How Today’s Aberration Of Capitalism Was Created

In the 1970s, a small group of activists and their allies got together and set out on an improbable quest to redefine what is good for society and put in place a discriminatory public policy to help themselves. Today in 2022, their followers are not only celebrating the victory but also in public denial as to what they are up to.

I am referring here, not to the current effort to upend women’s reproductive rights, but rather to the successful half-century campaign to subvert the normal functioning of capitalism and channel most of its gains to shareholders, executives, and their financiers.

In this current variant of capitalism, firms seek to maximize shareholder value as reflected in the current stock price. The result is increasing inequality, pervasive short-termism, self-dealing by executives, and declining social cohesion. It is putting in question the very legitimacy of capitalism itself: more of today’s young people say they prefer socialism than capitalism.

This current variant of capitalism is not how capitalism worked for the previous 200 years. It is an aberration of capitalism, peculiar to our current era. In capitalism before the 1970s, workers’ compensation mostly advanced in alignment with the gains in productivity they helped create. That’s one reason why millions of immigrants people flocked to America in search of a better living.

The contrary results of the last half century are visible in Figure 1. In one simple picture, we can see the “smoking gun” of this aberration of American capitalism and the root of its impact on income inequality.

After the 1970s, workers’ compensation stagnated, as gains to executives, shareholders and their financiers grew exponentially, as they set about systematically extracting value from the company. In the period 1978 to 2013, CEO compensation increased by an astonishing 937%, while the typical worker’s compensation grew by a meager 10%.

Note that the shift from equal, to unequal, sharing of productivity gains preceded by several decades the arrival of today’s digital giants: this aberration of capitalism was the brainchild of industrial-era economists, not the digital age.

Milton Friedman Is Not Wholly To Blame

How did it happen? Many point to Milton Friedman’s New York Times article in September 1970 as the opening salvo in the campaign. Friedman’s article argued ferociously that “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits…”

Yet if Friedman had made clear that he was talking about long-term profits, the consequences might not have been so noxious. Long-term shareholder value is a good thing: that’s how healthy capitalism works. Long-term profits require engaged employees and delighted customers and create the resources that can help meet social goals.

Two New Elements: Stock Price And Executive Compensation

The real culprits for the current aberration of capitalism are business school professors Michael Jensen and William Meckling. They began with their famous 1976 article, The Purpose Of A Firm, which added two vital elements to Friedman’s concept.

First, they defined shareholder value theory as maximizing shareholder value as reflected in the current stock price. The current stock price, the authors said, is the best indicator of long-term shareholder value. So, firms should focus on raising the current stock price as their goal. This created a pervasive short-term orientation in the thinking.

Second, in order to align executives’ self-interest with the firm’s goal, executives were to be paid generously in stock.

And indeed, when CEOs were so paid, they became very entrepreneurial—but in their own cause, not necessarily the firms’. Now, the long-term value of a company received less attention than their efforts to boost the current stock price. Their own compensation also skyrocketed.

In 1997, the Business Roundtable (BRT) made it official: maximizing shareholder value was the formally recognized policy of American business. For the next two decades, big firms put in place the processes, practices, and values that made maximizing shareholder value the standard way in which most big companies were run. It’s also what business schools have taught. Internally, it was simply the way to run a business.

Externally, however, it came to be seen as a toxic mix of soaring short-term profits, astronomic executive pay, internal bureaucracy, stagnant worker incomes, growing inequality, growing share buybacks, executive self-dealing, periodic financial crashes, declining corporate life expectancy, and overall, widening distrust in business.

In August 2019, several hundred CEOs of major corporations got together and signed a new BRT declaration ostensibly recognizing the problem, setting aside the goal of shareholder value and acknowledging the need to serve all the firm’s stakeholders.

But now in 2022, almost three years later, little has changed. The corporate processes, practices attitudes and values, that were installed in 1997-2019 are still in place. Firms say they are serving all the stakeholders, but their actions say otherwise. The 2019 declaration was a head fake. The focus on maximizing shareholder value continues with its well-documented, disastrous consequences;

It wasn’t capitalism itself that caused all these problems: it was the particular aberration of capitalism that needs fixing.

A Better Way: Customer Capitalism

Meanwhile, a smaller—and much more successful—group of firms has done exactly that, and are pursuing a better way: customer capitalism. There are different ways to express it. The Microsoft and Amazon formulations are shown below in Figure 2. “Loving your customer as yourself” is another version. “Co-creating value for customers” is still another. Other formulations dwell on balance and the authenticity and the joy that comes from cutting through the BS that affects so much of corporate life today, and then experiencing the extraordinary returns for everyone when that happens. Profits are the result, not the goal.

The difference between shareholder capitalism and customer capitalism is like night and day: everything is different. It’s the disparity between a group of self-serving internally-focused goals and a set of ethical other-directed objectives.

Delighting customers is not simply ethical. It is also highly pragmatic. Delighting customers helps deliver the financial gains that enable the firm to satisfy all the other stakeholders: staff, managers, partners, and shareholders, as well as society at large, as shown below in Figure 3. It enables firms to figure among the top firms in terms of both total return and attention to the environment. As Apple succinctly expresses it in their vision statement: “We aspire to leave the world better than we found it.”

Customer capitalism isn’t a secret. Firms like Microsoft and Amazon reveal their obsession with delivering value to customers in their vision and mission statements as shown in Figure 2.

IBM and GE, which have notoriously pursued shareholder capitalism, make no secret that the customer still doesn’t figure in their vision and mission statements: these firms are still focused on themselves.

As shown in Figure 3, the total return of these three firms over ten years is significantly less than the average S&P 500 firm, thus limiting their ability to deliver value to other stakeholders or to society.

We need to resolve the current crisis of capitalism, not by scrapping capitalism itself, but rather by removing the current aberration of capitalism.

And read also:

The Origin Of The World’s Dumbest Idea: Maximizing Shareholder Value

Why Stakeholder Capitalism Will Fail