Origins of Corporate Governance: west and east

1. Ugo Pagano University of Siena and CEU Origins of Corporate Governance: west and east Vienna, 2010.

3. From politics toeconomics (Mark Roe) According to Mark Roe corporate governance is influenced by the political conditions of a country and in particular by its degree of “social democracy” including such things as employment protection, union representation, redistribution ecc.). Public companies, characterised by fragmented ownership and separation between ownership and control, are only possible if managers are not captured by the interests of employees that is when its degree of social democracy is low.

4. From economics to politics Belloc M., Pagano U. (2009) Co-evolution of politics and corporate governance. International Review of Law and Economics  v. 29 pp. 106-114. Roe’s argument can be inverted: In firms where there is separation between ownership and control, family and other social ties are less important. A meritocratic system may prevail in the firm and union protection is not important. By contrast: when there is no separation between ownership and control, family and social ties become relevant and non-owners need to be protected when they work for the firm.

5. Empirical results: a question. In Belloc Pagano (2005) we show that both directions of causation hold and are robust. The direction of causation from politics to corporate governance is “stronger” when the US are included. The direction of causation from corporate governance to politics is stronger when European countries (especially Italy) are included. Question: If model of corporate governance and politics influence each other, is there a set of “original conditions”, which may push a national economy along a certain institutional path?

6. Political origins matter. By political origins we mean the political and social conditions under which big enterprises emerged. They may give the initial conditions for this process of cumulative causation between the corporate governance and politics. They are largely due to the conditions that characterized the different agrarian societies from which different models of capitalism emerged. We will distinguish here between two “families” of political origins but the situation is obviously much more complex.

7. Aristocratic Origins. • Because of the dominance of the landed aristocracy, society is characterized by a high concentration of economic and political power and by the rule of dynastic succession. Upward mobile individuals are despised. • When, in some sectors, large industrial firms become a superior form of organization, the possibility of concentrating capital ownership is not challenged by the political system and a new industrial aristocracy emerges. • Workers reactby organizing unions and social-democratic parties.

8. Democratic Origins. • Society’s wealth is relatively dispersed and political poweris attributed by some democratic mechanism. Rule of dynastic succession is confined to small firms and upward mobile individuals command high social esteem. • The concentration of economic power, due to to the emergence of big business, is confronted by political opposition and by an effort to limit its impact. • Workers’ incentives to organize unions and class parties are consequently weaker.

9. Concentrated equilibrium. In the case of aristocratic origins, the concentration of ownership anticipates and is likely to be the “first cause” of (social)-democratic policies. However, once social-democratic policies have been developed, causations flows also in the opposite direction. Because of the concentration of the “workers’ interests” the owners can have appropriate safeguards only if their interests are also concentrated. Delegating control may imply that managers are captured by organized workers. Concentrated ownership Organized workers’ interests

10. Dispersed equilibrium. In the case of democratic origins, active democratic policiestend to pre-empt the concentration of capital. The dispersion of capitalist interests is likely to decrease the incentive to organize workers’ interests. However, once workers interests are disorganized, causations flows also in the opposite direction. Because of the disorganization of “workers’ interests” owners can have appropriate safeguards even if their interests are dispersed. Delegating control does not entail the risk that managers are captured by organized workers. Dispersed ownership Disorganized workers’ interests

11. Political Origins and Entrenchment • Aristocratic or Democratic Origins may imply that an economy may be entrenched in a concentrated or dispersed equilibrium. • For instance, in a concentrated equilibrium, it may be impossible for capitalist to “disperse” their assets because workers are organized and for the workers to “disorganize” because capitalist ownership is concentrated.

12. Forms of Entrenchment There are many forms of entrenchment. See: Morc Wolfezon, Yeung Corporate Governance, Economic Entrenchment, and Growth. JEL 2005. Here I consider one form of entrechment that draws from: Pagano U., Rowthorn R. (1996) The Competitive Selection of Democratic Firms in a World of Self-Sustaining Institutions. In Pagano U., Rowthorn R. eds. Democracy and Efficiency in the Economic Enterprise, Routledge, London pp. 116-145. Earle J., Pagano U., Lesi M. (2006) Information Technology, Organisational Form, and Transition to the Market. Journal of Economic Behavior and Organisation Vol. 60 pp. 471-489. This form of entrenchment joins together the contributions of New-Institutional and Radical economists. Their relation with the Marxian theory of modes of production is considered in: Pagano U. (2007)Karl Marx after New Institutional Economics. Evolutionary and Institutional Economic Review. 2007 pp.27-55.

