Rejoining the north European mainstream

By Professor Simon Deakin

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The campaign to increase the £6.19 an hour national minimum wage to a living wage of £8.55 in London and £7.45 in the UK should be supported on the grounds of both equity and efficiency. The living wage is good for families and workers, but also for firms and for the UK economy.

Joint research by the Resolution Foundation and the Institute for Public Policy Research has found that gross earnings would rise by £6.5bn if employees were paid a living wage. It also showed that paying UK workers a living wage would save the Treasury more than £2bn a year by boosting income tax receipts and reducing welfare spending.

This comes as no surprise to those who conduct research on public policy. If employers do not pay a living wage the state has to make up the difference through tax credits. These arrangements benefit no one except, possibly, firms which use tax credits as a pretext for paying low wages. These firms are more profitable as a result and their shareholders may also be better off. But their gains are being made at the direct expense of low-paid workers and the taxpayer.

The Council of Europe sets a decency threshold which implies that the minimum wage should be around two-thirds of the median wage (that is, the wage paid at the midpoint in the earnings distribution). The UK's national minimum wage has generally been around 45 per cent of the median wage since the late 1990s. The gap between the legal minimum and the decency threshold set by the Council of Europe has been met, in practice, by tax credits. This system has been allowed to develop because of fears that a high minimum wage would cause unemployment.

When the minimum wage was introduced in 1998, the Low Pay Commission was set up to advise ministers on its level. The commission was given the remit of determining what the likely economic effects of the minimum wage would be. Its membership consisted of a number of academic economists, in addition to representatives of management and labour. The outcome was a statutory minimum wage set at a level which did not meet families' living costs. To meet the gap, the then Labour government, which was committed to reducing household poverty, expanded the system of tax credits which it had inherited from the preceding Conservative administrations. This worked for a while. The rise in child poverty levels was reversed, but only up to the mid-2000s. The burden on public expenditure of increasing tax credits to make up for persistently low wages was becoming excessive.

The living wage campaign began as a response to adverse effects of low pay on many working households. These included very long working hours which were often spread over two or three separate jobs as earners attempted to meet living costs. Supporters of the living wage do not argue that it should become legally binding in the same way as the national minimum wage. Rather, they call on employers to recognise the principle of the living wage on a voluntary basis, and to make their position known to their contractors and suppliers, and to the public at large. The campaign is based on persuasion and an appeal to employers' enlightened self-interest.

Why would employers want to sign up to the living wage? The direct benefits include a more loyal and highly motivated workforce. Indirectly, employers with a stake in their local community may view the living wage as contributing to social cohesion. This is undoubtedly a factor in the support given to the living wage by many local authorities, hospitals and universities. But private sector employers in the retail and service sectors are also interested. There is a growing realisation that employers cannot insulate themselves from the social consequences of the decisions they make on wages and terms of employment.

What would be the effect of employers more generally accepting the principle of the living wage? Would it increase unemployment? This seems unlikely. One of the arguments for taking a cautious view on the level of the minimum wage in 1998 was that firms had come to rely on low pay as a means of cutting costs. The introduction of a high minimum wage would have been a shock to the economy, leading to increased unemployment. This argument has less resonance today. Employers have had over 15 years to get used to the minimum wage. As a result, the idea that wages should more reflect real living costs is becoming more generally accepted. Because the living wage is not mandatory, progress towards achieving it can be tailored to the circumstances of particular firms.

From the point of view of government expenditure, the living wage would be largely self-financing, thanks to the offsetting effects on tax credits. It would also bring wider benefits to the economy. The most productive economies in the world, those of the Nordic countries and the northern European systems influenced by the German model, either have high legal minimum wages or multi-employer collective agreements which set basic minimum rates of pay which are high by UK standards. These pay norms provide an incentive structure for investment by workers and employers in firm-specific skills. High minimum wages do not work on their own; they must be combined with other policies. These include active labour market policy to support the welfare-to-work transition such as in the Nordic countries, or the national vocational training system in Germany. Such measures might seem expensive, particularly during an economic recession. In fact, they largely pay for themselves once their impact on productivity is taken into account.

The living wage can be the basis for Britain to become a high-wage, high-productivity economy. We should aim to rejoin the north European mainstream on this issue. Looking further overseas, the very last thing we should be doing, if we wish to compete with the BRIC countries, is further deregulating our labour market. Brazil is addressing the issue of informal employment by putting a floor under household incomes through a basic income guarantee, while China has adopted a labour code which acknowledges the need for protection of individual and collective labour rights. These developing economies are gradually building systems of collective wage determination and social insurance of the kind we used to have. They understand that a competitive economy requires labour laws and a welfare state to provide insurance against labour market risks. We have not completely abandoned the same idea, which served us well for most of the 20th century. It is not too late to reconstruct our labour market institutions around the twin themes of equity and efficiency, as exemplified by the idea of the living wage.

Also posted on Progressonline

Shares for Workers' Rights - why entrepreneurial firms need employment law too

By Professor Simon Deakin

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Under the government's current proposals for employment law reform, employees will be able to give up rights concerning unfair dismissal, redundancy pay, flexible working and time off for training in return for receiving shares in the company that employs them, gains on which will be exempt from capital gains tax.

