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August 20, 2014 |
Everyone from Warren Buffett to Robert Reich is talking about a favorite Wall Street trick called stock buybacks. But what are they and what do they mean to you?
William Lazonick is a leading expert on the history of the American business corporation. A professor of economics at the University of Massachusetts Lowell, where he directs the Center for Industrial Competitiveness, he has long been watching a trend that has only recently been attracting media attention and forcing many to reassess the nasty form of capitalism that has been unleashed on us in recent decades.
In an email interview with Lazonick, I asked him about how the widespread and little-understood obsession with stock buybacks among American executives is driving inequality and pushing prosperity further away from everyone except those at the very top. (Lazonick's in-depth exploration of this topic is available in thecurrent issue of theHarvard Business Review.)
His answers are a clarion call for changing the way America does business.
Lynn Parramore: You’ve been studying stock buybacks over the last 30 years. What exactly are they and why are you so interested in them?
William Lazonick: Let me start by answering the second part of your question first (in part because if I had just been studying stock buybacks over the past 30 years, I would be bored out of my mind by now).
In the mid-1980s, I was at Harvard Business School (HBS), working with the Business History Group led by the preeminent business historian Alfred D. Chandler, Jr. Previously I had spent 14 years as a graduate student and faculty member in the Harvard Economics Department where the main focus of my work was, as it remains, the role of business enterprise in the development of the economy. In working closely with Chandler, who in 1977 had published his pathbreaking book The Visible Hand: The Managerial Revolution in American Business, I learned five crucial lessons about my subject.
1) From the last decades of the 19th century, the growth of major business corporations drove the development of the U.S. economy.
2) Professional salaried managers controlled resource allocation in these business corporations, and hence their decisions determined the direction and intensity of corporate investment strategies.
3) The key investments that these executives made were in organizational structures made up of employees who had the abilities and incentives to engage in collective and cumulative learning.
4) The financial foundation for making these long-lived investments in organizational capabilities was after-tax earnings retained out of profits.
5) Public shareholders who received a portion of after-tax profits in the form of dividends were rentiers who had nothing to do with the investment strategies and organizational structures that would determine the success, or possibly the failure, of these companies.
By the mid-1980s, I was already a longstanding critic of the conventional theory that argues the "invisible hand” of markets will allocate resources to their most efficient uses in the economy. Rather, in line with Chandler’s notion of the "visible hand,” employment opportunities and standards of living depend on the resource-allocation decisions of executives who run large business corporations.
Based on 2007 data (the most recently collected), 1,925 companies in the United States that employed 5,000 or more people represented just 32-thousandths of one percent of all companies, but had 33 percent of all business employees, 37 percent of all business payrolls, and 43 percent of all business revenues. How the executives in control of these very large corporations allocate resources has a profound impact on how the economy performs.
In 1991, based largely on papers I presented at the HBS Business History Seminar over a six-year period, I published a book, Business Organization and the Myth of the Market Economy, in which I drew out the implications of the Chandlerian perspective (informed also by economists such as Marx, Marshall, Schumpeter, and Penrose) for a theory of how managerial capitalism can support stable and equitable economic growth.
Meanwhile, at HBS in the last half of the 1980s, I witnessed first-hand how free-market ideology became dominant in the teaching of MBAs. Legitimized by a new ideology that for the sake of economic efficiency corporations should be run to “maximize shareholder value” (MSV), a breed of Chicago-trained economists known as agency theorists argued that U.S. corporations should disgorge their cash flow to shareholders, not only in the traditional form of dividends, which reward shareholders for continuing to hold their stock, but also in the form of stock buybacks, which, by manipulating the company’s stock price, reward “shareholders” for selling their stock. Agency theorists argued that incumbent managers could be induced to disgorge corporate cash to shareholders either by the stick of a hostile takeover or the carrot of stock-based executive compensation.
I was one of the first academic critics of MSV. It is an ideology that argues for the allocation of corporate cash to those economic actors, public shareholders, who matter least to economic performance. I realized that MSV was not actually an ideology of public shareholders, either as individuals or institutional investors (for example, pension funds). Rather it quite quickly became an ideology of top corporate executives. If, as has certainly been the case since the 1980s, the companies that they control face new competitive challenges, they can just lay off thousands of long-serving employees, use corporate cash to manipulate their companies’ stock prices through stock buybacks, and join the top 0.1% of the richest households with their ample stock-based pay. It is a corporate allocation regime I call “downsize-and-distribute.”
