In the catechism of capitalism, shares represent the part-ownership of an economic enterprise. The value of shares is determined by the replacement value of the assets of the firm, including intangibles such as goodwill. The price of the share is determined by transactions among arm’s length buyers and sellers in an efficient and liquid market. The price reflects expectations regarding the future value of the firm and the stock’s future stream of income – i.e., dividends.

Alas, none of these oft-recited dogmas bears any resemblance to reality. Shares rarely represent ownership. The free float is frequently marginal. Shareholders meet once a year to vent their displeasure and disperse. BoDs are appointed by management – as are auditors. Shareholders are not represented in any decision making process.

The truth is that shares represent the expectation to find future buyers at a higher price and thus incur capital gains. In the stock exchange, this expectation is proportional to liquidity and volatility. Thus, the price of any given stock reflects the consensus as to how easy it would be to offload one’s holdings and at what price.

Another myth has to do with the role of managers. They are supposed to generate higher returns to shareholders by increasing the value of the firm’s assets and, therefore, of the firm. If they fail to do so, goes the moral tale, they are booted out mercilessly. This is one manifestation of the «Principal-Agent Problem». It is defined thus by the Oxford Dictionary of Economics: «The problem of how a person A can motivate person B to act for A’s benefit rather than following (his) self-interest.»

The obvious answer is that A can never motivate B not to follow B’s self-interest – never mind what the incentives are. That economists pretend otherwise just serves to demonstrate how divorced economics is from human psychology and from reality.

Managers will always rob blind the companies they run. They will always manipulate boards to collude in their shenanigans. They will always bribe auditors to bend the rules. In other words, they will always act in their self-interest. In their defense, they can say that the damage from such actions to each shareholder is minuscule while the benefits to the manager are enormous.

But why do shareholders cooperate with such corporate robbery? Shareholders and managers are allied against the firm – not pitted against each other. The paramount interest of both shareholders and managers is to increase the value of the stock – regardless of the true value of the firm. Both are concerned with the performance of the share – rather than the performance of the firm. Both are preoccupied with boosting the share’s price – rather than the company’s business.

Hence the inflationary executive pay packets. Shareholders hire stock manipulators – euphemistically known as «managers» – to generate expectations regarding the future prices of their shares. The corporate executives are allowed by shareholders to loot the company providing they generate consistent capital gains to their masters by provoking persistent interest and excitement around the business.

The Principal-Agent Problem arises in other social interactions and is equally misunderstood there. Consider taxpayers and their government. Contrary to conservative lore, the former want the government to tax them providing they share in the spoils. They tolerate corruption in high places, cronyism, nepotism, inaptitude and worse – on condition that the government and the legislature redistribute the wealth they confiscate. Such redistribution often comes in the form of pork barrel projects and benefits to the middle class.

This is why the tax burden and the government’s share of GDP have been soaring inexorably with the consent of the citizens. People adore government spending precisely because it is inefficient and distorts the proper allocation of economic resources. Most people are rent-seekers. Witness the mass demonstrations that erupt whenever governments try to slash expenditures, privatize, and eliminate their gaping deficits. This is one reason the IMF with its austerity measures is universally unpopular.

Employers and employees, producers and consumers – these are all instances of the Principal-Agent Problem. Economists would do well to discard their models and go back to basics. They could start by asking:

– Why do shareholders acquiesce with executive malfeasance as long as share prices are rising?

– Why do citizens protest against a smaller government – even if it means lower taxes?

– Could it mean that the interests of shareholders and managers are identical? Does it imply that people prefer tax-and-spend governments and pork barrel politics to the Thatcherite alternative?

Nothing happens by accident or by coercion. Shareholders aided and abetted the current crop of corporate executives enthusiastically. They knew well what was happening. They may not have been aware of the exact nature and extent of the rot – but they witnessed approvingly the public relations antics, insider trading, share price manipulation, opaque transactions, and outlandish pay packages. Investors remained mum throughout the corruption of corporate America. It is time for the hangover.

Source: Sam Vaknin, published: 2005-01-18, www.bebpronews.com