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William J. Bernstein

The Stakeholder Effect

The American economy is the most prodigious wealth machine in the history of the planet. Real U.S. per capita GDP—the best historical measure of the financial health of the average citizen—has risen by 1.89% per year since the founding of the Republic. Thus, the material well-being of the average U.S. citizen has doubled every 37 years. Remarkably, over the long run this miracle has proven nearly impervious to foreign invasion (1812-14), civil war, global catastrophe and, yes, even a dramatic increase in the portion of GDP consumed by the state.

Economic libertarians will be distressed to note that this trend was not disturbed after 1930, when government began getting its greedy hands on an ever-increasing slice of the national economic pie. In that year, government expenditure (federal, state, and local) consumed 9% of GDP, compared to 29% last year. The paradox of steadily increasing prosperity in the face of burgeoning statism raises issues that are profoundly relevant to the current uproar over alleged corporate malfeasance. Hint: It’s not good news if your name happens to be Lay, Fastow, or Grubman.

Let’s start by examining that great engine of modern Western prosperity: property rights guaranteed by rule of law. I define "property" in the broadest possible sense: financial property, real property, intellectual property, and business assets of all kinds. And by "rights" I mean two things: the presence of legally unassailable title and "alienability"—the right to transfer ownership to someone else at will.

At first glance, the institution of property rights seems to be an unalloyed blessing. Alas, it is not. Property rights are expensive to maintain. In the unlovely jargon of economics, there are "enforcement costs": an extensive judicial system, police and, at times, even the military and national security apparatus. Not infrequently, these costs exceed the economic benefits gained from securing alienable property. For example, in primitive hunter-gatherer societies, it is prohibitively expensive to protect ownership of huge tracts of land used by small populations. An oft-quoted example is that of the beaver-hunting Montagnais tribe in colonial Canada. For millennia, the cost of establishing individual property rights over vast swaths of beaver habitat greatly outweighed the modest economic benefits of these animals. By default, the tribe considered the beavers communal property, to be hunted by all. The arrival of the Hudson Bay Company, which offered astronomical prices for the pelts, changed all that; establishing private property rights for hunting grounds suddenly became a paying proposition. In modern society as well, some property rights may simply be too expensive to maintain: downloadable music comes most easily to mind.

More importantly, the costs of enforcing property rights vary greatly among societies. In relative terms, it is far cheaper to protect property in the United States than in Afghanistan; in Kansas City, all that is required is local police, while Kabul requires Special Forces commandos. The difference between Kabul and Kansas City is that in the latter, most people perceive themselves as stakeholders—law-abiding citizens with a real interest in ensuring the safety of everyone’s possessions, not simply their own. Where there are many stakeholders, few steal and it is easy to secure property. On the other hand, where the populace is disaffected and highly distrustful of the economic system, it becomes prohibitively expensive to secure property rights, and the economy suffers accordingly.

I submit that the stakeholder effect is the core reason why the United States economy has proven impervious to seven decades of increasing government involvement. Yes, inefficiencies have resulted from the dead hand of the state claiming an ever-larger portion of the economy. But most of that activity pertains to middle-class entitlements. Assuring citizens that they will not starve or lack shelter goes a long way towards insuring that they will maintain their "stakeholder mentality."

The stakeholder mentality is far more fragile than we imagine. As Harvard Law School professor Mark Roe points out in his upcoming book, Political Determinants of Corporate Governance, at the turn of the last century, Argentina had the world’s eighth highest per-capita GDP. Its debt obligations ranked among the most secure in the world, and commentators opined that its political stability was as high as Britain’s. Europeans immigrated there in droves. At the time, it was not immediately obvious that Argentina’s land ownership was highly unbalanced. When the Depression hit, millions of landless tenant farmers streamed into the cities in search of work and became sitting ducks for Juan Perón, who pandered to them shamelessly, derailing a once flourishing economy.

Which gets us to the current political and legal detritus from the collapse of the tech bubble. The mere perception—never mind the reality—that a small number of wealthy, well-connected scoundrels can ruin the lives of tens of thousands and financially savage millions, threatens the stakeholder mentality in a way that few calamities can. Pursuing these alleged miscreants in the most vigorous and humiliating form possible is a cheap and easy method of preserving the stakeholder effect and, thus, our priceless heritage of property rights. Is this not also class-warfare and scapegoating of the worst sort? Perhaps. Is it necessary to the survival of our market economy? Absolutely.

Plus ça change, plus c’est la même chose. After the collapse of the South Sea Bubble, dozens were sent to the Tower, including four MPs. Many saw their profits confiscated, in clear violation of common law. Worst of all, Parliament passed legislation that inhibited capital formation and degraded market efficiency for generations thereafter.

The 1929-1932 bear market produced a similar spasm of Old Testament justice: The president of the New York Stock Exchange went to Sing Sing and many other high rollers met even more ignominious ends. In contradistinction to the earlier British experience, the legislative fallout—the Securities Acts of 1933 and 1934 and the Investment Company Act of 1940—helped make the U.S. capital markets the envy of the world. Recent events have led some to propose mandatory instruction in business ethics for MBA students; it would be far more effective to offer them courses in financial history.

Professor Roe suggests that while certain "temporary" legislation, like Glass-Steagall and branch-banking restrictions, might not make Milton Friedman leap with joy, the economic and ideological losses can be considered a noble and necessary sacrifice in the name of a far higher cause: the preservation of the stakeholder effect and, thus, private property and the free market system itself.

The fact remains that the survival of our market economy requires, on occasion, a brutal and heavy-handed response to even the perception of financial misbehavior. Support for this notion abounds. For example, researchers from Harvard, Yale, and the University of Chicago have recently found that in 27 developed nations, the mere presence of laws against insider trading did not reduce the cost of corporate capital; enforcing those laws did.

The maintenance of property rights can be both a cornucopia and a curse to those who benefit most. On a per-capita basis, corporate executives profit more from property rights and the rule of law than almost any other segment of our society. It is critical that they understand this is a two-edged sword and behave accordingly.

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