WASTE

Better laws and judicial enforcement make outright theft harder but do not prevent waste or incompetence. These cannot be stopped by legal means without risking corporate paralysis. Since investments are intrinsically risky, a system that allows a manager to be sued every time she makes a mistake will ensure that no manager will ever make a risky decision. U.S. jurisprudence recognizes this problem and has adopted what it terms the “business judgment rule.” This rule keeps a court from second-guessing any managerial decision provided it follows the processes set down by law and is not tainted by possible conflicts of interest. Thus, as far as the law is concerned, managers cannot steal, but they can waste resources at will provided they do so following due process.

The problem is particularly acute for mature firms. Because of their size and past successes, mature firms face limited competition. They also generate tremendous amounts of cash and, with limited legitimate investment prospects in their existing businesses, have no need for new financing. They have what Michael Jensen, professor emeritus of Harvard Business School, calls the “free cash flow problem”: too much cash on their hands.²³ Instead of paying it back to investors, management may waste it on pet projects, plush offices, executive jets, or charitable donations that enhance their status more than the company’s image. When waste is unchecked, tremendous value can be destroyed since mature firms typically have sizable resources to run down.

For example, alarm bells should start ringing in investors’ minds when a firm spends immense sums making an architectural statement with a new building. This often reflects the fact that the firm has little better to do with its money than waste it and that the chief executive officer has little better to do with his time than build a mausoleum to himself. Examples of this kind of phenomenon are legion. Phillipe Kahn of Borland International started building a $100 million headquarters—complete with a full-size basketball court, pool, and two tennis courts—in 1992.²⁴ Almost to the year, the building of the new headquarters marked the beginning of Borland’s eclipse from the front ranks of software makers.

It is useful to see a more detailed example of how a mature company can suddenly find itself destroying value as the changing environment makes its strategy obsolete. Consider the case of Beatrice, a U.S. conglomerate.²⁵ Started in 1891 as a food distributor, by 1940 it became one of the largest dairy product firms in the country. Between 1940 and 1976, Beatrice grew through the purchase of other food businesses. During this period, Beatrice’s skill was to pick targets—typically family-run businesses—that could benefit from Beatrice’s ability to raise financing and its professional management techniques. Until the late 1970s, this approach seemed to work well: Beatrice’s shareholders obtained a healthy 14 percent annual return over a twenty-five-year period.

In the first half of the 1980s, however, Beatrice became the classic example of a company whose core strategy had become obsolete. Finance was increasingly widely available to the family-owned firms that had been Beatrice’s traditional target. These kinds of firms did not need Beatrice’s deep financial pockets as much as in the past. Moreover, once Beatrice’s financial control over its divisions started slipping because of the wide availability of finance, it had to reassert control by introducing more layers of supervisory management and giving up its old decentralized approach. Finally, in order to help headquarters add some value to the divisions, marketing was centralized and marketing budgets increased.

Beatrice management did everything but recognize the handwriting on the wall. It undertook new, expensive acquisitions—in particular, that of the Coca-Cola Bottling Division of Northwest Industries for over twenty-two times earnings. Beatrice’s stock price fell by 7.1 percent on the announcement of this acquisition. The drop infuriated stockholders, who had been expecting money to be returned to them via a stock repurchase. The response of the then CEO James Dutt was, “You buy back your stock when you don’t have better use for your money.”²⁶ He was right, except he did not recognize that Beatrice had no better use for its money!

Instead, the firm wasted money on all the things management does when it runs out of investment ideas. Management moved to larger and more luxurious buildings and increased the size of central staff, from 161 in 1976 to 750 by 1985. It “reengineered” the organization every year. It changed its name and embarked on a corporate awareness campaign that seemed primarily targeted at glorifying CEO Dutt. Particularly egregious was the sponsorship of two auto-racing teams, which led to the expenditure of more than $70 million over a number of years. Apart from Dutt’s enthusiasm for the sport and his hobby of collecting automobiles, there seemed little connection between Beatrice and racing. The only subsidiary remotely related to automobile racing was worth just $97 million and slated to be sold.

Between 1976 and 1985, an estimated $2 billion in Beatrice’s value was destroyed. Responding to the abysmal stock price performance and a revolt from middle management, the board finally fired Dutt in 1985. He had one of the saddest epitaphs a CEO can have: Beatrice’s stock price rose 6 percent on the news of his firing!

