The Slow Recovery in NOT due to the Dodd-Frank Law.

It is due to a dangerous doctrine: Shareholder Value Maximization (SVM)

robert-ayresThe goal of shareholder value maximization (SVM) is now widely adopted by corporate boards and taught in business schools. to the exclusion of all other goals.[1] SVM is a new doctrine in economics. It is most often attributed to Milton Friedman, who said in New York Times Magazine back in 1970: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits” (Friedman 1970). He also said that corporations are not “persons”, even though corporations have the legal status as persons, and that shareholders necessarily (being rational utility maximizers, by assumption) want to maximize profits, whence any act of corporate social responsibility to be ‘taxation without representation’. This fits the ‘principal-agent” theory of economics, which assumes that corporate managers are simply agents of the owners (shareholders), whence SVM seems to follow automatically (Jensen and Meckling 1976).

The activists and SVM “believers” (it is a religion, not a rational policy) have taken over most of the corporate board rooms.

However Lynn Stout (among others) has pointed out that, notwithstanding the claims of many “activist” investors, like Carl Icahn, corporations – being legal ‘persons’ – are not required to act as fiduciary agents for the owners (Stout 2012). They are only required to act in their own best interests (as determined by their Boards of Directors). This important legal difference has been confirmed a number of times in the courts. It explains why the activists always try to control the board.

They have been surprisingly successful. The activists and SVM “believers” (it is a religion, not a rational policy) have taken over most of the corporate board rooms. In 1981 the Business Round Table said “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment….provide jobs and build the economy” (Monier 2014) p.2. Yet by 1997 responsibility to customers, workers or communities was out of the (picture) window. The Business Round Table pronounced in that year that “The principal objective of a business….is to generate economic returns to its owners…if the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value” (Monier, op cit).[2]

Behind those words is another assumption, namely: that share price is the best measure of shareholder value. Monier’s paper goes on to compare the performance of two corporate icons, IBM and Johnson & Johnson (J&J), in total returns to shareholders, since 1973. Up to 1988 they were both managed essentially according to the dicta of the 1981 Business Round-Table, and they were roughly equal in terms of performance gains since 1973.[3]

The guiding principles of IBM, as recapitulated by T.J.Watson Jr. in 1968, were (1) respect for employees, (2) commitment to customer service and (3) achieving excellence. Similarly, the mission statement of J&J, written by its founder Robert Wood Johnson in 1943, said (and still says) “We believe our first responsibility is to [all persons].. who use our products, …We are responsible to our employees…We are responsible to the communities in which we live and to the world community as well…Our final responsibility is to our stockholders…When we operate according to these principles, the stockholders should realize a fair return.” And they have.

But from 1990 on, IBM – run by a series of SVM advocates starting with Lou Gerstner – has lagged far behind J&J in performance. In 1974 IBM, under the founding Watson regime, was the 5th most valuable company in the US. In that year J&J was not in the top 20. By 1994, IBM had climbed up to 4th place in value (after GM, Ford and Exxon-Mobil) and J&J was still not in the top 20. But by 2014, J&J was number 5 while IBM had fallen back to 13th place in the value stakes. This cannot be explained by IBM being in the wrong industry, considering that Microsoft, born in the 1980s, as a step-child of the IBM PC development, had reached 4th place on the valuation list by 2014, with Google in 3rd and Apple in 1st (Barry 2014).

What went wrong at IBM? Dedication to ‘main-frame’ computers and failure to respond adequately to the challenge posed by DEC, Compaq and other nimbler companies in the 1980s was the first cause of its fall from grace. (Why did IBM fail to acquire baby Microsoft when that would have been so easy?) But since the 1990s blind dedication to SVM (which continues) has led to unending emphasis on cost-cutting (by job cutting), lack of product innovation, and use of cash to finance corporate share buy-backs. Between 2005 and 2014 IBM delivered $32 billion in dividends to shareholders and spent $125 million buying its own shares (to prop up the share price), while investing only $111 billion in capital investment and R&D, combined. IBM today is a shadow of what it was in the 1950s, ‘60s and ‘70s.

This story is not unique to IBM.

