Corporate Governance, Economic Entrenchment, and Growth

sp05_Article 1 8/18/05 9:32 AM Page 655 Journal of Economic Literature Vol. XLIII (September 2005), pp. 655–720 Corporate Governance, Economic Entrenchment, and Growth ∗ RANDALL MORCK, DANIEL WOLFENZON, and BERNARD YEUNG Outside the United States and the United Kingdom, large corporations usually have controlling owners, who are usually very wealthy families. Pyramidal control structures, cross shareholding, and super-voting rights let such families control corporations without making a commensurate capital investment. In many countries, a few such families end up controlling considerable proportions of their countries’ economies. Three points emerge. First, at the firm level, these ownership structures, because they vest dominant control rights with families who often have little real capital invested, permit a range of agency problems and hence resource misallocation. If a few families control large swaths of an economy, such corporate governance problems can attain macroeconomic importance—affecting rates of innovation, economywide resource allocation, and economic growth. If political influence depends on what one controls, rather than what one owns, the controlling owners of pyramids have greatly amplified political influence relative to their actual wealth. This influence can distort public policy regarding property rights protection, capital markets, and other institutions. We denote this phenomenon economic entrenchment, and posit a relationship between the distribution of corporate control and institutional development that generates and preserves economic entrenchment as one possible equilibrium. The literature suggests key deter- minants of economic entrenchment, but has many gaps where further work exploring the political economy importance of the distribution of corporate control is needed. 1. Introduction Journal of Economic Literature, are relevant as points of departure. The first, reviewed growing body of work indicates that by Philippe Aghion, Eve Caroli, and Cecilia economic growth depends on the distri- A Garcia-Penalosa (1999), discusses reasons bution of control over capital assets. Two why economic inequality might impede vast literatures, already surveyed in the growth. The second, surveyed by Ross ∗ Morck: University of Alberta and National Bureau of Levine (1997), discusses the functional role Economic Research. Wolfenzon: Stern School of Business, of capital markets in stimulating growth. We New York University, and National Bureau of Economic build on these insightful contributions by Research. Yeung: Stern School of Business, New York University. We gratefully acknowledge helpful suggestions reviewing recent research relating the dis- from Mark Casson, Ron Daniels, Mara Faccio, Roger tribution of corporate control with the Gordon, Henry Hansmann, Campbell Harvey, Diana workings of capital markets and showing Kniazeva, Bruce Kogut, Ross Levine, Enrico Perotti, Andrei Shleifer, René Stulz, Paul Vaaler, Belén Villalonga, how these interactions affect economic Marina Whitman, and the referees. growth. 655 sp05_Article 1 8/18/05 9:32 AM Page 656 656 Journal of Economic Literature, Vol. XLIII (September 2005) The key insight in Aghion, Caroli, and investments. Raghuram G. Rajan and Luigi Garcia-Penalosa (1999) is that perfect capital Zingales (2003), Art Durnev, Morck, and markets make wealth distribution irrelevant Yeung (2001, 2004), and others argue that by allocating capital to each investment capital markets are inimitably, though cer- opportunity until its marginal return equals tainly not perfectly, effective in this regard. the market clearing equilibrium interest This is because, by creating incentives for rate. Simple capital market frictions, like self-interested investors to gather and moral hazard problems, drive a wedge process information, as well as to monitor between internal and external cost of capital. and control top corporate insiders, capital This can lead the wealthy to invest more markets generate conditions amenable to than is first best optimal, while the impecu- efficient capital investment decisions. nious invest less. Assuming diminishing rates Corporate insiders needing outside capital of return, redistributing wealth from the rich must submit to this analysis, monitoring, and to the poor directly raises total output. control by outside investors. When official Moreover, wealth redistribution from rich to regulations, laws, and enforcement make poor lessens overall borrowing in the econo- outside investors sufficiently confident of my, easing these moral hazard problems, their ability to undertake these tasks, outside raising overall production, and reducing the investors hold equity. Pooling their capital cost of debt financing on the margin under the