Countercyclical corporate governance
As the economy transitioned from the global financial crisis, through the ensuing period of prolonged stagnation and high unemployment, to the suspension of economic activity in the COVID-19 crisis, and now into a period of dislocation and ‘high inflation, the limits of macroeconomic tools have been revealed. Governments looked to existing fiscal and monetary policy tools to find solutions to each challenge, but found that these tools were often unavailable or ineffective. A new wave of legal scholarship has sought to expand the toolkit by identifying ways to change legal rules to incentivize businesses and individuals to increase investment and spending in times of economic hardship. But, with a few exceptions, relatively little has been done to use the lessons learned from the study of corporate governance to mobilize the capacity of companies to pull the economy out of a crisis.
A new article to appear in the North Carolina Law Review seeks to explore this gap. The conceptual and practical tools that the document develops could have a substantial impact. The companies have extraordinary financial resources and enormous operational reach. And because companies can act with flexibility and speed, they can easily respond to changing circumstances, from high unemployment to high inflation. Harnessing business capacity would significantly improve the ability of the economy to recover from various severe economic crises.
Corporate governance is a natural starting point in the effort to harness corporate power. Traditional macroeconomic policy tools aim to encourage companies to decide to invest and hire in times of recession by modifying the external environment in which they operate. But changing corporate governance arrangements — the incentives and mechanisms that drive corporate decisions — can have a more direct effect on companies’ investment and hiring decisions.
Corporate governance tools can also help address market failures. Recessions and other macroeconomic crises are market failures in which wealth-generating transactions do not occur. During a recession, there are unemployed people who would be happy to buy more goods if only they could find a job, and there are struggling businesses who would be happy to hire if only they could sell more of their products. Markets are slow to reach an efficient equilibrium in which these wealth-generating transactions take place. Governments and businesses can help coordinate this kind of beneficial activity without waiting for the market to clear. Where direct government action is not imminent or not effective, companies can step in.
Beyond the practical implications, the analysis may shed new light on long-standing theoretical debates in corporate governance. Macroeconomic crises shatter the intuitions that have shaped corporate governance. The traditional view of corporate governance is that directors and officers should focus exclusively on the interests of shareholders. While companies make decisions that affect many other stakeholders, including workers, creditors and local communities, these other stakeholders are meant to be protected by contracts and regulations. Since shareholders are paid only after these legal obligations to other stakeholders are satisfied, shareholders are expected to feel the effects of marginal changes in the value of the firm more directly. They are therefore believed to have the right incentives to create wealth by maximizing output and minimizing costs like wages.
When the economy is successful, this perspective roughly aligns with the goal of maximizing social wealth. Labor is a scarce social resource, and when a company uses a worker’s time, that time is not available for other useful activities. When labor markets function well, the social opportunity cost of deploying this working time in the firm rather than elsewhere is reflected in market wages. If an employee commands a salary of $20 per hour at a company when labor markets are strong, this likely reflects the employee’s ability to find another job paying around $20 per hour, indicating in turn that employee could create more than $20 of value at that time. other work. If the company found a way to maintain existing production without using the worker’s time, the worker would go to that other job and create that value – the $20 per hour saved by the company would reflect a real gain in efficiency that would allow society to redeploy productive resources and create additional wealth. Therefore, in ordinary times, the goal of maximizing shareholder profits has a rough correlation with the goal of maximizing social wealth creation.
But in a recession with dysfunctional labor markets and persistently high unemployment, wages may not match the opportunity cost of labor: if an employee is laid off, they may not be able to find another job or create value. The employee’s usual salary would still represent a cost from the perspective of shareholder profits, but would not reflect a true opportunity cost from the perspective of social wealth. Maximizing shareholder profits by laying off workers could also have destructive effects. A layoff would mean a prolonged period of unemployment for the worker, meaning the worker goes from creating some social wealth to none. Other costs of a layoff include loss of income for the worker, potential loss of productive capacity for the economy if the worker is unemployed for an extended period and loses skills, and loss of demand when the worker reduces his expenses. These costs are not borne directly by the company’s shareholders, and are unlikely to be part of the calculation of directors and officers who focus on a narrow conception of shareholder interests. It would therefore be useful to reform corporate governance to encourage managers to maintain spending and investment, even if some shareholders feel aggrieved.
Reforming corporate governance in response to these issues could bring substantial benefits, as US corporations control substantial resources. If companies could be incentivized to use their resources to increase investment and employment in times of economic hardship, they could have an impact comparable to a major government program. And due to their unique abilities, relationships with employees and other stakeholders, and ability to act quickly, their financial firepower may actually underestimate their usefulness. Whether complementing government efforts or replacing an inadequate government response, countercyclical corporate governance is worth exploring.
These points support a range of policy approaches, with the main aim of reorienting companies to serve constituencies other than shareholders during a crisis. Although not conceptualized as efforts to overhaul corporate governance, various features of the policy response to COVID-19 have suggested a growing recognition that corporations are vehicles for serving groups such as as employees and customers, and not simply to generate financial returns for shareholders. Stockholders and index funds alike can deepen this trend with thoughtful interventions with portfolio companies, mitigating recessions in a way that improves their long-term returns and improves their marketing position. The government can further support countercyclical corporate governance through appropriate regulations. The discussion of policy approaches here is not intended to be exhaustive, but should open up an important conversation about the ways in which corporate governance could support an economic recovery.
The full document is available for download here.