Managing Decline: The Economy of Value Extraction
REVIEW ESSAY
How the Looting of the Business Corporation Became the U.S. Norm and How Sustainable Prosperity Can Be Restored
by William Lazonick and Jang-Sup Shin
Oxford University Press, 2019, 256 pages
As I sit down to write, the coronavirus has completely paralyzed the U.S. economy. At this juncture, most conversations that are not about the plague seem a little off point. But some—like the ones in William Lazonick and Jang-Sup Shin’s recently published book, Predatory Value Extraction—are having their moment, too. Yes, it’s time to talk about share buybacks. Because they are, as Lazonick and Shin argue so persuasively, key to capitalism’s future. When we’re rebuilding whatever it is we have left after this is over, we should probably leave buybacks out of it entirely.
While the book takes aim at an entire ideology of corporate resource allocation, its main argument is the same one Lazonick has been making for years: the American corporation has been looted—legally—via the profligate use of stock buybacks. If you didn’t believe it before, you should have as of March 21, when the airline industry sent a letter to Congress begging the federal government for $29 billion in grants and another $29 billion in loans. If you give us the cash, they said, we will place limits on executive compensation and eliminate buybacks and dividends over the life of the loans. The implication? That they would stop doing the opposite. Over the last ten years, the industry has distributed most of its free cash flow to shareholders via buybacks (and some companies even more than that).
But let’s get back to the book, shall we? If you had acquired a negative point of view about the use of buybacks before the airline bailout, odds are it can be traced to Lazonick, emeritus professor of economics at the University of Massachusetts Lowell and currently president of the Academic-Industry Research Network. His September 2014 essay in Harvard Business Review, “Profits without Prosperity,” pushed the debate about the merits of buybacks into the public square. It was the kind of article that gets you a book contract, and—voilà!—a little over five years later his collaboration with Shin, an economics professor at the National University of Singapore, landed on bookstore shelves.
There’s a sureness to the book’s narrative that makes it clear that Lazonick has told it many, many times. That’s a good thing, because even as the tone from the corporate suite has begun to sound a little more progressive of late, the fact of the matter is that the looting continues unabated. And now here we are, being blackmailed into opening the public purse to the very same people who have just finished looting the corporate one.
What is the book’s main argument? During the middle of the twentieth century, America’s largest companies engaged in a retain-and-reinvest strategy; they were value creators. As they’ve shifted, over the course of the past several decades, to one of downsize-and-distribute, they have become value extractors. “[The] relation between value creation and value extraction within major business corporations has become unbalanced,” they write, “and, given the importance of big business to the U.S. economy, this imbalance has affected the entire U.S. economy.”
We’re talking about how we share the “gains of innovation”—if companies reinvest, they share those gains with employees in the form of greater employment security, higher incomes, and greater benefits. When they simply distribute excess cash (or, worse, borrow in order to distribute), they are favoring shareholders above all others. We’ve been leaning that way since the 1980s, but the size and proportions of the distributions are getting a little ridiculous. That’s where buybacks come in. In good times, companies use them to increase demand for their shares in the market, in order to prop up the prices of those shares. That’s drawn a horde of greedy outsiders—primarily hedge funds and institutional investors—who have conspired, not through plotting but simply through their actions—to keep the buyback machine well oiled.
In doing so, they deprive companies of the ability to summon what Lazonick and Shin call “the social conditions of innovative enterprise”—strategic control, organizational integration, and financial commitment. It’s a persuasive story that can be summarized as “if you spend all the money on supporting your share price, you aren’t going to have much left to position the company for the future.” I agree with that. Of course, there is no guarantee that a company that’s trying to innovate will be successful. But I think we can agree that a company that isn’t trying to innovate is unlikely to do so by accident.
Yes, I am aware that this is America, where capital is labor’s king, but Lazonick and Shin are right—things have gotten out of hand. And the size of the theft is so large as to deny our imagination a proper response: how angry should we be that the managerial class has collectively overseen the pissing away of about $4 trillion of corporate resources on behalf of just a single category of stakeholder, the shareholder? Adding insult to injury, it hasn’t just been with organic free cash flow; buybacks are often been paid for with borrowing, too.
