Politics-Business Interaction Paths: The Impact of Institutional Comparative Advantage on Economic Performance

1. RuleofLaw, Economic Performance, Institutional Comparative Advantage Ugo Pagano Orvieto, 13 Dicembre Università di Siena Politics-BusinessInteractionPaths.

2. Some references (others at web.me.com/ugopagano) • Belloc M., Pagano U. (2008) Politics-Busines Interaction Paths. Downloadable at web.me.com/ugopagano. • Belloc M., Pagano U. (2009) Co-evolution of Politics and Corporate Governance. International Review of Law and Economics. Forthcoming. • Pagano U. (2007) Cultural Globalization, Institutional Diversity and the Unequal Accumulation of Intellectual Capital. Cambridge Journal of Economics pp. 649-667. • Barca F., Iwai K., Pagano U. Trento S. (1999) The Divergence of the Italian and Japanese Corporate Governance Models: the Role of Institutional Shocks. Economic Systems pp. 35-60.

3. The End of History in Corporate Law. “Thereis no longeranyserious competitor to the viewthat corporate lawshouldprincipallystrivetoincreasetoincreaselong-termshareholdervalue. Thisemergentconsensushasalreadyprofoundlyaffected corporate governancepracticesthroughout the world. Itisonly a matteroftimebeforeitsinfluenceisfelt in the reformof corporate lawaswell”. From Henry Hansman & RenierKraakman (1997) “The End ofHistory in Corporate Law”. The presentcrisismarks the definite End of the End ofhistory.

4. Are Political shocks neutral? In New Institutional and New Property Rights theory, private governance is not influenced by politics. It tends to react efficiently to technological characteristics such as the specificity of resources. Corporate Control is efficiently acquired by the most specific owners that value it the most. Technology -----> Corporate Control Politics -/---/---/-> Corporate Control and technology

5. Two directions of causation. Specificity and Monitoring Characteristics of Assets Property Rights and Organizational Form The most specific and difficult to monitor agents can save the greatest amount of agency costs when they control the organization. : The agents controlling the organization will tend to become the most specific and difficult to monitor :

6. Inverting the argument. • In the standard framework, politics does not matter because technology is neutral and it is not influenced by property rights. • However, the New Institutional argument can be inverted: agents that acquire Corporate Control will tend to choose a technology where they become more specific. Both direction of causation are possible: Corporate Control <------> Technology Corporate Control and Technology define now different organizational equilibria that can be changed by political shocks. Political shocks <-----> Corporate Control - Technology

7. Globalization and the Biodiversity of Capitalism Different rights -----------> Different agency costs-----> Different factor prices------> Different Institutional Comparative Advantage -------- (Because of Globalization)---------> Increased specialization in the sectors where the country has an Institutional Comparative Advantage -------------------> Institutional Specialization ----------> ------> Increase in inter-countryInstitutional Biodiversity ------> Decrease in intra-country Institutional Biodiversity

8. Japan before the occupation. • Large firms were organized in zaibatsu: Mitsubishi, Mitsui and Sumitomo and Yasuda. • The Zaibatsu were still mostly family controlled and originated from a family firm. For instance, the Mitsui and the Sumitomo were two of the most powerful merchant families in Tokugawa Japan. But in the tradition of Japanese family system the whole emphasis was placed on the perpetuation of the family itself, or more appropriately the perpetuation of the family "name" (Kamei), rather than the continuity of blood lineage. • Managers had a role. New male owners could be adopted and given the family name.

9. The American Occupation. • Japan sudden surrender implied that there was no time to make any agreement with the zaibatsu families. • The Americans interpreted the faithfulness to the family name as feudal relations that were the basis of Japanese militarism. • They expropriated the zaibatsu families, nationalised their property and tried to sell all the stock to small shareholders. • Concentrations of ownership an power were considered to be dangerous. Banks’ ownership and cross shareholding were forbidden. Unions’ activities was (initially) encouraged.

10. The birth of the keiretsu system. • The war period and expropriation of the zaibatsu families had reinforced insiders’ feelings of job security and their specific investments in the companies. • The contradiction between these conditions and the system that the American intended to create became evident with the 1949 stock market crash which made take-overs very easy: new owners unconstrained by implicit contracts could jeopardise workers’ job security and their firm specific investments. • As a result cross shareholding and banks ownership of the stock was tacitly allowed: the keiretsu system based on main banking, cross shareholding and job security was born.

