The Infinite Economy – (Public) Corporations (Part I)

(12/18/2008) - Corporations and national governments are the dominate economic institutions of the world (I’d love to hear which you think is stronger in the comments).  In this article, I will first look at some of the most common but misleading statistics regarding corporations and their size and influence.  Second, I will look at five characteristics shared by all modern corporations, and examine some of the institutional patterns these characteristics help create.

Sometimes corporations are given a bit too much credit.  In his book The Bridge at the Edge of the World, James Gustave Speth writes that, “On a global scale, the thousand largest corporations produce about 80 percent of the world’s output.”  He adds one of the most oft repeated statistics about corporations, “Of the hundred largest economies in the world, fifty-three are corporations.”  Variations of these statistics are commonly used by anti-corporate activists and commentators to characterize their foes.  The point, I guess, is that corporations are all-powerful behemoths.

This portrayal is very misleading and I do not think it is the best way to look at corporations no matter what you think of them.  Let’s start with the first claim, “On a global scale, the thousand largest corporations produce about 80 percent of the world’s output.”  Speth doesn’t provide a footnote for this source, so I did a little Googling.  The general consensus seems to be that the 1000 largest companies produce 80% of manufacturing and industrial output, not 80% of all output.  According to the research firm Global Insight, “Globally, manufacturing accounts for only 17% of GDP (in nominal terms), while the service sector weighs in at 65%.”  Granted, the world’s 1000 largest companies perform many services as well.  But its terribly misleading to say that they are responsible for “80 percent of the world’s output” when you really mean manufacturing output.  80% of manufacturing output is only 13.6% of total GDP.

The 53 of 100 statistic is similarly stilted.  World economies are ranked by their gross domestic product (GDP), which is a measurement of, “the total market value of all final goods and services produced within the country in a given period of time (usually a calendar year).”  By contrast, the size of a company in the above statistic is determined by its revenues.  The problem is that a company can record a revenue for the sale of a non-final product.  Six of the ten largest corporations in terms of revenues are oil and gas companies (Exxon Mobil, Royal Dutch Shell, BP, Chevron, Total, and ConocoPhillips).  Although they make money through various means (ConocoPhillips has a lot of refineries, BP is in the wind turbine business, etc.), a huge percentage of their revenue comes from selling crude oil, which is by no means a finished product.  Because of this discrepency, the statistic is pretty meaningless.

So if you see people making these claims, send them my post.  It doesn’t mean the points they are making with this information are invalid, but we need to promote the use of accurate data.  

Corporations are not be quite as large and powerful as they seem at first glance.  However, any group of institutions that produces 80% of industrial output is going to have a great deal of influence.  If we are going to understand the infinite economy and its effects on our finite planet, we need to understand how corporations work as institutions, not just how big they are or how much economic activity they participate in. 

According to Wikipedia, “a corporation is a legal entity separate from the persons  who found it.”  Five common characteristics of corporations include:

1) Delegated Management – The people who manage the company’s operations usually own little of the company they are running.  Instead, they are professional managers who receive a salary and usually stock options.  In an effort to protect the interest of shareholders from management malfeasance, corporate law has developed the “best for the corporation” principle, which states that management must act in the best interest of the company, i.e. they must work to maximize the wealth of the shareholders in the form of increased equity per share or through dividends. 

2) Limited Liability – An stockholder’s liability financial liability is a fixed amount, typically the amount of money he or she has invested in the company.  For example, lets suppose Ma Rong, whose net worth is $200 million, provides $5 million in venture capital to Klein Construction Inc.  When the Feds fine Klein Construction of $100 million dollars for pollution and labor violations, which the company is not able to pay.  They are forced into bankruptcy and liquidation.  Even though Mr. Rong owns a substantial portion of Henry Klein Construction, he is not responsible for paying the fine because his liability is the initial $5 million investment (which he loses).  Likewise, the bank that had a $2 million line of credit with Klein Construction cannot come after Mr. Rong for repayment of unpaid debts.

3) Investor Ownership – The company is owned by shareholders.  More often than not, large corporations are owned almost exclusively by institutional investors, which can range from an invested endowment, to mutual funds, to national investment funds.  Even in the largest corporations, however, a single person or small group of people can still own a large percentage of the stock.  Companies where this is true include Microsoft, Berkshire Hathaway, ArcelorMittal, and Reliance Industries (I think this should be the name of an evil comic book corporation).  Other companies, such as Aldi (discount German grocer and owner of Trader Joe’s), are large enough to be included in the Fortune 500, but are not considered public corporations because they are privately held.

