My daughter’s been studying the global financial crisis at her French high school, inspiring me to write this piece. Every teenager, and every older person too, must remember how a group of short-sighted businesspeople brought capitalism itself to the brink of collapse.
Lecturing to General Motors in 1970, Milton Friedman railed against the idea of GM “providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers” (read: building safer cars that use less fuel). The sole responsibility of a business is to produce profits for shareholders, Friedman said, adding businesses mustn’t worry about the health and safety of customers, the well-being of employees, or the general welfare of the world.
GM listened and, after a couple decades of declining sales, ever-lower quality cars, and a stagnant stock price, declared bankruptcy in 2009. Shareholders were wiped out. Friedman’s so-called shareholder value theory was responsible for one of the worst shareholder losses in history.
Between then and now, Friedman’s theory did and continues to do enormous damage to both business and the public psyche.
Academics codified Friedman’s ideas into a top-cited 1976 paper, Theory of the firm: Managerial behavior, agency costs and ownership structure by Profs. Michael Jensen and William Meckling. If CEOs are paid in stock, they’ll do almost anything to bump up the stock price, the duo argued in their “new definition of the firm.” They defined increasing the stock price as the primary responsibility of executives, parroting Freidman.
Less than a decade later, the ideals of material goals as a positive end-all manifested in pop culture with a young Madonna, declaring herself a material girl in 1984.
You know that we are living in a material world
And I am a material girl'
In 1985, Prof. Michael Porter released his competitive theory, arguing business is war and the way to win is to fight potential new entrants, suppliers, customers, substitute products, and (of course), one another.
By 1987, the fictional Gordon Gekko declared Greed Is Good in the movie Wall Street, summarizing shareholder value theory and the ethos of a generation.
I am not a destroyer of companies. I am a liberator of them!
The point is, ladies and gentlemen,that greed, for lack of a better word...
Greed is right. Greed works.
Greed clarifies, cuts through and captures the essence of the evolutionary spirit.
Greed, in all of its forms-greed for life,for money, for love, knowledge -
...has marked the upward surge of mankind
And greed, you mark my words, will not only save Teldar Paper...
...but that other malfunctioning corporation called the USA.
The very real Uncle Miltie, as he’s called at the University of Chicago, would’ve loved the fictional Gordon.
In June, 1989, Connie Bruck released The Predators’ Ball, about Michael Milken and his raiders who used high-yield low-quality “junk” bonds to purchase and carve up businesses. A few months later, in October 1989, stockbroker turned author Michael Lewis released his first book, Liar’s Poker, about a group of crazed bond sellers. Lewis focused on mailroom clerk turned bond salesman Lewis Ranieri selling a new financial product, Mortgage-Backed Securities.
Blythe Masters of JP Morgan invented the Credit Default Swap (CDS) in 1994 that’d throw kerosene onto a by then already raging fire. CDSs work like insurance without the bothersome regulations. Swaps enabled behaviors prohibited in ordinary insurance, like failure to keep reserves or insuring something the insured didn’t own. By “swapping” risk, rather than insuring, anything was possible. As a well-known bond trader once told me, “don’t call securitizations bonds and don’t call swaps insurance and the regulators will stay away.”
The race was on and, for years, businesses did everything they could to slash jobs, outsource, cut costs, and increase executive pay, driving up short-term share price by any means necessary. CEOs with tenures measured in months gutted their businesses, taking ever-larger pay packages and cashing out before the long-term effects of their short-term thinking came home to roost.
There were a few speedbumps along the way.
In 1998, a group of brainiacs running the hedge fund Long Term Capital Management (LTCM) managed to nearly destroy the world economy with reckless gambles. Featuring Nobel Prize winners Myron Scholes and Robert Merton, and headed by former Solomon Brothers bond trader John Meriwether (Ranieri’s old boss), the no-can-fail firm failed spectacularly when Russia defaulted on its debt. Rather than risk a global financial catastrophe — which, coincidentally, would’ve centered on their friends and former classmates — the Federal Reserve organized a bailout.
