Freeman

ARTICLE

Against the Creation of Wealth: The Threatening Tide

JANUARY 01, 1989 by ARTHUR SHENFIELD

Dr. Shenfield was visiting scholar at FEE during June of 1988. He was formerly economic director of the Confederation of British Industry, director of the International Institute for Economic Research, and president of The Mont Pelerin Society.

In American memory President Coolidge is, to put it mildly, hardly an object of pride or admiration, still less of veneration. He is often derided for having supposedly declared, “The business of America is business.” Though they have not descended to the use of the term, some of his detractors have implied that in him the unfortunate American people had a Yahoo in the White House. In fact what he said was the following:

After all, the chief business of the American people is business. They are profoundly concerned with producing, buying, selling, investing and prospering in the world. I am strongly of the opinion that the great majority of people will always find these are moving impulses of our life . . . . Wealth is the product of industry, ambition, character and untiring effort. In all experience, the accumulation of wealth means the multiplication of schools, the increase of knowledge, the dissemination of intelligence, the encouragement of science, the broadening of outlook, the expansion of liberties, the widening of culture. Of course, the accumulation of wealth cannot be justified as the chief end of existence. But we are compelled to recognize it as a means to well-nigh every desirable achievement. So long as wealth is made the means and not the end, we need not greatly fear it. (Calvin Coolidge, Foundations of the Republic, 1926)

A more unexceptionable statement would be difficult to conceive. It merits perhaps only one improvement or extension. That the accumulation of wealth, within the American framework of liberty under law, produces the expansion of liberties, is true and important. But even more important is the fact that both the creation and the accumulation of wealth are, in their optimum forms, rooted in the liberty in which Americans claim that their nation was conceived. If Coolidge was any kind of Yahoo, then so too must John Wesley have been when he said to his followers, “Gain all you can. Save all you can. Give all you can.” And as Irving Kristol has happily said, his half of the Judaeo-Christian tradition has never held it to be sinful to be rich. Nor, on its best construction and contrary to not a few counter indications, has the Christian half.

Perhaps the causal link between liberty and the creation of wealth was rarely fully understood by more than a minority of Americans. Nevertheless, from before the birth of the American Republic to Coolidge’s time, the great majority did apprehend its existence and character in broad terms; and a well-instructed minority understood it fully and accurately. Now, by contrast, of all the siren voices which assail the American ear, perhaps the most insistent are those which urge the erection of impediments to certain liberties, new and distinct from former familiar impediments, such as import duties and the paraphernalia of regulatory commissions. By immediate effect these new impediments to liberty thwart the creation of wealth, just at a time when a sizeable and growing number of Americans, though as yet far from a majority, have perceived the evils of protective tariffs and industrial regulation.

The sound of some of these siren voices is rising to a crescendo, and their persuasiveness among the general public grows apace. Consider the animus which has thus been developed against the corporate takeover bidder. In public discussion it has become almost routine to picture him as a modern economic ogre. “Corporate raider,” “business predator,” and other even less complimentary appellations set the tone of debate. Hence legislators in 29 states have been moved to pass measures to block his path. Even so intelligent an observer as Irving Kristol, whom I have quoted with approbation above, has succumbed sufficiently to this agitation as to propose to limit company voting rights to shareholders who have held their shares for at least a year. The implication is that the “predator’s” wiles succeed mainly by the enticement of shareholders who are interested in quick in-and-out gains, not in the long-term progress of their companies.

Nowadays with the spectacle before our eyes of the manifest failures of other economic systems (including various forms of mixed economy, as well as those of central planning), it has become less and less plausible to impugn the superiority of the free enterprise system as a creator of wealth, though of course many continue to turn their faces against it on other grounds.

Free Markets

The free enterprise system is a system of free markets. Of all its markets, that which more than any other bears upon its efficiency as a wealth creator is the market in corporate control. Long ago, blinkered observers of the corporate scene noted that the owners (i.e., the shareholders) of the modern, large (or even not so large) corporation could have little or no direct control over the directors or managers, and so concluded that corporate democracy had to be a fiction. Hence, they thought, modern boards of directors had largely become self-perpetuating oligarchies. Their interest, not those of the shareholders, it seemed, determined the governance of the companies.

These observers failed to note that the market in corporate control enabled the baton to be passed to the shareholders. Even if they perceived this, they failed to see that it was not the actual event which was decisive, but the standing threat or possibility of it. It is this market which principally sees to it that managements must beware of elevating their own interests above those of their legal masters, or of falling into ways, of whatever kind, which produce less wealth than the assets under their control might produce.

