Changing Perverse Incentives

The Brookings Institution has released a report that I can only describe as “compelling.” Titled “More Builders and Fewer Traders,” it focuses like a laser on the perverse policy incentives that have contributed to dramatic levels of inequality.

In our new paper “More builders and fewer traders: a growth strategy for the American economy” we identify a handful of obscure but important shifts—in laws, regulations, and standard practices—which, taken together, have changed the incentive structure of leaders in American corporations. This set of incentives has led to short term behavior on the part of corporate leadership. These incentives are so powerful that once they became pervasive in the private sector, they began to have broad effects. No one set out to create this myopic system, which arose piecemeal over a period of decades. But taken together, these perverse new micro-incentives have created a macroeconomic problem.

The report zeros in on four trends that have contributed to what the authors call “short-termism.”  One consequence of these trends is that–while cash distributed to shareholders as a share of cash flow has surged– the share devoted to capital investment has fallen to a record low.

I don’t disagree with the authors’ focus on these trends, the problems they pose for the economy, or their contribution to inequality.  I do wonder, however, how much of the lack of investment in the future of American industry can be traced back to the way we  finance corporations and the separation of ownership from management.

“Ownership” can mean many things, but it is difficult to square our common-sense understanding of ownership with the purchase of a few hundred shares of stock in a major corporation. Such “ownership” carries with it no meaningful control, no right to make decisions, and “risk” only to the extent that there may be a decrease in the value of one’s stock.

The reality is that American corporations borrow money two ways–through the sale of bonds, which are more secure but which carry only a stated rate of return, and the sale of stock, the proceeds of which represent a gamble on the future of the enterprise: more risk, but the chance of a superior “reward.” Let’s be honest: Neither the bondholder nor the small or medium-sized shareholder is an owner in any meaningful sense of the word.

Meanwhile, the people managing these companies are frequently not “owners,” either. They’re hired hands, often with little investment in the business. Their compensation and continued employment depend significantly upon their ability to keep short-term stock prices high, thus they have every incentive to keep workers’ wages down and their own paychecks as high as possible.

None of this fosters the capitalist virtue of pride in the product, or good corporate citizenship (except as a marketing tool), or decision-making that is in the long-term best interests of the enterprise.

When a company is truly owned by an individual or small group, when those owners see their own prospects intimately bound up with the long-term success of the venture, corporate behavior changes. Such owners are certainly focused upon earnings and the bottom line–but they understand what innovations and behaviors will be needed to protect that bottom line into the future. Concern for long-term fiscal health provides incentives to care about their reputation, their workforce, the quality of their products and the health of the communities in which they operate.

When public policies incentivize short-term gains over long-term decision-making, the focus turns from producing goods and services to playing financial games–with broad negative consequences for job creation, wages, economic stability–and ultimately, American competitiveness.



We talk a lot about ownership in America: George W. Bush promoted an “ownership society;” people trying to change institutional systems are urged to help those involved to “own” the changes.

The disconnect comes when we consider corporate ownership–which, increasingly, doesn’t exist in any meaningful way.

Think about the origins of the business corporation. A Henry Ford, an Eli Lilly, a J. Randolph Hearst would begin an enterprise that continued to reflect upon its founder whether or not that founder retained majority ownership (which most did). Other shareholders profited or not, participated in the election of the board or not, attended annual meetings or not, but it was understood that they weren’t owners in the way we understand that word.

A business school colleague once described today’s shareholders and bondholders as two different kinds of lenders. The guy who purchases corporate bonds wants priority and a secure rate of return. They guy who buys shares is gambling, in a sense: he’s willing to risk a greater downside in hopes of a bigger return. Neither of them is really interested in the company or its business, except to the extent necessary to make an investment decision.

Meanwhile, the company is managed by hired guns who rarely have any sort of emotional connection to the corporation, and whose own “ownership” is limited to stock options and other incentives–incentives that tend to reward quarterly rather than long-term performance.

Real ownership is so different.

Last week, the Indianapolis Public Library hosted a small reception for the Lacy family, one of the increasingly rare exceptions to the picture I’ve just painted. The impetus for the reception was the family’s donation of a book–a history of the company–to the Indiana collection. The book traced the company from its origins manufacturing corrugated cardboard boxes to its current incarnation as LDI–Lacy Diversified Industries. During the brief talks, someone made the point that multi-generational family ownership like LDIs currently represents perhaps 3% of American businesses.

If you are thinking, “so what?” think about the contributions made to this community by family-owned companies like LDI or MacAllister Machinery. These are enterprises still run by their founders, or the children and/or grandchildren of their founders. Such businesses are connected to this community in multiple ways that the more impersonal, shareholder-owned companies and their managers are not. They are also far more likely to make business decisions based upon the long-term interests of the enterprise, rather than on the next quarterly or annual report. As a result, they are more likely to be corporate good citizens.

Mitt Romney to the contrary, corporations are not “people, my friend.” But a dwindling number are owned by identifiable people. And that kind of ownership is infinitely preferable to the lottery-ticket shareholder mentality that has largely replaced it.