It is right for the government to be encouraging worker ownership in companies; there is abundant evidence suggesting this improves labour productivity. What is completely unnecessary and counterproductive is to link this to the loss of employment protection rights.

Since the early 1970s, under laws initially introduced by a Conservative government, an employee with a minimum period of continuous service (currently two years) is protected against unfair dismissal. This means that if their employer wishes to terminate their employment, they must come up with a good reason, in principle, for doing so, such as misconduct, lack of capability or redundancy. The employer must also show that it has complied with certain procedures, including allowing the employee to put their case in a formal hearing. These laws do not confer a job for life and in no way permit "featherbedding". On the contrary, they give employers ample scope to incentivise and motivate employees. Nor do they prevent firms making workers redundant when there is a downturn in business. Their aim is to ensure that the workplace operates according to certain basic principles of fairness, which most of us could subscribe to: decisions on a matter as important as employment should not be made in an arbitrary fashion.

Although fairness is the main goal of these laws, they also have economic effects. They encourage workers to make a more serious commitment to the firm and to invest their time, effort and loyalty in it. Second, they provide firms with a strong incentive to treat the skills of their workers as a resource to be developed, rather than an asset to be disposed of at will. Employment protection laws encourage a virtuous cycle of investment in the knowledge and processes that are increasingly recognised as essential to economic success, particularly in high-technology sectors.

One of the government's aims in bringing forward this proposal is to encourage the kind of high-tech start ups associated with Silicon Valley in California. Silicon Valley is often said to have a "high velocity" labour market, in which employees move around from one firm to another, thereby promoting the circulation of knowledge. Employers, on the other hand, benefit from the flexibility that goes with having a skilled and mobile workforce. It is often assumed that the right of firms to hire and fire "at will" is critical to this type of flexibility. There is a major problem with this assumption, which is that it is simply not borne out by the facts.

The Californian law on dismissal is actually at the stricter end of the spectrum of US laws on employment. The principle that an employer can dismiss at will – that is, without good cause and on minimal, if any notice – has been qualified by the Californian courts, which require employers to demonstrate that they have acted in good faith when terminating a worker's employment. This principle is not so far removed from the notions of fairness that underpin British unfair dismissal law. The scope of the exceptions to employment at will have waxed and waned over the years, and it is possible to analyse the consequences of this for productivity and innovation. We know from econometric research that there is a correlation between tighter dismissal laws and innovation in California, as measured by increased number of patents and citations to patents. Not just that; as the law imposed constraints on the employer's power to dismiss, the number of small-firm start ups went up, as did the numbers employed in high-tech firms.

British dismissal law, like Californian, has varied over time, creating a similar "natural experiment" for research. The identical effect is also observed: stronger employment laws are correlated with innovation as measured by patents and citations to patents.

The intuition here is clear, and it is backed up by empirical research: when the law limits the right to dismiss, it enhances the confidence of workers that their efforts and knowledge will not be expropriated by the employer. The law can help to create an environment in which firms and workers make mutual investments in new technologies and processes, to the benefit of both sides.

Employment law plays another critical role in supporting technology-based innovation in US firms. In California, so-called "restrictive covenants" that prevent an employee resigning to set up his or her own firm or to work for a competitor are void. Californian courts refuse to enforce such clauses, on the grounds that they are a fetter on competition. This, rather than flexible dismissal laws, is the source of the much-vaunted "high-velocity labour market" of Silicon Valley. How does the UK compare? Under English contract law, contrary to the Californian practice, restrictive covenants are enforced by the courts almost as a matter of routine. We know this matters. When the state of Michigan changed its employment laws to make restrictive covenants enforceable, it saw a decrease in employee mobility.

So if the British government wants to do something to encourage innovation through employment law reform, there are two things it could do. The first would be to strengthen laws that promote fairness in the workplace. The second would be to take a closer look at judicial enforcement of restrictive covenants. There is clear evidence that these contract clauses restrict employee mobility and depress innovation.

Compared with these changes, which empirical evidence suggest would have a tangible effect, the proposed reforms are at best an irrelevance. At worst, they will set back innovation in British high-tech firms.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university

Also posted on FT's Economists' Forum

When US investors took on Japan’s executives

Hedge Fund Activism in Japan: The Limits of Shareholder Primacy, by John Buchanan, Dominic Heesang Chai and Simon Deakin, Cambridge University Press, RRP£60

by Sir Geoffrey Owen

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Whose interests should a company serve? Is it the property of shareholders, for them to do whatever they want with it, or does it have a wider social purpose?

This question lies at the heart of an extraordinary battle waged in Japan in the early 2000s between, on one side, activist hedge funds, mostly coming from the US or the UK, and, on the other, a group of Japanese business executives.

The funds, when they surveyed the Japanese corporate landscape at the start of the decade, saw it as littered with companies that were destroying shareholder value; they were hoarding cash that should have been distributed in dividends and sticking too long with low-return businesses.

The opportunity was obvious, and tempting. Tactics that had worked well in the US and to a lesser extent in the UK - identifying likely targets, acquiring a sizeable equity stake and then putting pressure on the directors to disgorge surplus cash - seemed certain to generate higher share prices. The hedge funds saw themselves as the shock troops of shareholder primacy.

Managers of the targeted companies, for their part, had little interest in shareholder value; they barely understood what the words meant. What mattered to them, and what constituted "corporate value" in their view, was not the share price or any other financial measure, but the ability of the company to prosper and to grow over the long term.

