Countercyclical Corporate Governance

Aneil Kovvali is a Harry A. Bigelow Teaching Fellow and Lecturer in Law at the University of Chicago Law School. This post is based on his recent paper, forthcoming in the North Carolina Law Review.

As the economy lurched from the global financial crisis, to the period of prolonged stagnation and elevated unemployment that followed, to the suspension of economic activity in the COVID-19 crisis, and now to a period of dislocation and elevated inflation, the limits of traditional macroeconomic tools were revealed. Governments looked to existing fiscal and monetary policy tools for solutions to each challenge, but found that those tools were often unavailable or ineffective. A new wave of legal scholarship has sought to expand the toolkit by identifying ways that legal rules could be altered to induce businesses and individuals to increase investment and spending in times of economic trouble. But, with a few exceptions, relatively little has been done to use insights from the study of corporate governance to mobilize the capacity of corporations to move the economy out of a crisis.

A new paper forthcoming in the North Carolina Law Review seeks to explore this gap. The conceptual and practical tools the paper develops could have a substantial impact. Corporations command extraordinary financial resources and have enormous operational scope. And because corporations can act flexibly and with dispatch, they can readily respond to changing circumstances from high unemployment to high inflation. Harnessing corporate capacity would dramatically improve the economy’s ability to recover from a variety of serious economic crises.

Corporate governance is a natural starting point in the effort to harness the power of business. Traditional macroeconomic policy tools seek to encourage businesses to decide to invest and hire in recessions by changing the external environment in which they operate. But altering corporate governance arrangements — the incentives and mechanisms that drive corporate decisions — can operate more directly on corporate investment and hiring decisions.

Corporate governance tools can also help address market dysfunction. Recessions and other macroeconomic crises are market failures in which wealth-generating transactions fail to occur. During a recession, there are unemployed workers who would be happy to buy more goods if only they could get a job, and there are struggling businesses that would be happy to hire if only they could sell more of their products. Markets are slow to reach an efficient equilibrium in which these wealth-generating transactions occur. Both governments and firms can help coordinate this type of beneficial activity without waiting for the market to equilibrate. Where direct government action is not forthcoming or is not effective, firms can step in.

Beyond practical implications, the analysis can shed new light on longstanding theoretical debates in corporate governance. Macroeconomic crises break the intuitions that have shaped corporate governance. The traditional view of corporate governance is that directors and officers should focus exclusively on the interests of shareholders. While corporations make decisions that affect many other constituencies, including workers, creditors, and local communities, those other constituencies are thought to be protected by contracts and regulations. Because shareholders are paid only after these legal obligations to other constituencies are satisfied, shareholders are thought to feel the effects of marginal changes in the firm’s value most directly. They are thus believed to have the right incentives to create wealth by maximizing output and minimizing costs like wages.

When the economy is succeeding, this outlook has a rough alignment with the goal of maximizing social wealth. Labor is a scarce social resource, and when a firm uses a worker’s time, that time is not available for other valuable activities. When labor markets are functioning properly, the social opportunity cost of deploying that worker time at the firm instead of elsewhere is reflected in market wages. If an employee commands wages of $20 an hour at a firm when labor markets are robust, it likely reflects the employee’s ability to find another job paying roughly $20 an hour, which in turn indicates that the employee could create more than $20 of value at that other job. If the firm found a way to maintain existing production without using the worker’s time, the worker would go to that other job and create that value — the $20 an hour saved by the firm would reflect a genuine efficiency gain that permits society to redeploy productive resources and create additional wealth. As a result, in ordinary times, the goal of maximizing shareholder profits has a rough correlation with the goal of maximizing social wealth creation.

But in a recession with dysfunctional labor markets and persistent high unemployment, wages may not correspond to the opportunity cost of labor: if an employee is laid off, they may not be able to find another job or create any value. The employee’s customary wages would still represent a cost from the shareholder profits perspective, but would not reflect a genuine opportunity cost from the social wealth perspective. Maximizing shareholder profits by laying off workers could also have destructive effects. A layoff would mean a period of extended unemployment for the worker, meaning that the worker goes from creating some social wealth to none. Other costs of a layoff include loss of income to the worker, a potential loss of productive capacity for the economy if the worker is unemployed for an extended period and loses skills, and a loss of demand as the worker curtails spending. These costs are not borne by the firm’s shareholders directly, and they are not likely to be part of the calculus of directors and officers who are focused on a narrow conception of shareholders’ interests. It would thus be helpful to reform corporate governance to encourage managers to maintain spending and investment, even if some shareholders feel slighted.

Reforming corporate governance in response to these issues could yield substantial benefits because American corporations control substantial resources. If corporations could be induced to use their resources to expand investment and employment in times of economic trouble, they could have an impact comparable to a major government program. And because of their unique capabilities, their relationships with employees and other stakeholders, and their capacity to act rapidly, their financial firepower may actually understate their usefulness. Whether as a complement to government efforts or as a substitute in the wake of an inadequate government response, countercyclical corporate governance is worth exploring.

These points support a range of policy approaches, with the primary goal of reorienting firms to serve constituencies other than shareholders during a crisis. Although they were not conceptualized as efforts to revise corporate governance, various features of the policy response to COVID-19 suggested a growing recognition that corporations were vehicles to serve constituencies like employees and customers, and not simply to generate financial returns for shareholders. Shareholders like index funds can deepen this trend with thoughtful interventions at portfolio companies, mitigating recessions in a way that improves their long term returns and improves their marketing position. The government can further support countercyclical corporate governance through appropriate regulations. The discussion of policy approaches here is not intended to be exhaustive, but should open an important conversation on ways that corporate governance could support an economic recovery.

The complete paper is available for download here.

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