13. Political origins and Specificity. In New Institutional and New Property Rights theory, private governance is not influenced by politics. It tends to react efficiently to technological characteristics such as the specificity of resources. Corporate Control is efficiently acquired by the most specific owners that value it the most. Technology -----> Corporate Control Politics -/---/---/-> Corporate Control and technology In this situation, political origins cannot entrench the economic system.

14. Inverting the argument. • In the standard framework, politics does not matter because technology is neutral and it is not influenced by property rights. • However, the New Institutional argument can be inverted: agents that acquire Corporate Control will tend to choose a technology where they become more specific. Both direction of causation are possible: Corporate Control <------> Technology Corporate Control and Technology define now different organizational equilibria that can be affected by political origins. Politics -----> Corporate Control and Technology

15. Concentrated equilibrium and specific investments. • In this situation controlling owners and workers have strong safeguards and may make high specific investments. In turn, these investments increase their effort to reinforce these safeguards. • By contrast non-owning managers have weak safeguards and make few firm-specific investments which, in turn, implies that managerial safeguards stay weak. • Both mechanisms of cumulative causation entrench the firm in a concentrated equilibrium

16. Dispersed equilibrium and specific investments. • In this situation, controlling owners and workers have weak safeguards and make low specific investments which, in turn, implies that managerial safeguards stay weak. • By contrast non-owning managers have strong safeguards and make considerable amounts of firm-specific investments. In turn, these investments increase their effort to reinforce these safeguards. • Both mechanisms of cumulative causation entrench firms in a dispersed equilibrium

17. Size of the firm. • In a “concentrated equilibrium” the size of the firm may be relatively small. In spite of many instruments such as pyramids and different classes of shares, families dynasties, seeking to keep the control of the firm, may still have to limit its size and efficiency. • The dispersion of ownership may be a condition for concentrating firms beyond a certain size.

18. Aristocratic origins: the British case. • In England the landed aristocracy was leading the initial process of modernization and a “puritanic revolution” that eventually led to the establishment of a parliamentary democracy. • Because of this flexibility, inherited wealth and all sorts of dynastic privileges had a strong legitimacy at the time of the second industrial revolution. Members of the aristocratic families were controlling firms well beyond their financial possibilities. • Workers were soon organizing unions and working class parties.

19. Aristocratic origins: the French case. • Unlike the British aristocracy, the French aristocracy continued to rely on traditional feudal privileges. In Britain a mutating aristocracy carried out the process of modernization against the king. In France the an absolute monarchy imposed the modernization against the king. • The French revolution gave a democratic turn to the modernization in France but the post-Napoleonic reaction implied that at the time of the second industrial revolution, class barriers and aristocratic political privileges were still important in France. • Workers reacted with the organization of unions and various rebellious activities.

20. Aristocratic origins:other European cases. • In other European countries, which industrialized later, the weight of the aristocracy, was even heavier. • In England the landed aristocracy adopted many entrepreneurial habits. The opposite relation held in Germany. The members of the bourgeoisie, who became connected with the aristocracy generally absorbed its habits and outlook. • Because of this behaviour, by the second half of the nineteenth century, the process of democratization was not only incomplete but also very uncertain. The “German concentrated equilibrium” took a much more authoritarian and tragic path.

21. Democratic origins: the U. S. exception. Becht and De Long (2005) mention two aspects of American exceptionalism: “A century ago academics like Werner Sombart worried why the United States was exceptional in that it did not have socialism. Today we academics worry about a different form of American exceptionalism: why is there so little block holding in the United States?” Both exceptions are the ingredient of a “dispersed equilibrium” and can be traced to a third American exception: the democratic origins of its corporate governance system.