The recent history of Hewlett-Packard (HP), the first of the great success stories in Silicon Valley, is equally or more depressing. When Carly Fiorina took over in 1999 she started a buyback program. During her term (until 2005) HP bought back $14 billion in its own stock, while earning only $12 billion in profits. (It should have invested in Apple shares). Under the next CEO, Mark Hurd, HP paid $43 million for its own stock, while earning only $36 billion in profits over 5 years. The pattern continued under Leo Apotheker ($10 billion in stock repurchase) and Meg Whitman, currently in charge. By the time HP’s “turnaround” (and breakup) is complete, it will have cost 80,000 jobs (Brettell, Gaffen, and Rohde 2015).

Nearly 60% of non-financial public companies in the US have bought their own shares since 2010. In the last reporting year (2015) share repurchases were $520 billion, along with $320 billion in dividends, adding up to $885 billion, as compared to net income of $847 billion (op cit.) Annual total real returns of US public companies (as percent) from 1940 to 1990 were about 7% p.a. However, real returns since 1990, allowing for the share price rises due to supply reduction due to share buy-backs, is barely 5% p.a. (Montier 2014) Exhibit 3. This is why pension funds and insurance companies are now in deep trouble, since they mostly predicated their pension and insurance offerings on a continuation of that 7% history.

Overall distributions to shareholders (dividends plus buybacks) have fluctuated since 1985, but generally between 80% and 90% of adjusted net corporate income, leaving barely 10% to 20% available for investment in R&D and capital investment. The investment high points were 1885 (26%), 2012-13 (25%) and 1996-97 (24%). The low points were 1989 (0%) and 2002 (-10%). The dividend share of payouts (the part that supports widows and orphans) was gradually declining to its recent level of about 33%, while the fraction spent on share repurchases was rising.

Bottom line: Some companies (especially in Silicon Valley) are still investing in new capacity, but many companies are now spending more than they earn, in terms of dividends and share buybacks. How can they do that? The answer is: by borrowing.

The economic cost of SVM

According to principal-agent theory in economics, as expounded long ago by Jensen and Meckling, agents who are not owners, may be induced to act as owners would act, by offering compensation based on some measure of corporate performance, namely share price. A variety of compensation plans, involving bonuses and options, have been adopted to achieve this ideal commonality of interest. One consequence of this trend has been the great increase in relative compensation between CEOs and their employees. Before 1980 over 90% of total CEO compensation was by salary and bonus. In the last decade, two thirds of CEO pay has come from share-price related schemes. And the ratio of CEO pay to median employee pay has risen from around 30:1 in the 1970s to over 300:1 currently.

This has contributed significantly to increasing inequality, especially when it turns out that, from the Great Crash in 1929, to 1979, the income share of the top 10% and the top 1% actually declined. The economy became less unequal. But since 1980, the situation reversed: almost all of the gains in the economy since then have gone to the top 10% and well over half to the top 1%. This has an adverse impact on economic growth: the bottom 90% of incomes are spent mostly on goods and services, adding to the GDP, whereas top earners “save” most of it, contributing to asset bubbles. According to standard economic theory, If the income distribution were more nearly equal the economy would grow faster, precisely for this reason. In short, inequality per se is another “headwind” to growth (lack of re-investment of profits being the first one), all other factors remaining the same.

One other immediate disadvantage of the option system, from a macro-perspective, is that executives bear no financial risk. When share prices rise, they gain, but when share prices fall, option-holders do not lose, even if shareholders lose. However this advantage only lasts while the CEO (or other top executive) is still employed. CEOs currently last about ten years in the job. However, founders tend to last longer, while successors have shorter times to rake in the dough.

Thanks to share-price based compensation for CEOs and other executives, that gave them incentives to act like rational owners, it follows that they took (and will take) advantage of any mechanisms to drive share prices up, in the short term, regardless of the long-term interests of the firm. The mechanism that they have used, since it was first legalized by the SEC (in 1982), is the ‘share buy-back’.[4]

The numbers are shocking: from 2004 through 2014 share buy-backs added up to at least $6.9 trillion. This constitutes 54% of the total profits of Fortune 500 companies. Profits, in turn, account for by far the majority of business investment (bank loans and stock sales account for a small fraction). So, by buying their own stock to drive the price up and to increase earnings per share (by reducing the number of shares outstanding, American companies have diverted over half of the money that would have been invested in “bricks and mortar” into an asset bubble. The main beneficiaries have been the CEOs and other top executives with share-price based compensation.

