Sunday, October 28, 2007

The Debate Continues (long post!)





Gavin Kennedy

Mark writes:

"The basic difference rested on whether joint-stock companies or any companies in fact, co-partnerys or regulated, were made monopolies or not. This seems to be lost on you."

How, then, do you read this statement:

"It is upon this account that joint-stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one."

To me, that doesn't read like the relevant distinction is monopolies, especially as "this account" appears to refer to agency ("negligence and profusion") rather than theft and fraud."

I replied:

Hi Mark

I hope I am not so arrogant as to assert that I have nothing more to learn about Adam Smith’s writings, so I am pleased when challenged to justify something I have asserted and compel me to re-look at my interpretations, and I thank you for presenting me with such an opportunity.

The relevant section of Wealth Of Nations is found between pages 731-758 (1976 Glasgow Edition from Oxford University Press), or between pages 690-716 (Edwin Canaan’s 1937 edition, Random House): ‘Of the Publick Works and Institutions which are necessary for facilitating particular Branches of Commerce’.

In this section, Adam Smith discusses the different institutional forms of commercial entities in the 17th -18th century. It is necessary to read it all in order to make conclusions about what Smith intended; quoting sentences from a part of it is no substitute.

For you, teaching 21st-century corporate governance at a Business School, the significance of Smith on the different forms of corporate governance is to teach the ‘principal-agent’ problem.

I believe that the principal-agent problem, recognised by Smith, was incidental to his essential message; specifically that ubiquitous forms of monopoly in foreign trade were another case of the wasteful prevalence of mercantile political economy, with the East India Company as the worst example, with the other chartered companies as ‘oppressive’ or ‘useless’ examples.

To facilitate commerce, ‘extraordinary expence’ was necessary in particular institutions (p 731). In ‘barbarous and uncivilised nations’ merchants required fortified protection; in ‘Indostan’ the East India Companies (English and French), though dealing with ‘mild and gentle people’ pretended they too needed fortified forts, and in Europe, the expense of a ‘permanent’ ‘ambassador, minister, or consul’ was sufficient to sort out arguments among merchants and local citizens (p 732).

Foreign trade attracted ‘pirates and freebooters’, and merchants ‘taxed’ themselves to cover such costs. At home, governments provided such protection. In foreign trade, merchants ‘perswade’ the sovereign to devolve protective powers to them and while ‘prudent’ initially, in the long run it ‘proved universally, either burdensome or useless, and either have mismanaged or confined the trade’ (p 733). By ‘confined’ Smith meant monopolised the trade; he saw it as the overriding economic problem of the 18th century.

Without ‘joint stock’ (each member sharing ‘common profit or loss in proportion to his share’) they must admit any person who pays the subscription (‘fine’), and trade at his own risk, i.e., become ‘Regulated Companies’, which ‘resemble’ ‘corporations of trade’ or ‘town guilds’, the particular institutions that Smith attacks through book IV, and were weak ‘monopolies’.

Smith considered regulated companies in foreign trade to be ‘useless’ and shows why from p 734-737 (their ‘directors’ have no interest in their success, only in their part of them). Their weakness and failure mean members drop out, competition is reduced, and individuals, for a while, enjoy profits (p 737). Parliament attempted to ‘restrain effectually the oppressive and monopolizing spirit which is natural to directors of a regulated company’ (pp 737-8.

He then discusses the structure of joint stock companies. Profits based on shares; cannot trade on own account; their interests connected to the interests of the company; they maintain forts and garrisons; and maintain them properly compared to regulated companies (pp 737-40).

He compares joint stock to co-partneries. Partners cannot sell their shares without the permission of other partners; joint stock members can sell in the market. Partners are liable for their entire fortune for debts; joint stock companies members are liable to the extent of their shares. (p 740)

Joint stock companies are managed by a Court of Directors, and ‘frequently’ meet the ‘proprietors’ (shareholders), who receive a dividend decided by the Directors. Independent ‘adventurers’ buy shares because their risk is limited. Large capitals were raised in this manner in millions, not thousands (p 740).

The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.” (p 741)

Mark focuses on ‘negligence and profusion’ as the determining characteristic of all joint stock companies, but this was not a feature of the joint stock companies that Smith praised (Bank of England, Bank of Scotland, Royal Bank of Scotland, and others). Also, he reads into ‘this account’ only ‘profusion and negligence’ as hindering keeping ‘private traders out’ when it is the entire problem of their weakness discussed beforehand that fails to stop ‘private adventurers’.

