De-Klein-ed: A Fictional Encounter in Five Acts

January 27, 2009

My post “Vaguely Defined Property Rights Indeed” was, at its core and in its title, a response to Peter Klein’s involvement in the “conflation debate”. Klein pointed out that cooperatives (his all-purpose stand-in for labor-managed firms) “all suffer from serious incentive, information, and governance problems, almost none of which are mentioned in the anti-corporation libertarian literature.”

Klein was referring to his 2007 article “Vaguely Defined Property Rights” where he essentially argues, using Mike Cook as a primary source, against the LMF on consequentialist grounds. There is a danger that by engaging him on this level, I may be validating the importance of efficiency over what essentially is an issue of inalienable rights, the proper imputation of responsibility and property appropriation. During the Abolition movement, it would have been unnecessary to argue about the relative efficiency of slavery for example. That said, I will carry on nevertheless.

I had the good fortune to discuss these concerns with David Ellerman, whose ideas I referenced in the previous post. Therefore, I will present here a fictional conversation in five acts between Peter (in the form of his article) and David (in excerpts from my conversation with him). Hat tip to David for allowing me publish this private correspondence and providing my readers with rare and valuable insight.

De-Klein-ed: A Fictional Encounter in Five Acts

Prologue

KLEIN: The shareholder model of the firm has come under increasing criticism from a variety of quarters. Stakeholder approaches argue that employees, suppliers, customers, community members, and others with relationships to the firm should have their preferences taken into account. Theories of worker empowerment, “flatter hierarchies,” and similar approaches advocate delegating decision rights to employees, not top management. Models of loose and open collaboration treat the firm as simply a node in a cluster or network of firms, with decision authority widely dispersed throughout the larger structure.

All these approaches, despite their differences, reject the standard shareholder model in which the firm’s owners, as residual claimants, possess unique rights of decision management and control. And yet, there is a substantial literature on the organizational costs of alternative models, particularly those in which residual claims are not alienable, separable from other agent roles in the organization, or marketable. These costs have not been widely appreciated in the literature on stakeholder management, worker-managed teams and firms, and the like.

ELLERMAN: These arguments about economic models often pit idealized textbook models on one side against the worse real world examples on the other side. One must be careful to try to compare idealized model to idealized model, or real world to real world.

I know of no example of general stakeholder models that have been thought through and spelled out. But the democratic firm (members = all who work in the enterprise) has been thought out in detail so a debate should be between it and the conventional firm based on the employment contract (most who work in the firm are employees) represented by the conventional corporation. Hence the question is the extent to which Klein’s points apply to the democratic firm (one can download my book on the topic from my website).

One of the main problems is that the conventional treatments of the conventional corporation involve the presupposition that there are certain property rights existing in that firm which do not exist in the democratic firm. The main mistake is the idea that there is a present “ownership” of the contractual position of being the residual claimant (this idea permeates Klein’s comments). There is the ownership of a corporation but that is only an asset-owning shell undertaking no production unless another set of contracts are made (e.g., buying inputs, hiring workers, selling output,…) which turns the corporation into the residual claimant with respect to that production process (using those inputs to produce and sell those outputs). There is no property right or ownership of that residual claimant’s contractual position in either the conventional firm or the democratic firm. This failure of their being a property right to RC comes out all over the place in capital theory, finance theory, accounting.

In a recent paper, I tried, probably in vain, to explain the matter to Marxist economists who agree with conventional economists on the existence of this non-existent property right and disagree only on whether it should be privately or publicly owned. That paper addresses most of the real concerns raised by Klein (e.g., the horizon problem) since Marxists are equally if not more confused on these matters.

For those who want only a short three-pager addressed to how these “non-ownership of goodwill” issues arise in accounting, see this reprint from a Dutch accounting journal.

Act I: The Free-Rider Problem

KLEIN: The external free-rider constraint is a common-resource problem occurring when property rights are non-tradable, insecure, or unassigned. De jure property rights in a patron- or worker-owned firm, or de facto property rights in a stakeholder-managed firm, are not well specified and enforced to ensure that current members and non-members bear the full costs or receive the full benefits of their actions. This occurs particularly in open-membership cooperatives. A more complex type of free-rider problem results from the common-property (or insider free-rider) problem. This occurs when new members obtain the same patronage and residual rights as existing members and are entitled to the same payment per unit of patronage. This set of equally distributed rights combined with the lack of a market to establish a price for residual claims reflecting accrued and present equivalents of future earnings potential creates an intergenerational conflict. Because rates of return to existing members are diluted, overall investment incentives are attenuated.

ELLERMAN: The problems raised in point 1 seem aimed at rather loosely structured hippie communes that I have no interest in defending.

