1. MUTUAL ENTERPRISE
Where people form a ‘club’ to provide various forms of financial protection, we refer to ‘mutual enterprise’.29 Mutuals have played an important role in insurance and banking in the past and still feature significantly in many countries in spite of considerable ‘demutualisation’ in the 1990s, especially in the UK. The basic explanation for mutual enterprise is that it economises on the high transactions costs that are associated with certain financial markets. In Chapter 2, the concepts of adverse selection and moral hazard were introduced, using examples from the world of insurance, and it is not surprising therefore that many early insurance companies and savings banks were structured as mutuals. Lenders would want to ensure that borrowers were of good character and likely to repay loans; providers of fire insurance that those insured would take reasonable precautions, and so forth. A club with a membership sufficiently well known to each other to take advantage of mutual monitoring, local information and the use of some social pressure to control opportunism was a natural response. The provision of life assurance was another area in which the mutual enterprise played an important role.
The Amicable Society for a Perpetual Assurance Office (which later became the Norwich Union) was founded in London in 1706. It established a simple mechanism for providing security for orphans or other family members after a person’s death. Each year the members paid a sum of money into a fund which was securely guarded. At the end of the year, the contents of the fund were distributed to the survivors of those who had died. Clearly, the sum assured was not guaranteed and would vary according to the number of club members that happened to die during the year. In the absence of mortality tables and in a world still subject to epidemics of life-threatening diseases, life assurance would have been difficult to arrange by any other means. By the 1770s, however, advances in statistical knowledge and in financial investment techniques had led to recognisably modern arrangements. The Society for Equitable Assurances on Lives and Survivorships, established in 1756, had introduced level premiums paid throughout life, varying with age at entry and with a specified sum assured.30 However, the mutual form of enterprise was still important for this development in life assurance. The financial calculations involved were so uncertain that investor-owned institutions offering similar promises of sums assured in exchange for premiums paid might find themselves either bankrupt and unable to honour their promises, or hugely profitable. A club could simply set the premiums at a prudently high level and then distribute any surpluses to the membership as time advanced (or add periodically to the sums assured).
During the nineteenth century in the UK and the USA, investor-owned life assurance companies developed and competed with the mutuals. In the UK, investor-owned institutions incorporated profit sharing for the reasons outlined in the last paragraph. The Deed of Settlement of the Prudential31, as amended in 1853, for example, provided for five per cent interest to shareholders with periodic valuations of new profits. Eighty per cent of new profits were to go to policyholders as bonuses and twenty per cent to shareholders.32 In the USA, investor-owned life insurance companies developed in the early nineteenth century but failed to overcome the problems of trust that confronted them. The first mutual life insurance company was set up in 1843. By 1849, there were nineteen mutuals and all but two of the investor-owned companies had withdrawn from the business by 1853.33 The mutuals were able to offer longer-term whole life policies compared with the shorter-term policies (one to seven years) offered by the investor-owned companies. After the coming of state regulation of insurance companies in the 1850s and 1860s, joint-stock life insurance companies recovered, although they remained more risky than the mutuals. Hansmann (1996, p. 274) reports that of the 205 stock companies existing in 1868, 61 per cent had failed by 1905 compared with 22 per cent of the mutuals. Perhaps because of this record of relative safety, or because of the ‘muck-raking’journalism of the Roosevelt years exposing scandals in the life insurance business, or because managers wished to avoid being taken over, conversions to mutual status were significant in the first forty years of the twentieth century. Only in the second half of the century did the joint-stock companies gain a definite advantage in the USA.
By the last decade of the twentieth century, pressure to ‘demutualise’ insurance companies was strong in the UK, although mutuals still have a significant presence in the market.34 A similar trend towards demutualisation has also occurred in the building societies (savings and loan associations). Other areas of demutualisation include stock and commodity exchanges (historically owned by their members) and automobile breakdown services. There are several differing explanations of this trend. As insurance companies and banks grew larger and less local, the ownership advantages of mutual status were substantially reduced. Monitoring managers by the members of a society is no less costly than monitoring managers by shareholders once an organisation becomes sufficiently big. Similarly, where the major transactional problem is lack of trust in borrowers or fire insurance policy holders, the advantages of scale and widely dispersed risk might outweigh the monitoring advantages of local mutual arrangements. Against these arguments, there remains the point that the existence of shareholders could encourage a riskier investment strategy than managers in a mutual would find attractive. Managers in a mutual (with no takeover pressure to consider) might be expected to be less cost efficient, more cautious and more inclined towards in-kind benefits. If financial prudence is to be encouraged, however, these consequences of ‘low-powered incentives’ might be a price worth paying.
