By Mark Blessington
In Adam Smith's day, investment of personal savings into business drove economic growth. Most economic activity back then involved small local companies, and nearly all of them relied on individual investor capital for formation and growth. Therefore, he argued, it was imperative to encourage individual investors by awarding them with shares of company stock that held an exclusive claim on company profits.
The world has changed dramatically since Adam Smith published Wealth of Nations in 1776. Today's economy, when viewed from an overall or macro perspective, no longer depends on stockholders. The cumulative net value of stock flows in and out of corporate coffers has been negative since 1987 (See chart. Data from the Federal Reserve Board). Between 1987 and 2014, nonfinancial corporations spent $5.8 trillion more on stock buybacks than they gained from issuing stock.
In other words, at the macroeconomic level, stockholders no longer add economic value when it comes to corporate funding. They have been replaced by banks; they now underwrite almost half of all corporate funding. While there are exceptions on a company-by-company basis, the macroeconomic truth is that shareholders are irrelevant to corporate formation and growth. There is a new game in the economic world, and it has nothing to do with that portion of classic economic theory that asserts shareholders are the driving force behind economic growth.
A different portion of classic economic theory, the principle of supply and demand, can help explain exactly what is behind the avalanche of stock buybacks since 1987. Stock buybacks reduce the number of shares available for active trading on the stock markets, which reduces supply. In general, when markets encounter a reduction in supply for an item with no change in demand, the item becomes more difficult to acquire, which drives up its price. When a company buys back shares of stock, they are trying to increase their stock price by reducing supply. In fact, it would be foolish for a company to buy back stock unless the likely outcome was a stock price increase; there is no better business reason for doing it.
We know for certain that a small portion of U.S. households own the lion's share of wealth associated with stocks. So it stands to reason that the major beneficiaries of stock buybacks are the top 10% of U.S. households. In other words, corporations spent $5.8 trillion to make the top 10% wealthier (see G. William Domhoff).
Does the economy benefit when stock prices rise? In Adam Smith's day, the answer was yes because it encouraged further investing in business expansion. But companies no longer use stocks to fund their investing, so that benefit is gone.
It has been argued, with almost no empirical success, that when wealthy people get wealthier, the whole economy benefits (aka trickle-down economics). The more impressive fact is that the economy benefits to a much greater extent when poor and middle class incomes rise. The reason is obvious and simple: poor and middle class families spend almost everything they earn, which in turn feeds economic growth. In contrast, wealthy households don't spend newfound wealth, they invest it. And, as we now know, investing no longer drives the economy, it only makes rich people richer.
The picture becomes even more unsavory when considering executive compensation programs. Corporations regularly issue gigantic stock packages as part of their executive compensation programs. When the company's stock price rises due to a buyback, executives can earn more from their stock sales. This is a nasty case of the fox guarding the henhouse. CEOs advocate for stock buybacks because they directly increase personal wealth.
CEOs also benefit from stock buybacks because it makes company performance look better, even if it is only a momentary jump in stock price. If the buyback is well timed, it occurs just before the board assesses top executive performance. High stock prices lead to more favorable assessments, and therefore bigger stock awards.
A third benefit of buybacks is to offset the dilution created by monstrous stock awards for senior executives. These stock grants increase the supply of stock, which puts a downward pressure on price. The buyback offsets this pressure and pushes price back up.
When a company has great ideas, classic economic theory holds that profits are plowed back into the company to generate even more profits. The massive level of buybacks suggests that either Corporate America has run out of great ideas, or CEOs are more interested in personal gains.
William Lazonick goes even further. He argues convincingly that stock buybacks actually hurt everyone except the top 10%. (See Profits without Prosperity, Harvard Business Review, September, 2014). His research shows two important things. First, the magnitude of stock awards is shocking. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received an average of $25 million each in stock and stock options. Second, Lazonick shows that profits from productivity gains are consistently diverted to executives at the expense of other employees. He concludes that stock buybacks are the core engine driving wealth disparity in the U.S., and he proposes sweeping reform of executive compensation practices.
Perhaps the most far-reaching implication of the last 30 years of stock buybacks involves the damage it does to the classic view of economic risk.
Adam Smith presented a six-step argument:
(1) Workers are paid immediately and fairly for their time at work.
(2) Some workers are more productive than others and earn more money.
(3) Some highly productive workers wisely save and accumulate some of their earnings.
(4) Some savers are brave enough to invest in businesses.
(5) Some investments are successful and create incremental profits.
(6) Incremental profits drive overall economic growth.
Adam Smith held the fourth step to be the only relevant economic risk because it was the essential ingredient in driving economic growth; without it there was none.
If we accept Smith's logic, then what happens when step four becomes extraneous to economic growth? Shareholder economic risk goes to zero. To Smith, there was zero economic risk for the worker and the saver because they were not instrumental to economic growth. Only one risk--shareholder risk--was imperative for economic growth. All other economic risks were zero. Since shareholders no longer create economic wealth, they also represent zero economic risk.
Now for the clincher: Since shareholders have zero economic risk in the classic sense, they have no legitimate claim on company profits. They fall into the same camp as the worker and the saver.
After recovering from the initial shock of this deduction, we see that it is actually a fairly accurate description of what is happening in the U.S. economy. Aren't most stock transactions mere speculation? Aren't shareholders powerless in taming CEO pay? Aren't shareholders upset by the $1.9 trillion currently held in reserve by American businesses rather than distributed as dividends? (See Adam Davidson, Why are Companies Hoarding Trillions? The New York Times, January 20, 2016.)
In the final analysis, shareholders have lost relevance in today's economy. Our rhetoric needs to catch up with reality. Enormous stock buybacks tell us that today's corporate mandate is not to maximize shareholder value, but to maximize executive pay.
Our economy is much better served by recognizing the complex role corporations play in society. They serve many masters with overlapping and unique interests. Employees, executives, shareholders, communities, society, and the environment are all valid stakeholders. Shareholders no longer stand head and shoulders above the rest. Today's most pressing economic question is: Why do we let executives curry favor with stockholders about their mutual interest in rising stock prices while minimizing other stakeholder interests? The economic interests of employees, communities, society and the environment seem far more palpable than those of a handful of executives and wealthy stockholders.
The new corporate mantra should be: "The shareholder is dead. Long live the stakeholder."
What do you think? Join the debate. Tell us what you think in the comments section below.
Mark Blessington is a sales and marketing consultant and has worked with many of the world's largest corporations. He has written four books, ranging from Deep Economics to Sales Forecasting.