Of course, where you stand on this whole issue depends entirely on the altar at which you kneel. Do stockholders deserve more than everyone else? Or are they simply the greediest and most effective interest group trying to get its hands on the fruits of capitalism? Yes, I have read the arguments in support of buybacks. And no, I don’t have time for any of them. They’re all small-ball, taking an unfair system for granted, and asking us to worry that we might kill the patient by taking them off of anabolic steroids and spending the money on healthy food instead. If large-scale public crises are good for anything, it’s that they can provide opportunities to put an end to personal or collective failure. This is one of those times, and buybacks are a collective failure whose time has come.
Lazonick is what you might call an unreconstructed Marxist, and he’s quite sure—as he should be—that buybacks are part of a corrosive philosophy that’s revealed Western market capitalism for what it’s become: a naked money grab. That doesn’t make him unique. What does? His ability not just to survive, but to make an indelible mark in an educational and even business firmament that doesn’t have a lot of patience for Marxists. He is a thoroughly reputable scholar who is doing something very important. Better yet, he’s not hiding his political views while he’s doing it.
For the most part, modern American economists have continued to go along with the charade that you can be apolitical about a topic (i.e., economics itself) which is clearly central to the conduct of democratic capitalism. The suggestion that economics is something akin to a “neutral” science is both absurd on its face and an offense against the intellect.
So Lazonick gets great marks for flouting one of the central insanities of modern economics. But he loses them again when he engages in another: he takes for granted the assumption that, political or not, it’s still possible to come up with a “theory of the firm” that corresponds to reality while still yielding to our incessant desire to “model” everything around us. The man is still an institutional economist, even if he’s been hanging around the margins of that institution for years. Considered in this light, his drive to develop a theory is understandable from a career standpoint, if not necessarily an intellectual one.
His “Theory of Innovative Enterprise” is important enough to him that he forces the reader to plod through it before getting to the real juicy stuff, the conflicts of interest at the upper levels of American management and institutional investing that both led to and continue to sustain the buyback boom. Taking our own prerogative, we will deal with the two topics in reverse order, eating the dessert before the main course.
Buybacks: Value Extraction through Stock Price Manipulation
Why do companies engage in buybacks? Ask the companies themselves, and you will typically hear one of a handful of explanations. The first is that they do it to “return capital to shareholders.” Yet when it comes to publicly traded companies, those shareholders almost surely never provided capital to the company in the first place. Rather, they probably bought their shares on the secondary markets, and the main beneficiaries are usually financial speculators.
Of course, who bought what, and when, and who gets to go first can be interesting questions. But one of the first requirements of a liquid market for securities is that you have to accept that kind of indeterminacy and move on. Which made it all the more annoying that, at a sponsored Q&A for this book in mid-February, the hedge fund manager Carson Block decided it would sound smart if he laid that piece of amateur hour on the rest of us in a tone of voice that suggested he’d found the Gordian knot at the heart of it all. Hedge fund managers: the guys with all the answers, even when they don’t understand the question!
If Carson Block had asked me, I would have pointed him to another conundrum. Both buybacks and dividends tend to get lumped in together as “returning capital to shareholders.” But they’re not really the same thing. If a shareholder sells into a buyback, they get cash only if they actually sell their shares. On the other hand, they also don’t pay taxes, unless they sell their shares, and if they do, only on the shareholder’s net capital gain—unlike dividends, the full amount of which is taxed in the year received.
So when Lazonick points out that buybacks surpassed dividends in 1997, and haven’t looked back since, we probably shouldn’t be too surprised. On the other hand, some might argue that it’s better than the alternative: at least public companies aren’t just dividending out the whole pile, the way private equity buccaneers like to do.
The second explanation for buybacks is that the shares being repurchased are undervalued—and who would know better than management about the company’s near- and long-term prospects?—so the buyback is simply a smart use of capital. That argument does have a simple logic to it, and it might be true in some circumstances. But as Lazonick points out, more buybacks occur in bull markets than in bearish ones, rendering it less tenable in reality than it is in theory.
The third explanation is that in this era of stock-based compensation—not just for management but for many employees as well—buybacks are used to counterbalance the constant issuance of new shares to employees. This argument makes sense, too, until you find out that the number of shares that are bought back by most companies usually dwarfs the number that have been issued as stock-based compensation. (And when it does apply to certain companies, why aren’t more people curious about why their management teams are getting paid so much?)