Beatrice is not an exception. Consider what managements do when they receive the corporate equivalent of manna from heaven—when they win a lawsuit where the judgment mandates a cash payment to the winner and has no other effect on the firm’s business opportunities.²⁷ An example of such a windfall is the one Pennzoil obtained from Texaco in 1988. Pennzoil had an agreement to merge with Getty. Texaco interfered with this process, got sued, and when the dust settled after all the litigation and appeals, Pennzoil obtained $2.3 billion in compensation.

What did Pennzoil do with the money? Pennzoil paid about 5 percent of the award as an increased dividend to shareholders over the next three years after receiving the award. But it also reduced share repurchases (a way for the firm to pay shareholders that, except for tax considerations, is equivalent to dividends) by about 32 percent of the award amount over this period. Perhaps Pennzoil had been repurchasing shares earlier in anticipation of the award. Be that as it may, the net payout to shareholders fell by 27 percent of the award amount! Far from paying more to shareholders, Pennzoil actually reduced what they got!

But Pennzoil managers did not seem to suffer with their shareholders. They started on an acquisition spree, only to divest the major new line of business they had acquired just two years later, and at high cost. According to an estimate, “Pennzoil . . . destroyed 2 to 4 billion dollars of value relative to a more passive investment strategy in the three years after the award.”²⁸ Interestingly, as the payment from Texaco to Pennzoil became more and more certain as a result of the litigation, the combined market value of the two firms declined. The market correctly anticipated that Pennzoil managers would be like children who chance on a hundred-dollar bill near a candy shop: shareholders (and the children’s anxious parents) would have been better off if their managers had never got the money.

Despite this terrible performance, managers also paid themselves more. Pennzoil’s president had retired a year before the award, but the company brought him back and delayed the retirement of two other senior executives. These three retired soon after the award, collecting over $20 million!

The conclusion from an exhaustive study of such cases is that “an evaluation of the investment and diversification strategies of these firms suggested that the median firm does not use the award to create value.”²⁹ Too much cash is a real problem!

Anticipating that cash will be wasted when a company matures, investors will be reluctant to fund young firms. Therefore, a developed financial market has to find ways of mitigating the free cash flow problem. The most controversial (at least in the public perception) is a corporate takeover.

A free market for corporate takeovers is one way that the inefficient parts of a diseased corporation can be destroyed and the profitable parts given a new lease on life. In theory, it works as follows. As the stock market becomes aware that a firm is not being managed well, its share price declines. The more it declines, the more profitable it is for someone to buy shares, obtain control of the company, and restructure it. Restructuring usually begins with a change of management and its policies and eventually leads to the closing of some loss-making units and the selling of others to those who can manage them better. By the end of it all, a bloated, overweight firm becomes a nimble competitor. This is, in fact, what happened to Beatrice.

Within two months of Dutt’s departure, the firm was sold to a management group allied with the leveraged-buyout partnership of Kohlberg, Kravis, and Roberts (KKR). The offer made by the buyout group to shareholders just about compensated for the value that had been destroyed by previous management. Much of the offer was financed through a mixture of bank and low-rated debt, so that Beatrice emerged with 85 percent of its capital structure as debt. There was no way this debt could be paid off without Beatrice’s cutting unnecessary expenditures, selling assets, and breaking itself up. But this was precisely the objective. The unwieldy mix of assets that had been assembled under Beatrice’s roof was now to be broken up and returned to more capable owners. In the process, the nearly hundred-year-old firm would disappear.

While it may seem sad that a firm with such a tradition vanished, this was almost inevitable given the changed environment. The buyout only speeded up the inevitable. If Beatrice had held together, the dysfunctional conglomerate would have slowly bled to death, taking all its parts with it to the grave. With the breakup, at least most parts of the firm survived, albeit under different owners.

Some employees, certainly those at headquarters, did lose jobs. But other workers benefited because they had the opportunity to create more value and earn more, unfettered by inept management. And yet others benefited because they got the opportunity to run a business well. Reginald Lewis became the first African-American CEO of a Fortune 500 company when he obtained financing to buy a piece of Beatrice.

