Wednesday, February 08, 2012

Systems thinking exposes major myths

It is a great pity that journalists and media commentators are not versed in systems thinking like Simon Caulkin In his most recent article Simon exposes the widespread myth of shareholder ownership of companies.  He writes:

"Where did the myth come from? For once it is possible to pinpoint the source with some accuracy. Flashback to the end of the 1970s, when a growing feeling that shareholders were being short-changed by corporate managers who had grown fat and lazy in the long post-war boom was crystallised by Michael Jensen and William Meckling in a paper that despite its less than pulse-quickening title, 'Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure', remains the most quoted ever in the economic literature.

The authors cast managerial underperformance as a 'principal-agent problem'. In their construct, shareholders are the firm's 'principals' who hire managers to run the company on their behalf. The 'agency problem' arises because if they can get away with it managers will (like everyone else) put their own interests first. In other words, the incentives are misaligned. Ergo, the argument runs, the way to get managers to do their job is to realign the incentives by giving them significant amounts of stock-based compensation, turning executives into shareholders too.

There is one glaring snag in the theory. In law, directors and managers aren't employed by shareholders at all but by the company as ‘autonomous legal person’. But that doesn't square with the new (and wholly ideological) assertion that the company’s sole purpose is to maximise shareholder value. That can only be the case if shareholders actually own the company. To sidestep this inconvenient fact, the authors simply dismiss the company's autonomous status as ‘legal fiction’— a ‘simple falsehood’, points out Gordon Pearson in his careful study,
The Road to Cooperation, on which is based the entire edifice of governance that has stood ever since.

Ironically, Jensen and Meckling’s pro-shareholder remedies were eagerly seized on managers who correctly spotted in them a bonanza-in-the-making that would make their previous pickings look like small change. The theory expected them to be greedy; they complied in full, demanding ever greater incentives for their alignment in a perfect example of the self-fulfilling prophecy

So at the root of so much of the current angst about bonuses, corporate greed and company non-performance are ill-equipped theories - ways of thinking - that become institutionalised. No wonder Maynard Keynes once said: 

‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist’

No comments: