Corporate Governance, Rebalancing & Institutional Reform
Sarah O’Connor has an excellent (and long) Analysis feature in the FT today on the UK’s poor export performance in recent years and the general failure to replace. I highly recommend it.
In particular, I was struck by two points. First Fathom Consulting’s Danny Gabon’s argument towards the end that the Government have given up on rebalancing:
In our view they’ve said: ’Do you know what, this rebalancing stuff, it’s hard isn’t is? There’s no votes in this. Sod it, let’s just go back to what we do best, debt-fuelled consumer spending based on houses, we’re excellent at that’.
This may sound a bit flippant, but there’s a lot of truth in it. The Government now expect only around one third of all growth in the next five years to come from net trade and business investment, compared to almost two thirds in the initial forecasts. If rebalancing has not been abandoned, it has at least been postponed.
O’Connor’s article looks in detail at why exports have failed to surge despite a 25% fall in the value of trade-weighted sterling. She fins answers in factors such as the composition of British exports (there is now less global demand for financial services) and the poor domestic demand in major trading partners. This all seems broadly correct to me, but I was most interested by another line in the report.
Paul Hodges, a former ICI executive:
…thinks Britain’s corporate culture helps explain why some exports used the cheaper currency to expand profits instead of market share. “You’ve got an attitude that says ‘the status quo is fine and I want to maximise profits in the short term”.
This analysis takes us all the way back to 2001 and Hall and Soskice’s landmark work on ‘Varieties of Capitalism’. In their introduction that that volume they noted work by Knetter in 1989 showed that British and German firms reacted differently to exchange rate shocks (in this case an appreciation rather than a depreciation). British firms generally passed on the price increase to maintain profits at a cost of losing market share, whilst German firms accepted lower returns to preserve market share.
As the authors wrote:
We would argue that British firms must sustain their profitability because the structure of financial markets in a liberal market economy links the firm’s access to capital and an ability to resist takeover to its current profitability; and they sustain the loss in market share because flexible labour markets allow them to lay off workers readily. By contrast, German firms can sustain a decline in returns because the financial system of a coordinated market economy provides firms with access to capital independent of current profitability; and they attempt to retain market share because the labour institutions in such an economy militate in favour of long-term employment strategies
I think this is a very interesting argument – our corporate governance institutions could be impacting directly on our export performance (and indeed on the pattern of labour market performance).
What is even more striking (to me), is that corporate governance might be having a large impact on the other component of rebalancing – business investment.
Though undoubtedly exacerbated by the experience of the past few years, the tendency towards greater short- termism amongst corporates does appear to have been building for some time.
The report further argued that the government should:
… embrace the recommendations of the Kay Review as the first step along the road towards dealing with the problem of short-termism… Moves to decouple the remuneration of management from quarterly performance targets towards measures which better reflect the underlying strength of the company would be beneficial in this regard.
Anthony Painter has recently written that getting the institutions is right key to getting better economic performance.
In this regard, it is worth reminding ourselves that last January the FT’s Martin Wolf wrote that “core institution of contemporary capitalism is the limited liability corporation” and it has “inherent failings”.
Incentives allegedly provided to align the interests of top employees with those of shareholders, such as share options, create incentives to manipulate corporate earnings, at the expense of the long-term health of the company. Shareholder control is too often an illusion and shareholder value maximisation a snare, or worse.
The Commission recommends that the Government consult on a proposal to amend section 172 of the Companies Act 2006 to remove shareholder primacy in respect of banks, requiring directors of banks to ensure the financial safety and soundness of the company ahead of the interests of its members.
This begs the question, however – why just the banks? While the consequences of bank failures have been particularly stark, there is no reason why shareholder primacy should work well for every part of the economy except for the banks. Shareholder primacy does not operate in a different ways depending on the sector of a company. If it contributed to bank failure by distorting the priorities of board decision making and encouraging short-termism and a lack of proper regard for risk, then there is every reason to suppose that it contributes to failure across other sectors of the economy, with a negative, if less dramatic, impact on company economic and social performance.
Our current model of corporate governance is not only a recipe for short-termism and under-investment it is also a key driver of inequality. A point picked up by David Collision in a letter to today’s FT.
…why should we expect that maximising the share of one particular contributor to wealth creation, whilst giving merely a satisficing (or minimal) share to others, would result in a socially benign outcome?
In order to boost share prices – and the stock-based pay of executives and other large shareholders – Fortune 500 companies have spent $3 trillion in the last decade on buying back their stock. Such value extraction has funnelled money away from areas that can increase long-term growth – for example research and staff development – to areas that only increase the inequality between the 1% (whose rewards are linked to stock price movements) and the 99% (whose rewards are linked to investments in the productive economy). Value extraction is rewarded over value creation.
A strong argument can be made that one important route to a more balanced, more long-term, more equitable economy can be found in corporate governance reform. This hardly the most exciting of policy areas but that doesn’t mean it is unimportant.