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.

Subsistence economies and self-sufficiency

Many of the protectionist arguments against capitalism rely on the idea of self-sufficiency and independence as a safeguard for unforeseen events. This idea wrongly stems from confusing prudence with self-sufficiency and risk mitigation with protectionism.

It is normal that after being fustigated by so many natural and human-made calamities people seek safety in self-reliance. In the absence of markets for risk protection, subsistence economies may be seen as providing such safety. Yet, such safety is achieved at an enormous cost in terms of living standards.

I shall illustrate this through the personal experience of my ancestors. Before the 1930s, most of my ancestors lived for centuries in a remote village by cultivating small plots of land. They consumed almost all they produced except for the occasional goat that they would sell to buy clothing. If the wolves decimated part of the herd or the weather ruined the harvest they would have a rough year surviving on potatoes and without replacing their rags.

It was a tough life but they were self-sufficient and independent without a need to rely on others. The same happened with the other villagers, with the exception of the only specialized inhabitant (a carpenter) who had to walk to the neighboring villages to offer his services.

My family fortune changed only when, at the age of fifteen, my father and a friend migrated to Lisbon. He survived doing multiple jobs and later returned home to work in a textile mill in a neighboring village, where he also found jobs for his sister and two of his bothers. As a result I and my five sisters had the opportunity to study and to escape the self-sufficiency trap.

The problem with small self-sufficient communities is not that they do not know about division of labor. Indeed, for those with a romanticized view of such communities, my village had a well-developed communal way of herding, a communal bakery and a kind of labor exchange.

However, isolation and small scale prevented them from participating in trade with outsiders and achieve the necessary scale and specialization needed for capital accumulation.

However, the subsequent construction of roads and communication services did break isolation but it did not stop the village decline, why?

Because the lack of transport infrastructures is not the only obstacle to the development of remote areas. Unless they are a tourist hive or their inhabitants are writers or similar professionals able to work from home for a greater market, they will not be able to combine the profit motive with the joint ownership and limited liability needed to undertake risky ventures which are indispensable for the success of capitalism.

So for many millions trapped in small communities, like my ancestors were, the simplest way out is migration.

Yet, there are many still arguing for self-sufficiency or independence in large communities. They typically invoke the lack of scale and the need to safeguard the supply of goods and services considered essential, with an elastic definition that ranges from food, social services, environment and energy. Such calls for self-sufficiency contradict Ricardo’s law on comparative advantage, probably the only consensual law in economics formulated in 1817.

And, this law is not being ignored in non-capitalist societies alone, but also in Western countries at the core of capitalism. For instance, until recently the USA had a law banning the export of crude introduced in 1975 as a retaliation against the Arab oil embargo of 1973. Yet the ban was never lifted due to opposition from oil refineries and environmental groups. Only now, after a sharp increase in oil supply brought about by the new fracking technology and geopolitical considerations, did the refiners opposition eased and there is some hope for lifting the ban.

Obviously, whether to export crude or refined products should be a business decision not a political one. However, once a country tolerates special interest groups based on protectionism it becomes almost impossible to eradicate them. Thus the importance of free trade to control rent-seeking behaviour that undermines capitalism.

Capitalism and joint ownership

One of the fundamental freedoms under capitalism is the freedom of association to form business organizations. Joint private ownership is different from joint public ownership in the sense that the first is voluntary and the second is compulsory. Various types of organizations have been developed throughout history, ranging from the Assyrian partnership, the Roman societates and the medieval guilds to the compagnia e banchi of the Italian renaissance. However, the modern from of incorporation as a joint stock company, that we identify with capitalism, had its origins in the XVI century with the creation of the so-called charter companies.

Chartered companies were established by private promoters that were granted some concession or monopoly by the state. For example, in London the Muscovy Company was first established in 1555 with a monopoly over the trade of goods to Russia. Indeed, since the first boom in the establishment of joint stock companies around 1719 more than 140 years passed before this form of company settled with the new British Company Law of 1862, which introduced the main features of a modern joint stock company.

This is an organization engaged in business, recognized as a distinct legal entity from its members, with certain rights and responsibilities and acting as a mechanism to share risks and rewards. Most importantly, it replaced the personal liability of its shareholders by various forms of limited liability which would allow a larger number of shareholders to be organized and therefore able to undertake much bigger projects.

The law permitted companies to be established indefinitely (without any time limit) and not, as before, only for a limited number of years. So, big corporations could now be established by private investors under the new form of a Joint Stock Company.