22. American Democratic Origins. • Since the early beginnings, the British North American colonies had been a refuge from aristocratic and ecclesiastical authority. • Moreover, by the time of the second industrial revolution, the United States had undergone through two major democratic revolutions: the war of independence and the civil war. • The Northern States had no landed aristocracy but numerous educated land owning farmers. • By the time of the second industrial revolution, the slave-owning aristocracy of the South had lost its economic and political power.

23. The American Reaction to the growth of Big Business. The U. S. had already antitrust law in 1890 (Sherman act), which was reinforced by the 1914 Clayton act. According to section 7 of the Clayton Act the ownership of one corporation of stock of another is forbidden whenever “the effect of such acquisition stock by the voting or granting of proxies or otherwise, may be substantially to lessen competition, or tend to create monopoly”. Wealthy owners diversifying in related business were considered with suspicion and the road of pyramids (as well as others!) were made more difficult than in Europe. Diversification could be above antitrust concerns only if it was such that the diversifying owners were losing the control of their business. Otherwise the possibility of “self-dealing” could have easily attracted the attention of the antitrust authorities.

24. FDR and the Elimination of Pyramids. • The first Roosevelt administration associated pyramidal business groups with corporate governance problems, market power, and an objectionable concentration of economic power. • The double (and multiple) taxation of dividends paid by one firm to another (intercorporate dividends) was explicitly included in the 1930s as a part of a package of tax and other policies aimed at eliminating United States pyramidal business groups. (Morck NBER 2004).

25. A unique Anglo-Saxon model? • Is there an Anglo-American model (rooted in common legal and cultural origins) which marks the “end of history” for corporate governance? • Even if the U. S. and U. K. share many things, their histories is substantially different. The British aristocratic families kept control of the firms well beyond the the shares that they owned and, according to Chandler, “family capitalism” was the main cause for Britain’s failure to continue to be a world leader at the time of the second industrial revolution.

26. Britain could have stayed “continental”. • Eventually, family ownership became so diluted that, post-war U. K. had become a “disequilibrium model” with dispersed ownership and strongly organized labour. In the 1950ties and 1960ties there were evident signs that the Britain could move towards a continental model, characterized by pyramids and different classes of shares. • British history proves that there is no unique “anglo-american” model based on common “legal origins” and eventually including countries like India where “common law” was exported during the colonial period.

27. An Anglo-American convergence? • However, in the eighties, with Margaret Thatcher Britain took a different road. The two declared objectives of her government were a “shareholder democracy” and the weakening of the unions (a policy that has not been substantially reversed, after 1997 by Tony Blair). • Britain has settled to a new equilibrium where a system of partial dispersion of ownership meets a partial weakening of the power of the unions. • There is still a considerable divide between the US and UK , even if the two countries are the closest ones in a line which plots the relationship between employment protection and ownership dispersion……….

28. A general convergence? • Britain’s partial movement towards the U. S. “dispersed equilibrium” may still suggest that some convergence may be taking place, perhaps more so under the pressure of “globalization”. • However, one can also argue that a global economy entails that each country may specialize in those sectors were the safeguards (and the related specific investments) of its corporate governance system are more appropriate. • At this stage, it is difficult to say whether globalization implies disregarding or rediscovering “political origins”.

29. How does India fit in this story? • I would like to submit to you the hypothesis that India fits the case of aristocratic origins. Industrialization is happening at the time when class and cast differences are very pronounced. • Like in continental Europe, Political Democracy is helping the emergence of a concentrated equilibrium where the power of the new industrial aristocracies is balanced by all sorts of social and political organizations. • Indeed, India was integrated in the British model and its casts reinforced by British domination. Barriers were even stronger than in Europe.

30. And China? By contrast, China seems to fit more the American model. Social mobility was always greater than in India. Confucius santified the founding fathers (the five emperors) and introduced the concept of celestial mandate. The State is stronger and both capitalist dynasties and unions obviously weaker than in India.

31. The hypothesis: • More than Asian capitalist values different from the West, there are two models with aristocratic and democratic origins: • 1) The Chino-American model. • 2) The Indo-European model The idea must be handled with some caution but I am sufficiently crazy to try to write a paper on this topic........