Like most Japanese executives, they saw the company as a community, a concept which, as Buchanan, Chai and Deakin explain in this well-researched and illuminating book, took root in Japan in the reconstruction years after 1945. Under this approach the interests of the company, and by extension those of the employees and customers who sustained it, were given priority over those of investors.

Not surprisingly, the invasion of the hedge funds led to confusion and acrimony. When Steel Partners from the US bought shares in Bull-Dog Sauce, a food manufacturer, and later announced its intention to take over the whole company, the Japanese managers were bewildered. Why had a 100-year-old company with a respectable record suddenly been put in play? What did Steel Partners know about the food industry? When the heads of the warring parties met face-to-face, the discussion merely reinforced the Japanese view that Steel Partners was not out to improve Bull-Dog but was simply a predator.

Bull-Dog adopted a defence strategy the Americans claimed was illegal but the Tokyo High Court ruled that the hedge fund was "an abusive acquirer" and that the defensive measures were legitimate. Although the Americans made a useful profit when they sold their shares, the outcome - like that of another contest, involving British hedge fund The Children's Investment Fund - showed that aggressive tactics by activist investors were unlikely to succeed in Japan.

In other ways - and for this the hedge funds can claim some credit - the Japanese system did become more shareholder-friendly during this period. Foreign institutions were increasing their holdings in Japanese companies; while they did not seek confrontation, they expected dialogue with the directors and higher standards of corporate governance, including in some cases the appointment of independent directors.

The head of Steel Partners once said he wanted to "enlighten" Japan about shareholder value. Today, shareholder value is a valid topic for discussion, but in no way the driving force behind management decisions.

The survival of the company as an enduring organisation still remains a more important consideration in Japan than the investors who happen to hold the shares at any given time.

The writer is author of 'The Rise and Fall of Great Companies: Courtaulds and the Reshaping of the Man-made Fibres Industry' and a former editor of the Financial Times

Also posted on FT's Business Books

Don’t shoot the pension fund managers!

By Professor Simon Deakin, Director, Corporate Governance Research Programme, ESRC funded Centre for Business Research, University of Cambridge.

Long-term investment in infrastructure needs a better policy mix

George Osborne's attempts to encourage British pension funds to invest more in infrastructure projects are to be applauded. Canadian and Australian pension funds have already invested heavily in infrastructure, but UK funds are still reluctant investors. Why?

British prime minister David Cameron tours Newton Heath rail depot. Getty images

Pension fund trustees have a fiduciary duty to get the best return for scheme members after taking due account of risk. Government cannot and should not dictate how or where and how these funds invest their assets. If government wants pension funds to engage with the long term needs of the UK economy, it must first understand the particular pressures they face as investors.

Pension funds must invest for the very long term because their beneficiaries, the scheme members, will be receiving their pensions decades after making their contributions. As investors, however, the pension schemes cannot just take the long view. They must balance risks and returns over the investment cycle, which in practice means taking advantage of liquidity when it is available and making the most of opportunities for profit taking when they arise. Thus it is implausible to believe that the interests of pension funds are automatically aligned with the public interest in sustainable infrastructure. The right incentives and structures need to be put in place to support infrastructure investment.

What can be done? We need to address both sides of the issue. On the one hand, an acceptable division of investment risk between pension funds and the government must be found. On the other, the risks associated with the organisation of large-scale infrastructure projects - so-called construction risk - need to be better understood and managed.

Let's take investment risk first. There is demand, on the part of pension schemes, for long-term investments which will provide a stable return. An asset class based on infrastructure investment may well provide part of the answer. Government would need to play a role in inflation-proofing and underwriting part of the financial risks. From the government's point of view, infrastructure bonds which operate in a manner similar to inflation-proofed gilts could be a feasible option, but not if they result in private investors just shifting long-run costs on to the public finances in the manner of PFI (‘moral hazard'). Getting this right, and avoiding the pitfalls of PFI, will require a high degree of transparency and trust on both sides in coming months if a viable solution is to be found.

M4 motorway near Bristol. Getty images

Now let's consider construction risk. Pension funds argue that too many large construction projects don't deliver, pointing to cost overruns and delays in completion on projects like Wembley stadium and the Jubilee Line extension. For this reason, they are more enthusiastic about investing in so-called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management.

From the pension funds' point of view, the government could solve the problem of construction risk for them by simply underwriting potential losses. The difficulty with this is not just that the Treasury has limited capacity to take such an open-ended risk, but that to do so on an open ended basis would risk repeating the ‘moral hazard' problem associated with PFI.

At least part of the solution must lie in addressing construction risk at its source, in the way projects are managed. Enormous strides have been made in recent years in managing the risks of large infrastructure projects, with the construction of the Heathrow Terminal 5 building leading the way. Lessons from Terminal 5 and other successful projects have been embedded in the procurement process and contractual design of the construction of the 2012 Olympics site. The construction industry has been actively promoting good practice through modifications to the standard-form contracts used in infrastructure projects. The government has encouraged this process and needs to continue doing so.

A British Airways aircraft takes off from Terminal 5. Getty images

Getting infrastructure investment right is therefore a twin-track process. The role of government is not to impose solutions on finance or industry, but to identify good practice and encourage information exchange and dialogue between the two sides. If the government sees its role in these terms there is every prospect of a workable set of solutions emerging.