The real reason for buybacks, argues Lazonick, is that they are used to support the company’s stock price for people who care about that—executives with impending stock grants or option expirations, as well as institutional investors who are looking to unload some stock on an uptick. The buybacks give manipulative boosts to stock prices, which can come in very handy to a management clique that is paid largely in the form of equity. In 2017, the average salary of the five hundred highest-paid CEOs in the country was $32.1 million, with 46 percent of that coming from stock options and 35 percent from stock awards.
(I would add a fourth argument to this list, which is that this is what we get for handing the keys to the corporate kingdom over to a bunch of MBAs, who are better at shuffling paper than they are at inventing things. What did we think would happen?)
Thus billions upon billions of dollars are spent every year to provide support for share prices so that executives can meet the stock price targets that are part of their compensation plans. That’s the long and short of it.
Yet, in a book that’s otherwise pretty pointed in its language, Lazonick goes soft right at the climax. “[In] the incentivized business enterprise,” he tells us, “these corporate executives may be incentivized to make value-extracting resource-allocation decisions that encourage stock price speculation and implement stock-price manipulation, both of which inflate their stock-based pay.” Please. It’s not that they may be incentivized—it’s that they are incentivized. They used to call the people who engage in this kind of three-card monte grifters; today, they are leaders—leaders who sold the rest of us out for a penny on the margin. Not only can you buy them off, you can buy them off for cheap! And we haven’t even gotten to Carl Icahn yet.
Extractive Corporate Governance: A Brief History
If you’re the kind of person who enjoys learning about underappreciated historical events that have had a much bigger effect than most people realize, Lazonick has a few for you.
In 1982, the SEC adopted Rule 10b-18, which gave corporate executives safe harbor from charges of stock manipulation through buybacks. That opened the floodgates.
In 1984, a man named Robert Monks joined the Department of Labor as administrator of the Office of Pension and Welfare Benefit Programs. From this perch, he proceeded to eliminate regulations preventing pensions and other institutional investors who don’t really “own” the stock in their portfolios—their clients do—from participating in corporate proxy votes. Henceforth, institutional shareholders weren’t just allowed to vote, they were obligated to. “This means that uninterested institutional investors are obligated to create justifications for their voting decisions, to purchase those justifications from third parties, or both,” write Lazonick and Shin. All together, it put institutional investors in the driver’s seat when it came to corporate control: in 2017, according to an estimate from Pensions and Investment, 80.3 percent of the market value of the S&P500 was in institutional hands. Am I losing you? Hang on, I will get back to this in a moment.
In 1992, the SEC changed its proxy rules to allow de facto investor cartels and allowed large investors to “engage” freely with management without worrying about potential breaches of insider trading law. That facilitated the rise of hostile raids. And here we are today.
Lazonick and Shin zero in on BlackRock to make a very important point. BlackRock’s specialty is investing in securities, not managing companies. But in 2012, with $3.39 trillion under management, the firm voted on 129,814 proposals at nearly 15,000 shareholder meetings worldwide. If that doesn’t seem like an impossible task, this will make it so: the firm’s corporate governance team, which oversaw those votes, employed just twenty people.
Five years later, BlackRock’s assets under management had nearly doubled to $6.28 trillion. That’s okay, though, because they hired sixteen new people to help carry the multitrillion-dollar load. “Far from taking compliance seriously,” write Lazonick and Shin, “the largest institutional investors, especially index funds, have limited their efforts to setting up skeletal research units that have barely paid lip service to the new rule.”
It gets better: After Robert Monks managed to get the proxy-voting rules changed, he left the Labor Department to start Institutional Shareholder Services (ISS), which sold those very shareholder vote “justifications” to institutional investors. At ISS, the numbers aren’t much better than BlackRock: Some 1,800 employees, including administrative staff, somehow manage to learn enough that they are able to recommend yes-or-no decisions on more than 10 million ballots representing 4.2 trillion shares in 115 countries a year.
Asked if he saw a conflict between his personal profit-seeking and his advocacy for the so-called public benefit of shareholder activism undertaken by institutional investors, Monks compared the two efforts to the double helix of DNA—one strand represented the “mission” of activism, the other the “money” to be earned. “[The] parallel spiral forces of the double helix do not touch but are indispensable to each other,” he concluded, effectively laughing in his interlocutor’s face.
