Of Pigs, Troughs, Mutual Funds, and the Logic of Collective Action

If men were angels,  no government
would be necessary.—James Madison

It’s funny what readers pick up on. Write a book about the history of the modern West viewed through the lens of economics (The Birth of Plenty, McGraw-Hill 2004), and what do you get asked most often? Executive pay packages, a topic that occupied all of a sentence or two near the end of the book.

This is not a subject I’d thought deeply about; the book mentioned it only within the context of the wider data on increasing income inequalities. Still, it’s an interesting question. Do executives at mediocre companies (or even good ones, for that matter) deserve eight- and nine-figure salaries and option deals? Of course not. How much do they damage the modern capitalist economy? Even more than you might imagine. Aside from the direct effects of the looting and dilution of bottom lines, there are few greater drivers of societal unhappiness than income inequality; the damage done to corporate morale by the chasm between those at the bottom and top of the ladder is beyond calculation.

Have the ethics of corporate executives deteriorated in the past few decades? Not at all. The primary benefit of exposure to the ancient Greeks and Romans is that they hit you over the head with the constancy of human nature—very little has changed in the past two-and-a-half millennia. Just as socialism’s fundamental mistake was to assert the perfectibility of human motivation, so too are the William Bennetts of the world and other like-minded right-wing culture warriors seriously off base when they assert a recent deterioration of our moral fiber. (Keno, anyone?) Both sides of this divide would profit from a bit more Aristotle and Thucydides.

Likewise, you don’t have to memorize the Federalist Papers to realize that the founding fathers, who were heavily influenced by the classics, had it exactly right: human nature is immutable, and men need governments. (Probably the most ardent proponent of government-as-character was John Adams, who was way too busy in Europe raising political support from the French, treaty concessions from the English, and money from the Dutch, to play editorial tag with Madison and Hamilton.) In the modern world, if moral fiber and ethics seem to have deteriorated, it’s not that the human beast is decaying; it’s just that not enough wrists are getting slapped.

No, I’m not suggesting that the federal and state governments inject themselves into the compensation-management business. The "government" I’m talking about is corporate-board oversight. And make no mistake about it, what we’ve witnessed in the past decade is nothing less than the complete collapse of the corporate-governance apparatus. The cookie-jar lid came completely loose, and mom and dad were nowhere in sight.

How did this come about? The answer lies in the work of an obscure thinker, the late Mancur Olson, best known among economists for a thin, insightful book, The Logic of Collective Action. In it, Olson examines just how it is that the greater societal good so often gets hijacked by small special interest groups. Consider, for example, federal sugar subsidies. Each year, the United States pays about $1 billion in price supports to sugar growers. Most of this money goes to a tiny group of extremely wealthy families. The program is the most egregious part of a much larger system of agricultural supports that distorts world trade and encourages terrorism by devastating third-world growers and driving up unemployment in nations already on the brink.

And yet, year after year, a small elite of sugar growers is able to perpetuate, to the detriment of just about everyone else on the planet, this reverse Robin-Hood scheme. Olson’s special insight lies in recognizing such a process and working out a mathematical model of it.

Translated into plain English, small groups are more cohesive, and thus more effective, than large groups. If you volunteer for the local beach cleanup, you’ll get a warm glow, but if you don’t participate, you'll benefit just as much from the pristine sand—what economists call the free-rider phenomenon. In a rural area, the cleanup organizers can use small-town suasion to get everyone to pitch in, but that doesn't work on Coney Island.

This logic of collective action applies in spades to sugar subsidies. It’s relatively easy to organize a small number of billionaire plantation owners, each of whom reaps millions in benefits, into a cohesive and effective group; not so for those on the other side of the bargain—the 290 million Americans who indirectly pay a few dollars each to these clowns.

Olson’s central intuition is that the larger the interest group, the harder it is to organize and the less effective it will be in achieving its goals.

Which is exactly what has happened to corporate ownership during the past few decades. Even fifty or a hundred years ago, governance was already diffuse enough that non-insider shareholders were no match for management. If you think that the recent shenanigans at Enron, WorldCom, and Adelphia represent something new under the sun, I suggest you reacquaint yourself with the Credit Mobilier scandal, which involved half of Congress and both of Ulysses Grant’s vice presidents.

What is new in the late twentieth-century capital marketplace is its democratization. By the mid-1990s, about one quarter of households owned mutual funds, and most of them contained some shares of the worst of the large corporate miscreants of the past decade. Olson’s logic of collective action dictates that diffusion of corporate ownership weakens the effectiveness of governance—it was just too hard to get the tens of millions of Enron or Time Warner-AOL shareholders to watch the beach, let alone clean it.

This may be changing. Large institutional shareholders, led by Calpers, have already begun to wield their share votes against greedy and incompetent managers. A more comprehensive solution, suggested by Vanguard founder Jack Bogle, would be a formal institutional-investor organization comprising the largest fund companies and pension funds.

Olson has much to teach the potential members of such an institutional consortium. The strength of any group, large or small, lies in the ability of its leadership to coerce members, through benefits, punishment, and social pressure, to cooperate and participate. A successful shareholder organization must find and push the hot buttons at Fidelity, Morgan Stanley, and Capital Research and Management; it will not be enough merely to set up an office on Connecticut Avenue.

Mr. Bogle might even want to have a friendly chat with some sugar growers.

Copyright © 2004, William J. Bernstein. All rights reserved.

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