By the mid nineteenth century, however, with the emergence of large-scale industries such as railways, steel and chemicals, the need for limited liability was felt increasingly acutely. Very few people had a big enough fortune to start a steel mill or a railway singlehandedly, so, beginning with Sweden in 1844 and followed by Britain in 1856, the countries of Western Europe and North America made limited liability generally available – mostly in the 1860s and 70s.
However, the suspicion about limited liability lingered on. Even as late as the late nineteenth century, a few decades after the introduction of generalized limited liability, small businessmen in Britain ‘who, being actively in charge of a business as well as its owner, sought to limit responsibility for its debts by the device of incorporation [limited liability]’ were frowned upon, according to an influential history of Western European entrepreneurship.[2]
Interestingly, one of the first people who realized the significance of limited liability for the development of capitalism was Karl Marx, the supposed arch-enemy of capitalism. Unlike many of his contemporary free-market advocates (and Adam Smith before them), who opposed limited liability, Marx understood how it would enable the mobilization of large sums of capital that were needed for the newly emerging heavy and chemical industries by reducing the risk for individual investors. Writing in 1865, when the stock market was still very much a side-show in the capitalist drama, Marx had the foresight to call the joint-stock company ‘capitalist production in its highest development’. Like his free-market opponents, Marx was aware of, and criticized, the tendency for limited liability to encourage excessive risk-taking by managers. However, Marx considered it to be a side-effect of the huge material progress that this institutional innovation was about to bring. Of course, in defending the ‘new’ capitalism against its free-market critics, Marx had an ulterior motive. He thought the joint-stock company was a ‘point of transition’ to socialism in that it separated ownership from management, thereby making it possible to eliminate capitalists (who now do not manage the firm) without jeopardizing the material progress that capitalism had achieved.
Marx’s prediction that a new capitalism based on joint-stock companies would pave the way for socialism has not come true. However, his prediction that the new institution of generalized limited liability would put the productive forces of capitalism on to a new plane proved extremely prescient.
During the late nineteenth and early twentieth centuries limited liability hugely accelerated capital accumulation and technological progress. Capitalism was transformed from a system made up of Adam Smith’s pin factories, butchers and bakers, with at most dozens of employees and managed by a sole owner, into a system of huge corporations hiring hundreds or even thousands of employees, including the top managers themselves, with complex organizational structures.
Initially, the long-feared managerial incentive problem of limited liability companies – that the managers, playing with other people’s money, would take excessive risk – did not seem to matter very much. In the early days of limited liability, many large firms were managed by a charismatic entrepreneur – such as Henry Ford, Thomas Edison or Andrew Carnegie – who owned a significant chunk of the company. Even though these part-owner- managers could abuse their position and take excessive risk (which they often did), there was a limit to that. Owning a large chunk of the company, they were going to hurt themselves if they made an overly risky decision. Moreover, many of these part-owner-managers were men of exceptional ability and vision, so even their poorly incentivized decisions were often superior to those made by most of those well-incentivized full-owner- managers.
However, as time wore on, a new class of professional managers emerged to replace these charismatic entrepreneurs. As companies grew in size, it became more and more difficult for anyone to own a significant share of them, although in some European countries, such as Sweden, the founding families (or foundations owned by them) hung on as the dominant shareholders, thanks to the legal allowance to issue new shares with smaller (typically 10 per cent, sometimes even 0.1 per cent) voting rights. With these changes, professional managers became the dominant players and the shareholders became increasingly passive in determining the way in which companies were run.
From the 1930s, the talk was increasingly of the birth of managerial capitalism, where capitalists in the traditional sense – the ‘captains of industry’, as the Victorians used to call them – had been replaced by career bureaucrats (private sector bureaucrats, but bureaucrats nonetheless). There was an increasing worry that these hired managers were running the enterprises in their own interests, rather than in the interests of their legal owners, that is, the shareholders. When they should be maximizing profits, it was argued, these managers were maximizing sales (to maximize the size of the company and thus their own prestige) and their own perks, or, worse, engaged directly in prestige projects that add hugely to their egos but little to company profits and thus its value (measured essentially by its stock market capitalization).
Some accepted the rise of the professional managers as an inevitable, if not totally welcome, phenomenon. Joseph Schumpeter, the Austrian-born American economist who is famous for his theory of entrepreneurship (
However, for decades after that, more pure-blooded advocates of private property have believed that managerial incentives need to be designed in such a way that the managers maximize profits. Many fine brains had worked on this ‘incentive design’ problem, but the ‘holy grail’ proved elusive. Managers could always find a way to observe the letter of the contract but not the spirit, especially when it is not easy for shareholders to verify whether poor profit performance by a manager was the result of his failure to pay enough attention to profit figures or due to forces beyond his control.
And then, in the 1980s, the holy grail was found. It was called the principle of shareholder value maximization. It was argued that professional managers should be rewarded according to the amount they can give to shareholders. In order to achieve this, it was argued, first profits need to be maximized by ruthlessly cutting costs – wage bills, investments, inventories, middle-level managers, and so on. Second, the highest possible share of these profits needs to be distributed to the shareholders – through dividends and share buybacks. In order to encourage managers to behave in this way, the proportion of their compensation packages that stock options account for needs to be increased, so that they identify more with the interests of the shareholders. The idea was advocated not just by shareholders, but also by many professional managers, most famously by Jack Welch, the long-time chairman of General Electric (GE), who is often credited with coining the term ‘shareholder value’ in a speech in 1981.
Soon after Welch’s speech, shareholder value maximization became the zeitgeist of the American corporate world. In the beginning, it seemed to work really well for both the managers and the shareholders. The share of profits in national income, which had shown a downward trend since the 1960s, sharply rose in the mid 1980s and has shown an upward trend since then.[3] And the shareholders got a higher share of that profit as dividends, while seeing the value of their shares rise. Distributed profits as a share of total US corporate profit stood at 35–45 per cent between the 1950s and the 1970s, but it has been on an upward trend since the late 70s and now stands at around 60 per cent.[4] The managers saw their compensation rising through the roof (
Now, this unholy alliance between the professional managers and the shareholders was all financed by squeezing the other stakeholders in the company (which is why it has spread much more slowly to other rich countries where the other stakeholders have greater relative strength). Jobs were ruthlessly cut, many workers were fired and re-hired as non-unionized labour with lower wages and fewer benefits, and wage increases were suppressed (often by relocating to or outsourcing from low-wage countries, such as China and India – or the threat to do so). The suppliers, and their workers, were also squeezed by continued cuts in procurement prices, while the
