Saturday, October 20, 2012

Who Creates Wealth? (IV)

In a previous post in this series we've seen that shareholders in general do not contribute to the firms they own. Yet, they gain from it.

One could be tempted to justify this (as many in the Austrian economics camp do) on moral grounds. In the latest post, we've seen that this objection seems to be irrelevant.

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Two new objections are possible now. What if Fred was an original capital subscriber? What if he contributed capital to the firm? Without his thrift there would be no Apple Inc! Surely he deserves a reward for that?

Or perhaps the reader would object the examples used on a different ground. Small shareholders don't control the firm. Big shareholders do; their momentous decisions on crucial matters, that's what creates wealth. (h/t Tao Jonesing, and comments here)

We'll consider the second objection (the decisions) in this post, leaving the capital contribution objection for a subsequent post.

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Let's consider this objection carefully. The point is not that shareholders in general deserve their gains (small shareholders, for one, don't deserve them), but that some shareholders (the big ones) do.

In other words, there is a difference between small and large shareholders, justifying big shareholders' gains. Namely, large shareholders contribute something (i.e. their decisions); small ones don't contribute anything.

This means that, if there is a justification for these gains big shareholders get, it must be these momentous decisions. Thus, anyone making those decisions would deserve those gains, perhaps proportionally to the decision's importance.

This introduces several questions, which we'll leave aside, for brevity's sake. [1]

Here we'll settle these questions in an arbitrary manner: big decisions are those made solely by the board of directors and senior management. We'll reconsider the whole issue later.

In their capacity as directors or managers, these individuals are in reality the owners' agents, legally obliged to act on the owners' behalf. And they are paid for the work they do in that capacity: salaries, directors' fees. Observe carefully: they work and get paid for it (by the way, extremely well paid), just like any other worker.

In other words, managers and directors are legitimately entitled to a compensation for the services they render to the firm. One might question, however, the magnitude of the compensation.

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As it happens, managers and directors are sometimes owners. But if these manager/owners get salaries and directors' fees for the work they do as managers and directors, what, then, justifies their keeping profits in addition to their salaries/fees?

For the moment, I'll advance the two possible answers that seem to be left:
  1. What explains their receiving profits/dividends is their legal ownership of the firm. Exactly like individual shareholders and speculators.
  2. The capital contribution (which, as already said, we'll discuss in a coming post).
Observe that this means that the crucial objection is not whether some individuals (big shareholders/managers or just top managers) make momentous decisions, versus small shareholders, who make no decisions. It's these large shareholders/managers' job to make these decisions and they are compensated for that: in the exercise of their functions they are extremely well-paid workers; but workers, all the same.

The crucial objection to my conclusion that profits and dividends are due only to ownership is the capital contribution, which small shareholders don't make and that large shareholders make (assuming, and only to the extent, they actually contributed something to the firm!). This explains my choice of leaving this last objection for the last post in this series.

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Before closing, we should go back to the arbitrary answer given before: crucial decisions are those made solely by top managers.

If this were so, then rewards should be proportional to the decision's importance to the firm. Good decisions, leading to good outcomes, must be highly rewarded. Bad decisions, leading to poor outcomes, must not.

I don't think we need to go to great lengths to see that this is not what happens:


Notes:
[1] For instance, everybody in a firm, from the chairman of the board, down to the receptionist and the janitor, makes decisions affecting the firm. What makes their decisions different? How do we measure a decision's importance? What is a big decision, anyway?

4 comments:

  1. "If this were so, then rewards should be proportional to the decision's importance to the firm. Good decisions, leading to good outcomes, must be highly rewarded. Bad decisions, leading to poor outcomes, must not."

    You need to define "good decisions" and "good outcomes." Unfortunately, it is easy to do so in a manner that justifies the rewards of which you speak, if you try.

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  2. Hi Tao,

    "You need to define 'good decisions' and 'good outcomes.' Unfortunately, it is easy to do so in a manner that justifies the rewards of which you speak, if you try."

    I am afraid I don't understand.

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    Replies
    1. Who decides what a "good decision" is? What a "good outcome" is? Could it be that the financial elite who reward top management for what you view as bad decisions and/or bad outcomes see those decisions and outcomes as good, not bad? If you start with the assumption that top management is actually being rewarded for outcomes and decisions you consider bad, first assume that those outcomes and decisions are actually good ones, then try to understand how one needs to define "good decisions" and "good outcomes" to make that assumption true.

      Here is the bottom line. All trading on the secondary equity markets is pure speculation, a form of gambling.

      The original investors in a company that goes public (through IPO) are provided outsized rewards not because of their thrift but because they own a firm that has proven to be worthy of speculation. Once a firm becomes publicly traded, it becomes something of a perpetual motion machine, every day generating transaction fees whenever shares are traded. Whether the share price goes up or down, exchanges and brokers make fixed fees on each share traded.

      The management and directors of a publicly traded company are rewarded for keeping the speculation going.

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    2. Unfortunately, I am still a little confused with your line of thought (particularly the first paragraph).

      Perhaps by answering these questions we can shed some light on the situation:

      (1) "Who decides what a 'good decision' is?"
      (2) "What a "good outcome" is?"

      Answer: Clearly, the owners are the ones who decide what a good decision and a good outcome are. Managers and directors, as said in the text, are obliged by law to promote the shareholders' financial interest; further, that is their job, and they are paid for that.

      Therefore, it's not up to me to define what a good decision is. Or a good outcome. More generally, this apply to third parties.

      To the extent managers and directors got the banks they managed broke, they failed their employers' mandate. The conclusion seems inescapable, to me.

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      (3) "Could it be that the financial elite who reward top management for what you view as bad decisions and/or bad outcomes see those decisions and outcomes as good, not bad?"

      Answer: Taking into account the previous answer, I'd say that what I might think is utterly irrelevant. And, although I can't presume to speak for the financial elites, I'd say for them, the situation is clear, too.

      Perhaps what you are aiming at is that, although the banks were to all purposes broke, they were bailed out, so the owners did not suffer.

      If that's your point, then you are right that the owners didn't suffer by their managers' action, but neither do the owners owe them any thanks: if someone or something is to be thanked it would be the Government.

      Or, to put this another way, imagine the Government, instead of issuing a rescue with no strings attached (as it actually happened), had attached strings, as many people were demanding?

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      I tend to agree with the rest of your comment, but its connection with the first paragraph is not clear, to me.

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