The Washington PostDemocracy Dies in Darkness

The fringe economic theory that might get traction in the 2016 campaign

Economists and legal experts who argue that the stock market has distorted corporate objectives are gaining sway among Democrats. (AP/Mark Lennihan)

Buying stock on the stock market seems like a simple idea. When you buy a share in Apple, for example, you take ownership of a small piece of the company. You and the other shareholders vote once a year on whether you think Apple's leadership is doing a good job of making as much money for all of you as possible. The larger your share, the more votes you get.

This is how most Americans think the stock market works: corporations exist to make money for their shareholders. Nobel laureate Milton Friedman made the basic concept, called "shareholder value," popular in an article in 1970. It has profoundly shaped how Americans think about publicly traded corporations, and policymakers have embedded it in regulations and the tax code.

Yet some economists and legal experts have long argued that the principle of shareholder value is mistaken or at least an oversimplification. These critics blame all kinds of societal ills on shareholder value, from the erosion of middle-class wages to the seeming stagnation of technological process. Now there are hints that Democrats might revisit it in the presidential campaign next year.

In the decades after World War II, many corporate executives felt a duty to improve society as a whole, not just to earn profits for their shareholders. Friedman argued that on the contrary, according to the logic of capitalism by which the pursuit of self-interest contributes to the greater good, the best thing that executive officers could do for society was to maximize profits.

The problem, some say, is that while the heads of corporations focus on immediate profits, they ignore their companies' prospects for expansion and vitality in the long term, whether by declining to pay for employees' training, neglecting research and development, or refraining from building new plants and factories. Over the decades, the result would be an economy that is less robust all around.

"We need a corporate sector that is investing decades ahead -- investing in infrastructure, investing in research, and investing in its employees," said Lynn Stout, a law professor at Cornell University and a prominent critic of the theory of shareholder value.

Finding an audience

There are indications that she and other skeptics are finding an audience in Washington. A commission at the liberal Center for American Progress in Washington recently produced a report on improving living standards for the poor and the middle class, which dedicated several pages to the debate over shareholder value.

"Corporations have shifted their traditional focus on long-term profit maximization to maximizing short-term stock-market valuations," the report stated.

One of the chairs of the commission was Larry Summers, an economist who held senior positions under former President Clinton and President Obama. And the founder of the center is John Podesta, a veteran Democratic strategist who is advising Hillary Rodham Clinton.

The former secretary of state's economic philosophy "calls for corporations to put less emphasis on short-term profits that increase shareholder value and to invest more in employees, the environment and communities," Amy Chozick wrote recently in The New York Times.

"I am very happy to see that the Clinton team might be focusing on a big problem that's been very much neglected in the political debate. and that of course is the problem of short-termism driven by an unhealthy obsession with the concept of shareholder value," Stout said.

An economic puzzle

In claiming that corporations are overly focused on the near term, critics such as Stout are not wholly rejecting the concept of shareholder value. After all, shareholders also come out worse in the long run if the directors of the companies they own are not thinking ahead.

Instead, these critics argue that shareholders and corporate executives are excessively impatient and, for a variety of reasons, may not act in their own best interests.

That argument contradicts another basic tenet of capitalism: that people with seek out any available opportunity for profit. Economists call a version of this principle the "efficient markets hypothesis."

"In the post-2008 era, we have many proofs that the invisible hand and its capital-markets corollary, the efficient markets hypothesis, doesn't work," said Pavlos Masouros, a law professor at Leiden University in The Netherlands.

There are at least indications that some cog or other in the capitalist machine isn't turning as it should.

For one, you'd expect that firms earning lots of money would expand their highly profitable businesses, or that rivals would set up competing firms where it's clear there's money to be made. Expanding a firm or establishing a new one means investing money, and for a long time, corporations invested more money when they were more profitable.

These days, corporations have ample opportunities to invest and make money, judging by their astronomical earnings. They're just not doing it, and no one's quite sure why. Paul Krugman illustrates the change with this chart at The New York Times:

Meanwhile, firms' decisions about borrowing money and paying cash out to shareholders are changing in odd ways. Corporations used to issue bonds when they needed money for new projects, writes J.W. Mason, an economist at John Jay College, City University of New York. These days, according to Mason, data show that corporations aren't using the money they borrow. Instead, he concludes, corporations are mainly borrowing money in order to issue dividends and repurchase shares from the public.

All in all, as companies pay out dividends or buy back shares, investors are getting more cash out of the stock market than they put in through initial public offerings and newly issued shares. That data suggests investors who own stock are more interested in having a ready source of cash than in making major investments.

Other evidence also suggests a bias toward short-termism. As shown at right, the length of time that a typical investor holds a position in a stock has decreased steadily over the past few decades, suggesting that shareholders may be less concerned about a company's success in the long term.

