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E-MailLuis Alfonso Dau is Associate Professor of International Business and Strategy and Robert and Denise DiCenso Professor at Northeastern University D’Amore-McKim School of Business; Randall Morck is Jarislowsky Distinguished Chair in Finance at the University of Alberta; and Bernard Yeung is Stephen Riady Distinguished Professor in Finance and Strategic Management at the National University of Singapore. This post is based on their recent paper, forthcoming in the Journal of International Business Studies.
Our paper argues that “good corporate governance” can be a sideshow, and even a distraction, in countries where decision-making power substantially does not rest with the CEOs, officers, and directors of individual listed corporations. In many economies, corporations are organized into business groups (Colpin et al. 2010; Colpin and Hikino 2018). The stock markets of such countries may appear to contain hundreds of distinct corporations. Each has its own shareholders, creditors, employees, officers, directors, CEO, and stock listing. But many, perhaps most, of these corporations belong to one of a handful of business groups. All the firm in such a group share a common ultimate controlling shareholder, usually a powerful family with deep political influence. The CEOs of individual corporations can be “hired help”, in careers of service to the family.
In the United States, vast power rests in the hands of the CEOs, officers, and directors of business corporations. The formal and informal constraints on corporate governance shape the wielding of that vast power. Consequently, American lawyers, economists and policy makers attach great importance to good corporate governance and, in proselytizing the American Way, encourage others to adopt similar laws and regulations. Misapprehending where real decision-making power rests can leave such efforts fundamentally misguided.
In many countries, the public policy focus might better be “good business group governance.” We argue that how business group governance interacts with corporate governance can shape a country’s long-term prosperity and institutional development. Good business group governance can leave individual corporations seeming badly governed by U.S. benchmarks, but this can be an economy-level problem or advantage. Insufficient attention to business group governance can ensnare countries in a low-income trap. Excessive attention to good business group governance can ensnare countries in a middle-income trap. Detours into economic development and history explain how.
Business group governance arises naturally in very low-income economies, where markets work poorly, trust is scarce, and corruption impairs government. Independent firms rationally expect to be cheated—held up at every turn by suppliers, customers, and officials reneging on commitments or seeking bribes—and are expected to act likewise. Dysfunctional property rights, courts, markets and governments make founding and growing a business difficult. However, a politically powerful elite family controlling numerous firms in diverse industries can order their CEOs not to cheat each other. Dysfunctional courts, government and markets can be avoided or dealt with from a position of power by the controlling family. Business activity can rise and the economy can grow.
Marginalizing corporate governance by elevating decision-making to the business group level stops corporations from maximizing their individual profits by cheating other corporations. Good corporate governance is sidelined, recast as obedient cooperation within a well governed business group. Thus, business groups are prominent in all major emerging economies and in the histories of almost all First World economies.
University of Chicago economist Ronald Coase (1937) showed that economic activity falls under the direction of markets or of command and control hierarchies, whichever costs less. Business group governance arises in early-stage development because the costs of market failures that independently-governed corporations would bear exceed the costs of centralized business group-level command and control governance. Business group governance is a route out of low-income traps (Morck and Nakamura 2007; Morck 2010).
Escaping the low-income trap can lead economies straight into a middle-income trap. After a successful ascent to middle-income levels, business group governance can become a problem. Business groups’ prosper because they can contend with weak laws, regulations, and markets. Stronger laws, better courts and regulators, more efficient and less corrupt government, and better enforced contracts and property rights all conspire to make independent corporations viable and to diminish the advantage of business groups and the families that control them. Those families and politicians associated with them come to view such reforms as anti-business. Pro-business policies to avoid or “manage” such reforms and thereby lock economies into a middle-income trap.
First World economies sustain and increase living standards over the long run primarily through ongoing technological progress—a process the Austrian economist Joseph Schumpeter dubbed creative destruction: creative new firms continually arise to destroy, or severely disrupt, old firms. New technologies displace old ones embedded in old firms. Ever more valuable outputs are made from proportionately ever less costly inputs—the definition of productivity growth. Ongoing productivity growth from creative destruction stabilizes high-income economies, but destabilizes their venerable corporations (Fogel et al. 2008). Middle income trap economies lack the laws, courts, regulators and financial markets necessary to let innovative new firms arise. Indeed, pro-business policies in middle-income trap economies are designed to prevent this. These economies are always developing, never developed—many for generations.
Transplanting good corporate governance, American-style, can make sense after business groups have served their purpose and created a middle income economies provides a tax base capable of supporting efficient courts, government, and markets. But actual institutional transplants can border on farce. One business group firm’s legally independent directors can be executives or former executives of another group firm subject to the same family. Families that control large business groups can also control pension fund management firms (Perkins et al. 2014). Yet well-trained foreign experts press middle-income trap countries to empower independent directors and institutional investors as in the United States.
Before such reforms make any real sense, business group governance must give way to corporate governance. The United States regulated its business groups out of existence in the 1930s and 1940s (Kandel et al. 2019) and broke up or neutered Japan’s after 1945 (Morck and Nakamura 2005). Israel adopted anti-business group laws in the early 21st century (Bebchuk 2012). Business groups slowly faded away after Australia and Canada industrialized, though both saw revivals of business groups in eras of energetic state intervention (Morck and Tian 2018; Vile 2018). Western Europe’s business groups retreated, revived during post-World War II reconstruction when rapid coordinated resource allocation again mattered more than innovation for a few decades, and are again declining (Colpan and Hikino, 2018). Rather than exporting todays’ U.S. conceptions of good governance, universities might teach students from middle income trap economies how and why business group governance was dismantled in the United States and replaced by real decision-making at the corporate level. Only after power is decentralized to individual corporations, worrying about corporate governance starts to make sense.
The complete paper is available for download here.
