A Short History of a Fabulous Invention: The Company

Even among economists, who ought to find the subject riveting, the company is a strangely neglected entity. Its study is a specialty within the literature, a backwater, you might even say. Non-economists, meanwhile, give the origins and characteristics of this remarkable invention scarcely a thought. Yet, second only to the family, the company has been paramount among the institutions shaping modern society.

Two colleagues of mine at The Economist, John Micklethwait (who edits the United States section of the magazine) and Adrian Wooldridge (who works in the Washington bureau, and is the principal author of the magazine's Lexington column) had the excellent idea of writing a brief, accessible history of the subject. They came up with The Company: A Short History of a Revolutionary Idea, which has just been published in the Modern Library Chronicles series. I recommend it warmly. The tale they tell is fascinating, and the book shows how wrong we are to take this institution for granted.

It is good to see that the authors have no problem with brevity: The first chapter, "Merchants and Monopolists," covers 4,500 years in 14 pages. This takes the reader to 1500; thereafter, the pace slackens, but not by very much. Successive chapters move chronologically and look at the premodern company as an instrument of imperialism; at the birth of the modern joint-stock limited-liability company; at its subsequent development in the United States, contrasted with experiences in Europe and Japan; at the development of managerial capitalism during the 20th century; and finally at the role of multinational companies. In closing, the book offers some speculations on what comes next. At less than 200 pages, the whole thing is a leisurely and enjoyable weekend read — quite an achievement.

Conservatives, and others who see themselves (often mistakenly) as friends of capitalism, talk as though the rivalry of competing privately owned companies is, in effect, a state of nature. Provided government restrains its instinct to run everything, they seem to think, modern capitalism is what happens. Anybody proposing some departure from this natural order, it follows, must carry the burden of proof. Not so, as this history makes clear. Today's economic landscape is no product of nature: It is an order that has been constructed (it would be an exaggeration to say designed), and it requires ongoing maintenance. Critics of modern capitalism — anti-globalists and the rest — are right about this, at least: That which has been assembled can fall apart, or be taken apart.

The crucial innovation in modern economic history, as the authors emphasize, was not a technology but a legal concept: that of limited liability, the idea that the owners of a company risk no more than the sum they have invested. This far-reaching idea was controversial from the start.

Adam Smith, for instance, was skeptical. He regarded limited liability as an unwarranted legal privilege and a kind of subsidy. Without it, he believed, the joint-stock company would not survive in competition with owner-managed firms, which were bound to be better run. A few decades on, Robert Lowe, architect of Britain's Joint Stock Companies Act of 1856, argued the opposite: "If people are willing to contract on terms of relieving the party embarking his capital from loss beyond a certain amount, there is nothing in natural justice to prevent it." In other words, nobody was going to force people to work for limited-liability companies, or sell goods or services to them, or extend credit to them. If limited liability made the risk of transacting with such firms too great, they would fail of their own accord; and if not, what's the problem?

On a point of logic, Smith was probably right: Limited liability is a generous protection. True, as Lowe argued, the terms of contracts can be adjusted to take account of the risks facing the various parties — but contracts are not the only way of incurring liabilities. Firms, like people, may harm nonconsenting third parties. Why should owners' liabilities be capped in such a case? There is no reason in "natural justice" why they should. Smith might even have been right that owner-managed companies are better run, other things equal, than the professionally managed companies with dispersed ownership that would flourish under limited liability. The answer to this, and to the subsidy argument, is that other things are by no means equal.

Even if limited liability is a kind of subsidy, as Smith insisted, he would have struggled to deny, had he lived another 200 years, that it proved to be a staggeringly fruitful one. Neither he nor Lowe nor any of the other parties in the early debates about company law can ever have guessed what force of innovation and capital accumulation would surge from that seemingly modest institutional departure. The main thing, this history shows, is that owner-managed companies are at a disadvantage in raising cheap long-term capital. The limited-liability company is an unrivaled mechanism for doing just that — for accumulating capital and then efficiently investing it. That ability trumps everything. This process, the world has learned, is the engine of economic growth.

Despite its brevity, The Company advances some theories — a few too many, if anything — while still telling a story. A recurring theme is the interplay of economics and politics.

Companies exist in the first place to lower the cost of internal transactions; this saving must be balanced, as the firm grows, against the extra costs of a proliferating managerial hierarchy. Micklethwait and Wooldridge believe that, so far as economics is concerned, the right balance — and, accordingly, the right size and shape of company — is mainly a matter of technology and, to some degree, of managerial fashion. Politics, as the authors tell it, operates in a somewhat separate domain, sometimes favoring business (notably big business) and sometimes opposing it. Governments and businesses constantly "jostle for power," and "the balance has unquestionably swung in the company's favor."

Since the days of the East India Company, maybe it has. But companies in America and Western Europe today are minutely regulated in every aspect of their behavior — more so, probably, than at any time in the past 50 years. I wonder, too, about this jostling notion. Businesses, on my reading of corporate history, are more interested in jostling for profit than for power — though power, of course, can serve that goal. In this, they often see government not as the enemy but as a mighty ally.

The politics of industrial regulation, and of trade liberalization, and of many other issues that seem to set business against government are better understood, in my view, as issues that set established businesses against emerging competitors (and the public good) with the incumbents set on recruiting government to their side. Competition, and efforts to avoid it, has always been at the center of business-government relations, as Adam Smith emphasized. I think the book could have examined this more frontally.

The Company might have shed a different light on current debates about corporate social responsibility. My esteemed colleagues, I fear, are quite keen on corporate responsibility. "There is a widespread feeling," they note, "that companies have not fulfilled their part of the social contract." Now for the good news: "Companies have become increasingly explicit about their social goals." This sits oddly at the end of a book that carefully explained that the managers of public companies do not own them — and that underlined how dangerous it is to let managers forget it. If managers have social goals, they are at liberty to pursue them at their own expense. Framing social goals, when the costs are to be met out of other people's pockets, is the proper task of democratic politics, not of the company boardroom.

Much of the talk about corporate social responsibility that decorates company statements nowadays is, of course, mere public-relations babble, and to that extent may be harmless. But some of it has substance, and may therefore be damaging. The key is always to ask whether the policy in question is anti-competitive. The managers of some multinational companies call for tighter health-and-safety regulations in developing countries, together with minimum-wage guarantees and stricter environmental protection. Some want trade restrictions against exports from countries that fail to comply. What lies behind this? Possibly, these managers desire to be full social partners in an enlightened order of global governance. Possibly, the fact that such measures would smash their foreign competition has also crossed their minds.

Companies do not need social goals to do social good — a point of overriding importance, and one that The Company makes perfectly clear. Companies do social good not because they want to but because, when they are made to compete with each other, they have no choice. That is the beauty of it.