But why should shareholders’ interests accord with optimum production of wealth? Are not shareholders often fickle, or conversely, gripped by mindless inertia, in their attachment to their companies? Do they not generally know little or care little about the business of their companies? Doubtless they have, as owners, the right to sit in judgment over the directors of their companies, but is it not ludicrous to envisage them as intelligent or informed judges of the directors’ performance? All this may be true (though it must be subject to at least partial qualification in the case of pension fund, mutual fund, and other institutional shareholders). However, true or false, it has little bearing on the matter before us.

Performance vs. Expectations

What counts is the difference between the performance of the existing management and the expectations of the “predator.” Hence, prima facie, if the “predator” is able to offer the shareholders a buy-out price above the current stock market price of their holdings, and to expect a profit for himself, it must follow that at least he, putting his money where his mouth is, and therefore acting with at least some circumspection, has confidence that the management’s performance can be bettered. However, this may be too simple a view, and so we must examine the contentions of those who criticize takeover activity.

First, it is loudly asserted that the typical “predator” has a short-term perspective; that he is primarily interested in a fast getaway with short-term gains, often by dismemberment of his “victim” companies and a sell-off of their parts. But why is a short-term perspective necessarily bad and a long-term perspective necessarily good? If a company is irrevocably heading for bankruptcy, a very short-term perspective may be right. On the other hand, if a company’s perspective is such that a particular investment in research and development is unlikely to recover its costs in less than a century, then the long-term view is almost certainly wrong. The correct view will be somewhere in a range of perspectives. It will be determined by the expected pay-off of an investment, discounted by the rate of interest over the period of expectation, long or short. In principle a relatively long-term perspective has no special sanctity over a short-term perspective.

But is it not true that the typical “predator” often dismembers companies, selling off parts of them soon after his takeovers? Does it not therefore seem to be true that his perspective tends to be undesirably short-term? For may it not be true that the value of a company may be greater than the sum of the market values of its parts?

In the first place, it is not true that dismemberment is an automatic or prevailing practice of the “predatory” process. Certainly it often happens, but that is because companies which are the object of “predatory” attention are often less successful than they might be precisely because they have parts which they would do well to get rid of. Indeed efficient managers often divest their companies of parts of their assets even though there is no threat or likelihood of a takeover bid. Thus in such cases divestiture, with or without the promptings of a “predator,” is a necessary step toward optimum wealth production.

Furthermore, the purchasers of dismembered parts must believe that their productive potential exceeds in value the prices to be paid for them. Thus on both sides the process of dismemberment can reasonably be expected to raise, not depress, the wealth-creating capacity of the economy. If, however, it is true that the value of a particular company is greater than the sum of the market values of its parts, only an inexpert “predator” would proceed with dismemberment, and inexpert “predators” are not long survivors. For in such a case the predator would find that the market value of the retained core of the company would fall. Then the result of dismemberment would be a net loss, not a quick gain.

But in any case is it true that the typical “predator” is predisposed to seek quick, short-term gains, whether by dismemberment or otherwise? This is one of those myths which easily gain popular credence, especially where the impugned characters are held up to public obloquy by those considered to be more respectable than they. In this type of case the respectable characters are supposed to be the businessmen in established charge of substantial companies, who are affronted by the pretensions of the “predators.” Often they are regarded as the pillars of the business community, while the “predators” are new men, to whom the epithet “smart” is applied in a pejorative sense.

In fact, studies of takeover cases have shown that takeover bidders are as much committed to rationally long- term purposes as other businessmen. They would be fools if they were not. For fast getaways with short-term gains Would not be the end of the bidding game. The gains would have to be invested somewhere, which would inevitably bring longer-term considerations into play. If the companies taken over were, or could be made into, good ones, why should the gains be invested elsewhere? Why not in the companies themselves? Thus if nur turing and developing the companies were likely to be profitable, the “predators” would be likely to perceive this as readily as the ousted managers themselves.

Secondly, it is often maintained that the “predator’s” buy-out price, which exceeds the current stock market price, deceives the shareholders into acceptance, because they do not realize that the stock market price temporarily underestimates the true value of their property. It does so, it is supposed, because stock market investors are likely to have shorter time perspectives than competent managers of sound companies may have. Thus competent managers may be ousted by the wiles of the “predators” against the true interests of the shareholders. Therefore, it is asserted, the shareholders should not fall headlong into the arms of the “predators.” They should wait. Then they would often find that the stock market price would rise above the “predator’s” apparently attractive offer, once stock market investors came to perceive the benefits of the managers’ longer-term plans.

It must be said that this is a travesty of the stock market’s performance. We need not go so far as the “efficient market” theorists, who hold that the market always takes account of all knowable factors beating on prices, to recognize that awareness of future possibilities indeed plays a role in the market’s prices. That is partly why some stocks sell at ten times earnings, others at fifteen times, and yet others at twenty times. The “predator’s” perception of these factors is more optimistic than the current perception of other market operators, but his feel for these things is likely to be well-honed by practice and experience. If it is not, he will not for long be a “predator.”

