Jean Tirole’s Core Contradiction of Corporate Governance

By William K. Black
February 14, 2017     Bloomington, MN (4^th in a series on Jean Tirole)

In my second article in this series I began to discuss Tirole’s 2001 article (“Corporate Governance”), which contains this remarkable admission about orthodox economists’ ‘group faith’ (no thinking involved) that results in the “implicit assumption” that some unexplained force “perfectly” protects employees, creditors, and the public from predation by firms.

The economists’ implicit assumption is that employees, suppliers, customers, and other natural stakeholders are protected by very powerful contracts or laws that force controlling investors to perfectly internalize their welfare whereas the contractual protection of investors when the natural stakeholders have control is rather ineffective, and so investors must receive the control rights. The details of the argument have not yet been worked out [p. 4].

My next article uses the specifics of Tirole’s article to illustrate many of the failures of how orthodox economists treat firms and their CEOs and stakeholders.  This article introduces the logical contradiction that lies at the heart of Tirole’s fantastic claims about corporate governance.  The sentence I quoted above from page four of Tirole’s article is particularly odd because the first two pages of this article contain an extended paragraph that shows that economists should have realized that their implicit assumption was false.

Classical economists, from Adam Smith (1776) to Berle and Means (1932), were concerned with the separation of ownership and control, that is with the agency relationship between a “principal” (investors, outsiders) and an “agent” (manager, entrepreneur, insider).There is now widespread awareness that managers, say, may take actions that hurt shareholders. They exert insufficient effort when overcommitting themselves to external activities, when finding it convenient to accept overstaffing, or when overlooking internal control. They may collect private benefits by building empires, enjoying perks, or even stealing from the firm by raiding its pension fund, by paying inflated transfer prices to affiliated entities, or by engaging in insider trading. Last, they may entrench themselves by investing in mature or declining industries that they are good at running, by taking risk that is either excessive (as when their position is endangered) or insufficient (as when it is secure), or by bending over backwards to resist a takeover.

Tirole’s next sentence deepens the contradiction in the underlying logic of these two quotations.

This basic agency problem suggests a possible definition of corporate governance as addressing both an adverse selection and a moral hazard problem.

Tirole, of course, does not see the quotations or underlying logic as contradictory.  He describes orthodox economists’ ‘group faith’ that some unstated magic “perfectly” protects everyone, except for shareholders, from firms’ abuses.  Because the unstated magic does not protect shareholders from abuse, they must control of the firm.  Under Tirole’s logic, there is no contradiction, between his passages.  Yes, CEOs have a long history of abuse, but they are only capable (for some unstated reasons) of abusing shareholders.

Once one probes why and how CEOs have abused shareholders for centuries, however, the obvious question is why CEOs would not also use the firm as a “weapon” to abuse others as described in the criminology literature (Wheeler and Rothman 1982).  Tirole and orthodox economists are not claiming that CEOs are so moral that they will not exploit opportunities to predate.  Tirole and orthodox economists are not claiming that CEOs’ reputational concerns prevent them from predating.

Something astonishingly powerful and unerringly successful must explain “economists’ implicit assumption” that the public, workers, employees, suppliers, and creditors are “perfectly” protected from abuse by CEOs using the firms they control as weapons of predation.  What mystic force is so unerring that CEOs never cause their firm to predate on anyone – except shareholders?  That is the problem with implicit assumptions and ‘group faith.’  Because the assumption is implicit, its disciples never test it or even explain what the mystic “it” is that works “perfectly.”  Because the assumption is a product of ‘group faith,’ referees for the top orthodox economic journals share a mutual devotion to their dogmas rather than demand that the assumption be explicit – and its validity tested.  The claim is preposterous on its face.  Reality constantly falsifies the implicit assertion, but orthodox economists like Tirole refuse to abandon it.