management of institutional (Aghion, Caroli, and Garcia-Penalosa 1999). investors allows small investors to attain Levine (1997) surveys a second literature economies of scale in accomplishing these on the functions of capital markets in eco- tasks. The resulting optimally efficient finan- nomic growth—the organization of informa- cial market directs capital to its highest value tion acquisition, allocation of resources, uses—a situation James Tobin (1982) monitoring of managers, and exercise of cor- defines as functional form stock market effi- porate control. If financial markets are large ciency. Note that functional form efficiency and liquid enough, and if investors’ property differs from the standard usage of the term rights are sufficiently well protected, individ- market efficiency in the finance literature, uals expend resources to acquire information which describes a situation where investors and conduct profitable informed risk arbi- cannot obtain abnormal returns after trans- trage, as modeled by Sanford J. Grossman actions costs. The two concepts are related, and Joseph E. Stiglitz (1980) and Andrei but not identical. Shleifer and Robert W. Vishny (1997), and Economists have little difficulty listing this trading capitalizes information into stock fracture points where actual capital markets prices as in Morck, Yeung, and Wayne Yu fail to satisfy functional form efficiency. The (2000). Richard Roll (1988) argues that this literature we survey below suggests that the mechanism is especially important for the functional efficiency of capital markets timely updating of stock prices with new depends on the distribution of corporate firm-specific information. Stock prices that control in an economy. In particular, this lit- closely track fundamental values aid outside erature views economic growth as critically investors and corporate insiders in capital dependent on institutions that restrain allocation decisions, simplify monitoring, and entrenched elites, who could otherwise facilitate the design of credible incentive con- come to dominate the capital investment tracts that induce managers to keep faith with decisions of an economy. outside investors and maximize firm value. This literature has its recent roots in cor- These two literatures converge on a cen- porate finance, perhaps because the extreme tral theme: economic growth requires that concentration of corporate control rights in savings be directed into value creating the hands of tiny elites observed in many sp05_Article 1 8/18/05 9:32 AM Page 657 Morck, Wolfenzon, and Yeung: Corporate Governance 657 countries raises concerns about corporate actual ownership. These sorts of structures governance in those economies. The corpo- can let a few wealthy families control the rate finance literature also considers greater part of a country’s large corporate entrenched management to be a corporate sector. They also leave the structure typical governance issue at the firm level in ways of large U.S. firms—stand alone firms with that are helpful in understanding diffuse ownership and professional manage- entrenched control in general. ment—the rarest of curiosities in most of the Our starting point is a curious empirical rest of the world. observation reported by Morck, David This concentrated control can lead to cor- Stangeland, and Yeung (2000). These porate governance concerns—a range of authors divide up the world’s U.S. dollar bil- agency problems. But, more importantly, lionaires into two categories—self-made bil- entrusting the governance of huge slices of lionaires and billionaires who inherited their a country’s corporate sector to a tiny elite wealth—and sum up the wealth owned by can bias capital allocation, retard capital each category of billionaire in each country. market development, obstruct entry by out- Unsurprisingly, they find that a country’s per sider entrepreneurs, and retard growth. capita GDP grows faster if its self-made bil- Furthermore, to preserve their privileged lionaire wealth is larger as a fraction of GDP. positions under the status quo, such elites What is more surprising is that per capita might invest in political connections to GDP growth is slower in countries where stymie the institutional development of cap- inherited billionaire wealth is larger as a ital markets and to erect a variety of entry fraction of GDP. barriers. These economywide implications The literature we review below points to can be most serious. possible explanations. These turn on wealthy Such an outcome is a suboptimal political individuals who magnify their already sub- economy equilibrium, which we dub eco- stantial wealth into control over multiple nomic entrenchment. While wealthy estab- corporations worth vastly more. Rafael La lished

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