Wednesday, October 1, 2014

Weak Labor, Strong Securities Markets

A vital distinction between market economies is the degree to which ownership of large firms is separate from a firm's day-to-day management. What makes a company's owners willingly hand over control to professional managers? That question is increasingly urgent as wealthy countries-as well as many transition and developing economies-attempt to create the robust securities markets needed to boost investment, productivity, and growth.

Separation of ownership from management and effective securities markets reinforce each other. The underlying theory is straightforward: if bosses can steal, distant owners will not buy shares. The formalistic civil-law systems that prevail in continental Europe supposedly provide inadequate protection, so ownership remains concentrated. By contrast, Anglo Saxon common-law systems empower judges to interpret open-ended fiduciary rules on a case-by-case basis, thereby establishing legal precedents that are binding on managers.

But this is a weak explanation. Before World War I, Europe's civil-law countries were developing securities markets as fast as the US and the UK. Indeed, regulatory agencies like the US Securities and Exchange Commission (SEC) arose because common-law fiduciary duties failed to protect distant owners.

Insider trading, for example, was generally legal under the rules governing fiduciary duties in America's states, which back then played a dominant role. By contrast, the SEC is a rule-generating institution of the type that civil-law countries like France or Germany would have little difficulty creating if they wished to .

Moreover, fiduciary duties only aspire to prevent insiders from stealing. They do not control the main costs that shareholders face when they do not manage the company themselves, such as unprofitable expansion, shirking, retention of free cash flow, and empire building. Unless there is a conflict of interest between a company's management and its board, owners in common-law countries have no legal recourse when managers' operational or strategic decisions are bad, stupid, or otherwise harmful to shareholders.

Throughout the rich world, institutions that raise the costs to shareholders of turning over control to professional managers play a powerful role in determining outcomes. But these institutions reflect the political power of social forces, not the differences between civil-law and common-law systems.

In particular, ownership separation in the wealthy continental European nations and the US can be linked with the role of labor inside the firm and within society. In some nations, labor greatly influences the firm through politics-i.e., opposing mass lay-offs and resisting restructuring plans that change the nature of the workplace.

Consider a simple scenario: a nation bars firms and owners from laying off employees for economic reasons. Faced with a no-fire rule, shareholders have reason to be very cautious: if expansion is not profitable, they cannot reduce labor costs. France, for example, is notorious for forcing foreign firms like Britain's Marks and Spencer to keep redundant workers on the payroll. Of course, no nation completely bans lay-offs, but flexibility varies greatly and can be central to profitability.

In a nation like the US, where employees can be fired easily, shareholders have less to fear. But in a labor-strong society, dominant shareholders-those with the most to lose if expansion goes awry-have reason to keep managers on a short leash. Italy's Fiat illustrates the problem: even a conservative government seeks to impede downsizing.

A second factor should also make owners want to stay close to the firm if labor is politically strong. Bargaining over the economic surplus is often open-ended, especially if competition is weak. Where employees have high bargaining power, the profits pie is constantly up for re-division, both within the firm and at the national level.

If managers are only loosely tied to shareholders, they could more willingly give up a bigger share of the pie to labor. Similarly, where shareholder interests do not come first, say, in a corporatist system, dominant owners have greater reason to keep financial information private, lest labor use it to press for more favorable terms. Both considerations support concentrated ownership and work against securities markets.

So, where political and social values strongly favor labor, managers' loyalty to shareholder interests will be weaker. Managers in such "left" societies are no less technically capable, but their organizational constraints, incentives, and goals are less pro-shareholder. When forced to cut employment, they are more likely to think that they are destroying lives rather than raising economic efficiency and increasing wealth. Such societies should have fewer public firms, and narrower or no ownership separation.

So they do. The OECD has indexed how easy it is to fire an employee in member countries. Employees enjoy the least protection in the US, and a high degree of protection in Italy, France, and Germany. The correlation with ownership separation is striking: a sample of the 20 largest firms in each country shows that, whereas 90% of the US companies have no shareholder with more than a 20% stake, none of the Italian, French, or German firms have such highly dispersed ownership.

True, with only 16 countries rich enough to be included in the survey, the correlation isn't perfect. The United Kingdom is in seventh place in terms of labor-market flexibility, but a higher proportion of its largest companies have widely dispersed ownership than sixth-place Switzerland-and double the share of fifth-place Denmark and fourth-place Australia.

But whatever measures of "political" qualities and ownership separation we use, the index of employment protection appears to be the best predictor of ownership separation in the wealthy West. More fundamentally, creating the regulatory institutions conducive to ownership separation may be impossible unless a society's political orientation towards labor and capital is more favorable to capital.

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