Thirdly, the “predator’s” plans may be repellent to many good citizens because, with his innovations and possible dismemberments, he may upset the attachment to local interests which existing managements may have developed and fostered. The ABC company may have become the long-established pride of Pleasantville, and the financier of many good works for its citizens. What the “predator” may do imports at least a risk that this will change for the worse. The company’s attachment to “social responsibility” may even be confidentially pinpointed by the “predator” as one of the causes of its sub-optimal economic performance.

Closing and Moving Plants and Factories

This problem is particularly evident in the widespread animus which has developed in recent years against the liberty of businessmen to close plants and factories, or to move them from established locations to others within the U.S. or abroad.

As far as closing, as distinct from moving, plants is concerned, public discussion so far centers only on the question of mandatory notice periods to workers. In some cases, extended notice may do little harm to business, and so is often given voluntarily. In many more it would do harm by adversely affecting the behavior of workers, suppliers, and creditors. Hence mandatory notice periods would be a typical example of the diseconomies produced by ham-fisted governmental action.

Now suppose that a company decides to move a plant from the Snow Belt (or the Rust Belt part of it) to the Sun Belt. We may assume that it is expected to be more productive in its new location than in the old (perhaps because of lower wages, but perhaps for other reasons). It is obviously good for the Sun Belt. It is also good for the United States, for any move from a less productive to a more productive location must raise the average national productivity. The notion that it may be bad if its purpose is to pay lower wages than the Snow Belt rates is groundless. Not only will the move have an elevating effect on Sun Belt wages, but quite apart from the Sun Belt’s equitable right to such industry as it can obtain, no valid national purpose can be served by using high-paid labor for work which can be done by less well-paid labor.

But what about the effect of the move on the Snow Belt? Surprisingly, except in the short run, the Snow Belt also gains from the move. By the side of the now famous principle “There ain’t no such thing as a free lunch,” we should erect the principle “If you want more jobs and better jobs, you must destroy jobs.” All economic history shows that the loss of jobs is a pre-condition for the elevation and increase of employment. For example, if New England had not long ago lost most of its textile jobs to the South, it would now be poorer, not richer, than it is. Indeed we can see this effect already in the Snow Belt (if not yet everywhere in the Rust Belt) which now has more and better jobs than it had before the southward move of jobs in recent years.

Suppose, however, that industry moves not from North to South, but from the U.S. to foreign countries, perhaps to gain the advantage of lower wage rates. The results are still on balance likely to be good for the U.S. and for the losing areas, North or South. There are four reasons:

1. Profits come home from the foreign location to the United States. Even if they are first reinvested abroad, they will still ultimately come home.

2. By moving abroad, American capital is able to produce cheaper goods for the American consumer, who thus has a surplus income to buy other home-produced goods or services and thereby to foster new American jobs.

3. Opportunities open abroad for well-paid managerial and supervisory jobs for Americans in the migrated plants.

4. The dollars paid for these cheaper American-produced imports ultimately come home to buy other American goods or services. As export industries cannot be protected against foreign competition, it follows that their jobs have a sounder economic foundation than that of protected industries.

Thus, on balance, the movement of industry abroad, when based on a realistic assessment of relative costs, benefits the United States. As for the losing areas, the net effect is likely, except in the short run, to be beneficial for the same reasons as it is for the Snow Belt in the case of movement to the Sun Belt.

The Concept of “Social Responsibility”

What about the effect on “social responsibility” to which I referred above? This is sometimes the most powerful motivator of public opinion against both the “predator” and the plant mover. We need not here analyze the concept of “social responsibility” at length. We need only state what full analysis establishes, that it is fundamentally misconceived. Businesses have no right, still less a duty, to espouse “social responsibility” except where, as may well happen, it coincides with and promotes the purposes of lawful and successful business itself. The business of business is business, just as the business of a surgeon is surgery, not other problems of his patients. Business has no expertise in the solution of social problems, except where, as stated above, it coincides with genuine business purposes. Worse still, having no expertise in the matter, it is unlikely to be skilled or successful in its pursuit. Only citizens, acting individually or in relevant groups, have a right or duty to be concerned with social problems; and this includes businessmen, but acting as citizens, not as businessmen.

The ideas and influences which seek to inhibit the takeover process and the freedom of businessmen to move their firms where they will, are sure to undermine the production of wealth and its impact on the admirable purposes outlined in the Coolidge speech with which this article opened. How deplorable it is that just when the American people are in some measure beginning to learn to grapple with older interests and influences inimical to wealth production, they are in growing numbers pursuing the will-o-the-wisps to which these new debilitating influences beckon them!

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January 1989

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