such a way that the managers maximize profits. Many fine brains had worked on this ‘incentive design’ problem, but the ‘holy grail’ proved elusive. Managers could always find a way to observe the letter of the contract but not the spirit, especially when it is not easy for shareholders to verify whether poor profit performance by a manager was the result of his failure to pay enough attention to profit figures or due to forces beyond his control.

The holy grail or an unholy alliance?

And then, in the 1980s, the holy grail was found. It was called the principle of shareholder value maximization. It was argued that professional managers should be rewarded according to the amount they can give to shareholders. In order to achieve this, it was argued, first profits need to be maximized by ruthlessly cutting costs – wage bills, investments, inventories, middle-level managers, and so on. Second, the highest possible share of these profits needs to be distributed to the shareholders – through dividends and share buybacks. In order to encourage managers to behave in this way, the proportion of their compensation packages that stock options account for needs to be increased, so that they identify more with the interests of the shareholders. The idea was advocated not just by shareholders, but also by many professional managers, most famously by Jack Welch, the long-time chairman of General Electric (GE), who is often credited with coining the term ‘shareholder value’ in a speech in 1981.

Soon after Welch’s speech, shareholder value maximization became the zeitgeist of the American corporate world. In the beginning, it seemed to work really well for both the managers and the shareholders. The share of profits in national income, which had shown a downward trend since the 1960s, sharply rose in the mid 1980s and has shown an upward trend since then.[3] And the shareholders got a higher share of that profit as dividends, while seeing the value of their shares rise. Distributed profits as a share of total US corporate profit stood at 35–45 per cent between the 1950s and the 1970s, but it has been on an upward trend since the late 70s and now stands at around 60 per cent.[4] The managers saw their compensation rising through the roof (see Thing 14), but shareholders stopped questioning their pay packages, as they were happy with ever-rising share prices and dividends. The practice soon spread to other countries – more easily to countries like Britain, which had a corporate power structure and managerial culture similar to those of the US, and less easily to other countries, as we shall see below.

Now, this unholy alliance between the professional managers and the shareholders was all financed by squeezing the other stakeholders in the company (which is why it has spread much more slowly to other rich countries where the other stakeholders have greater relative strength). Jobs were ruthlessly cut, many workers were fired and re-hired as non-unionized labour with lower wages and fewer benefits, and wage increases were suppressed (often by relocating to or outsourcing from low-wage countries, such as China and India – or the threat to do so). The suppliers, and their workers, were also squeezed by continued cuts in procurement prices, while the government was pressured into lowering corporate tax rates and/or providing more subsidies, with the help of the threat of relocating to countries with lower corporate tax rates and/or higher business subsidies. As a result, income inequality soared (see Thing 13) and in a seemingly endless corporate boom (ending, of course, in 2008), the vast majority of the American and the British populations could share in the (apparent) prosperity only through borrowing at unprecedented rates.