Monday, 30 November 2015

Wealth accumulation and the profit motive

From the early XX century the rise of large corporations and consequent separation between ownership and control has dominated the debate on entrepreneurship and capitalism. The debate naturally turned to whether – business concentration and owner absenteeism – would reduce the role of the market and the profit motive as foundations of capitalism and wealth accumulation.

In itself, wealth accumulation neither goes always pari passu with status and power nor does its regional and occupational origin follows a rigid stratification. Nevertheless, some periods are usually associated with a particular source of wealth or class of individuals.

For instance, at the turn of the XIX century in Britain, London commerce and finance were seen as the origin of the largest fortunes of the epoch. Likewise, at the turn of the XX century in America, the Silicon Valley internet entrepreneurs and the New York hedge fund managers were regarded as those more likely to accumulate great fortunes.

So, both in relation to the sources of wealth and to its distribution, we may identify cycles that are usually due to various causes but never as a direct result of capitalism.

Nevertheless, the path to capital accumulation does affect the efficiency of capitalism since different groups have different propensities to save and pursue different investment strategies. In particular, the rise of institutional investors adds new agency problems in relation to portfolio allocation and a possible dilution of the profit maximization motive caused by the owners absenteeism and a growing rent-seeking monopolization.

Indeed, these agency problems were already felt in the early XX century by authors like Thorsten Veblen (1921) who stated that: “The company … is, therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.“

The questioning of the role of the firm culminated in the classical book by Berle and Means (1932) arguing that: “The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital... [Such owners] have surrendered the right that the corporation should be operated in their sole interest...”.

This trend led finance theorists to treat shareholders as if they were debt holders and to a growing influence of managerial capitalism; with firms turning into bureaucratic organizations without the entrepreneurial spirit of the early promoters.

Many large firms frequently collude with governments and become more driven by rent-seeking than value added under competitive conditions. Often they are also managed through planning and search to grow through mergers rather than entrepreneurship. These fears, which were already present before the 1940s, are obviously a threat to capitalism, but they do not mean that modern capitalism is already following the path of Venice which transformed from a thriving trading city in the XV century into today’s museum city.

Accountants’ ever increasing recording of non-cash transactions in financial reporting also eroded the traditional use of profits as the right bottom line metric to measure business performance. As net income becomes less and less meaningful, investors moved up the income statement and use other measures such as operating and gross income. And, as these progressively become subject to creative accounting, they had to turn also to cash flow statements. This proliferation of metrics did not help the profit motive.

Moreover, finance experts progressively substituted profits by shareholder value which blurred further the use of profits. And things are getting worse, since many increasingly replace this concept by the broader one of firm value. Because these metrics are based on specific theories, they are easily abused by managers with self-perpetuating and self-aggrandizement agendas .

To conclude, the rising wealth created by capitalism facilitated the emergence of ever bigger firms, creating a growing divorce between owners and management, fostering the replacement of profit maximization by vague metrics of shareholder and firm value, which, together, compound the erosion of the profit motive as a foundation of capitalism. Fortunately, this is largely confined to the managerial sector of capitalism and, although a serious threat to be fought, the erosion of the profit motive will not be lethal to capitalism.

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