Some more dates: In 1996, the National Securities Markets Improvement Act allowed hedge funds to begin drawing assets from larger pools of investors, especially institutional investors. And in 2003, SEC-sanctioned changes in the proxy voting system made it possible for hedge fund activists to rattle the cages of management while standing on top of the tiniest of stakes.
The entire industry exploded, but we are interested here in activist hedge funds in particular, the assets under management (AUM) of which jumped from $15 billion in 1997 to $117 billion in 2003 and $507 billion in 2014. In 2003, 39 percent of proxy fights launched by the hedge funds resulted in settlements or victories; in 2013, some 60 percent did.
Here’s where we get to Carl Icahn. He’s shaken down a lot of companies, but the example of Apple is about as brazen as it gets. First, the man bought 52.8 million shares, or 0.9 percent of Apple’s total, for $3.6 billion between mid-2013 and early 2014. He then proceeded to relentlessly harass Apple CEO Tim Cook, privately and publicly, to start “returning” some of the $146 billion in cash it held on its balance sheet to shareholders. (The idea of pressuring companies to invest more never seems to cross any activist’s mind.)
Cook eventually caved. From 2012, when Apple started paying dividends, through mid-2016, when Icahn announced he’d sold his Apple stake, the company did $116.6 billion in buybacks and declared $39.1 billion in dividends. (In a recent article, Lazonick points out that between October 2013 and December 2019, Apple pissed away $326 billion on buybacks.) Steve Jobs wouldn’t have caved to Carl Icahn. But Jobs is dead and Cook—another MBA—had already revealed that his Apple was less of an innovator than it used to be, making it a prime target for an activist, raider, or a looter—call them what you want.
Icahn walked away with $2 billion in gains. If you don’t yet believe that we are living in Shakedown Nation, consider the fact that Donald Trump then named Icahn a presidential policy advisor, a position he held for three months before buckling to public pressure over the ridiculousness of it all and quitting.
Admittedly, as we sit here today, Apple has some $200 billion in cash on its balance sheet. So yes, sometimes there might be so much cash sloshing around that buybacks don’t, ultimately, get in the way of other opportunities.
But then there is Cisco. Was Cisco outflanked by Huawei, China’s state-sponsored competitor, because it shifted into value extraction mode via buybacks, on which it spent $118.7 billion between 2002 and 2018? That’s a tough one, but it certainly didn’t help. Huawei, as Lazonick and Shin note, doesn’t do buybacks. Nor, for that matter, does Jeff Bezos’s Amazon, at this point arguably one of the most innovative companies in history.
Perhaps the most pathetic variety of hedge fund “activism” can be seen in Bill Ackman’s March 18 appearance on CNBC. While he did urge U.S. companies to stop their buyback programs because “hell is coming,” Ackman also claimed to have seen the full extent of the pandemic in a dream in January and beseeched the rest of us to catch up to him, so far out in front. He even got a little emotional when talking about life and death.
I worry when I say the following, because Ackman is one of those simple-minded people who will find a way to take this as a compliment. But you can summarize his career the same way that Cameron Hawley summarized that of his protagonist in his 1955 book Cash McCall. Angry at having been outflanked again, one of McCall’s rivals described him as “the cleverest of all the jackals and vultures who prey upon the laggard members of the business pack.”
Ackman bragged a few days after his teary-eyed appearance about making big returns on his hedges, then turning bullish and increasing his long positions almost overnight. Good for him. But has anyone told him that all the money he’s made won’t buy back . . . his soul? (Also, a question: is there a more offensive organism than a parasite that brags when it isn’t being a crybaby?)
Models of Futility
Some of the best stuff in their book comes near the end, when Lazonick and Shin take aim at the specious arguments of Harvard Law School professor Lucian Bebchuk, a man who rivals his colleagues across the Charles River at Harvard Business School for the shamelessness of being a career water carrier for the management and financial elite. But Lazonick also returns to his Theory of Innovative Enterprise, the soft underbelly of an otherwise impressive body of research.
Lazonick is at his best when he’s demolishing other people’s silly economic theories, in particular agency theory per Harvard Business School’s Michael Jensen and the neoclassical economists’ ideology of maximizing shareholder value, or MSV. MSV’s cheerleaders, he writes, “railed against the evils of incumbent management but did not offer a theory of the value-creation process that could guide good managerial practice.”