4) Separate Legal Personality – Under U.S. law, a corporation is considered a “legal person.”  Other examples of “legal persons” include states, municipalities, political parties, trade unions, churches, ships and natural persons (real people).  This legal status grants some rights to corporations (and other legal persons), such as the right to free speech and due process. 

5) Transferable Shares – Shares, which express ownership in a corporation, are transferable.  Most transfers take place through sales on stock exchanges.

Institutional "Imperatives"

It can be said (and is) that corporations are just collections of humans, and therefore the actions of corporations are just the actions of humans.  But just as we are defined in many ways by the society they are part of, the actions and paths people take in life are sculpted by the institutions to which they belong.  In what way does the corporate institution influence the actions of its members?

Lets start with the first defining factor – delegated management.  Corporate management is typically hired from the ranks of experienced business professionals.  Though managers often receive stock as part of their compensation, it is usually a very small percentage of total ownership.  Unlike a sole proprietorship, corporate managers often do not benefit or suffer for the long-term consequences of their decisions.  Instead, their pay (and promotion) is largely determined by the corporation’s recent performance.  This made no small contribution to the meltdown of the financial sector in the Fall of 2008.  Managers and investors who were pessimistic and unwilling to buy into the housing bubble saw their careers suffer as executives who invested in the bubble saw their portfolios rise sharply.  This creates insentives for short-term, not long-term thinking.

It should be noted that delegated management doesn’t guarantee short term thinking.  Some corporate leaders, such as Warren Buffet, pick managers to run Berkshire Hathaway's numerous subsidaries who focus on long term business success.  However, in the corporate world as a whole, the structure of corporate compensation and corporate culture steers people (more often than not) toward short term objectives.  This needs to be fixed.  It is unreasonable to expect corporations to look out for the long-term environmental and social needs of society before they begin to look out for their own long-term needs.

The “best for the corporation” principle is a double edged sword.  On the one hand, it protects shareholders by assigning personal, legal responsibility to the manager.  The purpose of this law is to prevent managers from sabotaging the company they are managing in a way that benefits their other interests (for instance, if they have lots of stock in a competitor).  The downside is that managers face legal and institutional pressure to do what is best for the company without taking other issues – labor, health, or environmental policy – into separate consideration. 

The second defining feature – limited liability – helps to encourage enterprise and investment.  Limited liability allows entrepreneurs to invest capital without exposing all of their wealth (i.e. their home, their car, their fridge, etc.) to seizure if the enterprise fails.  But, as I pointed out in the example above, limited liability also shields individual shareholders from lawsuits and fines for damages resulting in the externalization of costs.  Lets suppose that X is the profit gained by externalizing costs, Y is the government fine if the corporation is caught, and Z is the percentage chance the fine will be implemented.  If X > Y*Z, there is no structural reason why managers wouldn’t externalize costs.  Getting rid of limited liability would solve this, but it would also create other problems.  Instead, I think government should do a better job preventing companies from externalizing their costs with a properly designed cap and trade system for emissions or stricter land controls for things like farming or forestry.

The last three characteristics linked together give corporations an indefinite lifespan.  Because corporations are a separate legal entity and ownership is transferable between investors, corporations are institutionally designed to last indefinitely.  Many of the world’s largest companies – Ford, GM, Exxon Mobil, BP, General Electric, Citigroup, Bank of America and more – were founded over a hundred years ago (or are directly descended from companies founded so long ago).  Though this sort of longevity is technically possible in privately owned companies, it is very uncommon.  Since owners usually pass their companies on to their sons, daughters, and/or other relatives, maintaining ownership becomes increasingly difficult as the years pass.  Some recipients don’t want to run the company, while others aren’t as talented and run their inherited companies into the ground.  An indefinite lifespan gives the corporation a competive edge and the ability to take up a long-term view, though that doesn't mean it happens very often.

These are just some of the structural components that have helped scuplt the corporation as it is today.  However, Not all corporations are the same  Some things, like corporate culture and the influence of primary shareholders, can have lots of impact on how a corporation acts.  The structural components I’ve outlined above push organizations in a specific direction, but do not require that they follow that path.  In Part II, I will look at some of these “soft” variables.