Act II: The Horizon Problem

KLEIN: The horizon problem occurs when a member’s residual claim on the net income generated by an asset is shorter than the productive life of that asset. This problem is caused in cooperatives by restrictions on transferability of residual claimant rights and the restricted liquidity through a secondary market for the transfer of such rights. The horizon problem creates an investment environment in which members have little incentive to contribute to growth opportunities. Because future earnings cannot be captured completely by current cooperative stockholders, managers and boards of directors are pressured to maximize short-term benefits to members even though such a policy may be harmful in the long run.

ELLERMAN: The horizon problem has been solved by the set of internal capital accounts that one can find in the Mondragon cooperatives or in existing partnerships. This is explained in the above mentioned book or the paper in the Marxist journal. The democratic firm structure accounts for all the real property rights that exist in the conventional firm; residual claimancy is owned in neither type of firm.

Some of the existing rights in a conventional corporation that are alienable property rights are turned into inalienable personal rights in any democratic organization such as a democratic corporation or a democratic unit of political government at the city, state, or federal level. All such membership or citizenship rights are not for sale and thus constitute market imperfections. If all rights were alienable to “perfect” the Market, then one is led straight to the right-libertarian argument for the voluntary slavery contracts or the political analogues, e.g., Robert Nozick or, his less well-known acolyte, J. Philmore in: 1982. “The Libertarian Case for Slavery: A Note on Nozick.” Philosophical Forum. XIV (Fall 1982): 3-58.

Act III: The Portfolio Problem

KLEIN: Because cooperative investments lack transferability, liquidity, and appreciation mechanisms for the exchange of residual claims, member-patrons are unable to adjust their cooperative asset portfolios to match their personal risk preferences. In cooperatives, the investment decision is “tied” to the patronage decision and thus, from an investment point of view, members hold suboptimal portfolios. This portfolio problem leads to situations where members attempt to encourage cooperative decision-makers to rearrange the cooperative’s investment portfolio even if the reduced risk means lower expected returns.

ELLERMAN: This point seems to assume that democratic firms have the investment decision tied to patronage distributions, as if investment in a conventional firm was solely determined by dividends. Both types of firms can take on debt. There also seems to be a comparison between a member in a democratic firm and a diversified player on the stock market whereas the more appropriate comparison would be to a shareholder in a closely-held corporation.

Act IV: The Control Problem

KLEIN: The control problem in a cooperative arises from the costs of trying to prevent the divergence of interests between the membership and the board. Governance is particularly costly in a cooperative because cooperatives do not publicly release their financial statements, cooperatives do not face the external pressures faced by publicly traded firms, and cooperative members serving as directors may have little or no experience in exercising control.

ELLERMAN: This point seems to argue that the staff in a democratic firm have little idea what is going on in the firm where they work eight hours a day and form the natural political unit to elect the board, and that it is preferable to have the “pressure” exerted by the corporate governance of the far-flung shareholders in a conventional widely-held corporation. I can make no sense out of that argument so I have no idea how to respond.

Act V:  The Influence Costs Problem

KLEIN: The influence costs problem arises when organizational decisions affect the distribution of wealth or other benefits among members or constituent groups of the organization. The affected individuals or groups, in pursuit of their self interests, attempt to influence the decision to their benefit. The influence costs problem can be viewed as a collective decision making problem. Because shares in most cooperatives are neither transferable nor tradable, members that cannot exit have little choice but to engage in influence activities. If the cooperative is engaged in a wide range of activities, diverse objectives among its members can lead to damaging influence activities that increase transaction costs within the cooperative, lead to wrong or no decisions at all, and finally, may lead to the dissolution of the cooperative. (See Cook and Iliopoulos 2000 and Cook and Chaddad 2004 for details.)

ELLERMAN: When I was writing the Nozick spoof as “J. Philmore” many years ago, it was great to take some of the old arguments for people to sell themselves into slavery and to express them in modern form as a contract which the “risk-adverse” could avail themselves of to finally find the “security” of being a slave etc. The old arguments for autocracy, Hobbes’ war of all against all being the locus classicus, argued that the costs of arguing and fighting with each other would lead people to give up their rights of self-government, on the condition that others do likewise, to transfer sovereign power to one person or group of people who would embody the Leviathan.

[He] does such a nice job of translating the old arguments for autocracy and against democracy into the jargon of agency theory with its “influence costs” as a catchall phrase for the costs of democratic decision-making–that I almost think he is also doing a spoof.  But I guess not since he is writing under his own name and is an economics prof at the U. of Missouri/Columbia. At the rights level, there is no need to answer such arguments which only give a modern gloss to old arguments against democracy, and do not even touch the inalienable rights arguments against such contracts.

