In 1976, Michael Jensen and William Meckling published “Theory of the Firm,” an article that became one of the most-cited economic articles ever written. In the article, Jensen and Meckling presented a theory of the firm that revolved around the goal of reducing agency costs by aligning the interests of executives with those of shareholders through incentive compensation structures such as stock options.1 Rooted in principal–agent considerations, this framework launched a new regime of corporate governance—the set of processes, institutions, and legal frameworks that determine how a corporation is run—that came to be known as “shareholder value maximization.” The Business Roundtable, a nonprofit association whose members are chief executive officers of major US companies, has recently issued a statement on the purpose of the corporation, professing a commitment to all stakeholders, and not just shareholders. If we take this statement at face value, the shareholder value maximization paradigm is being challenged.
As the research of William Lazonick has shown, the maximization of shareholder value was used—in the United States alone—to justify the extraction of some $3.4 trillion between 2004 and 2013 via dividends and share buy-backs, dollars that could have been spent on capital expenditures or to fund research and development activities.2 It should come as no surprise, then, that over the past decades increased corporate profitability has resulted neither in increased investment in labor nor in capital—a real “investment paradox” for both! We can point to a number of empirical trends beginning in the 1970s that demonstrate a weakening of economic power for workers, such as the decline in the labor share, the disconnecting of average wages from productivity increases,3 or the rescinding of the “post-war” settlement between Global North capital and labor. The decline in gross investment spending as a share of GDP is a trend that also started in the late 1970s, when companies based in the US started globalizing development and manufacturing work—not just low-value-added activities but increasingly more high-value-added capabilities.4 Investment is about 10% lower than it should be given corporate valuation levels, with the gap as high as 20% in concentrated industries.5
Through the market for corporate control—that is, the idea that poor management can be sanctioned by a successful takeover—stock prices become the main signal of efficient management—but efficient for whom?6 Shareholder value maximization assumes that only shareholders—and critically not workers—are taking risks and need to be compensated accordingly. The relationship between return and risk (as measured by volatility) is, of course, a central consideration in modern finance and in theoretical frameworks such as modern portfolio theory and the capital asset pricing model. With shareholder value maximization, this logic of pricing—pricing risk—emerges as a central guiding principle for the management of the corporation. Price volatility is something that needs to be managed for shareholders so as to maximize not just returns, but returns relative to risk.
Theoretically, stock valuations are supposed to reflect both profits already earned as well as future profits. There’s a sense in which the market acts as Saturn devouring its children: as soon as existing profits are incorporated into the price, they become irrelevant and the valuation is entirely forward-facing, that is, based upon expectations of future growth (modelled as free cash flow projections discounted to present value, with higher risk reflected in a higher discount rate). Market participants end up forming a personal view of the future on the basis of existing and available information, resulting in a “subjective” valuation and willingness to buy or sell at price points that differ across individuals. The market becomes an enormous Hayekian information processor7 that aggregates all perspectives to produce a unique price that clears supply and demand. In theory, all existing information is incorporated in the price (the so-called efficient market hypothesis).
Importantly, though, the process can become reflexive, when market participants try to outguess what everybody else is thinking rather than form their own independent view of value (Keynes’s famous “beauty contest”). The expectation of other people’s expectations is speculation, and speculation increases price volatility. Arguably this is because reflexivity is what gives rise to mimetic processes such as herd behavior and information cascades that fuel boom and bust dynamics. Markets are inherently more fragile and unstable than the efficient market hypothesis would have us believe. At critical moments, the severity of significant market corrections (or full-on crashes) may not be driven so much by a change in “fundamentals” as they are by the sudden unravelling of these types of dynamics.