That, in a nutshell, is what my article in the current issue of Harvard Business Review is all about.
What exactly are stock buybacks? As I explain in the HBR article, some stock buybacks, done as tender offers, can actually reinforce the control over resource allocation of executives who want to “retain-and-reinvest.” They retain corporate earnings, and reinvest in the productive capabilities of the companies that they control. Warren Buffett used tender offers in this way in the 1980s to take complete control of the insurance company Geico, which has been a key business for financing the growth of Buffett’s conglomerate Berkshire Hathaway (of which Geico became a wholly owned subsidiary in 1996). “Retain-and-reinvest” is what enabled large numbers of Americans (especially white males) who had secure career employment with corporations in the post-World War II decades to enjoy higher standards of living.
But that era of relatively stable and equitable economic growth is now gone, and the trillions of dollars that corporations have spent over the last three decades on open-market repurchases, which constitute at least 90 percent of stock buybacks, reflect the dominance of a “downsize-and-distribute” corporate allocation regime that is largely responsible for the concentration of income at the top and the disappearance of middle-class employment opportunities. Open-market repurchases have one, and only one, purpose: to manipulate a company’s stock price. And, with ample stock-based pay through which they can realize gains from a volatile stock market, prime beneficiaries of this mode of corporate resource allocation are the top executives who make the decisions to do buybacks, often on the scale of hundreds of millions of dollars per day when it suits their purpose to give their company’s stock price a manipulative boost.
LP: How do stock buybacks enrich CEOs at the expense of workers?
WL: On its Executive Paywatch website, the AFL-CIO charts the average pay of CEOs of major U.S. corporations to the average American worker, and for recent years has come up with a ratio of about 350:1. Actually, if executive pay is measured properly, the ratio is around 900:1. Even at 100:1, however, it would be way out of whack in cross-national and historical comparison. But a focus on the CEO:worker pay ratio misses the point. It is not the amount of pay CEOs rake in that causes untold harm to workers. It is how they get that high pay that is the major problem.
Let’s say (hypothetically) that by doing a billion dollars in open-market repurchases over several days, a CEO can boost his or her stock-based pay by $50,000 annually. It’s the billion dollars of buybacks that cost workers pay increases, career opportunities, and maybe even their jobs. The extra $50,000 in stock-based pay to the CEO is just an outcome, and redistributing some of that income to workers after the fact of corporate resource allocation will not restore the career employment opportunities that they have lost.
In my research, I provide lots of examples of ways in which a downsize-and-distribute corporate resource allocation regime characterized by massive stock buybacks hurts most Americans not just as workers but also as taxpayers. As a case in point, it is well known that in the United States, the price of pharmaceutical drugs is at least twice as high as anywhere else in the world. From time to time, this discrepancy has become an issue in Congress, with the drug companies responding that the profits from the higher drug prices enable them to do more drug R&D in the United States. Yet, even after paying dividends, it is not unusual for a major drug company to spend 50-100% of its profits on buybacks. To make matters worse, through the National Institutes of Health, American taxpayers provide critical R&D inputs to drug companies to the tune of $30 billion per annum. In effect, as both consumers and taxpayers, ordinary working households pay high drug prices so that corporate executives can do massive buybacks that serve to pump up their own pay.
LP: Take the case of a company like Apple. How do its stock buybacks impact ordinary Americans?
