## July 31, 2006

### One Big Mutual Fund, or, The Ownership Society (Modest Proposals for the Reform of Corporate Governance, Part 2)

Attention conservation notice: Over 1500 words on a wacky quasi-socialist economic scheme, from someone utterly lacking in credentials in economics. The scheme does not respect the sanctity of private enterprise, but at the same time would not reduce the alienation of labor one iota. Includes a lengthy quotation of a game-theoretic impossibility result. Also, you already saw it when it was cross-posted at Crooked Timber.

In the previous installment in this series of modest proposals, I looked at ways of making the incentives of the managers of large, publicly-held corporations align more closely with those of their long-term shareholders. This left alone the question of the beneficiaries of corporate value; assuming that the managers are busily working to maximizing their revenue streams, who benefits from their industry and diligence? Having just read Mark Greif's great essay on redistribution in n+1 (issue 4; sadly, not online), I would like to make a suggestion.

The text for today is Gary Miller's Managerial Dilemmas: The Political Economy of Hierarchy, an excellent book which I learned about from Henry Farrell. Ambitiously, Miller tries to explain why hierarchical corporations exist at all, why they take some of the forms they do, and how, in part, their form relates to their performance. Much of the book, especially the first part, is a partially-successful attempt to find good economic reasons for their features, i.e., efficiency-enhancing ones. (He does not seriously consider the option that enterprises are hierarchical for non-economic reasons, say that some people like bossing others around, which hierarchies let them do, and those people are able to select hierarchies over other, more efficient, forms. After all, it's hardly historically unprecedented for powerful people to prefer institutions which lower aggregate output but give them a bigger share of the product. See, e.g., here.) He also tries to explain why theories of corporate organization that rely solely on economic "mechanism design", i.e., structuring information and material incentives, will actually lead to sub-optimal results, for pretty basic game-theoretic reasons; getting beyond these impasses is fundamentally a political problem. This is potentially quite subversive in its own way, but it's really the first part of the work, about the economic justification of the hierarchical enterprise, that I'm going to twist and abuse.

One of the features of the modern corporation that Miller attempts to rationalize is the existence of shareholders who are passive and, in the overwhelming majority, utterly disconnected from the day-to-day or even year-to-year operations of the company. He does so by means of the following impossibility theorem, attributed to Bengt Holmstrom. Having tried to summarize Holmstrom's theorem better than Miller, and failed, I'll just quote Miller.

Holmstrom assumes that there are n agents whose actions determine a level of revenue x. The actions taken are unobservable and are costly to each of the agents. In particular, we assume the production function is a team production in which the productivity of each individual's action is determined by other individuals' levels of effort.

Holmstrom points out the desirability of three characteristics of an incentive system — and then shows that they are logically inconsistent. First, Holmstrom examines the Nash equilibrium outcome of an incentive system. At such an equilibrium, each individual will find that he or she could not do better by choosing a different effort level, as long as all others do not change their effort levels. Simple marginal analysis tells us that, in such an equilibrium, each person will find that his or her marginal cost of effort is exactly equal to the marginal gain; otherwise, the individual could be better off by working harder or not as hard. Second, Holmstrom stipulates that the outcome be budget balancing — that is, the incentive system should exactly distribute the revenues generated by the actors among the actors. Third, Holmstrom examines Pareto efficiency. This means that the outcome should be such that the individuals in the organization could not find a different outcome that would make them all better off.

Holmstrom shows that no budget-balancing system can create a Nash equilibrium that is also Pareto efficient. In other words, every budget-balancing incentive system will induce a social dilemma among its participants. The reason is that individuals will bring their own marginal costs of effort into equality with their own marginal gain. This means that each individual will not undertake an additional unit of effort that will produce less individual gain than individual cost — even if that extra unit of effort produces more gain for other individuals on the team.

As an example, suppose there is some individual who has a marginal revenue productivity of \$12: Each unit of her own effort generates an extra \$12 for the team. According to Pareto optimality, she should exert additional effort as long as the cost to her of that effort is less than or equal to \$12; each such unit of effort generates more revenue for the team that it costs her as an individual. The only way to motivate her is to make sure that she gets all of the marginal revenue of her last unit of effort. In a team, it is impossible for this to be the case for every individual, as long as the incentive system is budget balancing. If everyone gets all of the last dollar produced, the team will have to pay out more in incentives than it generates. But if the individual gets only one-third of the marginal revenue from her actions, she will work only as long as her effort costs her less than \$4 per unit. [pp. 129--130]

This suggests a rather unusual role for shareholders: they provide a money-sink, someplace money can go other than those actually involved in production. This means that the economic mechanism no longer has to be budget-balancing, which actually makes efficiency possible. Miller suggests that this is one reason why the modern public corporation, with its separation between legal ownership (by stockholders) and day-to-day control (by managers) can work, to the extent that it does. It is precisely because the shareholders are passive, with very limited influence over the actual running of the corporation!

Today's modest proposal — and I should make it very clear that Miller suggests nothing of the kind — is to take this separation of functions even further. Shareholders can use their legal ownership to intervene in the running of the company, though it is hard (and managers try to make it harder). By doing so, however, they become players in the team-production game, and lose their useful role as a money-sink. To limit this danger, while retaining the advantages of competitive markets for capital allocation and corporate control, I suggest the following. A substantial fraction — say three-quarters — of all profits of publicly-held corporations are to be paid to a new institution, which we might call the National Mutual Fund. (Closed corporations and partnerships are exempt.) Once a year, the Fund would pay out its accumulated profits as dividend checks, giving an equal amount to every adult citizen. And that's it.

Substantially reducing the flow of dividends associated with stock ownership should cause a large one-time shock to the level of the stock market. (Roughly speaking, shares should drop by about 3/4.) However, because the Fund collects uniformly, it should not distort relative prices, which are what matter for purposes of capital allocation. The net worth of stock-holders, likewise, will suffer a one-time drop, but this will be partially compensated for by their receiving payments from the Fund in the future. Anyway, lots of things affect the value of stock holdings; it's not like someone purchased their labor with a promise of future benefits, and then tried to back out of a freely-entered contract when it came time to pay up.

A further wrinkle would be to curb the practice of retained earnings. These account for a huge fraction of corporate capital formation, but they are also one of the ways in which managements escape market discipline. (For some figures on this, see Henwood's Wall Street, pp. 72--76.) I suppose one could make a Hayekian argument in favor of the practice, but, really, if management can make a good case that a pet project will earn at least a normal rate of return, it shouldn't be hard for them to raise funds on the open capital market, and if they can't make such a case, it's hard to see how they'd be discharging their fiduciary duties to shareholders by pursuing it anyway. This reform, I should add, is logically separate from that of instituting the National Mutual Fund. However, since corporations would pay more out in dividends, it would tend to increase the value of shares, reducing the shock to the level of the stock market.

It is hard to see why the actions of the National Mutual Fund could not be at least as rule-bound and de-politicized as those of a central bank run by skilled technocrats. Indeed, it would seem easier to reduce the discretion of the Fund's officials to the vanishing point, and to strictly keep it from meddling with the affairs of any corporation, which would be deeply counter-productive. For their part, the citizens receiving the dividends would get the benefits of "portfolio diversification in their income", but their incentives to meddle politically with individual firms, even quite large firms, would be quite muted. Moreover, they would have a direct and tangible incentive in the health of the corporate sector as a whole, making them less likely to support market-distorting measures to benefit particular firms, geographical regions or industrial sectors. We would move, in short, towards a true ownership society.

Posted at July 31, 2006 15:38 | permanent link