Michael Jensen, who died on April 2, did as much as any single thinker to shape modern financial capitalism, particularly as it is practiced in the Anglo-Saxon world. To his critics, he was the high priest of the greed-is-good era who justified exorbitant executive pay and vulture capitalism: Gordon Gekko with a doctorate. To his admirers, he was the surgeon who gave Anglo-Saxon capitalism a new lease of life by slicing off the fat, removing the malignant tumours and prescribing a strict exercise regime.
Nobody can deny his extraordinary influence. His elective at Harvard Business School was the most popular in the institution’s history, enrolling more than 600 students, two-thirds of each year’s class, many of whom went on to restructure American capitalism during one of its most excited phases.
And nobody can deny the rigour of his ideas about the central issues in business theory: the proper boundaries of the firm, the ideal incentive structure, the market for corporate control and the advantages and disadvantages of public versus private companies. His groundbreaking article, co-written with William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” has earned more than 130,000 Google citations, more than any other article in financial economics.
Jensen’s central idea was that the people hired to run companies (“agents”) will shortchange the people who own the companies (“principals”) unless they are motivated by the right mixture of sticks and carrots. This is particularly true of public companies where ownership is dispersed and monitoring mechanisms weak. The giant companies that dominated the US economy are monuments to the so-called “agency problem”: a bloated class of managers produced dismal returns for shareholders while living a comfortable life of perks and lifetime tenure, low risk and low return.
The solution was to apply the magic of shareholder value to change incentives: Pay the CEOs and senior managers of public companies like owners with share options — or better still take the companies private through leveraged buyouts. The more you turn “agents” into “principals,” the more you will give them an incentive to squeeze the maximum value out of the companies that they were hired to run.
This idea was at the heart of the revolution that transformed corporate life, first in America and then in much of the world, from the late 1970s onward. Hard-driving managers downsized companies in pursuit of shareholder value. Corporate raiders tore apart conglomerates and turned them into collections of leaner companies. Jensen’s ideas revolutionized attitudes toward everything from pay scales to corporate debt. CEOs who had once balked at the idea of seeming greedy now competed to earn the most. Analysts who worried about taking on debt now quoted Jensen’s advice that debt “creates the crisis atmosphere managers require to slash unsound investment programs, shrink overhead, and dispose of assets that are more valuable outside the company.”
The great HBS historian Alfred Chandler had preached that the end of corporate history is reached when the managers take over. His classic The Visible Hand (1977) is an encomium to postwar firms such as General Motors and DuPont, with their serried ranks of professional managers who acted as if their shareholders did not exist. Jensen preached the opposite: These giant institutions are nothing more than dinosaurs that need to be replaced by much smaller and more entrepreneurial outfits. If Chandler’s HBS students had happily become company men, confident that they were doing history’s work, Jensen’s students became venture capitalists, financial engineers, corporate raiders, equally confident that they were doing the market’s work.
Jensen’s work is as unpopular today as it was feted in the Reagan era. The Harvard Business Review failed to include his work in a collection of its most important articles of its first hundred years, despite the fact that “Eclipse of the Public Corporation” is about as good an HBR article as you can write. Nicholas Lemann, a former editor of the New Yorker and former Dean of Columbia University’s Graduate School of Journalism, has written a book, Transaction Man: The Rise of the Deal and the Decline of the American Dream, excoriating his ideas and influence. The younger professors at HBS have abandoned the idea of shareholder value in favour of fluffier ideas about corporate purpose.
Lemann argues that Jensen bears much of the blame for the dire state of American capitalism. Soaring executive pay ensured that the C-suite absorbed a disproportionate share of the economic surplus at a time when productivity growth was slowing down. Re-engineering and downsizing tore apart corporations that had provided a stable way of life for communities. Jensen-trained managers pursued short-term gains (a boost in share price often through financial engineering) at the expense of long-term investment in productive capacity. Jensen stoked the rage in the heartland against stagnant wages and shuttered factories that produced the angry populism of both left and right.
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This is an exaggeration. True, far too many CEOs lined their own pockets for mediocre performance. In the same week that Jensen died, we learned that Dave Calhoun, who is stepping down as CEO of Boeing Co during a safety crisis that has sent the company’s share price plunging, was paid US$32.8 million in 2023. Jensen nevertheless provided a mechanism for Joseph Schumpeter’s “creative destruction” to work its magic, cleaning out corporate capacity and putting it to productive use. As Don Chew, the editor of the Journal of Applied Corporate Finance, points out, the wave of highly leveraged takeovers and LBOs during the 1980s limited the waste of corporate capital on futile attempts to prop up sunset industries and companies and thereby made it available for the next industrial revolution.
