Commentary / World

Should shareholders always come first?

by Noah Smith

Bloomberg

U.S. Senator Elizabeth Warren has proposed a bill — the Accountable Capitalism Act — that would require large companies to create corporate charters that take account of the interests of workers, customers and communities in addition to shareholders. To enforce this dictum, it would give each company’s employees the power to elect 40 percent of the corporate directors.

Right now, U.S. corporations are set up to maximize the value of their shareholders. According to classic free-market theory, this will lead to companies maximizing their profits over the long term, which will be economically efficient. But Warren’s idea starts from the premise that society will be better served if workers are treated as vital stakeholders in the companies that employ them. Under her proposal, employees would be able to elect their own representatives, meaning more power and money for them and less for managers. This would be similar to the co-determination system used in Germany, although Germany also has other important systems for labor representation, such as workers’ councils.

Co-determination has potential benefits. The obvious one is distribution — countries with co-determination policies tend to have lower income inequality. This is just a correlation — countries that embrace the policy might also have societies that are egalitarian in other, more important ways — but it could be partly the result of workers pressuring their employers to reduce profits and executive compensation. Evidence on this point is inconclusive — some research papers find that companies with labor representation on their boards have lower stock market value, while others find no correlation.

Another potential upside is higher worker satisfaction and productivity. Worker representation on boards might allow companies to take better advantage of the specialized insider knowledge that workers possess. It might also give workers more of a sense of ownership and pride in their companies. Finally, workers might prize long-term performance more than fickle investors. Some studies show an association between co-determination and performance-based compensation, while others find productivity gains.

Free-marketers have been quick to attack the proposal. Some critiques, like National Review writer Kevin Williamson’s declaration that Warren’s plan would “nationalize every major business in the United States of America,” are wildly off-base. The Warren plan wouldn’t nationalize a thing; it would simply change the balance of power on corporate boards.

Other critiques, however, are more reasonable. Samuel Hammond, also writing in the National Review, worries that the plan would reduce productivity by giving American companies an incentive to stay small (since only large companies would be forced to include workers on their boards) thus preventing them from taking advantage of economies of scale. He also raises the possibility that co-determination would prevent new U.S. companies from growing fast or pivoting to new lines of business, ceding the industries of the future to countries like China. He notes that Germany failed to translate its dominance in mechanical and chemical engineering to dominance in the information-technology industry, and suggests that co-determination could be a reason.

These are legitimate worries. There’s another danger that Hammond doesn’t mention — co-determination could make American companies less resilient to economic shocks. Presumably, workers would push their companies to raise wages and operate at lower profit margins. This would increase equality in good times, but it might deprive companies of a financial cushion that they could use to weather bad times. A 2010 paper by Gary Gorton and Frank Schmid finds that companies with co-determination use more leverage, which makes them more vulnerable to economic shocks.

It’s also worth mentioning that other countries have moved in recent years more toward the shareholder-value system that prevails in the United States. Germany hasn’t discarded co-determination, but in the 1990s and early 2000s it implemented laws aimed at boosting shareholder value, while more corporate managers started publicly emphasizing the concept. Meanwhile, Japan — which never had co-determination but used to have very passive shareholders, low profit margins and boards dominated by management — has introduced a new corporate governance and stewardship code in order to strengthen outside control of management and make companies focus more on shareholder returns. It may be that countries like Germany and Japan went too far in the direction of stakeholder capitalism, while the U.S. focused too much on shareholder value, and now it’s time for a convergence between the two.

Co-determination, if adopted, would mark a big shake-up in American capitalism, with some opportunities and some dangers. Given the uncertainties involved, and the size of the change, the most prudent course of action might be a more gradual implementation. Instead of requiring every large U.S. corporation to embrace co-determination, the government could create a framework for worker representation on boards, and encourage it with tax incentives. That would help American companies experiment with methods of implementation, and allow policymakers to directly compare the performance of those that embraced the policy with those that eschewed it. After that, policymakers could make a more informed decision about whether imposing co-determination on all U.S. companies would be worthwhile.

Noah Smith is a Bloomberg opinion columnist.