During the period that the shareholder value maximization paradigm gained prominence, the volatility of average stock returns in the US increased by 6% annually.8 This is significant. From a purely technical financial standpoint, the primary driver appears to be the increase in idiosyncratic return volatility—that is, the component of stock volatility that can be reduced through portfolio diversification and, therefore, may not be apparent when one is looking at the market as a whole.9 In other words, the increase in individual stock volatility does not stem from an increase in market-wide volatility (for instance captured by a volatility index like VIX), which affects all firms, but instead appears to be something fundamental at the firm level, as reflected in firm-level variables such as employment, sales, profit-to-sales ratio, earnings, and capital expenditures.10 Therefore, and somewhat surprisingly, while idiosyncratic firm level risk increased at the micro level, in the aggregate the volatility of output (as measured by the standard deviation of the annual growth rate of real GDP) actually declined—this has been referred to in the economics literature as the so-called “Great Moderation.” (It was suggested back in the early 2000s that the decrease in the volatility of GDP played a major role in increasing the length of the business-cycle, which implied fewer and shorter recessions, though of course the severity of the 2008 crisis and the frequency of jobless recoveries cast doubt on this hypothesis.) The conclusion is that in public markets, a build-up of risk occurred at the level of individual firms, which was not perceptible and reflected in macroeconomic variables or in the performance of the stock market as a whole.
There was one exception. Shareholder value maximization incentivized higher levels of corporate concentration, which create superior returns and lower risk for shareholders. Superior returns because a few “superstar” firms in the economy—firms with large market shares and high profit margins—tend to deliver higher returns, and higher industry concentration levels are correlated with higher ROA (“return on assets,” a financial profitability metric).11 Lower risk because these firms could actually be facing lower profit volatility due to their entrenched (often monopolistic) position in the economy.12 For example, in the tech sector, they include behemoths like Google, Amazon, Facebook and Apple. To sum up: while a handful of superstars benefit from an optimized risk/return profile, for the rest of firms (the majority of firms in the economy), risk is actually on the rise.
How did companies react to the increase in stock price volatility—which again, shareholder value maximization tells us is something that needs to be managed to the extent it threatens the risk/return profile of the stock? One answer is that, increasingly, companies have tended to prefer to stay private, which altogether avoids the need to manage stock price. While the number of US listed firms and IPOs has been declining, private equity investments have surged (with the major growth starting in the early 2000s). A number of other factors could be driving the transition of equity funding to private markets, such as the regulatory burdens and reduced benefits to being public, the availability of funding, the privacy associated with raising equity privately, and the growing importance of institutional investors in public markets and their reluctance to invest in smaller firms.
Another answer is that companies have, in as much as possible, outsourced risk onto workers and society at large. One very compelling piece of evidence is the empirical link between the volatility of sales and the volatility of wages, particularly since the 1980s, documenting that companies have passed revenue instability onto their workers.13 This effect is stronger in the non-manufacturing sector. It is also stronger in large companies, virtually nonexistent for small companies, and mostly only relevant for public firms (in fact, privately-held firms have actually become less volatile since the mid-1970s, which is consistent with the hypothesis that firm size is relevant, since they tend to be smaller than publicly-traded ones).
One mechanism that may be involved in translating sales volatility into higher wage volatility is the use of stock-based compensation—supposedly most relevant when the assessment of individual performance is difficult, as might be the case in the non-manufacturing sector.14 This would be consistent with the empirical finding that it is mostly large firms that have passed on their turbulence to their workers, since value fluctuations associated with such compensation packages would be greater in larger firms. It would be of more direct concern to those workers at the top of the wage distribution.
The impact of firm turbulence on wages could also be pronounced at the low end of the distribution through employers’ ability to pressure precarious workers to absorb the unpredictability of working hours. In the service sector particularly (and also increasingly across the economy as whole) a growing share of new jobs is characterized by little to no job security, low wages, contingent work, and no benefits. The growth of the so-called “on-demand” or “gig” economy exemplifies this trend, with employers increasingly insisting on alternative work arrangements, and particularly the use of outside contractors expected to adapt to scheduling irregularity.15 This is not just limited to the “gig” economy of digital platforms, but also includes temporary help agency workers, on-call workers, contract company workers, and independent contractors and freelancers. Other features of regular employment contracts such as “at will” termination—well ingrained in the US and the default norm in emerging economies—could become a truly global standard if rich OECD (Organisation for Economic Co-operation and Development) countries with strong workplace protections are pressured to dismantle labor laws (as is increasingly the case) under the guise of liberalization. The hard reality is that worker precarity is simply more attractive for investors.
