Time to Rethink Capitalism?

The leaders of publicly traded companies are beholden to the capital markets. Just consider the relentless pressure to meet the quarterly numbers. There once was a solid logic to this arrangement, but it no longer holds. The very logic that originally gave rise to free-market, competitive capitalism now supports free-market, competitive laborism—a system in which those who work for a firm reap most of the residual returns and have the greatest decision-making authority within it. This arrangement makes sense in terms of ethics and competitiveness. Two hundred years ago, an individual investor might take the bulk of his assets and plunk it down in a factory. The factory would hire day laborers and pay them a day’s wage. Who took the biggest risk in this enterprise and therefore ethically had a claim to any residual profits? The guy who put down the capital. And who had the biggest incentive to ensure the success of the factory? Capital. And who had the best information about the business and the greatest power to ensure the effective implementation of decisions about its operations? Capital. That’s the logic of capitalism: Those who take the biggest risks should be the controlling owners and receive the residual profits for reasons of both ethics and competitiveness. Times have changed. Today individual shareholders are so diversified that they rarely bear substantial risk in the individual firms in which they invest. If one of the countless businesses in which you invest through your pension plan or mutual funds loses 50% of its market cap, there is a good chance you won’t know about it. (Do you even know the names of all the companies you invest in?) But what if the firm you work for lost half its market cap? You’d be pretty anxious. In the company where you work, you’ve made large investments that you can’t diversify away, such as learning the business, building relationships, and creating a reputation. Today the big risk taker is labor, not capital. The same logic of ethics and competitiveness that once supported shareholder value maximization now leads to the conclusion that firms should focus on maximizing returns for labor. This isn’t an argument for a wholesale shifting of profits from capital to the talent working for a firm. To stay in business, after all, firms need to give market rates of return to all those who provide critical inputs—labor, capital, customers, and so on. If a firm doesn’t give a risk-adjusted rate of return to investors, it won’t be able to attract and retain capital and will fail. Likewise, a firm must provide a market rate of return to labor, in the form of competitive employment contracts and working conditions. Finally, a firm must deliver an attractive value proposition to customers or it will not sell its products. But after all stakeholders providing critical input receive their market rates of return, laborism theory says that labor should get the bulk of the residuals. If those with the greatest risk are most motivated to ensure that a firm remains competitive, then we expect that companies with a primarily laborist governance structure will tend to have an advantage. This thinking jibes with many executives’ gut sense that strategic decisions driven by the short-term demands of the capital markets don’t optimize long-term competitiveness. In fact, many highly successful legal and consulting firms are structured so that profits and decision-making authority are distributed to the partners, a subset of labor. Similarly, many leading German and Japanese companies are directed by boards that represent both labor and capital. Interestingly, competitive laborism theory also aligns with the mainstream strategic thinking that says that only firms with unique and valuable resources or capabilities will gain and maintain competitive advantage. Capital is a fungible, nondifferentiating resource that rarely provides a competitive edge. Today it’s labor’s generation and use of knowledge that is the greatest source of advantage for most firms. It makes perfect sense that those contributing the most valuable resource—labor—should make the decisions and have the rights to residual returns. Adam Smith would be pleased.

Time to Rethink Capitalism?

Summary.

Partner Center