Hypothesis #9—Agents of Change: Institutional investors have the fiduciary responsibility and the democratic power to democratize capitalism by reforming company practices and government policies.
Institutional investors could move the American economy towards democratic capitalism in a surprisingly short time by using means that already exist, namely by influencing the policies of companies that are largely owned by working people, and by bringing to bear both on companies and the government the democratic voting power that this ownership of shares represents.
During the last quarter of the twentieth century, a new wage-earner capitalism emerged, called either “pension fund socialism” or “employee capitalism” by Peter Drucker, but I prefer to call it “democratic capitalism.” This new capitalism is a realization of Marx and Mill’s visions of a synergistic relationship between labor and capital, a development that has come about not through radical restructure or political revolution but through evolutionary means.
This new relationship between capital and labor was expedited by ERISA, a new federal law passed in 1974, that mandated the funding of future pension benefits out of current corporate earnings. The flow of funds started by this law increased with the 401(k) law that encouraged savings from pre-tax dollars. As a result of these new laws, the ownership of American public companies has shifted towards wage earners. Pension funds, mutual funds, insurance companies, banks, foundations, and university endowments increased the amount of money to be managed from under a half-billion in 1970, to $8.5 trillion by 2001. Ownership of public companies by wage earners grew from under 15% to over 50%.
The explosive growth of wage-earner capitalism should have diffused economic and political power. Instead of diffusion, however, wealth and political influence became more concentrated. Instead of becoming more accountable for the long-term financial and social benefits of their majority owners, most of the wage earners’ money managers supported ultra-capitalism, attracted by its presumed better short-term results. Ultra-capitalism came to dominate the economy because the enormous flow of new cash into the stock market gave new power to reward or punish CEOs based on how closely they follow Wall Street dictates (see chapter 8). If this observation sounds like a lament by an ex-CEO, consider the words of an ex-banker, David A. Hartman:
Corporate CEOs got the message. Forecast 20% growth and 20% return—or fake it. Does this provide any clue as to why the fictitious earnings of Enron, WorldCom and the like have become so widespread? Either CEOs and auditors play ball, or Wall Street has them replaced with more “performance oriented” players.
Wall Street’s new power came from an extraordinary contradiction in which more democratic ownership resulted in more concentration of wealth and a less socially sensitive capitalism. This contradiction can be traced to the egregious government mistakes that caused the excessive volatility and liquidity that launched ultra-capitalism (see chapter 7 and hypothesis #4). Instead of using the growing democratic power to counteract the lobby power of ultra-capitalism, institutional investors in most cases supported ultra-capitalism.
The Congressional designers of ERISA failed to analyze alternative uses of this new flow of democratic capital. In the early 1970s, when ERISA was being designed, Senator Russell Long (D., Louisiana) and his committee proposed, and Congress passed, new tax laws that encouraged employee ownership through ESOPs (Employee Stock Ownership Plans). A magic opportunity was missed to design new financial instruments to invest tax-favored ERISA funds in the job-growth economy, which would have resulted in large dividends, long-term appreciation, and security. The government, instead of responding to the needs of the people and recycling the capital into economic growth, responded to the Wall Street lobbyists and sent the money to the stock market where it pushed stock prices to artificially high levels in the bubble economy. A new chapter in the book of making money from special government privileges was being written: Since the beginning of the Industrial Revolution, finance capitalism had exploited the workers’ labor; now, in the early stages of the Information Age revolution, ultra-capitalism was learning how to exploit the workers’ capital!
We need to listen to, and act upon, the insight of Peter F. Drucker, who skewered ultra-capitalism in these words:
What emerged from this frantic decade [hostile takeovers, leveraged buy-outs, downsizing, et al.] was a redefinition of the purpose and rationale of big business and the function of management. Instead of being managed in the best balanced interests of stakeholders, corporations were now to be managed exclusively to “maximize shareholder value.” This will not work, either. It forces the corporation to be managed for the shortest term, but that means damaging, if not destroying, the wealth-producing capacity of the business. It means decline and finally swift decline. Long-term results cannot be achieved by piling short-term results on short-term results. They should be achieved by balancing short-term and long-term needs and objectives. Furthermore, managing a business exclusively for the shareholders alienates the very people on whose motivation and dedication the modern business depends: The knowledge workers. An engineer will not be motivated to work to make a speculator rich.
The alienation that Marx identified as the impediment to greater and more widely distributed wealth, should have disappeared with the advent of the Information Age and wage-earner capitalism. An industrial environment that releases the cognitive power of people is mutually exclusive with alienation because the working class (“labor”) is now also the owner class (“capitalists”), as well as the bosses (“management”). As Drucker pointed out, however, the alienation will persist as long as ultra-capitalism prevails.
I argue, therefore, that institutional investors ought to examine and accept the hypothesis that democratic capitalism maximizes long-term shareholder value because the system that maximizes the innovation and productivity of each will add up to the maximum profits to be shared by all. Exclusive concentration on short-term profits is eventually self-defeating because it destroys the motivation upon which the long-term success of any enterprise depends. Drucker made this point many years before the 2002 crash of ultra-capitalism, and so did I!
The first priority of the institutional investors should be to put pressure on companies to invest capital surplus in more growth and to pay the stockholders large dividends, rather than wasting surplus on non-strategic acquisitions and stock buy-backs. At the same time, institutional investors can become the antidote to Wall Street lobby power by lobbying changes in the tax laws for tax-free dividends and tax-free capital gains for low- and middle-income shareholders. This simple change will have the benefit of recycling surplus into stronger economic growth, and it will also build momentum towards greater worker-ownership plans and the full benefits of democratic capitalism. Most wage earners will be pleased to put their money into a plan that provides not only secure long-term appreciation but also large annual dividends that can be spent or reinvested in more equity, both stimulants to still greater economic growth.
Another change that institutional investors could implement is to measure corporations by making them accountable for management’s predictions for sales growth, cash flow, and profits over a three-year period. Adoption of this measurement and accountability—combined with large, tax-free dividends, with no capital-gains tax for the wage earner; control of the feeding frenzy in executive compensation; and a change of auditors every five years (see chapter 9)—would move the economy towards the stronger, steadier growth of democratic capitalism, and away from the boom/bust cycle of ultra-capitalism that has done such unnecessary economic and social damage.
After ultra-capitalism is purged from the system in part by the voting power of institutional investors, and after democratic capitalism receives support from the American culture and political structure, it will spread wealth throughout the world and unite people in economic common purpose. The visible improvement in the lives of hundreds of millions of people will then set the stage for a steady reduction and eventual elimination of violence among people and nations. The United States is positioned to lead towards this economic common purpose and its promise of global social progress. That ideal prospect, including cooperation with the United Nations in its mission to substitute law for violence, is the focus of hypothesis #10.