Mark Hodak's Fantasy Folly About Adam Smith

Marc Hodak writes in Forbes (25 Octover), “Adam Smith's Folly”(25 Oct)
Mark Hodak asserts:

“Were Adam Smith alive today, he'd be an activist hedge fund manager or a private equity raider. He had a decidedly pessimistic view about corporations. Most businesses of his day were proprietorships or partnerships. He didn't think corporations--joint-stock companies, as they were then called--would amount to much, because badly incentivized managers would inevitably destroy them…
…In other words, managers are invariably prone to waste. They will gold-plate their office equipment and cut out early for their kids' music recitals. And what about stockholder fraud, such a large source of angst among modern governance critics? Smith felt that the possibility of theft existed in every area of commercial life, yet commerce thrived. "Negligence and profusion," what economists now call "agency costs," were different; they were, and are, an inherent result of the separation of ownership and management.

Smith was well aware of the benefits of corporations, including their ability to concentrate large amounts of money into capital-intensive undertakings. But he thought that the costs of agency would always be too high. He believed that those costs scaled up with the business, as that was the experience of his day. Therefore, the bigger a business got, the worse the waste. He frankly didn't see any way around it, even if the corporation had monopoly privileges...

...Early corporations were chartered by the Crown or legislature. In the days before corporate income taxes, this was a novel way for a government to raise revenue. The monarch would grant a corporation special trading rights or other monopoly privileges in return for certain payments. The Crown might even invest money in this enterprise for a share of its dividends, or expect these enterprises to lend large sums to the government at favorable rates. The incestuous relationship between government and corporations no doubt colored Smith's view of these kinds of businesses.

Why was Smith so far off the mark on the survivability of corporations? For one thing, the relationship between corporations and the state has since transformed. Although the incestuous quid pro quo that was prominent in Smith's day remains the norm in most of the world, it's not typical in developed economies. Most western corporations operate without any special privileges, under licenses that are routinely offered to anyone willing to go through some simple administrative processes. The resulting lack of special treatment from the government forces corporations to become ever more competitive in minimizing unnecessary costs, including agency costs.

Nominally, the main tool for controlling agency costs has been board oversight. However, Smith was no more confident in the efficacy of that control than were many subsequent critics of boards, with good reason. Boards get fooled all the time, and they have their own issues with greed. The dramatic reduction in agency costs that made corporations feasible was, in fact, brought about by the development of two other, powerful tools that Smith did not foresee: transparency and internal incentives.

In the 19th century, railroads were the biggest promise of corporations--and the biggest challenge to their existence. Railroads were capital-intensive and operated on such a large scale that no central committee could supervise its operations. Money flowed in and out of the business through countless retail transactions. Railroads were ungovernable by any standards of Adam Smith's time. But the new technology spawned new kinds of organization, and new governance mechanisms to cope with it...

...Their managers simply figured that if they wanted the cash needed to grow the businesses, they needed to make their investors as comfortable as possible…
… Management incentives eventually evolved into tools for motivating even lower-level employees to work hard for the shareholders. Notwithstanding the paternalism of capitalists in his day, Smith could not foresee a sales manager and her family being sent to Aruba for winning a sales contest. How could any company afford to be so generous? Why would they give something like that away? Where is Aruba?
Adam Smith will go down in history as one who foresaw innumerable ways that market processes could adapt and organize themselves to allocate scarce resources between economic agents. He would be quite comfortable--and mighty pleased--with the dizzying scope of trade in every commodity, product and service imaginable, and the incredible wealth engendered by that trade. He predicted that. But he would be surprised by the degree to which economic agents themselves would evolve, that they could scale up dramatically while keeping their agency costs well under control. After realizing how utterly wrong he was about corporations, Smith would probably nod in satisfaction. Or, maybe he'd buy them out and fire the managers.

[Marc Hodak is managing director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance and he teaches corporate governance at New York University's Leonard N. Stern School of Business.]

