Beware the pitfalls of stakeholder capitalism

The philosophy of stakeholder capitalism has gained traction in recent years as people try to determine whether companies should help solve big social problems. Demanding that companies take a holistic view about how they serve the community has some merit.

A man works at a pencil production line in Shelbyville, Tennessee
Students of economics often learn how efficiently shareholder capitalism factors in the complexities of various value chains by studying a simple pencil. Its price contains information about all the various links in the chain that made it. © Getty Images
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In a nutshell

  • Stakeholder capitalism addresses some of shareholder capitalism's drawbacks
  • Taken too far, however, it can backfire, doing more harm than good
  • Long-term profit goals include more stakeholders while benefiting shareholders

Students are often introduced to economic complexity and the marvels of market coordination and value creation through the story of a simple pencil. Its production requires several components (wood, graphite, etc.), each requiring a myriad of other components (saws, iron, iron pits, and so on), in an endless branching regression. The lesson is that no one knows the whole process, nor is anyone in command of it.

In such complex value chains, each link is mostly ignorant of what is happening in the others. What matters for economic coordination are prices that signal scarcities and encourage entrepreneurs and consumers to economize or find substitutes. But price signals transmit only economically relevant information, not the entirety of knowledge about social or environmental conditions.

Beyond profits

This decentralized coordination works wonders and is the foundation of economic development. But this economizing of knowledge also means ignorance of other links’ impact on people and the environment, from extraction conditions to waste management. It is difficult to be fully aware of their effects.

These are the issues that the proponents of “stakeholder capitalism” want to tackle. Courts and regulation deal with many of shareholder capitalism’s negative outcomes. But companies are in the best position to manage the remaining effects, even if it means less profit and thus a reduction in shareholder value.

The debate about whether a company’s goal is to serve its shareholders or the wider community (stakeholders) goes back to at least the 1930s, when American economists Adolf Berle and Gardiner Means analyzed the separation of management and control in the corporation and called for “public spirit” in capitalism. In the 1970s, the rise of a philosophy geared toward maximizing shareholder value reignited the debate over corporate responsibility. For the past two decades, concerns about minority rights and environmental protection have gradually put the issue center stage and fostered the development of Corporate Social (and Environmental) Responsibility, frequently referred to as CSR.

The debate about whether a company should serve shareholders or stakeholders goes back to at least the 1930s.

For many years, World Economic Forum founder Klaus Schwab has tried to push an agenda of stakeholder capitalism, rejecting both shareholder and state capitalism. He has recently gained more traction with the support of the Business Roundtable, which announced in 2019 that it would adhere to stakeholder capitalism. The idea is for companies “to create value not just for shareholders but employees, customers, suppliers, local communities and society” and “commit to deliver value to all.” Mr. Schwab’s organization now provides a CSR dashboard to help companies implement stakeholder capitalism.

Negative impacts

Here, it is important to clarify that the existence of profits means value has been created for customers. This value creation is actually the basis of development and results in better lives for people. That said, “negative externalities” also arise throughout this process: companies can achieve value for customers by creating nuisances for third parties and the environment either during the production or consumption stage. Examples include towns enveloped in factory smoke, enslaved children in poor countries mining ore for electronic components, overfishing or a neighborhood suffering from a rapid influx of new customers to a nearby store. Sometimes firms can profit from political connections, for example by obtaining undeserved government subsidies.

If regulations are weak or nonexistent, and if there is no way to eliminate or mitigate negative externalities through the legal system, then it is ethically justified for companies and customers to increase their awareness and take action. Here, the stakeholder capitalism view stands on solid ground. However, the philosophy often goes further, insisting that companies produce “extra” positive outcomes, by engaging in philanthropic activities like planting trees or supporting schools in poor areas.

Drawing the line

It is worth defining two categories of externalities. The first includes cases of clear harm, like pollution, and the other comprises social demands, such as participation in the community or nondiscriminatory hiring. The border between these categories is not always easy to distinguish. Nor does it always align with the distinction between negative and positive externalities. However, it helps to try to keep them separated conceptually.

A factory in China producing air pollution
Taken to its extremes, shareholder capitalism can infringe on others’ rights. Factory pollution, as in this instance in Inner Mongolia, China infringes on property rights and causes health risks. © Getty Images

On the negative side, factory pollution certainly infringes upon others’ property rights, while child slave labor is clearly a case of human rights abuse. If those cases happen in countries where property and human rights are not protected, then there is room for stakeholder-driven action at the company level. On the other hand, international pressure and ending democratic nations’ support for corrupt regimes offer another – perhaps more efficient – path to remedying these ills. Crucially, those solutions require media and democratic transparency first.

Profit-seeking that leads to reckless risk-taking, such as in the banking sector prior to the 2008 global financial crisis, amounts to another type of negative externality. Yet here, before appealing to corporate social responsibility, it is worth reestablishing economic responsibility. Bailouts, cheap-money policies and the common practice of cutting interest rates to buoy markets have eroded the very notion of entrepreneurial responsibility in the financial sector.

