Tuesday, February 12, 2008

Adam Smith Was Not Opposed to Competitive Joint -Stock Companies

Selecting quotations from Adam Smith is foolhardy, misinterpreting them is dangerous. Ruari McCallion does both in today’s issue of Exec (‘Essential information for business executives’) 11 Feb, which can be found here:

The Executive Cull: The state of the British boardroom’

Has the response to the Higgs Report on corporate governance upset the delicate balance between functional executives and non-execs on British corporate boards? Exec investigates.

Corporate governance and company ownership has been a vexed subject for a very long time. Most people will think of Robert Maxwell but concerns go back a lot further. Adam Smith declared in The Wealth of Nations that managers (for which read, directors) could not be trusted to look after other people’s money; that ‘negligence and profusion’ were the inevitable result of businesses becoming incorporated. He said that in 1776, at which time shareholder-owned companies had been banned from the UK since 1720, after the South Sea Bubble. Exchange Alley, in the City, was the hang-out of con-men pushing stock they praised to the skies – early-style PR, perhaps? Shareholding was viewed as a way of parting fools from their money, which quickly found its way into the pockets of the company managers, before the inevitable collapse

Ruari McCallion has found a quotation from Wealth Of Nations, torn it out of context, and run with it. But anybody who knows of the context knows it is not quite as simple as that.

Adam Smith discussed the East India Company in a section he added to the 3rd edition of Wealth Of Nations and placed it in Book V, though they properly belong to Book IV where he discusses his ‘violent’ critique of mercantile political economy. (WN IV i.3: pp 731-58)

The trading companies required large capitals to produce their monopoly profits because although they were called ‘trading companies’ of necessity they were much more than that. They took on the role of mini-states too, with their own fortified ports, trading posts, and ships. Their charters came from the King or Acts of Parliament and they were legal monopolies. The most prominent of them, aside from the share-fraud scheme of the South Sea Company (1711-1720), was the East India Company founded in 1600 and which in the next two hundred years ended up ruling all of India.

All of Adam Smith’s severe criticism was centred on the East India Company, in particular, and the general notion of Chartered trading companies in general. This is confused with joint-stock companies that formed from the mid-19th century and I read accounts of modern international companies of this century and the last as if they are identical in all respects and in the same context. They are not.

The capital required in the 17th and 18th centuries for chartered trading companies –ships, fortified warehouses, armies, trading goods, and wages – were not trivial. Most commercial entities were small one-man, or one-family, businesses or small partnerships, with small capitals (stocks, workers wages, crude tools, and materials). These were not protected and if one of them was in financial trouble, all the assets of the owners were pledged to clear their debts.

The chartered companies were privatised instruments of British state policy – trade, colonies, exploration and conquest – and their joint-stock status was independent of the assets of shareholders, though loss of their money tied in the shares could be disastrous. Sir Isaac Newton was one of many caught by the collapse of the South Sea bubble. Most of the chartered companies were unsuccessful and useless, the facts of which Adam Smith details in Wealth Of Nations.

The East India Company was also distant in its operations and local management. It took over a year to send written messages back and forth from India to London, leaving the local management in the midst of temptation to ‘trade on their own account’ which few resisted, including the lowliest clerks. Today communication is counted in seconds and the world’s media reports on what it observes. Modern managements cannot get away with bare-faced theft of company property as recent criminal cases have shown.

Moreover, Adam Smith was not totally opposed to joint-stock companies. He certainly opposed them if they were granted legal monopolies. In fact he specifically approved of several examples of joint stock companies, such as the Bank of England, the Bank of Scotland, the Royal Bank of Scotland, as well as when they were instituted for ‘routine’ business such as insurance companies, major civil projects (navigable canals and water supplies).

It was long after he had died in 1790 that the spread of power-driven industry and larger-scale operations required a substantial increase in their capital that joint-stock companies became the most efficient (relatively speaking) to raise such capital sums. Hence, by the later 19th century new legal versions of competitive, not monopolistic, joint-stock companies became feasible and more popular. They have been closely scrutinised by the regulators and the law ever since.

‘Information for business executives’ should not be a tendentious misreading of history and of the Works of Adam Smith; false information is less useful than the accurate kind.


Blogger Alex said...

This is very commonly seen here in India. The context is more often submerged, and the author gives his/her own interpretation to Smith only because people know him as the father of economics.

This would be one such instance.


11:26 am  
Blogger Gavin Kennedy said...

I have noted how often articles in the India media repeat misinformaiton about Adam Smith regularly and I occasionaly comment on Lost Legacy about this.

These are too regular to comment on each one. Being a literate country this means there are widespread misconceptions in Indian business and the media.