Comment
Like many modern economists teaching in American universities, Mark Hodak reads Wealth Of Nations (or possibly a set of quotations from it) on joint-stock companies, focuses on Adam Smith’s criticism of 18th century joint-stock companies and jumps to erroneous conclusions about 19th-21st century joint-stock companies.

From the post above, I have selected some sentences or parts of sentences to illustrate what I mean.

First, a word about context. Smith’s criticism of joint stock companies concentrates on the chartered trading companies, under Royal Warrant or Act of Parliament, such as the East India Company, with side-swipes at other chartered trading companies governing British trade with other parts of the world. He accepted the benefits of joint stock companies for other purposes.

The relevant part of Wealth Of Nations is found in WN V.i.e.1-40: pp 731-58. pp 746-58.

“He frankly didn't see any way around it, even if the corporation had monopoly privileges.”

Comment
Sorry, wrong way round. It was the state-backed, legal monopoly of the Chartered Trading Companies, in particular the East India Company that was the cause of the problems of management – and its long standing criminality of its people, from the Directors to the lowliest clerk in its employ – and Mark Hodak misses Adam Smith’s point spectacularly.

“The incestuous relationship between government and corporations no doubt colored Smith's view of these kinds of businesses.”

CommentNot quite. Smith also saw a potential role for incorporating the financial interests of merchants into a joint stock company with a monopoly for a ‘certain number of years’ (WN Vi.i.e.30: p 754); the East India Company was founded in 1600 and by the last quarter of the 18th century it retained its monopoly, which Smith found, with good reason, to be unacceptable (it lasted for near on another 100 years). [Also see below].

Adam Smith believed in the efficacy of joint-stock companies for large capital projects to facilitate commerce (canals, etc.,), and for banks (he praised the Bank of Scotland, the Royal Bank of Scotland and the Bank of England, which were joint-stock companies but not chartered monopolies).

“Why was Smith so far off the mark on the survivability of corporations?”

Comment
Hardly appropriate as the East India Company had lasted c.180 years by the time he added his critical views in the 1783 edition and continued on into the 19th century.

His criticism was directed at their vast diversion of scarce capital to enrich the members and employees of the East India Company which could be better invested in productive activity, plus the plunder of the Indian economy for personal aggrandisement of the many thieves they employed.

“brought about by the development of two other, powerful tools that Smith did not foresee: transparency and internal incentives.”

Comment
It took a long time after the Company Acts in the late 19th century brought about ‘transparency and internal incentives’ and even today company fraud on customers, shareholders and employees have some ways to go before they can be (if ever) declared permanently ‘clean’.

To which, for balance, we should add that state-managed organisations are hardly monuments to superbly managed, efficient, and 'honest' organisations.

“Notwithstanding the paternalism of capitalists in his day, Smith could not foresee a sales manager and her family being sent to Aruba for winning a sales contest. How could any company afford to be so generous? Why would they give something like that away? Where is Aruba?”

Comment
Silly claim by Marc Hodak. Adam Smith was not in the prediction of future events business; he seldom looked forward and his whole perspective was historical not futurist. Marc Hodak would know that if he was familiar with Adam Smith’s works.

“Adam Smith will go down in history as one who foresaw innumerable ways that market processes could adapt and organize themselves to allocate scarce resources between economic agents” and “He predicted that..."”

Comment
See above. The only specific prediction of a future event that I am familiar with is his prediction that the ex-British colonies of America would in about a hundred years would become the richer than Britain in produce and therefore in taxation. (WN IV.vii.c.79: p 625)

He avoided predictions and thought the people of the future would deal with the future’s problems.

“After realizing how utterly wrong he was about corporations, Smith would probably nod in satisfaction. Or, maybe he'd buy them out and fire the managers.”

Comment
Fantasy nonsense. I don’t accept he was ‘utterly wrong’ about the chartered monopoly ‘corporations’, which were part of his critique of ‘mercantile political economy’(the main points of which stand true today of modern mercantile practice and should be read in that context.