Changes in corporate control effected through takeovers or management buyouts are yet another example of the gap between public perception and the reality of finance. Few arouse as much indignation as corporate raiders such as T. Boone Pickens, who made hostile bids for a number of oil companies in the 1980s. Their creed, immortalized by Gordon Gekko in the movie Wall Street, is supposedly “Greed is good.” They are often portrayed as vultures, profiting by destroying stable managements, laying off employees who have given their lives to the firm, and exploiting those who stay by paying them miserable salaries. In truth, as Jerry Sterner says in the popular play and movie Other People’s Money, their role is similar to that of undertakers, a loathsome profession to some but absolutely crucial to a well-functioning society. An economy cannot be vibrant unless resources are taken from dying sectors and redeployed in sunrise ones. It is this process that corporate raiders speed up. To see why this is important, one only has to look at Japan, where sick firms and banks have sapped, and continue to sap, the strength of healthy ones as the economy attempts to share pain collectively.

Corporate takeovers are only one, and not necessarily the most effective, way to address corporate waste. Institutional investors who own large stakes in companies can also pressure the management. Higher institutional ownership does seem to be associated with higher company value.³⁰ On average, a 1 percent increase in institutional ownership in the United States translates to a 0.6 percent higher market value (as a percentage of book value) or $125 million more in value for an average-sized firm. Of course, it may be that institutional investors simply choose to invest in more valuable companies and have no direct effect on firm value. There are ways of ruling this explanation out. When a company is included in the S&P 500 index, many mutual funds simply replicate the index and invest in the company. The higher institutional ownership in these “index” companies does not reflect the value judgment of institutional investors but simply the application of a mechanical rule. Even institutional ownership driven by such mechanical considerations has a positive effect on firm value.

More evidence that institutional ownership is beneficial comes from examining the consequences of regulatory change.³¹ Before 1992, if ten or more investors in the United States wanted to discuss the performance of a particular company, they had to file a report with the Securities and Exchange Commission, detailing the purpose of, and participants in, the discussion. These requirements made it onerous for institutional investors to coordinate their actions. In 1992, this rule was done away with. The relationship between institutional shareholdings and firm value is twice as large after 1992 as before, consistent with the idea that institutional investors force companies to be better managed. That institutional investors help reduce waste in companies flush with cash is bolstered by the finding that the relationship between institutional shareholding and firm value is especially strong in firms that generate more free cash flow.

For mature firms, therefore, financiers play the role of policemen and undertakers, preventing the theft of resources and burying the dead. In other instances, however, they play the more creative role of midwife. Young firms need a very different kind of assistance than established, mature firms. Young firms have tremendous growth opportunities, and in an economy with good laws and decent accounting, most managers of young firms have the incentive to succeed (rather than steal or waste investors’ money). Top management runs the company in trust, not just for shareholders but also for junior management, which expects to succeed top management. The rewards for a growing firm come not from misappropriating current free cash, which is meager, but from the prospect of running a larger, more profitable firm. So managers can be relied upon to keep obvious wrongdoing by other members of the management team in check.³² The reason management needs close monitoring is that management may be inexperienced and headstrong and may unwittingly do the wrong thing.

Consider how venture capitalists (VCs) help inexperienced management, as gleaned from venture capitalists’ internal memos, written at the time an investment is decided. After investing, U.S. venture capitalists typically expect to play an active advisory role in about 50 percent of their clients. For approximately 14 percent of their clients, they intervene even before investing.³³

It would hurt the management’s sense of initiative if a venture capitalist shadowed its every move. Consequently, venture capitalists, in general, monitor lightly. However, the intensity of VC monitoring increases when performance deteriorates, leading to more direct involvement in the company’s management. In biotech start-ups, venture capitalists replace a start-up’s chief executive officer in 18 percent of the cases and increase the presence of VC-backed directors after the officer leaves.³⁴ VC monitoring is so intense that being physically too distant is a problem. So the decision to finance a deal is influenced by whether the VC is geographically close. Over half of the VC-backed firms have on their board a venture capitalist with an office within sixty miles of their headquarters, and 25 percent have a VC within seven miles.³⁵

The benefits of monitoring are augmented if the monitor has the power to intervene when she identifies a problem. For this reason, the right contract should provide investors not only with the right incentives to monitor but also with the power to intervene whenever needed. Venture capitalists insert many contingencies in their financing contract. For example, the contract may have a clause requiring the firm to accomplish a certain goal, such as generating positive cash flows, by a certain date. These are meant to be financial trip wires. Their purpose is not to trigger default but to provide the financier with a warning that some intervention may need to take place at that particular moment. The contract may also give the financier greater rights in decision making or a greater share in the firm’s cash flows if the goal is not met on time. If appropriately designed, these contracts give entrepreneurs powerful incentives to perform and give the venture capitalist some ability to intervene when matters deteriorate.³⁶

