EPILOGUE

Why stop in 1919? The Roaring Twenties were only a year away. It would not be until late in that decade that Americans shifted much of their investment capital from bonds to stock and changed their investment styles from anticipating income to gambling for capital gains. It was not until the mid-1920s that the bull market really got going and collapsed into the Great Crash, one of the most spectacular and psychologically enduring events of American economic history. So one might say that my story remains incomplete.

I have two reasons for stopping where I have. The first, as I have already noted, is that finance had completed its triumph over industry and everything necessary for the modern market was in place by 1919. The second reason arises from the obvious parallels between the 1929 market crash, the stock market bubble of the late 1990s and the related corporate scandals that broke at the beginning of the twenty-first century.

One might reasonably argue that those parallels are all the more reason to extend this story through 1929 and its aftermath. But if I had given in to the temptation to do this I would have created a significant risk of distorting the history of the development of the speculation economy. I might have drawn too much attention to that manic moment in American history, a moment that was the exception, not the rule. That risk might have been exaggerated by inevitable comparisons with the more recent, and equally exceptional, events of the late 1990s. The lessons to be drawn from those episodes are important. But they are, in the main, lessons about how exceptional conditions can pervert individual and mass behavior. They do not teach the way the American economy is intrinsically speculative even under normal conditions. Manias and panics happen and speculative bubbles balloon and burst, all as episodic if unpredictable aspects of our economic life. But they are exceptional for all that.270

One can, I think, draw more important and enduring lessons from the story of the formative era of American corporate capitalism, lessons all the more important precisely because they come from the stuff of everyday economic activity rather than as a sometime thing. The speculative stock market capitalism I have described seems fundamentally and inextricably embedded not only in our corporate financial structure but also in our economic and cultural consciousness and behavior. Our modern corporate economy was stock market capitalism from the moment of its conception. The stock market is in our economic genes, embedded as a mutation that formed during the great merger wave. Speculative bubbles come and go, but it is the stock market that drives American corporate capitalism. As I will shortly describe, the events of the years following 1919 continue to bear this out.

Corporate capitalism driven by the stock market produces corporate behavior fashioned by the market’s demands and expectations. The market may from time to time take a long-term approach, favoring good wages and worker training, money spent for research and development, long-term strategic planning, sensible executive compensation and forthright disclosure. Or it may, as it did in the last decades of the twentieth century, demand short-term stock price increases that encourage executives to underpay workers, engage in promiscuous layoffs, cut training programs and research and development, ignore strategic planning and, in an extreme case like Enron, lie about corporate performance. In short, and as the historical development of American corporate capitalism demonstrates, the incentives created by the speculation economy make stock price the metric by which corporate performance and business behavior are measured.

There are reasonable expectations, and there are expectations that have no basis in reality. An economy characterized by widespread holdings of common stock might well be a market grounded in reality, a market that prices securities on the basis of business fundamentals such as the value of assets and past profits. Investors might hold stock for the long term, anticipating their returns as the business grows in the ordinary course, developing new markets, new efficiencies and new products. But speculation always exists in the characteristics of common stock. Speculation always exists in the capital structure of the American corporation.

John Maynard Keynes’s perceptive description of the market as a psychological guessing game captures the nature of the speculation economy. Far more common than investing on the basis of fundamental values is investing on the basis of expectations that are built upon others’ expectations, which themselves are floated upon the expectations of still others. Stocks trading at unsustainably high prices is a possible result. Sometimes companies, like Amazon in the late 1990s, trade at very high prices with no profits at all. Its stock, like the stock of many other companies at that time, was little different from the watered stock of the merger wave. Many other stocks regularly trade at very high multiples of earnings. But at some point expectations must give in to reality. Corporations must invest in productive assets; they must produce real cash profits. When they do and expectations are justified by performance, American corporate capitalism is at its best.¹271