Other negative externalities, however, involve racial or ethnic discrimination, or byproduct nuisances (like lines in front of a cinema). Addressing these may not require companies to take a stakeholder-driven view.

For example, economic action against a firm engaging in racist hiring practices can take the form of public shaming or boycotting. Nuisances can be dealt with by decentralized problem-solving. Communities can apply pressure on companies as they negotiate for a resolution to the problem.

However, such nuisances are often permitted thanks to political connections and cronyism. Economists like Ronald Coase saw the rise of environmental regulation partly as a way for cronyism to bypass traditional law in those matters.

Stakeholder conflict

But there are cases that are less clear. As Milton Friedman demonstrated in his classic 1970 essay on corporate social responsibility (“The Social Responsibility of Business Is To Increase Its Profits”), when companies finance philanthropic actions, it amounts to taxing customers, shareholders or wage-earners. The promotion of such stakeholderism induces an ethical problem, because someone must decide between “deserving” stakeholders. Hence Friedman’s stance that the responsibility of business is to increase profit “so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”

Communities can apply pressure on companies as they negotiate for a resolution to the problem.

Shareholder capitalism has the advantage of precisely defining the rights and duties within the firm thanks to “exclusive rights of ownership.” In stakeholder capitalism, anyone can claim to be a stakeholder, since there are infinite ways in which a company could “do better for the community.” Again, who decides who the justified stakeholders are? The risk of politicization is significant.

Crony stakeholderism

The 2008 global financial crisis is usually presented as the poster child for how shareholder capitalism can lead to a catastrophe. Ironically, it also proves how social responsibility goals can distort profit-making and create crony capitalism. The system created artificial profits from social activities that could not have happened in a free market, and then it collectivized the losses.

For example, U.S. government-sponsored mortgage giants Fannie Mae and Freddie Mac were encouraged to favor social goals over long-term financial sustainability by underwriting more and more mortgages from poor households. The cause was noble but disconnected from those households’ ability to repay their debts. Many executives, investors and political cronies profited from the programs. But as Friedman noted, someone had to pay: the effective tax in those cases was levied on other stakeholders in the economy.

Another good example is the Dexia disaster in Europe in 2008-2009. The Franco-Belgian bank specialized in financing local governments. It was founded by a French socialist technocrat and a Belgian businessman who thought that “banking is too serious to be left to bankers.” Besides its special mission, the politicians that filled its board ensured that the bank’s activities supported stakeholder-driven goals. The cost of collectivizing the bank’s losses on French, Belgian and Luxembourgish taxpayers – involuntary stakeholders – was about 18 billion euros when the bank finally collapsed. Professor Friedman’s predicted “tax” in that case was quite substantial.

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Scenarios

This is not to say that the stakeholder model is worthless. Yet, some scenarios are pessimistic. Theorists have already observed that some U.S. companies claiming to pursue stakeholders’ values were in fact just maximizing shareholder value. In such cases, stakeholder-driven activities will be a mere public relations exercise.

Companies that are serious about stakeholderism risk insulating managers from shareholders, weakening accountability. Worse, managers could use stakeholder-driven policies to gain power within their institutions. This would be detrimental to the economy and genuine stakeholders. For that reason, some economists call for simply implementing better regulations.

In fact, stakeholder-driven policies can lead to selection bias: managers choose the stakeholders and priorities that best help them accumulate power. This would then put stakeholders and managers in conflict against shareholders.

Stakeholders’ incentive would be to obtain as much as possible from firms, using their noble cause as a pretext. Managers could be confused as they pursue too many goals in complicated decision-making structures that foster indecision. Investors may not want to risk their money in such projects.

The power of shareholder capitalism lies in its simplicity and clarity in measuring performance. Assessing a firm’s stakeholder-driven performance is much less straightforward and less prone to economic calculation. Under such systems, it is difficult to evaluate managers and projects, despite stakeholder dashboards and accounting systems. The transaction costs are higher, which limits the available funds and ultimately hinders economic growth.

Stakeholderism has already been partly integrated into regulation. Various countries require worker representation on management boards, for example. This process could gradually creep further forward, as politicians increase regulation over the economy. There is a serious risk of regulating based on appearance rather than substance, for example by legally declaring electric car batteries as “green” when producing them and the electricity that goes into them does substantial damage to the environment. This process could not only distort regulation and competition in favor of politically well-connected companies, but also increase bureaucracy to such a degree that it morphs into something of a planned economy. Companies developing stakeholderism tools (such as various accounting applications) have an interest in making measurements and objectives more complex – indeed, creating their own market.

Under a more optimistic scenario, stakeholder-based systems would become more transparent. This could help avoid managers using social goals to serve their own interests and could lead to better regulation (provided it is designed in a democratic context).

As a complement to this scenario, the shareholder capitalist view would take into account a wide array of stakeholders – including customers, suppliers and employees – in an effort to secure long-term profit through creating genuine value for customers. After all, equity prices include future value. Besides, customers are increasingly demanding that firms act sustainably. Thanks to new software applications, customers can check the content of what they buy, and push back against the practices they dislike.

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