The biggest problem with shareholder value maximization is that it completely turns a tin ear to politics. The alternative is to maximize the value of long-term financial and non-financial investors in the firm—shareholders, of course, but also long-term debt holders, long-term suppliers, workers whose sweat equity is embedded in the firm, etc. It is important for the corporate board to make clear who these investors are, whose interests it will elevate above other stakeholders.
Editor’s note: To mark the 50-year anniversary of Milton Friedman’s influential NYT piece on the social responsibility of business, we are launching a series of articles on the shareholder-stakeholder debate. Read previous installments here. The following is based on a talk Raghuram Rajan gave during the Stigler Center’s 2020 Political Economy of Finance conference.
Every social problem we had before the pandemic has been exacerbated by it. We have rising inequality in many places. Many frontline workers are low-income, while better-paid people like us stay at home and work remotely.
There are many left-behind communities which have been hit hard. Many of the poorer countries in the world—Peru, India, Bangladesh—were hit by the pandemic. And we see the effects of climate change in the terrible pictures of red skies that we see from California.
We have paralyzed governments that can’t really seem to get their act together. In this kind of environment, there’s enormous pressure on corporations to do more than make a good widget, to move away from what Milton Friedman argued.
To some extent, the Business Roundtable in 2019 anticipated these pressures and came up with a statement that said, “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.”
Who could disagree with the statement? There was an interesting piece in the Financial Times, where the daughter of Shell’s CEO asked him, “You’re such a good corporation. Why don’t you sell out everything and give all your money to Greenpeace?”
According to the Business Roundtable statement, Shell’s adherence to the statement would be assured if Shell sold out its assets and gave all the realized money to Greenpeace—after all, Greenpeace is a stakeholder. What prevents that? Is the statement anything more than completely vapid? Unless a statement recognizes there are trade-offs and tells corporate management how to make those trade-offs, it’s vacuous. If everyone is essential or important, no one is.
The Business Roundtable statement is a nod to everyone and in that way, a nod to no one. There is a study by Wharton Professor Tyler Wry which seems to suggest this in fact the case. I haven’t been able to find the paper, so take this with a pinch of salt, but the headline finding cited in The Atlantic is that those who signed the Business Roundtable statement, in the first few weeks of the pandemic, were almost 20 percent more prone to announce layoffs or furloughs. They were less likely to donate to relief efforts, less likely to offer customer discounts, less likely to shift production to pandemic-related goods. In summary, signing the statement had zero pro-stakeholder effect.
In some sense, when Milton Friedman wrote 50 years ago, it was as if he was addressing this latest statement by the Business Roundtable. He said: “The businessmen believe they are defending free enterprise when they declaim that business is not concerned ‘merely’ with profit but also with promoting desirable social’ ends; that business has a ‘social conscience’ and takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers.” Then he says this is pure undiluted socialism, leading to his famous statement, “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game”—that is, it obeys the law.
To put that statement in context, Friedman was reacting to the Johnson administration exhorting corporations to stop raising prices in an attempt to combat inflation. Johnson thought that this was a national duty of corporations, and Friedman was doubly—or triply—incensed by this. First, the Chicago School believes prices are important, and he felt that tampering with prices would create more distortions. Also, given his theory of how inflation emerged, he thought price restraint by corporations would do nothing to combat inflation, because inflation was driven by the macro policies of the Johnson administration, which he disagreed with. In effect, corporations were being pressed to remedy the deficiencies of the government.
That was what he was reacting to. He believed that decisions driven by politics rather than the market were socialism, hence his statement.
Now it’s 50 years later, and it’s time to reassess. I would argue that Friedman has a point. He makes sense, but to a first approximation. We have to elaborate further to get closer to what is appropriate.
I will go through the argument in favor of Friedman and then move to the cons immediately after.
First, on the economic front, economists would tell you that shareholders are residual claimants. They capture the present discounted value (as some of our alums know) of long-term profits. So if you think of everyone else who contributes to the firm as fixed claimants, maximizing long-term shareholder value maximizes the value of the corporation to society. Now, that clearly means that we don’t run the firm into the ground for the benefit of shareholders. We do all the good things that people want us to do: we are nice to workers because workers are essential to the firm, make investments where appropriate, including long-term investments as in pharmaceutical research. It’s not about making every decision in the short-term in favor of shareholders—that may run the firm into the ground. It’s about the long term because the share price captures the long term.
As we go through the modern era, we have to question the statement a little. Shareholders are not always the residual claimants. Anybody who knows about the conflict between debt holders and shareholders knows that as a firm gets closer to distress, the residual claimants are really the debt holders, rather than shareholders. Continuing to make decisions in favor of shareholders at that time could actually reduce the value of the firm.
But more importantly, there are others who have made long term investments in the firm. In any human capital intensive firm, workers have made tremendous investments in the firm. And often, they become partners in the firm—sometimes they are explicit shareholders, sometimes they are implicit shareholders since their “sweat equity” is not formally recognized. Thinking about the firm in this way, about those who have made long-term investments, implies that it is not always appropriate to choose shareholders over these other claimants. Sometimes, both are residual claimants, and the board will have to choose one over the other, not always favoring the shareholder.
