with Michael Klein, Chief Economist of the International Finance Corporation
Adam Smith would not have been surprised by Enron, Parmalat and the rest. The father of economics famously believed that joint-stock companies could never prosper because managers had no incentive to take care of the interests of widely dispersed shareholders. “Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company,” he wrote in The Wealth of Nations.
But Smith was wrong. You might not know it to read the headlines, but cases of serious fraud remain exceptional. In most rich countries, tiny investors continue to put their money into vast companies over which they have no effective control, correctly believing that they will profit from the arrangement.
Given the varied opportunities for managerial fraud and expropriation, and the difficulty small shareholders have in co-ordinating themselves to prevent their being robbed, the success of joint stock companies is a minor miracle. It is also one of the cornerstones of modern prosperity. Obstacles that seemed insuperable to Adam Smith in 1776 have been surmounted and the occasional scandal helps keep investors and regulators alert. While there is room for improvement, the fact that abuses are so rare compared with Smith’s fears is a testament to the high standards of corporate governance in the developed world.
So Smith was too pessimistic about large corporations in rich countries. Sadly, he has been proved right (so far) when it comes to corporate governance practices in much of the developing world. In many poor countries, enforcement of company law is weak and various forms of managerial expropriation are sometimes perfectly legal.
Poor corporate governance in developing countries is a serious matter. It is true that some countries, such as South Korea, managed to join the industrialised world after an impressive record of sustained growth, despite flaws in corporate governance. But that strong record belies the fact that even South Korea has much to gain from improved standards.
Leading families continue to control the chaebol through Byzantine systems of cross-holdings. The result is that investors have little confidence in South Korean shares, which trade at a notorious discount. If governance in the country could be strengthened, its businesses would be able to secure cheaper finance – essential for the continued progress of a high-investment, high-innovation economy.
In other countries, the problem is more acute. If emerging market companies cannot attract equity capital, they are doomed to remain on a small, inefficient scale. If small businesses struggle to grow, so will poor countries.
This is a serious problem for the world’s poor, and the World Bank and the International Finance Corporation are working hard to improve it, in part by working with the Organisation for Economic Co-operation and Development to provide guidance.
The OECD’s new corporate governance principles, approved last month, are a welcome effort to set out the best possible standards. They were informed by the largest ever consultation of developing countries on corporate governance, facilitated by the World Bank. The task now is to make those high standards a reality for developing countries.
The challenge is to create approaches that work well in the local context. For example, in a small country such as Chile, which has a close-knit business community, it is unwise to rely too heavily on scrutiny by “independent” directors. Chile rightly recognises that investors need different forms of protection. The World Bank is helping developing countries to reform corporate governance, recognising reality but still giving investors good reason to be confident.
The desire to see poor people secure good jobs in thriving, growing companies is reason enough to care about this issue. But while poor governance is already an obstacle to development, it is about to become a critical topic for foreign-policy makers because in the future public policy on corporate governance will be about securing the rights of cross-border investors.
Rich countries have an increasing proportion of retired people. Some poor countries, notably China, are not far behind them on the demographic curve. The result is that retirees from both types of nation will be seeking to fund their pensions with productive investments all over the world.
This is a great opportunity for the developed and the developing world to gain from working together. More and more money will flow across borders, if investors can be confident of getting it back. If they cannot, the wasted opportunities will be staggering and will grow over the years.
By 2100, the funds seeking trustworthy, productive companies in today’s developing countries are likely to top $500,000bn, assuming economic growth continues at 20th-century rates, so that the typical global citizen owns the same size portfolio as US citizens do today. The foreign policy challenge of the 21st century is to make those cross-border investments possible, and help rich and poor alike.