Political Preconditions to Separating Ownership from Corporate Control

Abstract

The large public firm dominates business in the United States despite its critical infirmities, namely the frequently fragile relations between stockholders and managers. Managers' agendas can differ from shareholders'; tying managers tightly to shareholders has been central to American corporate governance. But in other economically-advanced nations ownership is not diffuse but concentrated. It is concentrated in no small measure because the delicate threads that tie managers to shareholders in the public firm fray easily in common political environments, such as those in the continental European social democracies. Social democracies press managers to stabilize employment, press them to forego even some profit-maximizing risks with the firm, and press them to use up capital in place rather than to down-size when markets no longer are aligned with firm's production capabilities. Since managers must have discretion in the public firm, how they use that discretion is crucial to stockholders, and social democratic pressures on managers induce them to stray from their shareholders' preference to maximize profits. Moreover, the means that align managers with diffuse stockholders in the United States--incentive compensation, transparent accounting, hostile takeovers, and strong shareholder-wealth maximization norms--are harder to implement in continental social democracies. Hence, public firms in social democracies will, all else equal, have higher managerial agency costs, and large-block shareholding will persist as shareholders' next best remaining way to control those costs. Indeed, when we line up the world's richest nations on a left-right continuum and then line them up on a close to diffuse ownership continuum, the two correlate powerfully. True, the effects on total social welfare are ambiguous; social democracies may enhance total social welfare, but if they do, they do so with fewer public firms than less socially-responsive nations. We thus uncover not only a political explanation for ownership concentration in Europe, but also a crucial political prerequisite to the rise of the public firm in the United States, namely the absence of a strong social democracy and the concomitant political pressures it would have put on the American business firm.