But expectations built upon expectations can take on their own life, as Keynes observed, and this has often characterized the American market. During the last twenty-five years, expectations have become exaggerated. The multiples of earnings at which stock is trading are a good metric for market expectations. In his book Irrational Exuberance, Robert Shiller showed an almost unbroken spike in average price-to-earnings ratios beginning in the early 1980s at around ten times earnings to reach forty-five in 2000, earnings multiples that far exceeded historical averages. The more unrealistic expectations become, the more the market puts pressure on corporate managers to fulfill its sense of reality. If they fail, the market punishes them by deserting the stock, dropping its price and jeopardizing management’s income and job security. The natural response is for management to do what it has to do in order to meet the market’s expectations, no matter how unrealistic those expectations may be. When this occurs, the long-term health of the American corporate economy suffers.²

THE MANAGERIAL ERA

The effects of the speculation economy that developed during the early decades of the twentieth century receded from view during the middle of the century. The period from the late 1920s through the early 1970s is known as the managerial era, a time when directors and managers did their best to keep corporate control out of the hands of public stockholders. Its development can be detected as early as the first decade of the twentieth century. Corporate boards protected their abilities to run their businesses by creating structures that relieved them of excessive pressure from the speculation economy they created. Leading bankers sat on boards to control the combinations they helped to put together. The interlocking directorates that resulted allowed them to maintain some assurance that the businesses they financed were run profitably and responsibly, providing returns to public stockholders but preventing the market from exerting pressure on management.

Interlocking directorates were only one device. Morgan, among others, used voting trusts as one way of vesting control in boards rather than markets. In their classic 1932 study, The Modern Corporation and Private Property, Adolph Berle and Gardiner Means found that 21 percent of the two hundred corporations they studied were controlled by means of voting trusts, nonvoting stock, super-voting stock and pyramiding, all of which placed control in the hands of managers, directors or controlling shareholders, and held off the pressures of the market. In fact, they claimed that 44 percent of these corporations were under some form of management control. Management also quickly learned to command the proxy machinery of their companies, leading to the well-known phenomenon that stockholder voting during the whole of the twentieth century was almost entirely ineffectual.³272

Corporate control seems to have been lodged in those with major financial interests in the corporation, whether as controlling families, banks, or executives with major assets invested in their own corporation’s stock and cross-owning significant amounts of stock in other major corporations. The Temporary National Economic Committee found that 140 of the 200 largest nonfinancial corporations in 1937 had a controlling block of stock. A 1959 Conference Board study found that 27 percent of the directors of 638 industrials either were nonemployee large stockholders or represented financial institutions that had an interest in the corporation, again suggesting significant controlling shareholder influence. Robert Larner concluded that between 42.7 percent and 58.7 percent of the 300 largest public corporations among the Fortune 500 were family controlled in the mid-1960s. Robert Burch found that, as late as 1965, corporate control of almost half of American corporations lay in the stock ownership of founding families and their descendants. Other data, less carefully collected and more anecdotal, support the conclusion that a significant degree of corporate control was in the hands of small groups of large shareholders. More recent studies suggest that large stockholdings continue to characterize the ownership structures of many of the biggest American corporations.⁴

The consequence was to allow those with long-term interests in the corporation to insulate management from market pressures in making their business decisions. This was hardly perceived as an unalloyed good. On the contrary, the consensus thinking about that period is that managers worked to serve themselves at the expense of shareholders, to pay themselves high salaries and sometimes shirk their responsibilities while avoiding excessive risk taking that might produce shareholder profits if successful or jeopardize their jobs if not. There is no doubt that this was sometimes true. We cannot know what the consequences of an unrestrained speculation economy would have been had the market been given free rein, because of course it was not. But there is evidence that despite their protection from the market, managers had strong incentives to serve the stockholders.273

For one thing, stock in their companies formed a significant proportion of managers’ compensation during the managerial era, making their earnings dependent on corporate profitability. One study shows that stock options alone comprised 36 percent of total executive compensation from 1955 to 1963. Still another found that 77 percent of NYSE and American Stock Exchange-listed companies had executive stock option plans by 1957. Inland Steel, for example, had set aside 11 percent of its stock for executive options, and Ford, although family controlled, allocated almost 7 percent.