11. Italy at the end of the war. • The crisis of the thirties was in Italy particularly severe. In order to save banks the fascist regime had to buy out their industrial holdings and transfer them to a new agency created especially for this purpose in 1933: IRI, Istituto per la Ricostruzione Industriale. Many large companies were owned by the state • Because of Banking Law of 1936 banks were prohibited from holding equity participations in industrial companies. No liquid stock exchange had been developed. • The firms that were not owned by the State were owned by families. Unlike for the case of the Japanese zaibatsu family membership was a question of blood and not a question of kamei.

12. The (Anglo-)American occupation • In the Italian case trying to apply the American model based on separation of ownership and control would have been much easier. Many assets were already owned by the state and a law separating banks and industry already existed. • But the political situation was different…… • Italy had not suddenly collapsed but the liberation took two years. In the meantime the Italian “zaibatsu” families had all the time to make deals with the Anglo-American forces. • In the end the Italian corporate governance system exited basically unchanged from the Anglo-American occupation.

13. Do political shocks matter? If we take much economic theory, and even Williamson type institutional theory, political shocks should not matter. Either the keiretsu forms was efficient in comparison to the zaibatsu and it will come out anyway or soon or later it will be undone by individuals seeking efficient forms of private governance related to technological changes. By contrast, asymmetric political shocks have long term consequences: in spite of some recent reforms, most of the differences between Italian and Japanese corporate governance of the private sector can still be traced back to the post-war period.

14. Democracy and Corporate Governance • Post-war Japan and Italy cases represent exceptional political situations. • In general, in a democratic society, politics may have an important role in avoiding an excessive power of concentrated capital ownership. • This may take two forms: (a) Preventing capitalist concentrated control. (US) b) Creating a counter-force to capitalist concentrated control. (Europe, especially Italy).

15. The “Anglo-American fashion” The pre-crisis success of the American economy and the revival of the British economy have attracted the attention of many economists and policy makers. Most approaches have focused on the conditions that have allowed widespread and dispersed share ownership in these economies: Legal origins: The Anglo-American model may have very old roots in the different common law and civil law traditions. Only in common law countries the former private owners, including the minority shareholders of large firms, could be better protected). Electoral systems: Non-proportional electoral systems, prevailing in the Anglo-American world, favors political coalitions which are more friendly to shareholders. Unions and social-democratic power: Insiders’ power prevents the possibility of delegating to non-owning managers

16. The No-Social-Democracy Explanation. • In modern capitalist economies, there is a causal relation running from social democracy to corporate governance. According to Roe (2003), the higher the degree of social democracy (and, in particular, the strength of employees’ rights) the stronger the employers' tendency to organize in concentrated forms of corporate ownership with one or few major block holders • The separation of ownership and control is not due to “better” corporate laws is proportional to the degree of “social democratic” political pressure and, in particular, to forms of job protection. When this pressure is present, strong and active owners are necessary to limit managers' tendency to collude with employees.In this case, by resisting this pressure,big block holders would provide a public service also for the small share holders

18. Business-Politics Co-evolution In a preceding paper we have extended Roe’s approach by observing that if social-democracy can inhibit dispersed ownership, the opposite is also true: the presence of block holders, linked by strong family and social ties, can be the very reason to seek some social-democratic protection. The concentration of the interests of one groups makes it more convenient the concentration of the interests of the other group. Like in a arms race, we can end-up with different level of (dis)armament, the extreme cases being very concentrated and dispersed equilibria.This is our interpretation of the inverse relation between employment protection legislation and ownership dispersion represented in the following slide.

19. Two directions of causation Two possible equilibria. Dispersed ownership Disorganized workers’ interests Concentrated ownership Organized workers’ interests

20. Out of Equilibrium:asimmetry of labor and capital Unlike labour, capital may be concentrated by the means of market transactions. Politics may act anticipating the concentration of ownership or may intervene later by balancing the excessive power due to this concentration. When, in the second half of nineteenth century, large firms emerged, only one great country and a small one were in the conditions that some form of democratic politics could act in advance.

21. The American exception. • At the time of the second industrial revolution, thanks to two major conflicts (independence war and secession war), the U. S, had already fought successfully against the old European aristocracy and the slave-owning American farmers of the South. • The development of large firms happened in the framework of a strong democracy. Large block holdings, present in more than one firm, were seen with suspicion by early antitrust authorities, (Sherman and Clayton acts). Pyramids were dismantled by F. D. Roosevelt by the means of appropriate fiscal policies. • This “exceptional” early dispersion of capitalist interests made it less important to concentrate workers’ interests in strong unions and in social democratic parties. A dispersed equilibrium emerged.