At the pragmatic level, there is a whole management literature (one good representative being the Douglas McGregor I dealt with in my Helping book) which argue that autocratic management imposes much greater costs on a company (low level efforts, slacking off, non-identification with the job and company, etc.) than management that treats people with respect and involves them in decision-making. It used to be an argument between American-style autocratic management and Japanese-style participation in management. The participative style took longer to make decisions but when they were made, people had buy-in and identification with the decision, so the implementation was quite effective (rather than quietly sabotaged and poorly done with low quality…). Toyota versus GM.

I guess we know how that comparison came out, but the arguments at the academic level will be endless since changing one’s mind is not “psychologically available” to a conventional economist.

Also Klein is technically wrong in assuming that one cannot exit a democracy if one is willing to bear the costs. One can exit a Mondragon-style cooperative at any point. One’s account is closed, the balance becomes a debt of the company to the ex-member, and would be paid out over a fixed period of years like any debt (terms as determined in the constitution/bylaws). It’s the same when leaving a partnership which has a capital account, or when triggering a buy-back agreement when several feuding siblings own a family company, or even in a divorce.

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3 Responses to “De-Klein-ed: A Fictional Encounter in Five Acts”

  1. Peter Klein Says:

    Interesting. I don’t know Ellerman’s work but was pleased for the opportunity to engage in some informed discussion on these points. Oh well. Ellerman begins by accusing me of the Nirvana fallacy, which is ironic, because that’s exactly the main argument I raised against Roderick Long in my posts that started this discussion! One will search my writings in vain for any arguments based on “idealized textbook models” of investor-owned firms. I guess Ellerman didn’t have the opportunity to read Roderick’s blogs or my responses, because my main point all along has been to call for a comparative institutional analysis of the advantages and disadvantages of alternative forms of organization, rather than to compare (as Roderick does) real-world investor-owned firms with idealized textbook models of patron-owned firms.

    To my first substantive point Ellerman responds that that the free-rider problem must exist only in “loosely structured hippie communes that I have no interest in defending.” Yes, that’s what Mancur Olson’s work was all about! (Actually Cook’s papers on the free-rider problem deal primarily with billion-dollar agricultural cooperatives, but never mind.) At this point I stopped reading.

  2. Neverfox Says:

    Peter,

    The constraints of “insecure”, “unassigned”, or “patronage” are neither necessary conditions of labor-managed firms nor conditions that are worth endorsing. To the degree that it is meant to represent an argument against labor-managed firms per se, it is a straw man and isn’t worth much more than a dismissal. To the degree that these large agri-co-ops are continuing this model, so much the worse for them.

    Mike Cook himself seems very aware of an extreme polarity problem inherent in comparing traditional co-ops with investor-oriented firms. There is simply no interest here in defending traditional co-ops as such against investor firms. In fact, Cook, in the same paper, says

    in general, the solution of perceived financial constraints in cooperatives entails some degree of organizational redesign rather than the extreme solution of of conversion [to an IOF] or demutualization.

    While I don’t feel the need to start at the hook of the co-op, it certainly undermines your concern for financial constraints.


  3. Neverfox, there is no straw man here. You’re confusing general arguments about patron-owned firms (e.g., the lack of tradeable equity shares) with specific arguments about particular types of patron-owned firms (e.g., the particular relationship between ownership and patronage). Obviously, an issue like, say, tying residual claims to the quantity of soybeans delivered to the firm doesn’t have much to do with labor-managed enterprises! But the general problems identified in my “vaguely defined property rights” post linked above apply to all types of patron-owned firms, including worker-managed enterprises, just not always in the exact same way. All these problems involve the relationship between ownership — and the corresponding residual control and cash-flow rights — and the owner’s relationship to the firm. In an investor-owned firm, the owners have no relationship other than as owners. In a patron-owned firm, the owners are either employees, customers, suppliers, or “stakeholders” in some other meaningful sense. This introduces potential benefits (better incentive alignment, stronger intrinsic motivation, etc.), but also potential costs (as described in my post). Look, this is all pretty standard stuff in the organizational economics literature (see, for example, Henry Hansmann’s books). I don’t understand why you think it’s so controversial.

    By the way, nobody in this literature claims — and certainly I have never claimed — that all investor-owned firms are more efficient than all patron-owned firms, or that the latter will all eventually convert to the former. Every type of firm, whether a proprietorship, partnership, cooperative, or corporation, is financially constrained, faces agency and information problems, and is “inefficient” relative to a textbook ideal. The point is simply that investor-owned and patron-owned firms face different versions of these constraints. Just as Marx wrote exclusively about the alleged defects of capitalism, without saying much about his proposed alternative, the Mutualist literature seems to me to focus exclusively on the alleged defects of investor-owned firms, without explaining how worker-owned firms (or cooperatives or whatever) are exempt from similar defects.


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