Another pro of Milton Friedman’s statement is that relative to the vacuous statement by the Business Roundtable, it may be relatively easy to monitor management when it has a well-defined goal such as shareholder value maximization. If I’m told basically to be good to anybody, how do I prevent management from giving away the firm to Greenpeace? Not clear. With shareholder value maximization—much more clear. Again, one can dispute this supposed clarity, because courts have often refused to intervene in the decisions of management. Their view is that what constitutes shareholder value maximization is not absolutely clear, and therefore we defer to corporations and allow them to use their business judgment. This argument in favor of Milton Friedman can also be overstated.
A third argument that is often emphasized is that when management focuses on maximizing shareholder value, it creates value for shareholders, who can then decide what they want to spend on. In other words, it’s not management that decides on corporate social responsibility, giving to charity, or giving to their favorite football team. Their job is to maximize the share value, and then the shareholders take that money and spend it—it’s their wealth, they are the bosses of the managers, they should decide whether they want to give it to charity or to their favorite political parties. That is, again, a powerful argument.
Recently, Oliver Hart and Luigi Zingales have argued that even that is a little problematic. Consider Walmart’s shareholders. Walmart sells guns—or used to sell guns—and that creates crime. If guns create crime, what Milton Friedman would say is: Let Walmart sell all the guns it can to generate profits, those profits will go to shareholders, and they can spend that money on fighting the NRA or compensating the victims of gun crimes. Hart and Zingales would say: Well, isn’t it a shorter route, given that shareholders have this preference, to just stop selling guns and not first sell guns and then prevent the crime that results from that, which may be much costlier and much more expensive?
Similarly, there are situations where workers have preferences that conflict with shareholder value maximization. A most recent example is Google’s employees, who basically went against Google’s involvement in Pentagon-supported programs that used artificial intelligence and video imagery to target drone strikes. They said: This is bad, this is evil, we don’t want to be part of it. And essentially, Google went in favor of its employees, believing that they were more important than shareholders.
Finally, Milton Friedman thought that there was a political argument for shareholder value maximization, which keeps the role of the government and the role of the corporation separate. He thought that was important because he felt that corporate social responsibility was a backdoor way for special interests to push what they could not get through Parliament and therefore make rules for the firm which they could not make through legislation. In some sense, this is a very important argument because it says that sometimes, these pressures can be anti-democratic rather than pro-democratic—that because you’re frustrated in Congress or in Parliament, you might try to push that stuff through the backdoor by directly targeting corporations.
The reality is that not every political pressure comes through Parliament. It is naive, in some sense, and this is the con to this argument, to believe that the only way that corporations should be affected politically is by action through legislation. There will be pressure groups that will build up, especially if the corporation is consumer facing, in order to change the way the corporation behaves. There will be pressure groups even within the firm, as we just saw with Google’s employees, that change what the firm does. So it is somewhat naive to believe these interest groups won’t actually affect the firm. Corporations will have to take that into account.
And that leads to what I think is the deepest problem with Milton Friedman: shareholder value maximization means completely turning a tin ear to politics. It sounds sinister. It sounds pro-rich. It sounds evil, even if it may be the right thing to do for society under many circumstances.
So what’s the alternative? I would argue that it’s clear what the alternative is, and firms have been doing it for a long time. Not every firm, of course, but many. The alternative, in my view, is to maximize the value of long-term investors in the firm. This is different from the Business Roundtable statement, in that you can identify who these long-term stakeholders are. If you are a firm with a lot of impulse customers, they’re not your long-term investors—they come in and buy as they wish. If, however, you have long-term employees, they are long-term investors because their sweat equity is embedded in the firm. Similarly, shareholders, long-term debt holders, long-term suppliers, these are long-term stakeholders. A firm could say, when forced to choose between two stakeholders: I will choose the action that enhances the overall value of these stakeholders. In the case of Google, it valued its employees more than it valued that contract with the Department of Defense.
This has actual bite. You can identify your key stakeholders and state that. What is important is that once you say that, those stakeholders feel their interests are going to be taken more into account, and therefore will act accordingly. What this does is in the long run is maximizing shareholder value. For example, if a firm says: I’m going to be more trusting toward my workers and work on their behalf, they respond by choosing that firm over others. That firm attracts more talent, they demand less pay because they trust the firm to not squeeze them in bad times, and they respond by going the extra mile for it.
The problem is that like shareholder value maximization, this idea of maximizing the value of long-term investors is very sterile. It needs a more politically-appropriate appellation, for example, maximizing societal value. But the details matter: Who does the corporation consider to be the important, relevant parts of society? That differs for each corporation, and that’s really what the corporation should make explicit. Ultimately, a corporation sinks or swims on whether it makes a desirable widget, but in order to do this sustainably, it has to weigh the interests of a broader set of stakeholders than just the shareholders. Corporate boards should take pride in the investors they stand for. Being nice to everyone is, however, infeasible, meaningless, and simply deflection. That is what I take away from Milton Friedman.