Given the great uncertainty surrounding start-ups, however, contingencies may be insufficient to provide the VC with the ability to intervene whenever needed. This is why most VC firms also use another instrument to control their investments: the staging of funds. Rather than providing a start-up with all the funds needed to develop its product, the typical VC funds a project for just a year. After that, the entrepreneur has to go back and ask for new money. Staging therefore assigns to the original VC a de facto right to terminate a company once a year. Between financing rounds, the lead venture capitalist visits the entrepreneur once a month on average and spends four to five hours at the facility during each visit.³⁷

All these forms of direct monitoring, however, are very expensive. The minimum return venture capitalists need from a successful project for it to be worth investing in is around 50 percent. While this required return reflects, in part, the high probability of failure of start-ups (out of four companies, one fails, two do moderately well, and only one is successful enough to go public), it cannot be justified on that basis alone. A large part of the justification for such a high return is compensation for the time and effort spent monitoring and advising a company. Financiers in developed systems do earn their pay.

Summary

In the first chapter, we illustrated the obstacles in the way of expanding access to finance and the consequences on everyday life when access is limited to those with collateral and connections. In this chapter, we have shown how these obstacles can be overcome. What is especially noteworthy is the extensive infrastructure that makes expanded access possible, ranging from academics who resolve knotty financial problems to investment bankers who find creative ways of allocating risk, from credit-reporting agencies that make credit histories widely available to experienced courts that know how to enforce complex financial contracts.

With this infrastructure in place, financiers can move away from lending only against collateral or on the basis of prior contacts to financing on a truly arm’s-length basis. This is not to say that there will be no role for collateral or contacts, but there will be substantial quantities of financing available even without them. Financing will rely much more on spreading risk widely, making use of publicly available credit histories and real-time information on borrower performance, and on designing financial contracts to provide the right incentives.

In the last thirty years, dramatic changes in financial systems around the world amounting, de facto, to a revolution have brought many of the advances described in this chapter to us. We have come closer to the utopia of finance for all. In the next chapter, we describe the magnitude of the changes, which will explain why we think of this as a revolution. We then examine some of the steps that made this financial revolution possible and explore how expanded access has changed our lives, giving us more economic freedom than ever before.

CHAPTER THREE

———————

The Financial Revolution and Individual Economic Freedom

A VERITABLE REVOLUTION has taken place in finance throughout much of the developed world in the last three decades. In 1970, the ratio of the value of all listed U.S. stocks to GDP was 0.66; by the year 2000, it had climbed to 1.5.¹ The increase in other countries is even more dramatic. In France, stock market capitalization rose from just 0.16 of GDP in 1970 to 1.1 times GDP in the year 2000.² Despite the recent fall in stock prices, markets today are many times larger relative to the economy than they were a few decades ago. The explosion in the size of stock markets is just one indication of what has happened. Entire new markets such as NASDAQ have emerged catering specifically to young firms. Institutions such as money market funds did not exist in the early 1970s. Now they hold over $2 trillion in assets in the United States. A large number of financial derivatives that are commonplace today, such as index options or interest rate swaps, had not yet been invented three decades ago. The turnover in the trading of such derivative instruments was $163 trillion in the fourth quarter of 2001, about 16 times the annual gross domestic product of the United States.³

In the same way as corporations have obtained new instruments with which to raise finance and allocate risks, individuals also now have expanded choices. Revolving consumer credit such as credit card debt has exploded from near nothing in the United States in the late 1960s to nearly $700 billion in late 2001.⁴ Firms and individuals can borrow not just from domestic institutions but also from foreign markets and institutions. Gross cross-border capital flows as a fraction of GDP have increased nearly tenfold in developed countries since 1970 and more than fivefold for developing countries. In the decade of the 1990s alone, these flows more than quadrupled for developed countries.⁵

We explain later in the book why the financial revolution took place when it did. For now, let us focus on the process by which it came about. There was no single magic action that led to this explosion. Instead, there were many interconnected processes at work. Let us examine some of these, then see what the consequences of expanding access to finance have been on daily life.

