State of the Union January/February 2006

Executive Privilege

The CEOs of too many public companies enjoy the power and rewards of ownership without the risks. Corporate values have deteriorated as a result

In the late 1990s growth in productivity accelerated, and share prices—especially in technology—soared. It was a new economic era. As at the dawning of previous new economic eras, the old rules were said to no longer apply. Investors were prodded in the chest and told they either got it or they didn't. Financial orthodoxy and traditional business virtues were mocked. Financial inhibitions were cast aside. Rather than watching sports, investors of modest means watched television pundits pick stocks. Some quit their jobs to become day traders—and did well, because it is hard to lose money in a rising market. Accountants (accountants, for heaven's sake!) were invited to seminars on "thinking outside the box."

This climate of opinion did not merely tolerate financial heterodoxy but demanded it. In 2001 a writer at Fortune was the first to ask questions about Enron's bookkeeping—but not before the magazine had hailed the company as America's most innovative for six years running. The firm's auditors missed what was going on; but so did its creditors, its analysts on Wall Street, the press, and everybody else. The mood of the moment prevailed.

In this environment CEOs were often anointed as visionaries. Naturally, celebrity bosses are expected to be buccaneers—and they often are, disdaining advice and believing what they read about themselves in the papers. Many disdain the rules as well; rules are for the timid. Most hazardous of all, they tend to forget that (in the case of public companies) they are employees of the firms they lead, and not owners—that they are fiduciaries, entrusted with the care of other people's money. Hence their too frequently outlandish pay deals; hence, in many instances, their taste for ventures that a conscientious fiduciary would have regarded as too risky.

How did the real owners come to let this happen? The answer lies partly in the changing pattern of shareholding. Large shareholders in a company have both the means and the motive to remind managers whom they are working for—to insist that costs (including managers' pay) be contained and assets not squandered on reckless new ventures or vanity projects. Shareholders with small diversified holdings are unable to exercise such influence; they can only vote with their feet, choosing either to hold or to sell their shares, according to whether they think that managers are doing a good job overall. Shareholdings have become more dispersed in recent decades, and the balance of power has thereby shifted from owners to managers.

The growth of institutional investment—through pension funds and mutual funds—accelerated this trend. In many ways, of course, it has been a boon for popular capitalism, giving people who are not wealthy the opportunity to save more effectively, and giving millions of Americans a real stake in the economy for the first time. But it has also created a class of owners who do not behave like traditional owner-capitalists. The typical investor in pension or mutual funds may be entirely unaware of what shares the funds hold. The institutions themselves, it was once believed, would behave like owner-capitalists—but on the whole, for a variety of reasons, they have not. They see their job as picking stocks and trading them; except in the most extreme cases, they think, it is not their role to hold company managers to account. Index funds, which have grown in popularity, take this practice to the extreme—they explicitly refuse to make any judgments about companies, and instead seek to hold a representative basket of stocks, with no attention to the performance of individual companies.

Ownership has grown more distant and diffuse only slowly, over decades. But in the late 1990s the effect of that diffusion on the control exercised over managers was suddenly magnified by a complacency born of strong returns. Investors came to expect extraordinary returns all the time, without paying much attention to how they were generated. The message to managers was clear: gung-ho risk-taking was in, and cautious stewardship was out. Far from resisting this shift, investors cheered it on.

Even though the boom is now over, surprisingly little has changed. If anything, the structure of ownership is more diffuse. And investors have only partly lost their appetites for vainglorious corporate leadership. Today celebrity CEOs are no longer quite the rage they were in the late 1990s, but the delusional desire to crown corporate bureaucrats—not merely the handful of genuine visionaries—as business heroes is still there. If an outright economic slump had followed the stock market's fall in 2001, bubble modes of thinking might have been more thoroughly renounced. But Alan Greenspan's Fed contrived a soft landing, so the mental correction was comparatively mild as well.

To be sure, the boom of the late 1990s had a real foundation, and the economy continues to benefit. Behind the stock market's astonishing rise lay a surge in economy-wide productivity; behind that lay the growth of the Internet and the development of new business processes aimed at taking advantage of information technology. Those forces are by no means spent. If, as many economists now believe, long-term productivity growth has increased by a full percentage point from its average in the 1970s and 1980s—from 1.5—2.0 percent a year to 2.5—3.0 percent—that represents a genuine transformation in the country's economic prospects.

The catch, it seems, is lower standards of corporate governance. This is a shame, but it may just be the way of the world. Eliminating episodes of irrational exuberance and the errors that attend them would require eliminating the underlying economic transformation as well—which would be undesirable even if it could be done.

Nowhere is the noxious blend of unwarranted expectations and occluded oversight more apparent today than in the growth of hedge funds: largely unregulated companies that invest in a wide range of sometimes exotic financial instruments, generally leveraging their holdings (that is, multiplying risk and return with borrowed money). Precise figures are hard to come by, but the amount under management by the 8,000 or so such funds appears to have doubled over the past five years, to about $1 trillion.

Driving this growth is disappointment at stock-market returns since 2000. The boom taught investors to expect high returns year in and year out. For most investments this was too much to ask after the tech bubble burst, yet some hedge funds were able to maintain impressive returns even as equity markets sank. Exactly how they did it remains a mystery, because they typically disclose little about their investment methods. For some investors that seems only to increase their allure. To the mystique of the corporate shaman add the mystique of the hedge-fund wizard.

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