Looking for solutions

Yet if short-termism is a problem at publicly listed firms, experts disagree on why, and how to fix it. One school of thought puts the blame on shareholders for being greedy and shortsighted. Others argue that managing a large, publicly traded company is complicated enough, and that doing so with the long term in mind is more than can be expected of chief executives in many situations.

Summers has collected survey data suggesting that pressure from shareholders prevents executives from planning ahead. And a recent study found that privately held firms invest about 10 percent of their businesses' total assets annually, compared to only 4 percent at publicly listed firms. What's more, the privately held companies were nimbler, better able to act quickly on new opportunities for making money.

Alexander Ljungqvist, one of the authors of that study and an economist at New York University, said that investors are not necessarily at fault for the inertia at public firms. When the leadership of a publicly traded corporation becomes aware of a new opportunity to invest, they have to find a way to explain their plans to shareholders without divulging any sensitive information their competitors can use against them, he noted. That could be one reason why public firms hesitate to invest.

One idea for addressing short-termism, laid out by venture capitalist Nick Hanauer in a recent essay in The Atlantic, would be to limit executives' ability to buy stock back from the public. Hanauer suggests that as a result, shareholders would stop pestering corporate executives for cash, which the executives would then be free to invest.

Yet Ljungqvist noted that the alternative to stock buybacks are dividends, and he argued that if investors begin agitating for dividends instead, the pressure to neglect long-term investment could intensify. Once a company begins issuing regular dividends, executives will do anything to avoid skipping payments to shareholders and panicking the market, even if that means passing up a chance to invest.

"This may actually lead to the wrong kind of incentives," Ljungqvist said.

The Center for American Progress's report has few specific proposals, but the report does suggest that the apparent short-termism of public companies may be due to the fact that corporate executives are often paid based on the price of their firms' stock. That could give executives a reason to keep stock prices elevated, whatever the consequences over the long term.

If so, short-termism is at least partially a problem of the federal government's own making. Cornell's Stout and other skeptics of shareholder value often cite a 1993 tax break that encouraged executive compensation based on stock price. Congress passed it on the reasoning that an executive officer's job was improving the price of the stock, and therefore the wealth of the shareholders.

Washington can exert a powerful influence over the behavior of corporations through the tax code -- but if lawmakers decide changes are necessary, they should keep whatever unintended consequences they ascribe to the 1993 revision in mind and proceed with caution.

"If we blame the capital markets and gum them up in response, we may absolutely get a worse problem," said Harvard University's Rebecca Henderson. She doesn't think shareholders are to blame for short-term thinking at companies, arguing that the main reason that investors hold shares for shorter periods of time is the rise of computerized, high-frequency trading.

Henderson might point to a recent proxy vote at Berkshire Hathaway, in which investors overwhelmingly rejected the idea of paying themselves a dividend. Ninety-eight percent of the company's ordinary shares, many of them owned by amateur and retail investors, came down against the dividend.

"My sense of recent investor sentiment is that investors are pushing for longer time horizons, rather than shorter," Henderson said.

Another set of proposals in the report relates to giving employees greater sway over the decisions of management. Unlike shareholders, many employees are committed to a firm's viability for the long run. In order to pay off the mortgages, say, they depend on the employer's being there for them every month with a paycheck. In foreign countries such as Germany, the report notes, employees are represented by "works councils," which may have the right to consult with the employer and work together toward compensation agreements. Policies to improve the bargaining position of unions generally or to encourage companies to pay their employees with voting shares in the firm would accomplish the same thing.

On the other hand, firms making new investments sometimes have to take on financial risks that their employees might be uncomfortable with. If the ultimate goal is to get firms to invest again, giving workers more influence might only go so far.

Playing the politics

Maybe the eventual Democratic nominee for president, whoever it turns out to be, won't enter into any of these debates. Maybe she'll lose even if she does. All the same, it's easy to see the political appeal of an platform including a few planks on shareholder value. It's a plausible agenda for economic growth that might not require any substantial new government spending. Revisions to the tax code could even raise revenue.

Meanwhile, there are already plenty of examples out there of the corporate sector adopting other priorities than shareholder value. At Google, most shareholders are effectively denied the right to vote on the direction of the company, which is mainly up to founders Larry Page and Sergey Brin. Until last year, Chrysler was partially owned by a trust affiliated with the United Auto Workers.

And here's how a lobbyist for retailers responded to Wal-Mart's recent announcement that it would raise wages for its employees: "Like many other retailers, Wal-Mart made its decision based upon what is best for their employees, their customers, their shareholders and the communities in which they operate." In other words, shareholders are just another item on the to-do list for Wal-Mart's leadership.