Financial Development

The foundations for today’s vibrant financial system in the United States were laid in the 1930s. That was a time when many countries decided to curtail financial markets and replace them with government control. There was such an undercurrent even in the United States—and we dwell on these issues later in the book—but it came up against a tradition in American political thought that has always retained a healthy skepticism about the possibility of fixing problems by legislative fiat. In a letter in 1922, Justice Brandeis wrote:

Do not believe that you can find a universal remedy for evil conditions or immoral practices in effecting a fundamental change in society (as by State Socialism). And do not pin too much faith in legislation. Remedial institutions are apt to fall under control of the enemy and to become instruments of oppression.⁶

Instead, his proposed alternative was what we would now call transparency, which he referred to as publicity.

Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policemen.⁷

This philosophy permeated the “New Deal” financial legislation that was rushed through Congress in 1933 and 1934, soon after Franklin Roosevelt became president. In fact, Roosevelt’s speeches often paraphrased the above quote from Brandeis.⁸ Some of the New Deal legislation was politically, rather than economically, motivated, and not all of it, especially not the banking legislation, promoted competition.⁹ But the legislation gave the U.S. financial system the accounting, regulatory, and legal foundation on which to build. When the shackles were finally taken off finance in the early 1970s, a truly vibrant financial sector emerged.

In this process of financial development, deregulation, competition, and innovation—both in academia and outside—fed on one another in a way that is impossible to disentangle. Consider first a case in which academia influenced the process of deregulation, which then led to financial innovation.

DIVERSIFICATION AND THE EMERGENCE OF THE PRIVATE EQUITY MARKET

Harry Markowitz’s work, described in the previous chapter, showed that a well-diversified investor may be able to tolerate a risky investment when it is held in a portfolio even if he would not be willing to hold it if that were his only investment. This idea seems obvious today, in part because Markowitz’s message has so completely permeated the investment industry. (Markowitz also provided the less-obvious mathematics to calculate diversified portfolios that would offer the lowest risk for a given return.) Eventually, these advances changed the way the investment industry was regulated.

Consider the so-called prudent man rule. This rule describes what are considered reasonable investments for pension fund managers. Over time, it has become the standard of behavior to which fund managers adhere. Until 1979, the prudent man rule was interpreted as preventing any significant investment in assets considered risky. Even stocks of companies that did not pay dividends, typical of most stocks today, were considered too risky then! In 1979, the U.S. Department of Labor finally clarified the concept of prudence: risky investments were deemed legitimate if they were part of a well-diversified portfolio strategy.

As a result of this decision, pension funds and large endowments were able to start investing in riskier intermediaries such as venture capital funds (which finance start-up companies), buyout funds (which finance the acquisition of existing companies), and “vulture” funds (which buy debt of financially distressed firms while hoping to profit from their restructuring). This new market, called the private equity market, emerged and grew with breathtaking speed. While in 1980 the U.S. private equity market accounted for only $5 billion in investment, in 1999, it was over $175 billion. This is roughly equal to the total amount of investment made annually by a country like Italy, the fifth-biggest economy in the world.¹⁰

The financial intermediaries that the private equity market funded broadened access in all kinds of ways. Unlike relatively passive institutional investors like mutual funds, we have seen that venture capitalists are more hands-on and are more nurturing toward the young companies they fund. In 2000, venture capitalists channeled more than $100 billion into 5,608 new companies.¹¹ In 2001, even after the collapse of euphoria about the Internet, 3,244 companies obtained more than $38 billion in venture capital finance. Only ten years earlier, the total amount financed was just $3 billion spread over 1,143 companies.

The private equity market also funded buyout funds, which, through breakup takeovers of companies like Beatrice, have been key to the changes in corporate governance that have taken place in the last two decades. Buyout funds also buy small private companies, making it easier for entrepreneurs to exit their investment at a reasonable price, thus facilitating a better match between these companies and new entrepreneurial talent (recall the search fund, discussed in the introduction).

Finally, the private equity market gave rise to vulture funds. Their name, though curious, is apt. In the same way as vultures dispose of corpses and keep the environment clean, vulture funds search for corporate carrion—buying companies on the verge of bankruptcy—and help to clean them up by divesting what is redundant and straightening out what is worth keeping. In doing so, they prevent these firms from wasting their investors’ money. This then improves the access these firms have to funds early on in their lives, as investors lend, confident that the company, if troubled, will not be able to destroy their investment completely. In sum, the explosive growth of the private equity market broadened access to funds not only directly but also indirectly, enhancing the overall efficiency of the financial system.