In addition to managers’ dependence upon their corporation’s stock performance for their pay, they also invested substantial amounts of their personal wealth in their corporations. A 1939 study of executives and directors of the 97 largest manufacturing companies found that on average they together owned 7 percent of the stock of their respective companies. Another study found that the directors of the 100 largest industrials owned on average 9.9 percent of their company’s stock in 1957. Several others confirmed that management stock ownership in their own corporations represented significant portions of their investment portfolios. Another study of the CEOs of 94 corporations during this period concluded that the expected annual return from managers’ ownership of stock in their own corporations was equal to 41 percent of their median salary and bonuses. Recent evidence suggests that managers’ ownership of their corporation’s stock continued to increase throughout the century.⁵

Managers were deeply invested in their own corporations, but they were also heavily invested in stock more generally. One historian, writing of the early 1950s, identified “the managerial class [as] the largest single group in the stockholding population” with a larger proportion of that class owning stock than any other group in America. “Management is the class most interested in the highest dividends…. To talk of a separation between management and major stockholders in the United States is obviously quite impossible; they are virtually one and the same.”⁶

Compensation and performance data support the conclusion that managers were devoted to the interests of stockholders during the managerial era. A number of careful studies showed no statistically significant correlation between board structure and executive compensation. They did find statistically significant positive correlations between corporate profitability and managers’ compensation. It seems that stockholder profit was a primary determinant of executive pay during the managerial age.

The control and compensation structures of large corporations during the managerial age served the interests of stockholders even as managers were protected from the pressures of the market in running their businesses. It was also during this period, starting at the end of the 1930s, that financial institutions began to become significant investors in corporate stock in addition to the stock they held in their trusteeship roles, beginning with preferred stock and moving into common stock in the 1940s. While these institutions were decades from asserting their inchoate power, their interests were arguably aligned with those of manager-stockholders.274

While the mid-century corporation continued to look after the interests of stockholders, the pressure of the speculation economy was kept in check from roughly the mid-1920s until the early 1970s by the ownership, compensation and control structures of the giant modern corporation. The twenty years between 1940 and 1960, the height of the managerial era, were, for the most part, a time when price-to-earnings ratios were maintained at one of their lowest points since the creation of American corporate capitalism.⁷

SEPARATING STOCK FROM BUSINESS

While corporate managers were concentrating on running their businesses as they saw fit during the middle of the century, theoretical developments in financial economics, theories with profound practical consequences, completed the domination of industry by finance, largely by separating stock from industrial concerns. These developments paved the way for the transformation from financial domination over industry to the full-blown triumph of the stock market over industry. The crowning glory of this line of theory was the development of the capital asset pricing model (CAPM) by William Sharpe in 1961. Sharpe’s work was based on Harry Markowitz’s earlier-developed portfolio theory. The common investment wisdom prior to Markowitz’s work was that diversification of low-risk stocks was the safest form of investment, albeit with ordinary returns. Markowitz demonstrated that a portfolio of carefully chosen stocks, whatever their risk level, could maximize an investor’s overall return as long as they moved in different directions from one another as market conditions changed.

The capital asset pricing model began with Markowitz’s conclusion that the risks of investing in a specific corporation could be diversified away. Consequently, corporations did not need to compensate their stockholders for corporate-specific risks. The only nondiversifiable risk was the risk inherent in the market itself and therefore common to all securities. This was the risk for which stockholders were compensated. CAPM thus predicts a stockholder’s expected return on the basis of the stock’s risk with respect to market movements without any regard to the individual risks presented by a given corporation. It does so by measuring its past performance in relation to the rest of the market in a single number, the product of a regression analysis called beta. CAPM allows investors to build the kinds of potentially lower-risk, higher-return portfolios described by Markowitz, based solely upon a narrow range of information about the stock. The business itself matters little, if at all. All an investor needs is beta. No balance sheet, no profit and loss statement, no cash flow information, no management analysis of its performance and plans, no sense of corporate direction, no knowledge of what is in its research and development pipeline, no need even to know what products the corporation makes or what services it provides. Just beta. The stock is virtually independent of the corporation that issued it. CAPM has been adopted and is daily used by countless stock analysts and institutional money managers. Almost every American who invests in the market through mutual funds or other institutional media has invested on the basis of CAPM.⁸275

Now one might object that I overstate the separation of stock from the corporation, of finance from business. There is truth in the objection, but the objection is largely hollow. That truth is that a business needs profits to survive, and to earn those profits it must grow and evolve. But stockholders in the speculation economy want their profits now, and they do not much care how they get them. Once the stock has been separated from the business, all that really matters is the movement of the stock. Modern financial derivatives take things a step further by allowing investors to profit from stock price movements without even having to take the risk of owning the stock.

