We Need More Gordon Gekkos

A while back, writing on the origins and causes of the banking crisis, Michael Lewis said the principal-agent problem was to blame:

John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation…He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders…But it made fantastic sense for the investment bankers.

And before he waxed poetic on greed, you’ll remember in the movie Wall Street, Gordon Gekko had this to say to the shareholders of Teldar Paper:

The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake. Today, management has no stake in the company! All together, these men sitting up here own less than three percent of the company…you own the company. That’s right, you, the stockholder. And you are all being royally screwed over by these bureaucrats, with their steak lunches, their hunting and fishing trips, their corporate jets and golden parachutes.

Gekko was the villain. He shouldn’t be. Robin Hanson has a thought-provoking post up on why we need a freer market for Gordon Gekkos to roam in. The source article he cites on a market for corporate control is here. Excerpt:

Firms whose share prices are lower than they could be if managed by more talented or highly motivated managers are attractive takeover targets. By buying up enough shares to vote in a new board of directors, a bidder can then replace an inefficient or ineffectual management team. The bidder profits when the new management team gets results, which come in the form of improved corporate performance, higher profits, and, ultimately, higher share prices…

Numerous studies show that shareholders in firms that are the subject of takeovers enjoy significant profits. Gains to target shareholders average 40–50 percent above the prices at which target firms’ shares traded immediately prior to the takeover.

There’s a subtle point that both Gekko and Michael Lewis miss in their analysis. Yes, they suggest, one way to avoid the negative consequences of a principal-agent problem is to collapse the distance between the agent and the principal, as would be the case in a private company. In this way we could have avoided the banking crisis Lewis says. If the bankers had had to face the full consequences of their risk-taking–instead of passing it onto the shareholders–then these financiers would have been more prudent. Likewise Gekko says Teldar is run poorly because the management has no stake in the company.

But that begs the question about the shareholders–why are they so lazy or incompetent with their own money?

In truth, it’s not so much having a direct stake in the company that matters.  Gekko’s analysis is off, but he’s a player in a very important game. Shareholders need a free market in corporate control. If you artificially diminish the supply of able managers (with stifling, anti-corporate raider regulation), then the quality of management will decline, too. Even if no one raids a corporation, a threat can be as good as the execution.

The differences between a market in corporate control and one in government control deserves exploration. Perhaps in a later post. I offer one passing thought: if you think the collective action problems shareholders face are insurmountable and lead to excessive risk-taking, then you can’t possibly believe voting is any better.