Shareholder value quietly morphed into shareholder protection; gains for the wealthy few with risk borne by the unwashed many. The theory Milton Friedman once promised as protection against “pure and unadulterated socialism” had turned into a new type of economics where the rich were protected from market discipline by the pockets of the middle class and poor who didn’t share in the gains.
Not long after LTCM, the shareholder value maximizers at Houston Energy Trading firm Enron spectacularly imploded. As Enron executives urged shareholders to hold their stock, the same executives simultaneously sold it while running shredders full-speed in the back office. Enron was allowed to fail, and a few executives even went to jail, though protecting the firm would’ve proven politically difficult after traders were taped manipulating energy prices and purposefully causing rolling blackouts.
The dot-com stock bubble burst, Al Queda attacked, and the stock market crashed. Rather than invest in building the information superhighway, Wall Street turned its attention to building condos in Lake Worth and Las Vegas. Securitization and derivatives, like credit default swaps, enabled ever lower-cost, lower-quality home loans. It was a race to the bottom. I personally watched a condo conversion project overseen by a lawyer who’d spent 4.5 years in federal prison gut a community (his conviction was overturned after they found a government agent sleeping with his former client, a drug lord, in prison).
Suddenly, everybody was a real-estate baron or used their homes as piggy banks. Rating agencies marked bundles of garbage loans good as gold and bankers figured out they could purchase default swaps on these same bundles, counting on the insurance to pay out more than the loan losses cost, which happens to be the classic definition of moral hazard. All that predictably collapsed leading to massive bailouts for the bankers but a “free market” for the rest as foreclosure auctions threw millions into homelessness with cases filed en masse by crooked lawyers working for bailed-out banks.
A period of anger grew as the wealthy grew ever wealthier, the poor ever poorer, and the middle-class gutted on the altar of Friedman’s shareholder value where the wealthy and well connected keep the upside of their bets but everybody else eats the losses.
Raiders rebranded as private equity but were largely the same people doing the same thing with impunity. Mitt Romney, a private equity banker, almost beat Obama despite the bailouts and foreclosures. Finally, with the election of Donald Trump, the message came through to the upper crust; shareholder value was causing political instability.
Realizing Friedman’s shareholder value theory, and the Greed is Good ethos, was bad for both business and society, the business world embraced a new idea, Stakeholder Value. The Business Roundtable defined stakeholder value as delivering value to customers, investing in employees, dealing fairly and ethically with suppliers, supporting communities in which they work, and, lastly, generating long-term value for shareholders. One hundred and eighty-four CEOs of the largest businesses in the world signed on.
GE was one of the few businesses that refused to sign. The original Dow index company — since unceremoniously kicked off — had moved from building toasters into financial speculation over the years. “Neutron Jack Welch” was especially known for shuttering businesses: firing the workers and leaving the buildings empty. Under his watch, GE famously exceeded Wall Street expectations by about one percent, quarter after quarter, for decades - a seemingly impossible feat matched only by Ponzi schemer Bernie Madoff. GE apparently agreed with Friedman that Stakeholder Value is a form of socialism, never mind their quiet emergency loan from the Federal Reserve during the financial crisis allowing them to make payroll.
In any event, firms that do well for everybody also tend to do better for shareholders. Report after report shows stakeholder value isn’t only more socially sustainable, it also returns more money to shareholders. The few reports which refute that are weak, arguing stakeholder value firms would’ve done well even without their social commitments.
As we enter a post-covid world, stakeholder value is the new center. Value for customers anchors businesses to what matters and concern for employees and communities ties that to those who actually create the value. Shareholder matters matter, though they’re no longer front and center. Some firms don’t even give shareholders a meaningful right to vote for management, which is arguably excessive in the other direction. But, watching the fictional Gordon Gekko above do his thing, along with the very real Michael Milken, Ron Perelman, Carl Icahn, and Ivan Boesky that Gekko is based upon, it’s clear where they’re coming from.
Maybe stakeholder value will fix what ails the soul of business. Just recently, Black Rock’s Larry Fink declared “Stakeholder capitalism is not about politics. It is not ‘woke.’ It is capitalism.” I agree and hope he’s right. Businesses need to focus on value to buyers, to employees, to their communities. Get that right and there’s plenty of value for shareholders.