The Institutional Truth About Free Markets

The theory which, over the past three decades, has become the ubiquitous orthodox free market wisdom, is widely assumed to be simply the current version of classical economics originally expounded by Adam Smith. Moreover, it might be reasonable to assume, it being the latest, it is the most insightful and effective, having been shaped by the errors and excesses of previous versions. The current free market model certainly includes Adam Smith in its provenance, but what makes it different from previous models is the fact it is also based on certain theoretical foundations which are demonstrably false and which previous versions did not share. It has become what J K Galbraith described as an institutional truth. That is, not a truth at all, but a downright lie, but one to which all associated must subscribe if their careers are to prosper.

The essence of the theory is encapsulated in the late Nobel laureate Milton Friedman’s corrosive assertion that ‘corporate officials’ have no other ‘social responsibility than to make as much money for their stockholders as possible’. When a simplistic yet fundamental dictum such as this becomes so firmly embedded in the popular psyche it is extremely difficult to dislodge, even when, as is the case here, it is not only wrong, but supports behaviour which contravenes company law.

The fixation with maximising shareholder wealth has been discussed in other postings on this site. The never ending search for short term gain has led to a deal making culture which is destructive of the real economy, supported by ‘creative’ accounting to hide risk and liability, authorised by collusive auditing. Which is what got us into the current mess.

Media coverage seems hardly to recognise the theory has failed. Despite public outrage, the media clings to the institutional truth. Even while condemning City greed, they offer no serious critique of the primacy of shareholder interests within a wholly free market economy.

Of the falsities on which Friedman based his dictum, a prime candidate is what economists refer to as agency theory. Others will be identified in future posts. It’s not a theory at all, but a simple assertion that the directors of limited liability companies are employed as the agents of the shareholders. Agency is a legal relationship which requires the agent to act in the best interests of the principal, in this case the shareholder. But the application of agency to this situation is dishonest. Directors are not the agents of shareholders. The limited liability company is a legal entity in its own right and, as discussed in ‘The Rise and Fall of Management’, the directors and managers have their employment contract with the company, not the shareholders. The directors have no direct contract with shareholders. Moreover, the shareholders’ only contract with the company is the purchase of share certificates which provide them with the possibility of dividends and capital growth, both of which are known to be at risk.

The problem for agency theory is that company directors, who it assumes are, like everyone else, wholly amoral self-interested individuals, would pursue their own interests, rather than those of shareholders. A widely applied solution is to convert directors into shareholders via the now familiar and famously generous share bonus schemes. The aim is less to do with performance incentives than the direction of that performance, turning it from the company’s long term interest, as required by company law, to the shareholders’ short term gain.

So the orthodox wisdom is both dysfunctional and dishonest. The question is what can replace it? Media pundits need some alternative to ‘business as usual’. The answer is far from clear, but perhaps the grain of an idea is contained in company law which requires directors to be concerned not only with the company’s long term but also to take account of the interests of all its stakeholders. This will never be achieved while only shareholders have a vote. Providing some enfranchisement of other stakeholders might be a start down a new road. A first step might be to grant employees, as the most fully engaged stakeholders, some franchise over strategic decisions such as mergers and acquisitions,.

Germany, for example, grants some franchise to employees through the two tier board system which provides employees with 50% of the supervisory board. This ensures some careful consideration of stakeholder interests before the company is sold off for a shareholders’ windfall. As a result the real economy in Germany has experienced rather less rape and pillage than in Britain, as any survey of manufacturing industry will vouch.

2 thoughts on “The Institutional Truth About Free Markets”

  1. The Origin of Financial Crises by George Cooper discusses another aspect of the failings of free market theories.
    In particular he makes a very good case that the efficient market theory doesn’t really hold for(financial) asset markets

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  2. Thanks for your pointer. Efficient market theory is one of two other false foundations on which I suggest Friedman based his approach. The other is transaction cost analysis. Together with agency theory, these three provide fertile ground for academic researchers but seem to do untold real world damage.

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