The more pronounced effect within large firms could suggest that corporate concentration and monopsony dynamics—that is, market structure where large employers have significant hiring power over the workforce, which tends to weaken wages and the bargaining power of labor—could play a role in this regard. Incidentally, it should come as no surprise that superstar firms tend to employ relatively few workers relative to their revenue, and that industries with larger increases in market concentration have experienced larger declines in the labor share.16 Uniquely positioned to maximize their risk/return profile, superstar firms are increasingly claiming an outsized share of the economy, and restricting profits to a small core of well-compensated workers. Those superstar firms that pay higher wages on average (for example superstars like Google, Facebook, and Apple) still drive down the labor share because they tend to employ relatively few workers relative to their revenue and share of market capitalization, while outsourcing the majority of jobs to contractors.
Wage turbulence is now well established. Substantial fluctuations in family income have become the norm, and there has been an overall increase in earnings volatility and economic instability for workers and American households in the past few decades.17 This is more pronounced at the bottom of the wage distribution, as workers turn to self-employment to supplement income in the face of insecure labor markets. The neoliberal view of the world celebrates this mechanism for coping with precarity as self-reliance and entrepreneurship—what Philip Mirowski (drawing from Foucault’s prescient insight) has described as the “entrepreneurial version of the self” that will eventually extend to every conceivable social activity.18 The discourse of “risk-taking” portrays risk as something liberating and empowering. It is by giving people “access” and “opportunities” for economic risk-taking that the neoliberal subject takes shape (thoroughly redefining what it means to be a human being), aiming to become the entrepreneur of its own destiny. As Mirowski identified, this is one of the key mechanisms for how neoliberal principles and the neoliberal order survived the 2008 crash.
More generally, a gradual and profound transformation in the nature of employment relationships and labor markets in the last forty years has resulted in a clear empirical trend of more economic risk being shouldered by workers. This includes things like technological change, skill obsolescence, and business fluctuations. Workers are expected to take on the full responsibility (and financial burden) for the development of their own human capital. It is their own loss if the investment does not pan out, if, for instance one’s degree is not as marketable as anticipated, or one struggles to reimburse student debt within a reasonable timeline (as discharge through bankruptcy is very difficult to obtain). If the job market has no need for you, it’s your own fault for not having invested in the right skills. Even when employers do provide employee benefits, these are often outsourced onto extra-firm entities, and the emphasis is always on the individual to absorb and manage risk and to do so through market-based solutions, such that firms can save costs and walk away from their own social impacts. One can think here of the rising costs of already hollowed out healthcare, the effective abandonment of retirement, where, even in many best cases, guaranteed-benefit plans have been replaced with defined-contribution plans. Any socially undesirable outcome must be managed, if it can be, through individual consumer choices. Employees who diligently contributed to a 401(k) plan yet lose a significant percentage of their life savings in a market crash should have better researched the funds in which they were invested, or sought professional investment advice to minimize portfolio fluctuations.19 So the proliferation of individual risk-taking in the general population parallels the growth of a profitable private infrastructure to support it, in the form of various firms and professions with claimed expertise in risk management—selling and marketing products designed to offer us some degree of control and protection.20
With the shift in risk exposure comes the end of what workplace security there was. In its place are ever more generalized precarity and the erosion of the once hegemonic ideal of “jobs” as providing guarantees or stability. As much as risk-taking, “self-starting,” and “reinvention” are feted across society, the actual distribution of risk across the economy is becoming sharply skewed; economic conditions shift ever more unbearable risks away from firms and onto those who are least able to absorb them. For most workers, wages are stagnating and risks are increasing such that they are made doubly worse off from a risk/return standpoint. Meanwhile, investors are rewarded in literal dividends. While shareholder value maximization sees corporate savings as a fair return on investment, it does not recognize workers as having any claim to the value that is created through shifted risk. What is needed is a radical new understanding of what it means to take on risk and be compensated accordingly. This begins with the proper acknowledgment that workers are risk takers too.