Hansmann’s framework of analysis would suggest that either the relative ownership costs of mutuals or the relative transactions costs have risen. As we saw with the history of retail cooperatives in the UK, the gradual decline in transactions costs with consumers probably played a major part in their eventual eclipse. This might plausibly also have happened in the financial sector, with the evolution of greater trust and reputational capital in investor-owned insurance companies and banks. Similarly, on the ownership side, the inherent disadvantage of large mutual organisations is the likely heterogeneity of holders of control rights. Savers will have different priorities from lenders, old members of an insurance society might favour different investment strategies from younger members, married people might be more risk averse than younger single people and so forth. Even in the case of stock exchanges, differences in interests between large institutions and smaller stockbroking firms can be important. The high cost of collective decision making has been cited as an important contributory factor in the demutualisation of stock exchanges.35
Changes in government fiscal and regulatory policies might also have had a significant influence on the fate of the mutuals in the financial sector. If both mutual and investor-owned organisations face similar regulatory oversight, this will subtly undermine one of the principal advantages of the mutual – the fact that ‘ownership’ by members and lower-powered incentives to managers are conducive to greater ‘trust’. Consumers of financial products will not pay any price for extra security if they think that government regulation makes all financial institutions equally reliable. Matters of governance then become arcane issues for lawyers and of no day-to-day significance for prudent consumers. The mutual form of enterprise becomes a victim of adverse selection and a form of Gresham’s law – ‘bad governance drives out good’ – comes into operation. Similarly, if governments regulate utility companies, the option of consumer ownership is subverted; if they regulate healthcare services, non-profit governance structures have their advantages eroded; and if they regulate takeovers, private responses to vulnerability in the form of partnerships or worker control are discouraged. This is not to argue that government regulation is always undesirable but merely that its costs can take many important and hidden forms. The role of regulation in influencing enterprise governance seems to be an under-researched area in economic organisation.36
Rent seeking can also undermine mutual status in the financial sector. Over many years the mutual societies have built up valuable brand-name capital. In addition, conservative valuation policies and the tendency of managers to accumulate reserves within the mutual rather than to distribute them fully to policyholders have encouraged members to establish privately exchangeable claims to these reserves by means of demutualisation. As a member of a Society, a person can gain from collectively held reserves, but people may judge that establishing a private and exchangeable right in their share of this ‘inheritance’ is more valuable than taking the benefit in the form of a higher return on their premiums over the period of their membership. The value of a higher return on their premiums is uncertain, subject to dilution from new members, vulnerable to further diversion in favour of managerial interests, and dependent on the expected duration of membership. The single ‘windfall’ gain that accompanies demutualisation is often preferred to the continuing flow of benefits associated with remaining in a mutual society.37
We have seen that firms are usually owned by investors but may also be owned by consumers, workers or other users of the firm’s services. We have also seen that ownership is usually assigned to a single relatively homogeneous group and we have reviewed Hansmann’s explanation of this observation. Homogeneity of the ownership interest economises upon collective decision-making costs. Some writers, however, have advocated sharing ownership rights among wider groups of patrons. Hutton (1997, p. 9), for example, argues that ‘corporate governance (should be) reformed to reflect the various interests that converge on the firm – suppliers, workers and trade unions, banks, as well as shareholders and directors. This is the central idea of the stakeholder economy.’
Writers taking this position on corporate governance tend to do so not on grounds of economic efficiency but on rather wider grounds of political or, more specifically, democratic principle. The governance of the firm is, for these writers, a sub-branch of politics. Hutton (1995, p. 294) writes that ‘the constitution of the British firm . . . self-consciously reproduces the unwritten British constitution’. He advocates the ‘democratisation and republicanisation of the state’ (p. 286) and the reform of corporate governance to reflect what he sees as similar (stakeholder) principles.
From the point of view of the theory of economic organisation, the problem with stakeholder analysis is that it does not at any point confront the issues of transaction and ownership costs. It might be argued, for example, that transaction costs prevent stakeholder firms being formed and that, although social gains are potentially available from such governance arrangements, they can only be achieved through the intervention of the state. In societies such as the UK and the USA, however, where the legal system is flexible enough to permit considerable experiment with governance arrangements, it is not clear that costs of transacting are so great as to prevent the emergence of stakeholder-controlled companies. As has been seen, cooperatives and mutuals have been established and have thrived in the past. An alternative view would be that stakeholding has never emerged spontaneously because it incurs levels of collective decision-making costs which render it vulnerable to investor-owned competition.
Consider the history of the retail cooperatives again. These were originally local societies. They attracted support from socialist thinkers and were considered to be ‘good employers’. Yet, as Robertson and Dennison (1960, p.91) observe, ‘the relations of the co-operative societies with their workpeople are almost precisely similar to those of capitalist industry . . . The building of the bridge between consumption and control has left the gulf between day-labour and control nearly as wide as ever.’ The pioneers and those that followed in the cooperative movement seem intuitively to have recognised that extending control rights to labour would complicate matters without conferring any additional advantage. Life was complicated enough as it was. The cooperative was a response to transactional hazards in consumer markets. It was therefore logical to give control rights to consumers, providing ownership costs could be kept within bounds. If there were no significant hazards in the market for local retail labour there was no point to extending ownership in that direction. Robertson and Dennison write that the cooperators’ ‘shrewdness’ was thus carried to ‘disappointing lengths’, but the pursuit of purely ideological goals requires very special conditions to be successful in a market setting.38
Similar comments could be made about the failure of labour-capital partnerships to evolve in spite of the attractive potential properties discussed in section 6. Although Meade cleverly aligns the interests of labour and capital using a neoclassical framework, the possibilities for disagreement among the labour force deriving from differing levels of skill, differing trades, geographical locations and ages would still be substantial. If, on the contrary, the labour interest were plausibly homogeneous, there might then be no advantage to giving outside investors control rights. Small amounts of equity capital could be financed internally while a requirement for non-firm-specific capital assets could be debt financed. For labour-capital partnerships to evolve, we would have to imagine large transactional hazards in both labour and capital markets combined with low collective decision making and monitoring costs for the outside investors and inside workers.
Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.