Neoclassical theory, he says, “posits the entrepreneur as an arbitrageur who exploits disequilibrium conditions, rather than as someone whose actions create disequilibrium conditions.” It also “assumes that the entrepreneur requires no special expertise to compete in one industry rather than another.” I agree with Lazonick about all that. I wrote about the second point myself at great length, particularly with regard to MBAs, in my 2017 book The Golden Passport. When Lazonick called neoclassical economics “nonsense,” he was using one of my favorite words to describe this kind of stuff.
I also agree with him that once American management shifted from a retain-and-reinvest mode to a downsize-and-distribute one, that’s when the wheels started coming off the bus, maybe never to be put back on. That’s how we find ourselves dealing with a century-long high in inequality in this country today—and an inability to manufacture even basic medical equipment when we need it most. In April 2019, much was made of the Business Roundtable’s decision to redefine the purpose of a corporation to promote “an economy that serves all Americans.” The very first step toward that would be to halt buybacks. But that hasn’t happened, so the announcement was, for all intents and purposes, complete bullshit.
But Lazonick loses me when he argues that we should replace the neoclassical economic model with another economic model, his own Theory of Innovative Enterprise. My problem isn’t with any particular aspect of that theory—it makes sense, within its own constraints. My problem is that it’s a model, period. But we’ll get back to that in a moment.
What is the Theory of Innovative Enterprise? Well, let’s start with what it’s not. Lazonick points out that the neoclassical theory of monopoly contains a fundamental error of logic: “it posits that the monopolist maximizes profits subject to the same cost structure as perfectly competitive firms.” If that were actually the case, he argues, how could the monopolist even become a monopolist in the first place? The neoclassical model, in other words, posits “the most unproductive firm as the foundation for most efficient economy.” That, he argues, is nonsense. Agreed.
The Theory of Innovative Enterprise is his solution to that problem. In it, the firm grows large “by transforming its cost structure as it generates a product that is higher quality and [at] lower unit cost than products previously available.” Let’s take that in steps: First, you use learning processes to develop a higher quality product. (Those processes cost money.) If you’re successful, you gain market share, which spreads your fixed costs over more units, transforming the high fixed costs of developing higher quality into lower unit cost. By doing so, the innovative firm “outcompetes the unproductive firms operating in so-called perfect competition.”
Lazonick’s problem with buybacks comes into play at the first step: cash distributions throw a wrench into the works by depriving the company of the resources needed to foster an atmosphere of innovation. It’s all pretty straightforward, and a damn sight better than the neoclassical model and its sidekick, the ideology of MSV.
So what’s the problem? Well, it is this: in putting forth his own model, Lazonick has revealed which side he’s on in an even bigger debate than the ones surrounding buybacks or the eternal quest for how to bottle innovation. This is the big divide, the mother of all “there are two kinds of people” schisms: There are those who understand that we live in a context of uncertainty, that the nature of reality is not and never will be reducible to a formula. And there are those who refuse to stop trying to do just that. Classical economists are obviously of the latter sort; they think that everything can modeled.
So even if Lazonick is right about many things, he’s still using the very same tools that the bogus “scientists” of neoclassical economics used to build their degrading model of humanity in the first place. The lure of theory-generating closure is difficult for all but the most renegade of economists to resist, and while Lazonick is a renegade, a renegade economist he is not.
The question isn’t which model is better than the other. It’s methodological: can mathematical models accurately analyze firm behavior at all? In the end, Lazonick’s rousing critique of the practice of buybacks is blind to the implications of his decision to throw his lot in with the mathematical modelers anyway. And the problem with that is that those models are laden with assumptions about the nature and practical relevance of the “variables” being modeled—and, by extension, those not being modeled. But this is not simply a game like chess. If economics is to be worth anything at all, it has to be about the real world. And the real world is uncertain. It will not yield its secrets to a chart.
To be fair, Lazonick does include a nod to the notion of “uncertainty” in his model, but it’s only uncertainty of the simplest—and least interesting—kind: ignorance of what we presume to be knowable. But our uncertainty doesn’t just derive from ignorance. It also stems from incommensurability (our view of the world is always heterogenous and fragmented; none of us sits at the Archimedean fulcrum to see things “as they really are”) and indeterminacy (we interact respectfully with others who see differently and pursue different goals, so social reality defies measurement anyway).