The US thus escaped the stagnation that continues to afflict Japan, a country that, when Jensen started writing, looked set to supplant the US as the world’s leading economic power. By contrast to Japan’s over-layered and over-staffed behemoths, America’s companies look astonishingly fit: The old-line industrial companies have refrained from putting on too much weight since the Jensen revolution and the new IT behemoths are still tightly managed (though they may yet go the way of yesterday’s pampered conglomerates).
What about the soar-away pay and perks of even mediocre managers? Jensen’s defenders blame two things: the stock market boom that lifted all boats regardless of performance and a widespread misunderstanding of his work. Central to Jensen’s argument was that CEOs needed to experience the downside as well as the upside of the free market: Their pay should go downward as well as upward, and they should lose their jobs if they performed badly. CEOs gamed the system to ensure that they won whatever happened. They provided themselves with golden parachutes in case things went badly and they manipulated share prices to make sure that they sold their options at the right time. Far too many behaved like rent-seekers who benefited regardless of whether they created value or not.
Jensen was profoundly disappointed by what he saw as the misuse of his ideas to justify alpha rewards for beta performance. “Managerial heroin” was how he described the implementation of share options in many US companies. In the late 1990s he underwent the equivalent of a religious conversion. He became a follower of Werner Hans Erhard, the founder of Erhard Seminars Training, more popularly known as EST, a quasi-religious movement that promised to empower its followers and heal their spiritual wounds. Jensen collaborated with Erhard to produce a thousand-slide PowerPoint presentation heralding the wisdom of their respective lifetimes, a mishmash of management theory, self-help, neurobiology and linguistics. He also devoted much of his time to delivering seminars, some of them lasting for days. For Jensen, his collaboration with Erhard supplied the missing piece of the jigsaw of the agency theory: Provided that managers followed the precepts that he and Erhard laid out, they would refrain from the self-dealing that had hitherto marred his theory; instead, they would act like honest capitalists.
Few of us would be willing to follow Jensen down this path. But the “misuse” argument is only a little more plausible. Jensen’s problem is that he fails to carry his rent-seeking argument to its conclusion. If “agents” act as rent-seekers when they are running big companies, lining their own pockets at the expense of the company’s owners, why would we assume that they will behave differently if they are given share options?
Jensen failed to reckon with the importance of power. CEOs are not just regular players in the marketplace. They are powerful people who can structure their remuneration systems and decide when to sell their own shares. This is particularly true in America’s CEO-focused companies, where CEOs often double as chairpersons and exercise a disproportionate influence over the composition of the board. Because he ignored the importance of power, he failed to acknowledge the importance of having a robust moral code to regulate the behaviour of the elite.
Jensen and Meckling began their great 1976 article with a quotation from Adam Smith’s Wealth of Nations (1776), a book that, among many other things, explained how the acquisitive urges (self-love, egotism, self-interest, pride, and acquisitiveness) can be transformed into social virtues if they were channelled by the free market. But Smith also wrote another great book, The Theory of Moral Sentiments (1759), that argued that markets require more recondite virtues if they are to flourish in the long run: the higher virtues of wisdom, benevolence, self-sacrifice and public spiritedness. Keeping these virtues alive in a market society is difficult because the market doesn’t know how to value or reward them. The job of doing so belongs to a small party of the “wise and the virtuous,” what Samuel Taylor Coleridge was later to call “the clerisy” and we call public intellectuals, who devote their lives to studying and correcting the public sphere.
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For all his theoretical brilliance, Jensen was a creature of his time. His ideas delivered a needed shock to a sclerotic and self-indulgent business world. But this worshipper of the stock market failed to reckon with the growing market bubble. When he first pondered agency costs in the 1970s, the big problem was the under-utilization of company assets and their consequent under-valuation. When he was in his pomp, as a star HBS professor and a leading figure in the Monitor Group, a strategic consultancy, the big problem was over-valuation. This ultimate cynic about human motivation was strangely naive about the propensity of powerful people to destroy incentive structures. As a result, the Jensen revolution devolved into an excuse for cost-cutting and self-indulgence.
The challenge today is to go beyond agency theory — beautiful though it is — and produce a new framework that combines the dynamism of the market with a broader sense of common purpose, social justice and political sustainability. If stakeholder capitalism, the purpose-driven corporation and other attempts to displace agency theory thus far seem jejune by comparison, that’s all the more reason to try harder. - Bloomberg Opinion
