Finance In The Neoliberal Order

If I had to summarize the essence of the neoliberal order, the prevailing economic thought for the past forty years, I would argue that it allowed private, especially shareholder, profits to become its central organizing principle.  In this mission it did not have a more loyal handmaiden than finance, both as an academic discipline and a practiced profession.

These thoughts came back to my mind after learning of the passing of Michael Jensen, one of the most influential finance academics and a driving force behind placing finance at the center of the neoliberal order.  The other driving force was Eugene Fama, the 2013 Nobel Prize winner in economics.  Fama has been the high priest of capital market efficiency, that is, the theory according to which the prices of financial securities, like stocks and bonds, reflect the aggregate information of all buyers and sellers in these markets.  As such, prices give reliable signals to firms and investors about the values of firms and other assets.  The Great Recession of 2007-2008 put this theory to its toughest test and many economists found it wanting. 

For Jensen, the villains were entrenched executives who having to choose between an option that aligns with their interests and one that enhances shareholder value they will opt for the former.  In 1976, Jensen came up with the so-called agency theory that exposed the conflicting interests of managers and shareholders and suggested that the most effective way to align the interests of the two parties was to turn managers into shareholders.  This could be accomplished by granting executives stocks and options to buy stocks.  This way value maximization would be the common goal for shareholders and executives.   By the early 2000s, in the wake of the Enron debacle and other managerial abuses, Jensen had come to regret the corruptive effect of stock options which he called managerial heroin. 

As with many “great” ideas the law of unintended consequences had spoiled expectations.  Although the agency theory was sound, it became the spring board for executive compensation packages that blasted away any measure of moderation.  The result was exorbitant compensation packages which are still central in our current discontent with inequality.  In the 1960s, executive compensation averaged around 20 times the average worker salary.  By 2000 it had reached its highest level at 366 times.  Was there any credible evidence the new industry captains were that superior compared to their predecessors? Hardly.  In the earlier decades the American economy had thrived and the productivity gains were shared fairly between profits and wages.  More corrosive, though, was the moral hazard problem the new compensation schemes created for executives.  If their wealth depended on the value of the firm’s shares, why not attempt to boost their value by unethical, even unlawful, means.  Misinformation, lack of transparency, pursuing irrational risks, could be employed to boost stock prices and executive wealth.  The Enron and similar cases around 2000 and the housing crisis of 2007-2008 had the finger prints of such moral failings. 

Creating corporate efficiency by aligning the interests of executives and shareholders was not sufficient for value maximization.  What about firms that continued to operate under inefficient managers?  Wouldn’t it be better if these firms were put under the control of more successful executives?  Michael Jensen was again influential in shaping and promoting the corporate control theory and its business applications.  Corporate takeovers facilitated by investment bankers and funded by private equity firms, hedge funds, and the infamous junk bond markets became the tool that held the promise for new value creation.  Hundreds if not thousands of finance research papers provided the empirical justification as they amassed lots of evidence that this type of creative destruction indeed created new value.

Finance practitioners and academics started to view firm balance sheets as if they were made of Legos.  Move these pieces here and there, spin off or sell some businesses, go offshore, take on more debt, pay hefty dividends, this was the new language of finance.  The problem with these restructurings was not that they did not produce profits, at least in the short run.  The problem was that they were evaluated with one beneficiary in mind, that is, the shareholders.  No wonder, therefore, the empirical studies found supportive evidence.  

What was left out though was any negative consequences for other stakeholders.  The laid off workers, the hollowed towns, the decayed social fabric of previously bustling industrial hubs, the deaths of despair caused by alcohol, opioids, and suicides.  From the 1950s to the 1970s, under the bargaining power of labor unions, corporate executives had accepted a social contract of reasonable shared prosperity.  The neoliberal order had nothing to do with that.  Markets were supposed to operate with as few rules as possible and everyone was supposed to fend for him/herself.   Entrepreneurs, the so-called producers, were responsible to organize businesses for maximum profits and workers had to retool themselves and follow businesses to their new more profitable locations.  Of course, that was impossible if the new locations were in Mexico, India, China, and Southeast Asia. 

The question is why finance academics followed this narrow perspective.  By the early 1980s, finance professors had soured on managerial power and they had concluded those post-War II executives were sacrificing value to build corporate empires and accommodate generous union contracts.  For conservative academics the choice was easy.  Economic efficiency had to be restored and unfettered markets were the best instrument to that end.  Liberal finance academics just rode the wave of the New Left (a term found in Gary Gerstle’s The Rise and Fall of the Neoliberal Order) which also counted on markets and entrepreneurship to set creativity free for the new digital age.  In addition, creating a global economy and lifting all boats around the world was a commendable economic project.

With hindsight, we can contemplate the flawed consequences of putting so much faith in capital markets and the ability of managers to strike a fair balance between the private and the common good.  The reality, though, is we all followed in the intellectual footsteps of Fama, Jensen and the mantra of shareholder value maximization.  I am not sure how present finance academics think about the social responsibility of their craft, but I hope they have learned what we missed.