The issue of infrastructure investment has wider lessons for economic governance in the UK. The question George Osborne needs to ask is: what can be done to encourage an investment regime that more effectively internalises the risks of complex projects, not just in infrastructure but more generally in innovative areas of manufacturing?

On the finance side, this means thinking about the way that pension funds are structured and governed, and about the role played by asset management firms and other market intermediaries in the investment process. Are the right structures and incentives in place for pension funds and their agents to represent the interests of scheme beneficiaries in stable returns which also bring wider benefits to the UK economy?

On the corporate side, some thought needs to be given to whether company law and associated regulatory measures, such as the Takeover Code, are sending boards of listed companies the right signals.  A legal and regulatory regime which is widely, if arguably incorrectly, interpreted as requiring listed companies to prioritise short-term shareholder value, is not compatible with the country's long-term investment needs. Are Britain's corporate governance arrangements, so long held up as an example to the world, part of the reason for the continuing decline in investment in R&D by UK firms, by comparison to our competitors, and for the presence of no more than a handful of globally successful British manufacturing companies when Germany and Japan have a dozen or more each?

Also posted on FT's Economists' Forum

Kay needs to replace “shareholder value” with “corporate value”

By Professor Simon Deakin, director, Corporate Governance Research Programme, Centre for Business Research, University of Cambridge

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John Kay's interim report finds that equity markets are failing in their primary tasks, which he identifies as enhancing the long-term growth of listed companies and providing savers with an appropriately high, risk-adjusted return on their investments. The failure lies, he suggests, in the way that market actors are currently incentivised. If asset managers are assessed on a quarterly or biannual basis, it is not surprising that they apply benchmarks based on the short-run performance of the firms they invest in.

Corporate managers, on the other hand, believe that they have a legal duty to maximise short-term shareholder value, and act accordingly. Kay rightly suggests that this view is mistaken as a matter of law but, again, it is no surprise that directors and managers think in these terms, given the way that shareholders are routinely described as the 'owners' of the firms they invest in. Disclosure rules add to the problem, in particular those requiring quarterly reporting of corporate results. Lawyers will recognise that shareholders are the owners of their shares, not the company, and that they have no right to manage the firm, having delegated this power to the board, but these subtleties are clearly being lost in translation.

What can be done?

It is not just a question of getting across a more accurate understanding of the legal structure of the company limited by share capital. The idea that managers should run listed companies in such a way as to maximise share prices is deeply embedded in UK corporate governance practice. It is reflected in the way top managers are remunerated, through bonuses and options linked to share price movements, and in the way that company performance is benchmarked, through metrics such as earnings per share and return on equity. Kay takes aim at some of these practices which, he points out, do not just privilege the short-term, but also tend to discourage large-scale capital investment by companies.

Kay also reports suggestions that there are elements in the regulatory framework beyond company law which favour corporate restructuring and deal-making over long-term growth, notably the City Code on Takeovers and Mergers. While the Takeover Panel's view that the principal aim of the Code is to protect minority shareholders is undoubtedly correct, it is no less clearly the case that its main effect is to facilitate hostile takeovers of UK-listed companies by denying boards the room for manoeuvre that they would have in virtually every other developed economy.

How should these concerns be addressed?

The final report will have to set out a plausible agenda for regulatory reform if it is to be more than a well intentioned review of existing practices. There are some practical changes Kay could suggest such as making clarifying the legal duty of the board to have regard to the long-term interests of the company under section 172 of the Companies Act 2006 and making clear that this duty takes priority over the terms of the Takeover Code. But going forward, Kay also needs to give a clearer account of the philosophy that would guide reform.

Kay argues that shareholders should act as 'stewards' of the companies they invest in. This is fine as far as it goes, and may chime with the ambitions of some pension fund trustees and asset managers to support investment in innovative manufacturing and infrastructure. However, the final report needs to recognise that there are numerous instances in which the interests of shareholders simply do not coincide with the wider public interest in maintaining a sustainable and competitive corporate sector in the UK.

The restructuring of British enterprise through hostile takeover bids, hedge fund activism and private equity over the past three decades was not just the consequence of decisions taken by capital market intermediaries acting without regard to the interests of their shareholder 'principals'. Institutional investors were highly critical of listed companies which did not prioritise shareholder value, and pressed for a greater role for independent directors on boards as a way of getting their views across. There is more than anecdotal evidence that some of the deals involving the restructuring of companies with a core role in the British economy, from the takeover of BAA by Ferrovial through to RBS's bid for ABN Amro, were driven by a combination of pressure from boards and shareholders for quick returns, with considerations of corporate strategy pushed to the margins.

It is naive to see hostile takeovers, private equity and hedge fund activism as addressing problems of 'failed' companies. Much more often, these forms of investment simply extract value from companies for the benefit of investors and intermediaries, at a direct cost to workers (who lose jobs and protected terms and conditions of employment), customers (who experience a deterioration in the quality of products and services) and the taxpayer (who foot the bill through tax reliefs on corporate leverage).

What has brought us to this point?