THE RELEASE OF THE SPECULATION ECONOMY

Managerial ism began to collapse in the 1970s, unleashing a stock market that had been restrained over the preceding four decades. A number of factors ended the managerial era. The conglomeration movement of the 1960s was rapidly reaching a crisis point and the stock market was collapsing. The new conglomerates themselves presented problems for directors, including conflicts of interest among various conglomerate boards and an overwhelming complexity of worldwide business. The Watergate investigation’s revelation of illegal corporate campaign contributions followed by the SEC’s questionable payments investigation discovered corporate domestic and foreign bribery that diminished confidence in corporate America and brought forth calls for reform. The impregnable Pennsylvania Railroad, once the nation’s largest corporation, had gone bankrupt as the newly merged Penn Central without ever missing a dividend, and with its failure came an SEC investigation into the causes, numerous suits against directors and the development of the securities class action. A number of other bankruptcies and severe financial losses, brought on in part by recession, occurred, and with them the resignations or firings of some prominent CEOs. Chrysler was in need of its eventual federal bailout and even New York City faced bankruptcy. An activist SEC, aided by the United States Court of Appeals for the Second Circuit, had a string of successes in its attempt to make the securities laws into a body of federal corporate law with far more teeth than state law. Shareholder proposals by activist groups advocating a variety of social causes were being thrust on corporations and litigated in court.⁹276

Corporate governance reform was the result and the target was the managerial board. The American Law Institute began to develop principles of corporate governance advocating a board comprised mostly of independent directors whose job would be to monitor management’s performance. By definition, the independent director had no other relationship with the corporation, so the theory was that their only loyalties would be to the public stockholders. Acceptance of this model would break the barriers that had protected managers from stockholder pressure during the managerial era.

Although various business organizations initially fought the idea, the model of an independent monitoring board had become reality by the early 1980s and, by the 1990s, firmly enshrined in Delaware corporate law. Shareholder voting did not exert meaningful pressure on boards and managers, for shareholders remained largely dispersed and the rising class of institutional investors typically voted with management. But breaking the old protections in this way did provide the exposure that made stock market pressure a highly effective way of channeling managerial attention to the needs of the market.

The takeover decade of the 1980s dawned and the speculation economy that had been suppressed during the managerial era took off. As it did, a new term for American corporate capitalism came into use. Shareholder-valuism was used to describe the purpose of the corporation. Rising stock prices would be the proof that it had succeeded.¹⁰

The modern exaggeration of the domination of finance over industry started during the takeover decade of the 1980s, when the hostile takeover became an extreme way to satisfy stockholders’ demands for short-term profit maximization by buying them out at a substantial premium over market. Stockholders began to invest in the hope of finding the next big takeover target. The looming pressure of the takeover market began to lead managers to do what they had to in order to keep their company’s stock prices high and reduce the risk of hostile takeover. Corporate lawyers developed defensive devices like poison pills to keep bidders at bay, and state legislatures followed by enacting antitakeover laws to protect their corporate franchises. But stockholders had again tasted the fruits of easy money.¹¹277

At the same time, institutional investors such as mutual funds, pension funds and insurance companies, whose stakes in corporate America had been swelling since the middle of the twentieth century, became major shareholders in even the largest American corporations. Most observers in the late 1980s and early 1990s hoped that institutions would use their market power to demand better performance from corporate managers. They did. But better performance meant continually increasing stock prices and the institutions began to show growing impatience. As the 1990s wore on into the twenty-first century, they began to use their power to demand corporate governance reforms that reversed the effects of antitakeover devices and exposed their portfolio corporations to the market for corporate control. CEO turnover rates began to increase and boards felt threatened. Keeping their eyes on their stock prices was the key to survival, or at least to high paychecks.¹²

Institutions also reflected their short-term interests in the way they compensated their portfolio managers. These typically young portfolio managers, who could expect to peak in their early forties, were generally compensated on the basis of their quarterly performance. This gave them powerful incentives to manage their institution’s portfolios to achieve the highest quarterly prices possible.