This is why the economic recovery from the 2008 financial crisis has been slow. By the way, even if Congress gives a “tax holiday” to allow firms with large piles of cash in overseas banks  without paying corporate income tax, do you think they will spend it on domestic infrastructure? They will use as much as possible to repurchase their own shares, to drive the prices up. Bet on it.

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[1] In an email answer to a recent question from Reuters, Itzhak Ben-David, Professor of Finance at  Fisher College of Business, Ohio State University, said “Serving customers, creating innovative new products, employing workers, taking care of the environment ….are NOT the objective of firms. These are components in the process that have the goal of maximizing shareholder value” (Brettell, Gaffen, and Rohde 2015). Presumable he teaches what he believes.

[2] The title of Monier’s paper is “The World’s Dumbest idea”. He credits those words to the legendary Jack Welch of GE, who said them in an interview with Financial Times in March, 2009. Welch isn’t the only dissenter.

[3] I was a summer intern at IBM in 1954, as the firm was getting started in the computer business under T.J. Watson Sr. The company motto was “Think”. In those days. Employment in the company was regarded as an honor.

[4] Under rule 10b-18 of the Securities and Exchange Act of 1934 it was illegal to “manipulate” share prices. However Reagan’s appointee to head the SEC, a former CEO of the NYSE, changed the rule, creating a “safe harbor” for companies to do it.

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About the author

Robert U. Ayres is a physicist and economist, currently Novartis professor emeritus of economics, political Robert Ayres Inseadscience and technology management at INSEAD.. He is also Institute Scholar at the International Institute for Applied Systems Analysis (IIASA) in Austria, and a King’s Professor in Sweden.   He has previously taught at Carnegie-Mellon University, and as a visiting Professor at Chalmers Institute of Technology. He is noted for his work on technological forecasting, life cycle assessment, mass-balance accounting, energy efficiency and the role of thermodynamics in economic growth. He originated the concept of “industrial metabolism”, known today asindustrial ecology” with its own journal. He has conducted pioneering studies of materials/energy flows in the global economy. Ayres is author or co-author of 21 books and more than 200 journal articles and book chapters.  His most recent books are Energy, Complexity and Wealth Maximization (Springer, 2016), The Bubble Economy (MIT Press, 2014)  “Crossing the Energy Divide” with Edward Ayres (Wharton Press, 2010) and The Economic Growth Engine with Benjamin Warr (Edward Elgar, 2009). He can be reached at



3 thoughts on “The Slow Recovery in NOT due to the Dodd-Frank Law.

  1. The myth that lower taxes will result in greater investment seems to have strong staying power in spite of the evidence to the contrary that Ayres cites. It is also interesting to note that the post WWII period referred to, was a time of high wages, very high corporate and personal taxes and high unionization, as well as the most equal period the U.S. has seen in terms of wealth distribution. It was also the time nostalgically thought of as “the Great American Dream”, a time the current administration states it would like to recreate.


  2. Don Rogich commented on: The Slow Recovery in NOT due to the Dodd-Frank Law. It is due to a dangerous doctrine: Shareholder Value Maximization …

    The myth that lower taxes will result in greater investment seems to have strong staying power in spite of the evidence to the contrary that Ayres cites. It is also interesting to note that the post WWII period referred to, was a time of high wages, very high corporate and personal taxes and high unionization, as well as the most equal period the U.S. has seen in terms of wealth distribution. It was also the time nostalgically thought of as “the Great American Dream”, a time the current administration states it would like to recreate.

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  3. Would it be OK if I cross-posted this article to I’ll be sure to give you complete credit as the author. There6 is no fee, I’m simply trying to add more content diversity for our community and I liked what you wrote. If “OK” please let me know via email.




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