Since the early 1980s, company law and corporate governance regulation have given shareholders many more rights to 'hold management to account'. Kay recognises that trading in the secondary market for shares does not bring in new capital for firms, but he justifies shareholder influence on the grounds that investors can exercise effective oversight over firms' capital allocation decisions and over their governance. This is implausible.

In today's liquid capital markets, shareholders are for the most part transitory owners who have no lasting connection to the firms whose traded securities they hold. The question we should be asking is why law and regulation have ceded such large influence to this group. It is partly intellectual fashion, a misguided belief in the informational efficiency of liquid capital markets. It is also down to intense lobbying by the market intermediaries (the asset management firms, legal advisers and investment banks) who benefit most from current arrangements.

John Kay is on the right path in arguing for a long-term approach to investment decisions, but too optimistic in believing that shareholders will always act as enlightened owners.

We need to replace shareholder value with corporate value as the objective of management and take a detailed look at corporate governance regulation and practice with this guiding principle in mind. If this means sidelining the Takeover Code and subordinating it to the wider goal of a reformed company law in promoting sustainable enterprise, so be it. This is the kind of hard choice we will have to make if we want capital markets to make a real contribution to prosperity and growth.

Also posted on FT's Economists' Forum

Executive Pay - Your Questions Answered

Professor Simon Deakin, Programme Director CBR

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1. Do bonuses and incentive plans work?

The real problem is that share options benefit executives in the event that the share price goes up and the Company does well, but if the share price goes down executives rarely see a fall in their pay and they simply don't exercise the share options concerned. It is pretty much a one way street for them and there is no real accountability to shareholders or to anybody else by these means.

2. Does shareholder accountability work?

There is a real misunderstanding here. Shareholders don't have the right to manage the company and don't have the right to give direct orders to the Board on matters like this. At the moment they are entitled to give an advisory opinion and that is really as far as it goes so there is a mismatch here between the reality of shareholder powerlessness in the face of what has become an accepted way to pay executives and the view of the politicians and others that if only shareholders could get their act together they could stop these practices. Basically they can't.

3. Is there a culture of short-termism?

The case for paying Stephen Hester, the Chief Executive of the Royal Bank of Scotland Group, is that he was brought in to do a specific job and this is the going rate for people of his position so it is unfair to focus on one person. In the case of Sir Fred Godwin, the former Chief Executive of RBS, the issue would be was one man really to blame for the failure of RBS and the government bailout? The question in his case was why policy makers, regulators and others allowed a bank like RBS to operate in the way that it did to be such an aggressive takeover bidder in the markets for corporate control and why the clear risks that the Bank was running were not taken on board earlier by the regulators?

4. Does naming and shaming work?

If in the case of RBS if there had been a breach of duty by the members of the Board the Executives and the non-Executives the right course of action would have been for legal proceedings to have been brought in the name of the Company against those Directors for a breach of duty or for the Directors to be disqualified under various regulations and to stop them practicing as Directors. That has happened in just one case, but legal action has not been taken against the others. The FSA said there was no case for taking action against Sir Fred Goodwin, the Company itself has presumably decided not to sue former directors for breach of a duty of care either. There are legal mechanisms for dealing with these issues. It is one thing for somebody to be singled out in these circumstances by others, when there are also legal routes that weren't taken for good reasons. Naming and shaming under these circumstances is simply wrong and unfair to the individual concerned.

The real issue here is that the law is inadequate. RBS wasn't well run and had been run for a number of years in a highly risky way sometimes those risks paid off, but eventually they didn't pay off and the taxpayer had to foot the bill for that. This is wrong but the error lies in the regulatory framework and in the view that Companies like RBS should have been active in a takeover market, that hostile takeovers are a good thing for all concerned and that the City and the UK benefits from being at the hub of this international global market for corporate control. Those are all serious errors but those are the errors of- to a large extent - policy makers, the City establishment and also of intellectuals and others who supported this line of work.

5. What else would work, I know you think we could use tax law, how would that work?

One reason why we have seen such great use of share options is because they were encouraged by the tax system. The tax system also encourages takeovers because it allows tax relief to companies where they take on debt which is often the consequence of a takeover or a private equity buy-out. The tax system has been driving hostile takeovers and has been driving private equity deals and it has also been driving share options. The tax system has been driving all the things that have been contributing to excessive risk taking in the financial sector in the run up to the crisis which began in 2008. It is not right to say this is just the consequence of particular corporate strategies or maybe of a particular individual like Sir Fred Goodwin. Policy makers systematically set out to encourage practices, through the tax system, that turned out to be very risky indeed and had a huge public cost.

6. Do we need a more fundamental reform of the legal systems in which boardroom pay is regulated?

For the past thirty years there has been a view that governments should take a back seat in all this and that by giving voice to independent directors, we could deal with the risk of corporate excess and of a lack of accountability. This was a false perspective. Shareholders can only do so much to control managers and if we have a government that just takes a back seat, and even worse if governments' just put in a place a tax regime and a company law regime that encourages the idea that a company should be engaged in the pursuit of shareholder value at all cost and hostile takeovers whenever possible, then what happened in 2008 will simply happen again. We do need a fundamental rethink of what the function and purpose of a big company like RBS is, are they just serving short term financial needs or a wider range of interests?

