Wednesday, October 12, 2016

Contract Theory and Adam Smith.


Luke 16:1-13. (Source)
A fascinating thing about "A Scorecard to Keep Track of Players and Their Agents", which I mentioned last time, is that it traces contract theory back to a 1976 paper by Michael Jensen and William Meckling, and, much more distantly, to Adam Smith's 1776 "Wealth of Nations" (the whole section is well-worth your time):
"The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honor, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company." (Emphasis added)
That quote is 240 years old. Note that Smith already uses the word "manager". "Stewards of a rich man" apparently alludes to an even earlier source: Luke 16:1-13. Concerns about managers/capitalists aren't recent by any means.
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Smith did not favour joint-stock companies, whose general organisation he describes as:


Arguably Smith's "General Court of Proprietors" is the modern Shareholders' General Meeting and/or the Board of Directors (invested with the ultimate corporate authority, including to hire/fire managers); "Court of Directors" is the modern CEO (in charge of day-to-day decisions).

Smith reckons, the problem with a joint-stock company -- compared to a "private copartnery" (modern partnership) -- is twofold:
  1. As the previous quote emphasises, normally managers cannot be expected to watch over the company "with the same anxious vigilance" which partners devote to their own firms. Although he may not be the first expressing those doubts, Smith's concerns about managers anticipated shareholder activism by two centuries.
  2. Not mentioned above (present in Smith's text): the limited financial responsibility a joint-stock company affords proprietors encourages them to "become adventurers", investing in businesses they don't understand, dependent on whatever dividends managers decide to distribute.
"Negligence and profusion, therefore, must always prevail", Smith concludes, making joint-stock companies uncompetitive, even though they "commonly draw to themselves much greater stocks than any private copartnery can boast of".

While astute readers might oppose that Smith overlooks the fact that joint-stock companies' ability to attract larger capitals is in itself a competitive advantage, we'll leave that for another opportunity.

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I can't tell how successful contract theory is in practice, but it seems to address (1): Smith's rather unflattering views of managers. It does that by aligning theirs and shareholders' interests.

What about (2)? It seems contract theory doesn't deal with proprietors' own ineptitude. Wouldn't that be a weakness?

Quite to the contrary: it may be its greatest strength. By aligning the interests of managers and capitalists, capitalists don't need any competence whatsoever, not even the dubious one of a beating heart.

They only need to own the company.

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In the rest of that text Smith mentions a series of historical joint-stock companies (South Sea, Royal African, Hudson's Bay, English East India) and their stories. There is material for many posts.

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