Not only did the clarification of the prudent man rule make more risk capital available, but the ways in which the capital could be deployed were also multiplied by innovations that stemmed from the better understanding of risk. Consider one example: junk bonds. Having studied finance at the University of Pennsylvania’s Wharton School, Michael Milken, an upstart investment banker working for a third-tier investment house, was convinced that the rating agencies were overly cautious in handing out ratings to companies. They focused on a firm’s track record and the cushion of physical assets it had, ignoring the talent its management possessed and its likely future prospects.¹² He felt that low-rated bonds, unflatteringly labeled “junk” bonds, were much less risky than people thought, especially if held in a diversified portfolio (he did study Markowitz!). According to Milken, their high yield more than compensated for any additional riskiness. He then started selling this message to institutional investors.

While there is some controversy about whether Milken was actually right about the profitability and riskiness of these bonds, what cannot be disputed is his success in creating a liquid market for these instruments. In a matter of a few years, issues of junk bonds went from $1 billion to more than $30 billion.¹³

Some financial instruments may appear very risky a priori, and apprehensions about their risk may indeed be justified. But if sufficient investors become interested in them, liquidity in the instrument increases, and more resources are devoted to understanding and laying off its risks. As a result, the instrument may eventually turn out to be quite attractive and safe. This is what happened with junk bonds. After an initial setback, the junk bond market survived both the incarceration of Michael Milken and the demise of the investment bank for which he worked. By early 2002, outstanding junk bonds exceeded $650 billion.¹⁴

Junk bonds play a major role in financing young, medium-sized firms. These firms are too small or have too few hard assets to be able to issue highly rated public debt and are too large or too risky to borrow from their local banks. Moreover, they typically have not established connections with large banks. Junk bond financing tides them over till such time as they become more acceptable to large financial institutions or to the equity market. Junk bonds are an example of how an improvement in the financial sector’s understanding of risk and return can allow individuals and firms to escape the tyranny of collateral and connections.

Junk bonds also help improve corporate governance. A market for corporate control, as we saw in the last chapter, helps reallocate corporate assets to their best use and helps discipline lazy or incompetent management by taking away its control. But bad management is unlikely to depart willingly. And first-tier commercial and investment banks are usually reluctant to upset their blue-chip clients by financing raids on them. This is where junk bonds come in. Because investors in junk bonds have no relationships to protect, they are willing to finance anyone who looks reasonably creditworthy. During the takeover boom of the late 1980s, less-established challengers obtained financing in the junk bond market to undertake “hostile” takeovers (takeovers opposed by incumbent management) of large blue-chip corporations like Beatrice, Revlon, Singer, and RJR Nabisco. Once they realized that size did not buy protection from takeovers, established managements started paying more attention to improving efficiency and creating shareholder value. In turn, this drew more investors to the stock markets. Finance became more available.

THE COST OF TRADING AND THE GROWTH OF THE MARKETS FOR DERIVATIVES

We have just seen a situation in which academia laid the groundwork for deregulation and financial innovation. Consider now the elimination of fixed commissions on the New York Stock Exchange, where deregulation created an atmosphere in which the ideas of academia could be implemented and financial innovation could flourish. Before Congress mandated that the practice of fixed commissions end by May 1, 1975, exchange members were not allowed to offer quantity discounts to their clients. If a brokerage firm received an order to buy 100 shares at $40 per share, it received a commission mandated by the exchange of $39. If the order was for 100,000 shares, the commission rate remained proportionately the same—that is, $39,000. Since buying 100,000 shares was only slightly more labor-intensive than buying 100 shares, there were huge profit margins for the brokerage houses built into large orders.

Before fixed commissions were eliminated, large financial institutions such as mutual funds and pension funds were doubly disadvantaged relative to individual investors. Not only did they not pay lower commissions, but since they had to trade large amounts, they also obtained unfavorable prices.¹⁵ Once fixed commissions were eliminated, large financial institutions had a very low cost of trading. This had a number of knock-on effects.