7. Do we need new laws?

We certainly do need new laws. We need a fundamental review of the way the corporate tax system operates and we also need a review of the way corporate governance is structured which gives an overwhelming voice to the shareholders at the expense of other stakeholder groups but also at the same time not giving those shareholders the power they think they should have to control managerial excess. The simple truth is that at the end of the day neither shareholders nor workers nor customers, these so called stakeholders, can control some of the corporate excess that occurred in the run up to 2008. We need much more effective financial market regulation, but it would certainly help if other stakeholders apart from shareholders were given a voice in corporate governance. Employee membership of remuneration committees is just a first step in this process, we should also be thinking seriously about employee representation at Board level.

8. Codetermination, can we look to other Countries and systems that work much better than our own?

We have rejected the idea here that workers should have a voice in corporate governance, their position has been completely marginalised. In Germany by contrast workers do have a voice they have Board level representation in big companies and they have representation on works councils on issues of workplace representation and this does engender longtermism and also a more co-operative approach to the running of big firms. We can see that this has very clearly benefitted the German economy and its productive base has remained very strong not withstanding globalisation.

The same is true of Japan which doesn't have formal codetermination but on the whole Boards of Directors do not think that their job is just to return value to shareholders. They think the job of the Company is to build up a productive organisation over the long term and to provide jobs and a high level of service for customers and consumers. The German and Japanese models have been very, very, successful in building up productive stable companies that provide jobs and support, public infrastructure and communities in those countries. We instead, have companies which support the City and engage in hostile takeovers sometimes successfully but very often not, and we have also seen the whittling away of our productive economy in the last twenty years.

9. Is more regulation now needed?

There is going to be a need for more regulation through the tax system and through Company law that is unavoidable. The question now is how to get that regulation right. The current government has quite rightly pointed to the need for pension funds to be more serious long term investors in such things as UK infrastructure projects and that is a really promising sign that this Government is taking these issues very seriously. They shouldn't be afraid of pointing to the mistakes of the past twenty or thirty years, we now know that some aspects of the 1980s settlement on the City, unravelled in 2008, so now is the time for David Cameron and George Osborne to really grasp this nettle.

New Governance Research - Your Questions Answered

by Professor Simon Deakin, Programme Director CBR.

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1. Why is governance research of interest at the moment?

There is a growing realisation that markets need governance and they need regulation in order to work. There is not a straightforward conflict between markets and governance; markets need governance and we have to get governance right. Policy makers and social scientists realise that if we want to make a market economy work, producing a competitive national economy and sustainable companies, we need to think about governance. The term governance includes regulation and law, but also self-regulation by industry and through contract. We need to look at how self-regulation by the industry works and how that fits together with the legal system - these are critical issues.

2. Was the financial collapse of 2008 a defining moment for governance?

The debate about governance goes back further to the financial crisis of the early 1990s. Financial crisis does make people think hard about governance systems. Back in the early1990s the response to the financial crisis then was not to halt the wave of privatisation and deregulation which began in the 1980s, but to harness the forces of the market, particularly the capital market, along with self-regulation by industry, to the goal of better governance. This was the emerging model of corporate governance. It produced some good results but that particular model has probably exhausted its possibilities. The idea that shareholders will perform a monitoring role and that the capital market will work efficiently to allocate resources has failed. The financial crisis of 2007 and 2008 was not only not prevented by shareholder monitoring; there is also quite a lot of evidence that the excessive focus on short term shareholder returns was responsible for aspects of the financial crisis. We need to think about a new paradigm for corporate governance after the crisis.

3. What areas of governance work will the Centre for Research be looking at in the future?

The really critical issue for us now is whether institutional investors and other shareholders can support investment in other long term projects which are needed to promote a competitive economy and sustainable economy. This means pension funds in particular thinking about their contribution to complex long term projects that involve innovation, are risky, but are vital to the long term competitiveness of the UK and other economies and also for long term sustainability. Can we set up an investment regime that enables long term risks to the environment and social risks to be internalised and factored into these decisions? This is a critical issue for us.

There are many things we can do to create an investment climate that would make this possible. We need to think carefully about company law, and also about aspects of tax law, and we need to think about the way that pension funds are structured and governed. We need to think about the role of boards of directors and also about employee voice and the voice of other stakeholders in corporate decision making. We need to look at how other countries do this, at mainland Europe and in particular Germany, and also Japan, which has a corporate governance system different to ours, and which has arguably produced better results, greater competitiveness, and more successful manufacturing innovation. We also need to think about the strengths and weaknesses of the American model which has produced Silicon Valley and the financing of innovation through venture capital.

4. Is there too much regulation for business today and are there new ways of looking at these same problems in organisations?

There is no such thing as "no regulation". Sometimes we say that governments should intervene or the legal system should do something, as if there was no regulation or governance in the first place. In fact there is no situation in a modern market economy where there is no regulation. The legal system provides a basic framework of property rights and contract rights which are needed for the market to function. The State, the government, or the legislature has to regulate to deal with externalities and market failures, and if we don't do that, markets won't work. The issue is always: can we regulate effectively and properly? That means identifying what regulation by government can do and what self-regulation by industry can do.

We need to think about the link between government action and self-regulation and the constitutionality and legitimacy of self-regulation by industry in a situation where much of what industry does produces both costs and benefits for third parties. Should the voice of those third parties be factored into industry self-regulation? If we don't get this right then there will be serious regulatory failures, which means that the public or collective goods on which we all depend for markets to function just won't work, they won't deliver.