Partly, this is caused by Indian media using syndicated materials from US and UK media, though I notice that Indian academics of standing are no less guilty of repeating myths about Adam Smith.

Thanks for your comment.

8:41 pm  
Blogger Ruari said...

Dear Prof Kennedy
What a shame you don't appear to have taken your own good advice about context.
The article from which you extract a small quotation was a discussion about the current state of corporate governance and the role of non-executive directors in particular.
I open the piece by considering the plight of shareholders in Northern Rock and quoting a lawyer who posed the question ‘…what on earth were the non-executive directors doing?’ You didn’t mention that. Just beyond the sentence you comment on can be found the following:

“Dilution of Ownership

The connection between ownership of the company and its operations was one that deeply concerned Adam Smith and, coming up to date, it’s identified as an important factor in economic activity and growth by Martin Carree, André van Stel, Roy Thurik and Sander Wennekers of Cranfield University School of Management. In their paper, The Relationship Between Economic Development and Business Ownership Revisited, the authors establish that a high rate of economic growth tends to go hand-in-hand with high rates of individual business ownership – self-employment or small business activity. True, such activity is also associated with high or rising unemployment, but there are some very interesting equations that explain it all and they can be accessed here [the original article had a hyperlink - www.som.cranfield.ac.uk/som/research/researchpapers]. Read and be enlightened.

“But today’s global economy is based upon large businesses interacting with each other and they can’t all be family-owned. The problem for society – and the companies themselves, long term – is how to control them, and the dilution of ownership in the shareholder form tends to work against effective control.”

Not exactly condemning shareholder-owned companies, though, am I? Rather considering the challenges of effective governance and control of large corporations, which could have a global presence.

You cannot deny that my quote from The Wealth of Nations was accurate. If I put a particular interpretation on it, please explain what it was. You may not like the implication - that corporate governance has been a vexed subject for a long time - but that is true. Your mention of the East India Company is, I suggest, completely irrelevant to today’s corporate structures and governance – with the possible exception of consideration of liability, as well as benefit, to company owners. Limited liability corporations did not appear until well after Smith’s death – the Limited Liability Act 1855, to be precise. Whether the idea was a good or bad thing was not the subject of the article.
I did not suggest that Smith was against private enterprise - clearly, he was not. I was not writing for the Morning Star or Socialist Worker: I was writing a 1500-word piece for a business magazine.
I appreciate you're a busy man but may I ask you to take the time to read an entire article - 1500 words isn't that long - before expending time and energy on blogging about it. Especially on a small extract taken out of context.

Yours sincerely
Ruari McCallion

7:45 pm  
Blogger Ruari said...

"Selecting quotations from Adam Smith is foolhardy, misinterpreting them is dangerous. Ruari McCallion does both in today’s issue of Exec (‘Essential information for business executives’) 11 Feb, which can be found here:..."

"Ruari McCallion has found a quotation from Wealth Of Nations..."

FYI - Ruari McCallion has read 'Wealth of Nations' and regards it as one of the three great works of economics. He didn't 'find', he deliberately selected the quotation to illustrate the article.

You do not, Professor, have a monopoly on knowledge, interpretation or the wisdom of Adam Smith. He didn't like priestly pretensions - those who claim a special knowledge of mysteries unrevealed to the rest of us. I'm with him on that and I'm in good company - Tom Paine, Martin Luther, Ayn Rand and others didn't like it, either.

I'm sure Smith would have recognised all too well the symptoms that led to the parlous state in which Northern Rock now finds itself, and which brought down Enron, WorldCom, Tyco, Maxwell Communications (all of which I mentioned in the article) Marconi, Railtrack, Barings, BCCI, etc, etc; they were symptoms he was familiar with. He would have been outraged that investors - individual shareholders - had been so ill-served, and so long after he was writing.

9:31 pm  
Blogger Iain said...

I know I'm a few days late, but I just read these comments and thought I'd wade in on the side of Ruari here, and I’m also a fan of Adam Smith. I am not sure whether it is possible to avoid "selective" use of quotations under any circumstances without going on to quote the rest of the book. While Professor Kennedy is quite right in stating that Smith was highly critical of the East India Company he is wrong to state that he reserved his criticism for that company alone. In fact, he was highly skeptical of the "joint stock company" per se and here is another "selective” quote where Smith states this quite unambiguously:
“The joint stock companies which are established for the public-spirited purpose of promoting some particular manufacture, over and above managing their own affairs ill, to the diminution of the general stock of society, can in other respects scarce ever fail to do more harm than good.” (Wealth of Nations “Books IV-V, p.347). He also had a number of nasty things to say about the banks and their role in the financial scandals of his day, whilst appreciating their important role in capital transactions. I must say that I enjoyed the original article that began this little debate.

1:30 pm  

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