The first was the growth of the market for derivatives. We have seen how financial derivatives like the guarantee Bankers Trust wrote for the employees of Rhone-Poulenc help investors obtain fixed minimum returns. They also help firms and farmers reduce risk by enabling them to lock in the prices of essential inputs or key outputs. Key to a financial institution’s selling such an instrument is its ability to hedge away the risk in the instrument. While academia in the early 1970s had explained how derivatives could be hedged exactly with a series of trades in financial markets, fixed commissions made such trades prohibitively expensive. With the elimination of fixed commissions, however, financial institutions like commercial banks could offer derivatives fairly cheaply, and the use of derivatives to lay off risk grew exponentially, as did entirely new areas of financial activity, such as risk management and financial engineering.¹⁶

The second effect was the institutionalization of stock ownership. As we saw in the last chapter, large institutional investors have a large enough stake in each company to find it worthwhile to analyze the companies they hold very carefully and to call up management if anything troubles them. They also can organize together more easily to force management’s hand. With the elimination of fixed commissions, it made much more sense for individuals to invest their money passively in large funds and allow the funds to manage it on their behalf. From 1980 to 2000, the fraction of public equity owned by institutional investors in the United States went from below 30 percent to over 60 percent, while the fraction owned by individuals declined in tandem.¹⁷ The number of mutual funds increased from 564 in 1980 to 8,171 in 2000.¹⁸ There are now more mutual funds in existence in the United States than there are domestic companies listed on U.S. stock exchanges!

As institutional investors with larger stakes took over from individual investors, and as raiders obtained easier financing, the power of investors vis-à-vis company management has grown. The official statements of the Business Roundtable, an association of chief executive officers of leading U.S. corporations aimed at promoting the CEOs’ policy perspective, provide a good indicator of the radical shift in the balance of power. Until the mid-1990s, the Business Roundtable consistently opposed any substantial change in corporate governance practices, defending the right of CEOs to resist takeovers, even those that greatly increased value for shareholders. In 1997, it changed its position and declared, “the paramount duty of management and the board is to the shareholder and not . . . to other stakeholders.”¹⁹

Because governance has improved, firms have been paying more attention to the utilization of the funds they generate from operations. These so-called internal funds were traditionally thought to be free by corporations. Corporations only factored in the cost of money actually raised from outside in evaluating investment decisions, placing a very low cost on internally generated funds. But internal funds can be paid back to shareholders, so they should not be thought of as “free cash flow.” The pressure from hostile takeovers during the 1980s and from institutional investors during the 1990s changed practice. Now most companies do factor in the cost of internal capital in evaluating managers, as evidenced by the popularity of measures of managerial performance like economic value added (which subtracts a cost for the capital a manager uses from the profits she generates, thus forcing her to face up to the cost of even investments made out of internal cash flow). The consequence of this newfound awareness has been a substantial increase in the average rate of return on corporate assets. While in 1980 it had dropped as low as 5.7 percent, by 1996, it was a healthy 9.9 percent.²⁰

As governance improves, and managers begin to work in their investors’ interests, everyone benefits. Resources are not wasted. Investors become more confident that they will get a return and become more willing to entrust managers, even those they know less well, with funds. Access to finance expands.

We have described only some of the ways that the revolution in finance has expanded access. There is much that this sketch has left out—for example, how individuals now have much greater choice in managing their finances than ever before. We do not have the space to describe how this came about. Suffice it to say that forces similar to those we described above have played a part: they include advances in academia, the increasing ability of financial institutions to price a variety of exotic instruments and to assess and spread their risks, the greater availability of timely and accurate data on potential customers, greater competition leading to better prices in financial markets, a variety of more appropriate new institutions as a result of deregulation, courts that are more conversant with finance and enforce contracts speedily and predictably, regulators who are more skilled and informed (but who nevertheless still lag behind the complexity of the market) . . .

We could go on and on about the changes in finance. But at the same time as the revolution in finance was taking place, there were other major changes in developed economies. We think two are particularly important: the increases in competition and the spread of new technologies. The greater availability of finance has been critical to these developments, and in turn, competition and technological progress prompted a change in the political mind-set leading to other changes such as deregulation. All this has fundamentally altered the nature of the interaction between the capitalist and her employee. That is what we turn to now.

The Breakup of Vertically Integrated Firms

Vertically integrated firms dominated capital-intensive industries in the second industrial revolution. They commanded profits because their assets, brand names, or even government charters gave them a strong position in domestic industry, a position made impregnable because access to finance was limited. Despite antitrust legislation passed to combat these behemoths, industry became increasingly concentrated right up to the 1970s, for reasons we examine later in the book.²¹ Some countries nationalized these firms, but this merely changed the identity of the monopolist owner without changing the behavior of these firms.

The cozy cocoon that enveloped these firms was shredded by a number of forces starting in the 1970s. It is hard to be precise about what came first and how the increased access to finance strengthened and interacted with these forces, but here is a quick interpretation of what happened.