I focus on the problem for the Chartered trading companies engaged at long distances on their lack of ability to ‘maintain the competition against private adventurers’, who were trading in ship loads of cargo each way between England and India at some cost to the Chartered Company (including collusion under bribes of local officials in the matter of customs dues, if they landed or loaded their cargoes in a Company port). This is particularly important as such competition (presented to parliament as ‘ruinous’) required, they claimed, the remedy of a legal monopoly. The power of enforcement east of Cape of Good Hope was devolved to armed Company ships, itself a power open to wide and tyrannical abuse.

Smith’s discussion (pp 740-46) on company structure is interrupted by a long discussion on trade with Africa, the Hudson Bay company (a joint stock company that worked successfully because of its remoteness, climate and short weeks in which the sea was free of ice, plus manned by 120 persons only, and no independent ‘adventurers’ able to interfere, p 743), the Spanish West Indies and the South Sea Company. Smith asserts that ‘Their ill success was imputed, by their factors and agents, to the extortion and oppression of the Spanish government; but was, perhaps, principally owing to the profusion and depredations of those very factors and agents, some of whom are said to have acquired great fortunes even in one year.

Again, this is a problem exacerbated by distance and time lost in assessing what was going on. All organizations of all kinds, publicly funded armies, navies, small trader shops, co-partneries, regulated companies, joint stock companies, even churches, have been subjected over the years to ‘negligence and profusion’ whenever the perpetrators can get away with it and whenever there is something of value to misappropriate. The foreign trade business in the 16th-19th century was particularly open to such malfeasance independent of the joint stock structure – ship’s cargoes ‘disappeared’ regularly as world trade grew, both from collusive piracy and independent opportunism (and sinking).

Smith gives a case history of the East India Company. In the early years its capital was small (£740,000) at £50 a share, and their dealings ‘not so exorbitant, nor their dealings so extensive, as to afford either a pretext for gross negligence and profusion, or a cover to gross malversation’ (p 747). Its original charter was not ‘confirmed by act of parliament’ and did not ‘convey an exclusive privilege’. It was reconstituted in 1698 (for a while there were two East India Companies) and their rival trading and ‘private traders’ ‘well nigh ruined both’ (p 748).

Smith states the economics: ‘The increase of demand, besides, though in the beginning it may sometimes raise the price of goods, never fails to lower it in the run. It encourages production, and thereby increases the competition of the producers, who, in order to undersell one another, have recourse to new divisions of labour and new improvements of art which might never otherwise have been thought of. The miserable effects of which the company complained were the cheapness of consumption and the encouragement given to production, precisely the two effects which it is the great business of political œconomy to promote’ (p748).

When legislation affecting the company finally settled down, there was a period of prosperity, following its legal monopoly from 1711, and its capital rose to £3 million, dividends were paid and the government received loans. Such events do not pass unnoticed by managers, clerks and cargo handlers, again exacerbated by the distance separating the men on the ground in India (with collusive relatives and others in London’s docks). Smith notes ‘The great increase of their fortune had, it seems, only served to furnish their servants with a pretext to greater profusion, and a cover for greater malversation, than in proportion even to that increase in fortune’ (p 751).

The road to state control was underway, a ‘solution’ with which Smith was likely to be opposed. A governor-general was sent out with four assessors, then a new court of judicature was appointed, as the scandal of the Company’s management became public knowledge. Smith thought it all fruitless:

About the prosperity of the great empire, in the government of which that vote gives him a share, he seldom cares at all. No other sovereigns ever were, or, from the nature of things, ever could be, so perfectly indifferent about the happiness or misery of their subjects, the improvement or waste of their dominions, the glory or disgrace of their administration, as, from irresistible moral causes, the greater part of the proprietors of such a mercantile company are, and necessarily must be’ (p 752).


But if the company were bad stewards, and bad sovereigns, when the whole of their nett revenue and profits belonged to themselves, and were at their own disposal, they were surely not likely to be better when three-fourths of them were to belong to other people, and the other fourth, though to be laid out for the benefit of the company, yet to be so under the inspection and with the approbation of other people” (p 753).

Smith accepts the case for a temporary monopoly: ‘When a company of merchants undertake, at their own risk and expence, to establish a new trade with some remote and barbarous nation, it may not be unreasonable to incorporate them into a joint stock company, and to grant them, in case of their success, a monopoly of the trade for a certain number of years” (p 754.

If this becomes a perpetual monopoly (an aim of mercantile political economy) it is a worse solution, for it merely enables ‘the company to support the negligence, profusion, and malversation of their own servants, whose disorderly conduct seldom allows the dividend of the company to exceed the ordinary rate of profit in trades which are altogether free, and very frequently makes it fall even a good deal short of that rate.’