There is never "too much regulation", it is not something you can measure in this sense. It could be that for a particular firm there is sometimes too much regulation, but if you deregulate in one area you are redistributing the regulatory burden onto somebody else. If we say firms are regulated too intensively in the labour market and there needs to be deregulation of employment law, then the burden of that deregulation will simply fall on third parties, possibly other firms, and other workers who are not receiving skills training, for example. Consumers may be adversely affected by deregulation of product markets, so again there is no such thing as reducing the overall "burden" of regulation; the distribution of that "burden" is a critical issue. The question for government and the issue for us is: what overall mix will work for the good of the economy and hence the general interest?

5. How can what you call 'institutional design', improve social and economic wellbeing, and can we really measure equality?

We can measure some of the effects of regulatory interventions through statistical analysis and also through more qualitative fieldwork-based research. The purpose of focusing on 'institutional design' is to point out that many of the benefits of free markets only come about because institutions have been designed in order to make it possible for the self-interest of workers, employers and consumers and others to be reconcilable with the overall general good. The market is itself an institution which is partly the consequence of deliberate design and partly the result of an evolutionary or spontaneous process. We ignore at our peril the role of conscious design of the institutions that make market economies work, and this is what the phrase 'institutional design' is getting at.

There is a very important issue here about how much inequality a market system can wear. For the past 30 or 40 years most economists were worried about too much equality in markets, they were worried about the effects of progressive taxation blunting incentives and the effects of job protection regulation. We can now see that deregulation and reregulation of the labour market has produced more inequality, and the results of that inequality are now to be seen in the under-utilisation of capacity in the economy. There is a waste of resources implied in casual employment, and low pay, because employment like that does not generate investment in skills and capacity. Inequality hurts the market economy at a fundamental level, and that is why many social scientists are now thinking about the costs of inequality when they think about institutional design.

Part Two:

6. Why are you looking at complex infrastructure projects are the problems of governance more difficult to comprehend and enforce?

A complex project like Heathrow Terminal 5 is governed by the set of contracts put in place by the main client and the various tiers of contractors and subcontractors. These contracts are a mini constitutional code for that project. The contracts set out the terms upon which the different parties will deal with each other. They also set out the terms upon which risks and costs are allocated between the parties, and, critically, they put in place procedures and processes for dialogue between the parties to resolve them in a way which will allow the different stakeholders to make an input into decision making.

Terminal 5 was successful not just because it was well designed by far sighted people, but also because of processes put in place for dialogue and deliberation between the different stakeholders. Talking and communication between the parties really helps to ensure that coordination in a very complex project like that works in reconciling the different interests, in resolving problems and in allocating risks.

T5 is a great example of industry self-regulation. This wasn't done by the government or by the legal system coming in, it was done by industry itself learning from its past mistakes. The construction industry learnt from its past mistakes with the Wembley Stadium Project and the Jubilee Line extension project. These lessons were embedded through the learning process in the contractual design of T5. This is a great example of what can be achieved. It is also a good example of patient long term investment by the City in the Terminal 5 project. When it was being set up, the main client BAA, effectively sold the idea of this huge capital investment project to its own shareholders on the basis of the long term returns they would get. In the UK context, it is a myth that we always think of the short term; capital can be "patient", it can be stable and long-term.

We can be like Germany or Japan if we want: we can incorporate some of the good aspects of their systems. We don't necessarily need government to tell us how to do it, but the wider lesson of T5 is that some of the successes of that project were not sufficiently well embedded for them to be repeated on a continuing basis. This is where government can come in and can capture the wider benefits of projects likeT5. It can help embed this learning into longer lasting enduring institutions - this is the facilitative role of the State.

7. Can Capital have human characteristics?

We need investors to factor in long term costs and benefits more effectively than they currently do. At the moment a lot of investment is short-term, shareholders often do benefit from short term share price movements. Much of it is churning, a lot of it is about decisions taken in milliseconds by computers about whether to buy or sell shares. This is fine, this will always go on in the City and there is some benefit in terms of liquidity to be had from these processes, but we also need the other type of investment, where investors understand and factor in not just long term costs, but also the benefits of long term projects like T5. There is a lot of evidence that we don't do enough of that long term planning at that investment stage in the UK.

8. Do innovative enterprises require specific State frameworks to work in or should they operate without regulation?

Innovation is based on learning, and learning is an evolutionary process whereby we learn from our failures and we embed that learning in institutions, and then the benefits are more widely spread across the whole economy. That is what we mean by institutional learning. It is not the State dictating the right answer to industry, it is industry learning from its own experience what the right answers might be, and the State assisting by disseminating that learning, often through putting incentives for disclosure in place. We may need more disclosure, but we also need to encourage deliberation and dialogue. So there is a division of labour between the State and the private sector: they need each other to make this work, it is not a simple question of the State versus the market.