If you even entertain the possibility of incommensurability or indeterminacy, you’ve admitted the impossibility of rigorous models. Unfortunately, Lazonick doesn’t entertain them; he gives us his model instead. That’s the positivist perspective, which presumes the possibility of certain knowledge because it also presumes that everything “knowable” is out there, not to mention logically constructed—the only thing standing between us and certainty is a little more research. And while most people can admit that we’ll never quite get there, they keep pressing on in the name of “science.” In the end, they build nonsense models of imaginary lives, the total value of which is ultimately nothing—at least if you’re talking about the lived universe—the one in which we interact with other people like ourselves.
Contrast the drive to model, says the management historian J. C. Spender, against the eternal openness of life, where we never know what comes next—something we are brutally discovering at this very moment. In that world, everything written is, to a greater or lesser extent, poetry—specifically the poetry that tricks us into believing that we understand something of the human condition. Science is that way, too—real science, when you are doing something new, is every bit as much poetry as T. S. Eliot or John Dunne. Of course, we live in an age of scientism, where the parody is greeted with the same enthusiasm as the real thing.
Neoclassical economics is, at its core, a fundamentally fraudulent conception. “The master science of desire in advanced capitalist nations,” writes Eugene McCarraher in his enthralling new book The Enchantments of Mammon, is one that’s built on “shabby and degrading claims about human nature” (i.e., we’re all selfish) and the “mercenary principles of pecuniary reason” (i.e., we’re all rational). Until such time as its practitioners give up the fantasy and accept that economics is as much art as science, we’re not going to get anywhere important. And while Lazonick is talking about some very important things, he’s not doing that.
For all its limitations, economics is, at root, a philosophy of capitalism. But only an inhuman idiot thinks the “rigor” of mathematics can provide a sufficient foundation for a useful philosophy. We are running into this very issue with regard to coronavirus right now, with medics having to make choices about who lives or dies. There’s no formula you can use to make that decision. Because humanity deserves more than a formula, even the best mathematical model will always be insufficient, even repugnant, to anything short of a totalitarian regime.
Totalitarian regimes deny individual choice. We can argue that World War II was choice’s defense of itself. At this very moment, as Spender points out over a Zoom call during the quarantine, the world’s nations are conducting a never-before-attempted “natural experiment”—seeing which political regimes can best protect their citizens’ lives under this particular horseman of the Apocalypse. Is the future going to be a burnished Chinese Communism? In that case, our notion of economics and entrepreneur-driven growth will go out the window.
But we’re not there yet. And until that happens, let’s be clear about this: mathematics is but one language—that singularly fantastic achievement of humanity that’s given us a degree of access to other people’s minds—that we can use to overcome the challenges of indeterminacy. (Witness Einstein’s humble astonishment that mathematics was able to say anything interesting about mass, space, time, and the cosmos.) And economics is merely another one.
Why do we crave certainty? Because we are scared; we fear the unknown when we could be embracing it instead. And economics is just one of many contexts where we are confronted with that choice. What are the others? Well, all of them. The questions are always the same, and they’re the ones that Matthew Stewart (author of The Management Myth: Debunking Modern Business Philosophy) lays bare in his wonderful book The Courtier and the Heretic: Leibniz, Spinoza, and the Fate of God in the Modern Era. Leibniz argued that our uncertainty derives almost entirely from our ignorance of ultimately knowable things—that there will be, in the end, a theory of everything. Spinoza, on the other hand, got comfortable with the fact that people are what they are, and that some things can never be known. Economists need to admit the latter before they can truly engage our imagination, and thereby the realities of commerce and real people, who are struggling with uncertainty to make sense of themselves, their world, and their lives.
Don’t get me wrong: Predatory Value Extraction is an important book. We all owe Lazonick and Shin a round of applause for providing us with a better understanding of one of the central problems facing American capitalism. But what should we do with the Theory of Innovative Enterprise? Well, we can file it away with all the other perfect models of imaginary things, the products of a stunted intellectual apparatus that thinks we can figure it all out and then explain it with a handful of charts. To those who succumb to it, the desire to apprehend the world through science can be nearly impossible to let go. But some things just aren’t knowable. Welcome to the real world.