Smith clearly considered that chartered trading companies, institutions of mercantile political economy, were inappropriate in that role. It was in their nature to fail. He quotes the French economist, Abbé Morellet’s list of 55 joint stock companies for foreign trade that failed since 1600 (p 755). He approved of joint stock companies ‘without an exclusive privilege’ in businesses where ‘Routine, or such uniformity of method admits of little or no variation’, including the banking, insurance, making and maintaining canals, and water aqueducts (p 756), and considered them to be ‘very successfully managed’.

He summarises his main criticism of those joint stock companies formed for general purposes as unreasonable when they ‘exempt a particular set of dealers from some of the laws which take place with regard to their neighbours’, when then cannot show that they are of ‘greater utility’ than the ‘common trades’ and when they cannot show that they need a greater capital than can easily be collected in a private co-partnery, or several co-partneries entering the same trade and, necessarily, competing.

His critique is against mercantile trading monopolies, sheltered by monopoly, buying cheap and selling dear, but burdened by distance (encouraging ‘negligence and profusion) and with insufficient enforceable control exercised by its ‘proprietors’, and by law. He did not misjudge joint stock company structures and did not live to see their legal structures in the 19th century that resolved some of the monopoly problems but, alas, not the ‘negligence and profusion’ of the likes of Enron.

Smith gives some good case material for classes on business scandals; he does not justify being 'utterly wrong' on joint stock companies.


Blogger Marc'n'NY said...


I’m billed as a professor of business history, but I rather see myself as a student of business history. Your extensive exposition about what Smith had to say about institutional forms is a fine lesson.

I understand what you say at the start of it: “I believe that the principal-agent problem, recognised by Smith, was incidental to his essential message; specifically that ubiquitous forms of monopoly in foreign trade were another case of the wasteful prevalence of mercantile political economy…” I would grant that, and everything that follows. But his insight about agency was not incidental to MY message—it was central, and a valid insight to use in a piece about evolution of the corporation. My message, quite simply, was that Adam Smith could not have foreseen the dominance of the corporate form we see today. This does not counter anything else he wrote about trade. It is certainly not an indictment of his intellect or his achievement. It does not presuppose that he was in the business of predicting the future, which I grant he was not. It’s simply an extrapolation of his views about joint-stock companies as they had evolved up to his time.

I understand that Smith wrote very little about joint-stock companies, at least in WoN. I doubt there are more than a couple of articles in his entire tome that specifically references them. Quotes like “They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one,” or “That a joint stock company should be able to carry on successfully any branch of foreign trade, when private adventurers can come into any sort of open and fair competition with them, seems contrary to all experience” or “Without a monopoly, however, a joint stock company, it would appear from experience, cannot long carry on any branch of foreign trade” may represent incidental sentiments regarding his main message. But they seem to convey a distinct skepticism about the likelihood of a global economy as free as we have today looking the way it does today vis-à-vis corporations.

I understand that Smith did not forsake the joint stock form for every kind of business. As you state, he saw a role for them in certain, defined circumstances. But this view seemed, to me, a rather restrictive one: “The only trades which it seems possible for a joint stock company to carry on successfully without an exclusive privilege are those of which all the operations are capable of being reduced to what is called a Routine, or to such a uniformity of method as admits of little or no variation.” This hardly seems to foretell of a globally competitive GE, or BAE Systems--what he would have certainly characterized as outside of his restrictive definition, and in fact likely have characterized as “foreign trading” companies, albeit without special privileges.

Granted that everything in your fine explanation is true to Smith’s views, nothing in that explanation contradicts my assertion that Smith viewed agency costs as an inherent problem in joint stock companies, whether or not they were monopolies. That assertion is tenable, even granting that he might have felt the same about the impact of agency costs on other business forms (which, I think is debatable; he simply didn’t seem to have the same level of skepticism about those forms in a globally competitive environment).

I won’t presume to debate Smith’s main concerns or central intent in his WoN. Frankly, it’s been a while since I read it. But I don’t think my reading of the quoted passages was incorrect, out of context, or “silly” or “nonsense.” At worst, we have a disagreement on emphasis regarding how Smith might have weighted the relative impact of agency on various institutions— something that would be difficult to guess, even with all the supporting material on his views about each. One might disagree about how Smith might have viewed the modern world, but that is an admittedly speculative exercise that would properly remain outside of any thematic discussion.

8:49 pm  

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