9. Should Pension Funds be encouraged to invest in infrastructure projects?

Pension Funds must invest for the very long term because their beneficiaries want to be receiving their pensions in twenty or thirty years' time. On the one hand, they should have a natural long term focus because of this, but on the other hand they also have short term pressures, they have to balance risk and returns over both the short term and the long term, and it would be naïve to believe that just because the beneficiaries of a pension fund themselves have long term interests, that those long term interests are automatically, costlessly and seamlessly translated into action by those pension funds. It is not an easy set of choices for pension fund trustees or the asset managers who they empower to take decisions on their behalf to make. So what we need is a system whereby there is better information exchange and there is more disclosure, but also more transparency about long term benefits and costs. Pension fund trustees have a fiduciary duty to get the best return for their members after taking account of risk and a need for diversification, so government should not dictate how or where they can invest. However, the government can say to pension funds: it is in your enlightened long term interest to support an innovative and competitive British economy as well as investing globally; you need to do both. At the end of the day the beneficiaries of these pension schemes are British workers and British households with insurance policies and saving policies, and UK governments have an interest in getting pension fund governance right as part of ensuring a sustainable and competitive British economy.

10. Why do knowledge intensive labour markets need regulation? It is going to be very hard to pin down what belongs where? Isn't it in a global world?

There is already regulation of labour markets both nationally and globally, but often the regulation doesn't work. We have a big problem with casual labour and self-employment, so how do we regulate to avoid that? How do we create the conditions for self-employment to be a pathway to entrepreneurial activity for many individuals, but also for self-employment not to be abused or mis-used for tax avoidance and casualisation? This is a very difficult set of problems.

There may not be a straightforward answer to this, but my point is that there is a public interest in getting this right. The way we regulate low paid employment, what rules we have on dismissal, how we tax employment: these all have critical implications for firms and for workers. It is not just a question of firms versus workers. Both employers and employees have an interest in creating a situation where we can invest in capacity, we can invest in human capital, we can invest in skills and training, and often that can only be done by getting the regulatory framework of tax law and employment law right.

At the moment in the UK we are having a big debate about unfair dismissal - on the one hand it is probably the case that some aspects of employment law give rise to an excessive amount of paperwork and procedure for firms, but on the other hand, we don't want to create a situation in which we entirely lift the so-called burden of regulation for firms, as that would be a further invitation to the casualisation of employment. The result of casualisation would be less investment in human capital.

11. Is a cross disciplinary approach important to the work of the CBR and if so why and how are you going to set about it?

We at the CBR are bringing to the social sciences what the sciences have always done. There is an appreciation in physics and chemistry and biology and the engineering disciplines that real progress is made in interdisciplinarity, so we have to bring together the insights of different disciplinary teams. In our case it means bringing together the insights of economists, management specialists, sociologists, and legal specialists, they all have knowledge and combining that knowledge is not an easy task. They should be working together, with deliberation and dialogue between the different disciplinary teams to get value-added from the research.

12. You will also be creating new data sets at the CBR for the analysis of legal and institutional phenomena, why are these datasets of importance?

We have been creating new datasets and that means a lot of survey work, interview work and collating data about trends in the economy concerning corporate governance and small and medium size enterprises in particular. We are also creating new data and measuring for the first time things which often haven't previously been well measured. Thus one of the things we have done through the use of innovative methodologies is to try to quantify institutional phenomena like the rules made by legal systems. We are trying to get a better grasp quantitatively of how legal rules work in practice, through a combination of legal analysis, survey work and economic statistical analysis. This is a new area of social science that we have called 'leximetrics' to signify the use of quantitative methodologies originally pioneered in the hard sciences and economics to understand legal phenomena. The underlying approach that we have taken here is to say that we cannot very well understand these complex institutional phenomena without getting a better quantitative and statistical grasp of how they work. We need to apply some of the techniques of the mainstream sciences to get a better understanding of how they operate.

13. Is there going to be new Governance regulation that takes into account the global world and new technology?

There are some difficult questions about the relationship between technology and the regulatory or institutional environment. We are living in a context where markets change very quickly. Technology reshapes the entire structure of markets, so established markets, like media markets, are "merging" because of new technologies derived partly from the internet. We see market barriers breaking down and existing patterns of economic relationships fundamentally changing. When that happens the regulatory framework has to adjust. It isn't a question of it being endlessly flexible as it has to provide a stable framework for economic activity, but it has to be capable of adjusting to these very turbulent technological conditions. So a lot of this is about learning again.

We need to study and understand from technologists themselves how the particular features or structures of a given technology, like the internet, shape economic relationships and create new opportunities but also new blockages and new distortions. The technological requirements, which are initially often only understood by engineers, create new market structures which then become an issue for wider economic and social analysis. We can bring together computer scientists and engineers who have this knowledge of the way certain technologies work and we can then put that knowledge to use in the context of economic models and social models which explain how regulatory systems work. At the CBR we are bringing together these different disciplinary approaches to get an integrated understanding.

14. Can new operating frameworks increase co-operation and stability across disciplines and across borders on governance issues and thereby improve effectiveness for firms and workers?

This is what economists call a "collective action problem". Sometimes people know what they should do but it is not in the interests of any one individual or group to do what is necessary, creating a "tragedy of the commons". Often we end up with a less than ideal situations because what is needed is political action or regulatory intervention or maybe the action of an influential player in a particular market to move things along, but there is no guarantee that this will happen or we can get to the right answer even though we can all where we might want to get to. This is the situation we are now in. We have had a financial crisis; we are living in a period of technological turbulence where market boundaries are shifting all the time. There is an ever greater need to understand what is possible through institutional design to solve "collective action problems". This means we need more social science research to understand these issues.