“The Origin of ‘The World’s Dumbest Idea’: Milton Friedman.”
That is how Steve Denning titled his article in 2013, describing the wacky concept that the sole purpose of a corporation is to make money for its shareholders.
I spent considerable time in the 1980s being concerned about a then-recent trend in big corporate America and wondering why virtually no one was publicly complaining about it. We were clearly in a different era of big business, and the general operation of big corporations was damaging the country.
Before that era, whenever big businesses, especially manufacturers, went into significant debt, positive outcomes were expected—most notably the creation of new jobs. But, in the 1980s, some large corporations were going into debt and harming the economy.
Previously, manufacturers borrowed money to increase their production capacity, which almost always meant hiring more workers, which was good for workers and good for the economy. However, in the 1980s, corporations were going into debt to buy smaller companies to liquidate them merely to increase stock prices. In the process, they almost always decreased their workforce, negatively impacting the economy. This was indeed a new phenomenon, especially in the extent of its prevalence.
It was about this time that I realized there was a disconnect between the share value of stocks on the NY Stock Exchange reported in the news every day and the U.S. economy. The stock market said more about the worth of stocks than the state of the economy.
I wondered what had caused this transformation of the actions of large manufacturers. And then, a few months ago, I discovered in Denning’s article the smoking gun—economist Milton Friedman, the person with famous and influential extreme free-market ideas.
Friedman was the leader of the Chicago school of economics and the originator of several wacky ideas.
A leading candidate for the Nobel Prize in economics, which he would win in 1976, Friedman wrote in an article in 1970, arguing that a corporate executive is an employee of the owners of the business, the shareholders. This idea was contrary to logical and traditional thinking, which held that an executive is the corporation’s employee.
In Friedman’s strange world, the money made by a corporation belonged to the stockholders, not the corporation as commonly recognized. But remember, the corporation owns its money.
He argued further that the corporate executive had a responsibility to conduct the business in a manner as to make as much money as possible–for the shareholders, as he claimed. To support his argument Friedman made the outrageous claim that a corporation—the legal entity—is a legal fiction, and the critical thing that mattered was the shareholders.
Shareholder value theory—the label for this approach—was not a sound idea; however, people in the private sector latched on to it. Many welcomed the idea of focusing totally on making money and forgetting about any concerns for employees, customers, or society.
Shareholder value theory pushed the idea of compensating CEOs with high pay related to stock prices and payments in stock shares. But this model of business has failed. Among other problems, it ceased to accomplish its primary objective—to make money. Critics say it has made less money.
One of the reasons for the failure of shareholder value theory is there is too much emphasis on short-term goals related to stock prices and not enough attention on long-term plans that would make the company more money.
Jack Welch, the famous CEO of GE, was once the poster boy for this theory, as in his 20 years as CEO of GE, the value of GE stock increased from $14 to $384 a share.
However, through time Jack Welch came to be one of the strongest critics of shareholder value. In 2009 he said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers, and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”
Unfortunately, some of the tenets of shareholder value theory are still prevalent in the world of big business.