22. The European rule. • The European countries (with possible exception of Switzerland) followed a different path: at the time of the second industrial revolution, their societies were hierarchical and still permeated by aristocratic privileges. • No democratic authority could limit the concentration of the power of the capitalist dynasties occurring with the second industrial revolution. • A social-democratic reaction concentrated also workers’ interest and a concentrated equilibrium emerged in all these countries.

23. The British Metamorphosis (I): from concentrated equilibrium to disequilibrium. • At the time of the second industrial revolution, aristocratic influence, early unionization and a deep sense of class division made Britain a typical case of concentrated equilibrium. • However, transmission and division of inheritance, coupled with the international role of the city produced a dispersion of property. • In seventies the UK was characterized by a situation of "institutional disequilibrium" where the traditionally well-organized British unions were not matched by a countervailing centralization of firms' ownership.

24. The British Metamorphosis (II): from disequilibrium to dispersed equilibrium. • This institutional disequilibrium coincided with a crisis of the British economy - which, for some times, seemed to lead to "continental solutions" such as pyramids and cross-share holding on one side and some "responsible" centralization of union's activity on the other (Franks, Mayer, Rossi 2005). • These "continental solutions" were, however, opposed by the city. Eventually the Thatcher government made a sharp move towards a dispersed type of institutional equilibrium, characterised by strong limitations of unions' activities and by a (much advertised) shareholder popular capitalism. These arrangements have not been substantially reversed by the subsequent Labour Party governments.

25. Switzerland: an Alpine America? • There are remarkable similarities between U. S. and Switzerland historical backgrounds. Both countries came to an early tolerance of religious and ethnic diversity and the "cement of society" relied more on shared values and ways of life than on ethnic or religious homogeneity. • Also Switzerland achieved an early definitive exit from aristocratic privileges (in 1847). Swiss feudal ties were traditionally weak. The peasants were difficult to dominate because they were often far away on the Alpine pastures and because they were well trained in military activities (serving, often, as the most valuable mercenaries all around Europe). • Like the U. S., at the time of the second industrial revolution, Switzerland had a robust democracy and satisfied the conditions to realize a “dispersed equilibrium”.

26. Explaining exceptions. • Like the other theories our approach explains the current divide between Anglo-American and European Continental models and it is a matter of quantitative analysis which one of them is more likely to fit the evidence. • Our analysis can also explain the “British metamorphosis” as the difficult transition from a concentrated to a dispersed equilibrium and the “American features” of Switzerland as arising from analogous initial historical conditions. • By contrast, we believe that the other theories would find very difficult to explain both the “British metamorphosis” and the American features of the Swiss economy.

27. Facing exceptions:alternative approaches • The legal origins theories cannot easily explain: why, in spite of her ancient common law origins, England was moving from one equilibrium to another why Switzerland in spite of his civil law legal origins has such developed and dispersed share holding. • The electoral systems explanations face similar problems: With the same electoral system England moved from concentrated ownership an strong unions to dispersed ownership and weak unions. The “over-proportional” Swiss electoral system seems to be compatible with dispersed share holding.

28. Pre-Crisis Conclusions (1) • According to some political views, the introduction of corporate legislation similar to that of the US has the advantage to anticipate an inevitable global prevalence of the American model of corporate governance • Some of the policy implications stemming from the current work on comparative corporate governance are: • 1)introduction of better minority shareholder protection (typical of the systems of common law), • 2) reform of electoral systems favouring political electoral results (supporting shareholder democracy) • 3) removal of protective labour legislation (inducing expropriation fears of absentee share holders) • Our analysis does not havesuch straightforward policy implications.......

29. Pre-Crisis Conclusions (2) • In our view, American populism and European social democracy have been two very different political strategies by which the various societies have made the concentration of power associated to large-scale production compatible with democracy and safeguarded the human capital investment of non-owners • Once a particular set of business institutions is established, a country may find a path to the accumulation of human and material capital that fits better these institutions. The complementarities among political power relations, business institutions and economic resources may make changes very difficult • Our approach is consistent with the possibility that, if potential complementarities are considered, some combination of coherent policies may be beneficial. By contrast, one-sided measures, which import only one characteristic of a particular system, may decrease economic efficiency pushing the system towards a fitness valley of inconsistent attributes. And they may even upset the country-specific balance between economic power and political democracy

30. Post-Crisis Conclusion • The excessive power of finance has not only ended up in dramatic crisis. It has also upset the (Swiss)American and the Continental European ways of conciliating democracy and capitalism. • One can imagine that after the crisis U. S. and Europe may move back to their decentralized and concentrated equilibria while the crisis of the recent british metamorphosis can end up in any direction. • However, the financial crisis may induce major political crisis and corporate governance changes. In this cases the old roots will be a very poor instrument for predicting a very uncertain future........