Corporate managers did not need institutions to tell them how important the stock market was. Congress amended the tax code in 1993 to encourage corporations to compensate their executives with stock options. By the late 1990s, the average Fortune 500 executive received more than half of his or her compensation in this form. And waiting periods on exercise were few and far between. The idea was to align management’s interests with those of the stockholders. But the stockholders with whose interests management was now aligned were not the controlling families and individuals whose long-term investments in their businesses had dominated during the era of managerialism. They were the impatient stockholders of the public market. It worked devastatingly well. Some companies even developed option plans like that of Computer Associates, which was triggered only when the company reached and maintained a certain stock price for sixty days. Despite their best judgments as to the well-being of their corporations, managers were given irresistible incentives to maximize stock prices at almost any cost to the corporation’s long-term health.¹³

The market reflected these developments, showing a dramatic increase in short-term stockholdings. Annualized turnover of all stock on the New York Stock Exchange was 118 percent in December 2006 as compared with 36 percent in 1980 and 88 percent even as recently as 2000. The average mutual fund had a 2006 turnover rate of 110 percent. There can be little question that American business is driven by finance. And the demands of finance have become short-term.¹⁴278

As I noted in the Prologue, a 2005 survey of more than four hundred chief financial officers found that 80 percent said “they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets, and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation.” But the problem goes beyond business self-mutilation. As the Conference Board put it, “the pressure to meet short term numbers may induce senior managers to search for a number of business costs (i.e., the cost of a state-of-the-art pollution control system) to externalize, often to the detriment of the environment and future generations.”¹⁵

The dominance of finance over business is, taken alone, a neutral fact. Wise and patient investors whose interests are grounded in the long-term health of the business align well with the long-term growth and sustainability of their corporations and the American economy. But we have reached a stage in the United States where our economy is characterized not simply by the triumph of finance over business, but by the domination of a stock market that has followed the logic of a widespread common stock structure to largely detach itself from business. Finance now is vested in a huge, anonymous, constantly changing market of public stockholders ranging from day traders to TIAA-CREF. When the chance to get rich quick presents itself, as it has so often in our economic history, the market takes advantage. It is only in the rare case that management can resist this pressure, usually with help like a controlling interest in the stock.¹⁶

Public common stock ownership is not, of course, unique to America. But the speculation economy is. Much of the rest of the industrialized world is characterized by ownership and control structures that provide some insulation for corporate management from the pressures of the market. In continental Europe and Japan, corporate ownership is characterized by concentrated stockholdings in families, investor groups or banks in a manner that centralizes control. Canada, New Zealand and Australia also have economies characterized by large blockholdings of stock. Widely dispersed stockholdings are not common in these economies, nor is frequent trading. Only Britain’s corporate economy resembles that of the United States, and that economy developed historically in a very different manner.¹⁷

The history of American corporate capitalism is a story that has not ended. We continue to live in and embrace an economic order that was created at the turn of the twentieth century. The history of American corporate capitalism is living history, and the course of living history can be changed. We may choose to accept that history as we have developed it. Or we can alter it, keeping what is good and modifying or changing the aspects of our economic story that trouble us. The history of the speculation economy is a history of choice.279

When corporate economies are ruled by concentrated ownership, the responsibility for success or failure is primarily on those who own the controlling interests. When a corporate economy is ruled by a stock market characterized by the dispersal of ownership throughout the society, responsibility shifts. Members of the speculation economy typically treat their participation in American corporate capitalism as a private matter with their decisions to be made on the basis of their own self-interest and without much regard for the behavior or decisions of others. But the nature and power of the speculation economy make the well-being of corporate America and, with it, the financial health of the nation, a matter of public concern. Most Americans participate in the speculation economy in one form or another. It is we who bear the responsibility for the consequences. It is we who create the demands of the market, who shape the incentives that drive corporate management. Perhaps the most important lesson of the history of the development of American corporate capitalism is that the continuing strength and health of the American corporate economy and thus American society requires market behavior that encourages management to work for the long-term economic welfare of their businesses, their people and thus of the nation. Those incentives can only be provided by the market for, in the end, the market is the master.

The speculation economy is ours. It is what we make of it.