When I first submitted my Technical.ly Philly article on B Corps to Zack, the editor, it contained the following tangent of totally obnoxious intellectual showboating. Being a kind man, he simple said “it’s a bit much,” and asked me to condense it into a paragraph. That I did, but we decided to include a link to this, in case anyone wanted to see the basis for some of the broad pronouncements I made in that replacement paragraph.
The question became: how do we reign in these rogue robber barons from blowing the defenseless stockholder’s money?
The answer came from economists like Michael Jensen and William Meckling, whose work on agency costs propelled shareholder wealth maximization to its intellectual apotheosis. Corporate executive’s incentives could be almost perfectly aligned with shareholders if companies started paying them primarily in bonuses, stock options and other performance-based packages.
Encouraged by these monetary motivations, executives began to load up on debt, aggressively leveraging their balance sheets per equity’s desires. In the de-regulated financial world, banks loaded the other side of the balance sheet with complex securitized assets they barely understood, like mortgage-backed securities and credit default swaps, that international banking accords treated nearly as safe as cash. Privately held debt spiked, and as Richard Vague has argued quite convincingly, the expansion of such debt constrains growth and triggers financial crises.
Being smart men, many executives saw where this was going, but felt powerless to defy shareholder expectations and reduce exposure to these risky markets. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. And we’re still dancing,” then Citigroup CEO Chuck Prince told the Financial Times in July 2007, mere months before Bear Stearns’ collapse.
Months later, Lehman Brothers would file the largest bankruptcy in US history. Defending his golden parachute package, former CEO Richard “Everyone calls me Dick, now” Fuld would tell Congress: “We had a compensation committee that spent a tremendous amount of time making sure that the interests of the executives and the employees were aligned with shareholders.”
The financial crisis of 2007-2008 and the ensuing recession made it obvious that something had to be done. Congress responded with re-regulation of the financial industry, passing the Dodd-Frank Act in 2010, creating new regulators and empowering old ones.
But Dodd-Frank only addressed the symptoms of this incentive-based sickness. New rules and more powerful referees didn’t do anything to change the fact that businessmen were still encouraged economically to maneuver around regulatory burdens. If anything, Dodd-Frank empowered shareholders, exacerbating the underlying problem. As Friedman correctly noted, businesses act through businessmen, and businesses remain remarkably agile compared to the regulatory Leviathan. And as the Segarra tapes have made so readily apparent, regulators remain susceptible to regulatory capture.
Really, the polluted microeconomic environment – Wall Street’s unflagging devotion to the false prophet of shareholder profit – inevitably led to the financial crisis and subsequent macroeconomic slowdown.
In A Failure of Capitalism, Richard Posner explained how the “rational myopia” of the Dick Fulds and Chuck Princes of the world caused the financial industry’s collapse: “A bankruptcy is not the end of the world for a company’s executives, or even for its shareholders if they have a diversified portfolio of stocks and other assets. But a cascade of bank bankruptcies can be a disaster for a nation.”
The New Yorker’s John Cassidy called this “rational irrationality, rationality that is rational at the individual level but that leads to socially irrational outcomes.”