- 1. Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, agency costs and ownership structure,” Journal of Financial Economics, Volume 3, Issue 4 (October 1976): 305–360. https://doi.org/http://dx.doi.org/10.1016/0304-405X(76)90026-X. ↩
- 2. William Lazonick, “Stock buybacks: From retain-and-reinvest to downsize-and-distribute,” Center for Effective Public Management at Brookings (April 2015). ↩
- 3. According to the Economic Policy Institute, from 1973 to 2017 net productivity rose 77.0%, while the real (that is after adjusting for inflation) hourly pay of average workers increased by only 12.4%. Had wages risen in line with productivity, an American earning around $40,000 today would be making close to $61,000. What can often be missed when looking at aggregated economic variables, such as average wages, is what is happening at different parts of the distribution. In real terms, the minimum wage today is actually worth less than a few decades ago, while annual wages of the top 1% and 0.1% of earners have grown significantly more than the bottom 90%. ↩
- 4. Though investment has remained high in a few “grounded” industries that are less susceptible to offshoring (such as the energy and telecommunications sectors), it has been stagnant pretty much everywhere else, including in fast-growing sectors such as the high-tech or retail sectors with the highest growth and valuations. One possible explanation for this trend is that firms began to abandon long-term investments in plant and equipment in the mid-1970s in response to uncertainty in the macroeconomic environment (inflation and then high interest rates). Yet overall investment remained sluggish after the 2008 global financial crisis, despite historically low interest rates, strong corporate profitability and high valuations. The context of low interest rates, particularly, makes the collapse in investment particularly puzzling. ↩
- 5. It has been suggested that declining investment has to do with the displacement of physical assets by intangible assets, which may not be properly accounted for, but that is not the full story—recent research suggests that the investment gap is entirely driven by industries with high corporate concentration. Germán Gutiérrez, Callum Jones, and Thomas Philippon, “Entry Costs and the Macroeconomy,” IMF Working Papers, Volume 2019, Issue 233 (2019); Germán Gutiérrez and Thomas Philippon, “Declining Competition and Investment in the U.S.,” Mimeo (2017), https://www.nber.org/system/files/working_papers/w23583; Germán Gutiérrez and Thomas Philippon, “Investmentless Growth: An Empirical Investigation,” Brookings Papers on Economic Activity 2017, no. 2 (2017): 89-190. doi:10.1353/eca.2017.0013; Callum Jones and Thomas Phillipon, “The Secular Stagnation of Investment,” (2016), http://pages.stern.nyu.edu/~tphilipp/papers/Q_ZLB.pdf; Thomas Philippon, The Great Reversal (Cambridge, MA: Harvard University Press, 2019). ↩
- 6. This idea was first described by Henry G. Manne in “Mergers and the Market for Corporate Control,” Journal of Political Economy, 73, no.2 (1965): 110–120. http://www.jstor.org/stable/1829527. ↩
- 7. See F.A. Hayek, “The Use of Knowledge in Society,” American Economic Review, Volume 35, no. 4 (1945): 519–30, in which he argued that decisions are best made on the basis of decentralized, local information. ↩
- 8. See: Diego Comin and Sunil Mulani, “Diverging Trends in Aggregate and Firm Volatility,” The Review of Economics and Statistics 88, no. 2 (2006):374–83. http://www.jstor.org/stable/40043002; Margaret, M. McConnell and Gabriel Perez-Quiros. “Output Fluctuations in the United States: What Has Changed since the Early 1980’s?” American Economic Review, Volume 90, no. 5 (2000):1464-1476, doi: 10.1257/aer.90.5.1464; James H. Stock and Mark W. Watson “Has the business cycle changed and why?” NBER Macroeconomics Annual, Volume 17, no. 1 (2002):159–218, https://doi.org/10.1086/ma.17.3585284. ↩
- 9. See: Paul J. Irvine and Jeffrey Pontiff, “Idiosyncratic return volatility, cash flows, and product market competition,” Review of Financial Studies, Volume 22, no.3 (2008):1149–1177. https://doi.org/10.1093/rfs/hhn039. ↩