This facilitated the public offering and negotiability of ordinary shares, essential for pooling funds and sharing the risk and rewards of investment. The issue of tradable shares had existed ever since the early Roman times when the Societates issued their shares or particulae. Even the chartered companies, such as the East India Company, were established by pooling together the capital of about 250 merchants. Yet, as they were typically placed among a limited group of people, mostly family or business acquaintances, they were not widely held by the public and were not actively traded in the early years of the Stock Exchange.

This was due to the basic distrust of issuers about disclosing their profits and sharing them with unknown people and risking the loss of control of the business to other people. Investors were also suspicious about any hidden reasons as to why a business owner should want to share their business. This was stimulated further by the recent memory of the occasional speculative bubble and other flotation scams such as the infamous South Sea and Mississippi companies in 1719-1720.

Only after the first slave-trade mania between 1827 and 1836 were shares widely held and tradable in the Stock Exchange. Still, most of these shares were preference shares, a class of shares that dominated the issue of equity instruments until the early years of the 20th Century. Preference shares were clearly preferred by company managers as a way of keeping control of their companies.

The process to recognize by statute the existence of incorporated companies was also a long journey. Initially incorporation was seen as a very cumbersome process, which was only worthwhile if it involved the granting of some Government monopoly, as was the case with most chartered companies. For most businessmen the partnership form had the major advantage of avoiding interference of the state. Also, public opinion associated incorporation with promotions of speculative companies such as the South Sea and the Mississippi Companies.

Similarly, the process of raising capital by instalments also gave rise to scams and many investors were easy prey for unscrupulous issuers. The most common scam was to make big issues requiring little paid-in capital to attract less sophisticated investors and then run away with their money.

For many of the same reasons, the separation of ownership and control was also a long process. The overriding idea or obstacle was summarized in Carnagie’s motto that “what is anybody’s business is nobody’s business” and it is much more so when there is a large dispersion of institutional ownership.

Not surprisingly, the separation of ownership and control only reached a significant level between 1900 and 1920, with a clear separation of responsibilities into three distinct levels: the company, the shareholders and its directors. To these, one should now add a new layer made up of professional fund managers. This was partly due to the rise of investment trusts, holding companies and the result of better accounting (despite the standards of modern accounting having been developed only from the 1940s onwards).

The separation between shareholders and the company was instrumental to reach the widespread use of equity and the impressive growth in share dealing. Other factors highlighted in modern theories of the firm such as reduced transaction costs and information technology also played an important part. But, bearing in mind that the growth of big firms also implies the growth in non-market transactions, one must question if its trade destruction effects are smaller than the trade creation effects resulting from more investment and more activities being carried out by profit-driven organizations.

Marxists and other anti-capitalist thinkers in the late 19th century pointed out that capitalism had a self-destroying mechanism, since the untamed rise of big firms would cause so much trade destruction that competitive markets would account only for a residual share of total transactions, unless the growth and size of such firms was capped. This led to the introduction of antitrust laws in most countries, inspired in the US Sherman Antitrust Act of 1890. These laws were aimed at curbing anti-competive practices by prohibiting cartels, dumping and other collusion practices as well as laws to regulate corporate consolidations ending up in the creation of monopolies or oligopolies that would limit competition.

As usual, left and right wing interventionists (e.g. socialists and corporatists) wanted as much regulation as possible while right and left wing laissez-faire supporters (e.g. classical liberals and anarchists) wanted no regulation at all. So, the role of antitrust laws has been permanently questioned and changed. Yet, after more than a century we still do not have enough empirical evidence to define a "good degree of regulation". Nevertheless, a middle-of-the-road solution is to have tough anti-competition laws and flexible anti-concentration regulations.

In relation to the various forms of joint private property one needs to remember that many of the alternatives to joint stock companies like partnerships, mutuals, friendly societies, credit unions and so on, although still in operation, have been increasingly opting for corporate structures, in particular in the mortgage-banking sector.

Finally, it must be noted that joint private ownership could not develop without limited liability. Indeed, the size of large business operations needed a large number of shareholders which could be reached only if the partnership was not entirely dependent on the life of its main owner-shareholder or heirs and if the transfer of shares was possible. Moreover, this liberated the poor from their dependency on the state to invest their meagre savings. And, as a consequence, most large firms today are owned by institutional investors whose end-owners may be big or small investors. For instance, pension funds in the OECD countries accounted in 20111 for about 10% of the US$D 32 trillion invested by institutional investors in listed equities.

In conclusion, joint private ownership is an essential right under capitalism since it is one of the main drivers of its success as a wealth production machine. Nevertheless, it must be exercised mostly through regulated corporations financed by small and big capitalists alike so that capital accumulation can benefit from the pooling of resources without unnecessary damage to competitive markets.