Tirole concedes that orthodox economists have known since at least 1776 that CEOs predate on shareholders.  Tirole concedes that orthodox economists share a “widespread awareness” about that form of predation.  CEOs bear fiduciary duties to shareholders – not creditors, employees, suppliers, or the public.  Tirole concedes that CEOs have engaged in “stealing from the firm,” by which he means stealing from the shareholders.  It CEOs are willing to steal from those to whom they owe a fiduciary duty – which makes them more vulnerable to being successfully sued – then they should be far more willing to steal from creditors, employees, suppliers, and the public.

Note also the myriad, inventive ways that Tirole concedes CEOs use to predate on shareholders.  Many of these forms of predation are enormously difficult to detect because they rely on abstruse accounting under the CEO’s control and because the CEO has enormous information advantages compared to directors, creditors, the public, and suppliers.  The economics jargon for this is asymmetric information.  White-collar criminologists add critical points that also encourage fraud by CEOs.  CEOs have exceptional power and status.  This means that we do not even consider CEOs as fraud suspects and that is very difficult to get them prosecuted, convicted, and sentenced to any serious prison term.  At the same time, “systems capacity” restraints are extreme when it comes to prosecuting CEOs because society will provide so few resources to investigate and prosecute elite white-collar criminals.  Orthodox economists, pursuant to Gary Becker’s theories on deterrence, should predict rampant elite white-collar crime.  Becker’s theory also predicts that the deterrence of CEO predation will be least effective where when the CEO is predating against those to whom he bears no fiduciary duty.  Tirole, however, concedes that “economists” believe the opposite – that some mysterious force “perfectly” protects everyone to whom the CEO does not owe a fiduciary duty from the CEO’s and the firm’s predation.  Tirole does not even attempt to address the logical contradiction.

Tirole is also unintentionally revealing in what he excluded from his lengthy list of means by which CEO’s predate on shareholders.  First, he ignores George Akerlof and Paul Romer’s 1993 article – “Looting: The Economic Underworld of Bankruptcy for Profit.”  Indeed, though his article is primarily an application of asymmetrical information theory, Tirole never cites Akerlof’s work.  Akerlof was famous for his 1970 “Lemons” article on asymmetric information.  Akerlof and Romer extended that theory to the corporate governance context to explain how CEOs loot shareholders and creditors.  Tirole’s primary source should have been Akerlof (1970) and Akerlof and Romer (1993).

Second, Tirole’s list of forms of CEO predation ignores the largest and most damaging form of predation, one discussed by Akerlof and Romer.  CEOs predate on shareholders and creditors primarily by paying themselves out of firm funds extraordinary compensation.  In order to provide the pretext for these bonuses CEOs frequently commit other frauds to create real or fictional corporate income.  CEOs inflate corporate income largely by inflating asset values through accounting fraud or creating real, supra-normal profit through crimes, fraud, and other forms of predation.  Akerlof and Romer’s “Looting” article is the economics article on these modes of predation.  As I explain in detail in the next article in this series, Tirole’s corporate governance model ignores the ability of CEOs to predate against creditors, employees, and the public by inflating asset values and the firm’s capital.  Tirole’s failure to consider these factors renders his model, theory, and predictions about corporate governance abject failures.

Akerlof and Romer’s article also discusses moral hazard and adverse selection in the corporate governance context.  These are two insurance and finance concepts emphasized by Tirole as creating perverse incentives for CEOs to predate.  It is telling that Tirole ignored Akerlof and Romer’s discussion of moral hazard and adverse selection, which is so relevant to his model of predation.  Akerlof and Romer’s findings falsify Tirole’s model of corporate governance, so it is disappointing but not surprising that he ignores hose findings.  Similarly, Tirole ignores Akerlof’s (1970) equally relevant discussion of the Gresham’s dynamic, a concept he first brought to economics that explains how predation by CEOs can quickly become the dominant strategy in an industry.  White-collar criminologists use the Gresham’s dynamic to explain how CEOs are so successful in suborning private sector actors that are supposed to verify the asymmetrical information that the CEO uses to predate.