- 10. These recent volatility trends seem attributable to an increasingly competitive environment in which most firms have less market power—“heightened creative destruction” in a Schumpeterian sense, magnifying productivity shocks for individual firms. Empirically, there seems to be a very strong correlation between high firm volatility and the intensity of research and development (R&D expenses). See: Diego Comin and Sunil Mulani, “A theory of growth and volatility at the aggregate and firm level,” Journal of Monetary Economics, Volume 56, no. 8 (2009):1023–1042. https://doi.org/10.1016/j.jmoneco.2009.10.004; Diego Comin and Thomas Philippon, “The rise in firm-level volatility: Causes and consequences,” NBER Macroeconomics Annual, 20 (2005): 167–20 (2005) https://doi.org/10.1086/ma.20.3585419. Publicly traded firms represent 95% of total private R&D expenses in the US, and R&D alone accounts for 60% of the increase in firm volatility. This is by no means the only possible explanation, and other research has focused on other factors, such as the role played by the rise in institutional ownership in driving up the volatility of individual firms. ↩
- 11. For an analysis of the period 2001–2014, see: Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are U.S. Industries Becoming More Concentrated?” (October 25, 2018). Forthcoming, Review of Finance, Swiss Finance Institute Research Paper No. 19-41, https://ssrn.com/abstract=2612047 or http://dx.doi.org/10.2139/ssrn.2612047. ↩
- 12. There is, for instance, a strong negative relationship between ROA and future idiosyncratic volatility. ↩
- 13. Comin and Mulani find that the average pay is more volatile in firms that have experienced higher volatility in sales, and conclude that increased firm turbulence has raised the volatility of wages. Diego Comin and Sunil Mulani, “A theory of growth and volatility at the aggregate and firm level,” Journal of Monetary Economics, Volume 56, no. 8 (2009):1023–1042. https://doi.org/10.1016/j.jmoneco.2009.10.004. ↩
- 14. This is indeed one hypothesis put forward in Comin and Mulani, “A theory of growth and volatility at the aggregate and firm level.” ↩
- 15. The percentage of workers covered by alternative work arrangements had risen from 10.7% in 2005 to 15.8% in late 2015. Lawrence F. Katz and Alan B. Krueger, “The Rise and Nature of Alternative Work Arrangements in the United States, 1995–2015,” ILR Review 72, no. 2 (March 2019):382–416. https://doi.org/10.1177/0019793918820008. ↩
- 16. The recent work of David Autor is very illuminating in this regard. See: David Autor, David Dorn, Lawrence F. Katz, Christina Patterson, and Jon Van Reenan, “Concentrating on the Fall of the Labor Share,” American Economic Review, Volume 107, no. 5 (2017):180–85, doi: 10.1257/aer.p20171102; David Autor, David Dorn, Lawrence F. Katz, Christina Patterson, John Van Reenen, “The Fall of the Labor Share and the Rise of Superstar Firms,” The Quarterly Journal of Economics, Volume 135, Issue 2 (May 2020):645–709, https://doi.org/10.1093/qje/qjaa004. ↩
- 17. For instance, the standard deviation of two-year income changes in individuals’ family income grew 51% between 1971 and 2004, and the share of individuals experiencing a 50% or greater drop in income over a two-year period has increased from 4% of working-age individuals in the early 1970s to 10% in 2002. This sharp rise in volatility was initially concentrated in less-educated workers in the 1970s and it was only later, in the late 1980s and early 1990s, that it also came to rise for the more educated segment of the workforce. See: Elisabeth Jacobs and Jacob Hacker, “The rising instability of American family incomes, 1969-2004: Evidence from the Panel Study of Income Dynamics,” Economic Policy Institute Briefing Paper (May 28, 2008); Peter Gottschalk, Robert Moffitt, Lawrence F. Katz, and William T. Dickens, “The Growth of Earnings Instability in the U.S. Labor Market,” Brookings Papers on Economic Activity no. 2 (1994):217–72. https://doi.org/10.2307/2534657; Peter Gottschalk and Robert Moffit, “The rising instability of U.S. earnings,” Journal of Economic Perspectives, Volume 23, no. 4 (2009):3–24, doi: 10.1257/jep.23.4.3; Robert Moffit and Peter Gottschalk, “Trends in the transitory variance of male earnings methods and evidence,” Journal of Human Resources, Volume 47, no. 1 (2012):204–236, doi: 10.3368/jhr.47.1.204. ↩
- 18. See: Philip Mirowski, Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown (New York, Verso, 2014). ↩
- 19. Similarly, home owners who were unable to cover their mortgage payments with adjustable rates are to blame for not getting the right product and not reading the fine print of the financial products involved—and so forth. ↩
- 20. We see this well at work in the consumer lending, mortgage or insurance industries, for instance. ↩