WL: In its history as a publicly listed company going back to 1980, Apple did a lot of buybacks from 1986 through 1993, and then got into major financial difficulty. When Steve Jobs returned to the company in 1997, he eschewed buybacks and dividends, and the rest is history. Since April 2013, under CEO Tim Cook, Apple has put in place two buyback programs totaling $90 billion, and through June 2014, in just over a year, the company has repurchased $51 billion. Nevertheless, Apple remains a highly profitable company, with $164 billion in cash and securities at the end of June 2014. So why not “return” some of these billions to public shareholders? Here’s why not:
Except for $97 million that Apple raised in its IPO in 1980, public shareholders have never invested in the company. So why should the company “return” money to non-investors? Apple’s investors have been taxpayers through government expenditure on science and technology and workers through their involvement in organizational learning. The public pressure on Apple to disgorge its cash to shareholders has come from corporate predators (aka hedge fund activists) such as David Einhorn and Carl Icahn who have taken big stakes in Apple’s shares, but have never made any contributions whatsoever to Apple’s competitive success. They are value extractors, not value creators. The gains they can extract as Apple does massive buybacks to manipulate the price of its shares will flow into a financial system in which those funds will be mobilized to extract even more value from Apple and other companies in which the financiers played no roles in productive investment.
From this perspective, Apple is part of a productive economy that in large part through stock buybacks has permitted the growth of a financial economy that, as we saw in the Great Financial Crisis, systemically reaps where it has not sown. And whatever Apple’s past and current success in selling its innovative products, its CEO and board are supporting the further financialization of the U.S. economy.
In the 1980s when a corporate raider such as Icahn went after a company’s assets, it was called a hostile takeover. We don’t hear the word “hostile” that much anymore because a CEO such as Apple’s Tim Cook, with $209 million from the vesting of stock awards in 2012-2013 alone, is not at all hostile to the wolves of Wall Street. They have joined together in the financialized feeding frenzy.
So that’s one big problem exemplified by Apple. Corporate executives have become self-centered and greedy – some have called them sociopathic – with apparently no interest in or understanding of the roles of taxpayers and workers in making their successful companies possible. Drunk on the ideology of MSV, they fail to see the relation between economy and society, and the central role of the business corporation in shaping that relation. I am doubtful whether such financialized corporate executives can have much of a vision about the innovative future of the companies that they head, let alone a vision of the path to sustainable prosperity of the society in which they are privileged and powerful participants.
As for all of the ways that Apple as a business enterprise could use its cash hoard rather than fuel the financialized economy with buybacks, let’s save that for another interview.
LP: You mention that stock buybacks took off with deregulation in the 1980s, particularly the SEC’s adoption of Rule 10b-18. How do we put this genie back in the bottle?
WL: As shown in research that I have done with Ken Jacobson, in 1981, with President Reagan’s appointment of Wall Street banker John Shad to head the SEC, this government agency was transformed from a regulator to promoter of the stock market. Shad, like the Chicago economists who influenced his thinking, really believed that a more unregulated stock market would be a more “efficient” stock market, mobilizing that nation’s savings for corporate capital formation.
Today, the SEC remains captive to this erroneous view of the world. A fundamental role of the stock market for business enterprises in the United States has been to permit private-equity investors to exit their investments in companies, not to bring in fresh capital to finance new investments in productive capabilities. SEC Rule 10b-18, passed under the radar in November 1982, encouraged companies to do large-scale buybacks to support their stock prices, and effectively legalized stock-price manipulation. As a result of buybacks, over the past decade net equity issues of U.S. stock markets have averaged minus $376 billion per year. Companies fund the stock markets; the stock markets do not fund companies.
How do we get the SEC to actually regulate manipulation and fraud, as is its mandate? I suggest that we start with a massive re-education of the economics profession on the relation between business organizations and stock markets in a successful economy. The intellectual and ideological issues involved go far beyond the particular use of stock buybacks as tools of value extraction.
LP: If we can’t curb buybacks, where are we headed?
WL: The current commitment of corporate executives to MSV, and their liberal use of buybacks to achieve that objective, can only serve to reinforce the orientation of U.S. business to “downsize-and-distribute.” The concentration of income among the 0.1% of richest households, among whom top corporate executives are by far the most numerous single group, will increase, while the 30-year-old erosion of U.S. middle-class employment opportunities will escalate as “retain-and-reinvest” companies in other parts of the world out-innovate their U.S competitors.
It is not that difficult to see where the United States is headed once we understand how, over the past three decades, we have gotten to where we are. More employment instability, more income inequity, and a gradual but perceptible decline in innovative capability. Sorry for the pessimism. I am by nature an optimist!
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