Capital (and income) in the 21st century

29^th April 2014

'The first step to cutting income inequality is to break the link between shareholder value and executive pay' says author Simon Caulkin

Thomas Piketty’s magnum opus Capital in the 21st Century, with its charge that inequality in much of the Western world is reaching Victorian levels, has rightly pushed the subject to the top of the political agenda. Coincidentally, with the publication of a discussion note by the IMF showing that reducing inequality not only doesn’t harm economic growth but indirectly encourages it, it puts a premium on urgently finding means of shrinking the gap.

Piketty proposes draconian taxes, including a wealth tax, a remedy that, as even the author concedes, tests to the limit the bounds of political feasibility. But an alternative to redistribution would be to start at the other end: by modifying the way the market generates inequality in the first place. That would have to pass by way of modernising corporate governance.

One of the differences between today and other periods of great inequality, such as the late 19th century, is the striking preponderance (60 to 70 per cent of the total) of corporate executives, or ‘supermanagers’, as Piketty calls them, among the new 1 per cent. This is a new phenomenon. Only since the late 1970s, when the staggering surge in executive pay levels began, has it been possible to get seriously rich by managing large established corporations. US CEO pay is now 331 times as much as the average American’s $35,000 a year and 774 times as much as the minimum wage.

Driving this rise is partly what Piketty dubs ‘meritocratic extremism’, a competition for wealth and status in which executives see themselves as hard done by (yes, you read that right) in comparison with those who inherit. Why should real wealth would be the sole preserve of the already capital-rich, they argue. Rewarding talent and energy rather than birth, stratospheric pay is in their view an aid to rather than an offence against social justice.

Piketty is right to retort that current pay levels have little to do with managerial merit (most large companies grow at roughly the same rate as the economy) and are a product of a tacit collusion between executives and boards, and boards and shareholders.

But we can go further. It is no coincidence that pay escalation began in the 1970s. In fact, we can date it even more precisely than that. As no less than McKinsey’s global managing director, Dominic Barton, told a US journalist recently, the moment Western capitalism started veering off the rails was 1970, when Milton Friedman famously declared that ‘the business of business is business’ and the only duty of the chief executive was to maximise value for shareholders.

That subsequently triggered the ‘revolution in management pay’ that Andrew Smithers describes in his recent book The Road to Recovery. It consisted in devising schemes that incentivised managers to focus on shareholder value by paying them in shares and options, which now make up 83 per cent of total US top management pay. Friedman’s programme, as later developed by Harvard’s Michael Jensen and James Meckling and Chicago’s finest, has since then wormed its way into every interstice of the management edifice, including formal governance codes, to the point where it, and the assumptions that it is based on, are not only unchallenged but have become completely invisible.

Yet, as speakers unanimously agreed at a Brussels conference of legal and management heavyweights in February, all the taken-for-granted assumptions that underpin the cult of shareholder primacy and rewards for managers based on it are false. In law shareholders don’t own companies, which are separate ‘legal persons’; shareholders aren’t principals, and executors and directors are not their agents; directors’ duty being to the company itself, there is no fiduciary obligation to maximise shareholder returns; most shareholders are secondary investors (or just punters) and don’t provide capital for firms, and in any case in recent years the function of stock markets has been to extract capital via share buybacks rather than raise it. Finally, evidence is stacking up that shareholders have done worse under the shareholder primacy regime than they did in the postwar period when managers were less well paid and considered their job to be to satisfy the claims of all their stakeholders. Because of managers’ ever shorter time-frames (CEO tenure in the US is now down to four years), the attempt to align their interests with those of shareholders has had the opposite effect to the one intended, driving a wedge between them and investors who are in it for the long term.

The cost of un-mooring executives from the fortunes of their co-workers and those of society as a whole and attaching them instead to those of remote shareholders is incalculable, and we are still paying the price. The link with shareholder value is the hidden ratchet that continues to polarise incomes by pulling executive pay upward while forcing the pay of other ranks down. This is what it is designed to do, and Vince Cable’s pleas for restraint are so much whistling in the wind so long as it is left in place. Conversely, though, snapping the link at a stroke pulls the rug from under any need to maintain such discrepancies. There is no intellectual or empirical justification for paying a chief executive 331 times more than the average, nor is it an inevitable outcome of economic determinism: it is a declaration of ideology, pure and simple.

The question of great inherited wealth, sometimes amassed by dubious means (as Balzac, one of capitalism’s sharpest observers and much quoted by Piketty, unequivocally wrote, ‘The secret of great wealth with no obvious cause is a forgotten crime’), is another matter, in which redistribution no doubt will have a role to play. But regrounding executives in their own companies to cut pay differentials would be a huge and relatively painless first step towards a more equal society. As the Brussels conference heard, that wouldn’t even need a law change (it’s today’s received wisdom that has got it diametrically wrong), although it would require a rewrite of the governance codes. But at a time when at least some of those who have gained most from it are beginning to query the shareholder value doctrine (‘Shareholder value is the dumbest thing in the world,’ famously declared GE’s own arch-supermanager Jack Welch a year or two ago), along with McKinsey’s Barton and many of the most thoughtful business school gurus, politicians should should not hesitate to push at a door that is already cautiously ajar. Reducing income inequality at source would make capitalism work better by marrying market dynamism ‘to a sense of shared purpose and achievement’, to quote the FT’s Martin Wolf, promote social cohesion and at the same time nip in the bud the growing danger of a politics in total thrall to corporate wealth and power. There are simply no arguments against it.