The Meritocracy Trap

by Daniel Markovits

  immensely profitable: “Twilight of the Gods,” The Economist.

  so profitable today: See Michael Lewis, Flash Boys (New York: W. W. Norton, 2014).

  less valuable: Gerald F. Davis, Managed by the Markets: How Finance Reshaped America (New York: Oxford University Press, 2009), 37–38, and Greta Krippner, Capitalizing on Crisis: The Political Origins of the Rise of Finance (Cambridge, MA: Harvard University Press, 2011), who document the shift from originate and hold to originate and distribute. See also Mark S. Mizruchi, “The American Corporate Elite and the Historical Roots of the Financial Crisis of 2008,” in Markets on Trial: The Economic Sociology of the U.S. Financial Crisis: Part B, ed. Michael Lounsbury and Paul M. Hirsch (Bingley: Emerald Group Publishing, 2010), 103–39, 122–23; and Andrew Leyshon and Nigel Thrift, “The Capitalization of Almost Everything,” Theory, Culture, and Society 24 (2007): 100. The first to do this was Fannie Mae. Guy Stuart, Discriminating Risk: The U.S. Mortgage Lending Industry in the Twentieth Century (Ithaca, NY: Cornell University Press, 2003), 21–22, 68.

  shadow banks and other investors: See Greenwood and Sharfstein, “The Growth of Finance,” 7.

  many with PhDs: The Financial Strategies Group at the Fixed Income Division of Goldman Sachs is a prime example. See Derman, My Life as a Quant, 123.

  “talent is the most precious commodity”: Duff McDonald, “Please, Sir, I Want Some More. How Goldman Sachs Is Carving Up Its $11 Billion Money Pie,” New York Magazine, December 5, 2005.

  a typical Wall Street firm’s net revenue: “The standard portion of net revenue (total revenue minus interest expense) earmarked for compensation at Wall Street firms stands at a staggering 50 percent.” Ho, Liquidated, 255 (quoting Duff McDonald, “Please, Sir, I Want Some More. How Goldman Sachs Is Carving Up Its $11 Billion Money Pie,” New York Magazine, December 5, 2005). In 2011, 42 percent of Goldman Sachs’s revenues were paid to its employees (who received, on average, $367,057); in 2010, compensation accounted for 51 percent of revenues at Morgan Stanley, 34 percent at Barclays, and 44 percent at Credit Suisse. See Freeland, Plutocrats, 122.

  for other workers: See Philippon and Reshef, “Wages and Human Capital.” In another paper, Philippon and Reshef estimate the premium at nearer 50 percent. See Philippon and Reshef, “Skill Biased Financial Development.” Although college graduates in certain technical fields enjoy a wage premium similar to that received by college graduates in finance, finance workers with postgraduate degrees increasingly out-earn even postgraduates in these technical fields. See Rajan, Fault Lines, 142.

  down through the generations: On the feedback loop between returns to elite education and educational investments by elite parents, see Frank and Cook, The Winner-Take-All Society, 148.

  “research and development sector”: See Goldin and Katz, The Race Between Education and Technology, 40 (“Finally, education contributes to innovation and technological advance because scientists, engineers, and other highly educated workers are instrumental to the research and development (R&D) sector as well as to the creation and application of new ideas.”). The effect becomes especially large when elite education reaches a critical mass, so that innovators do not work severally or in isolation but instead come together and support one another. See Oded Galor and Omer Moav, “Ability-Biased Technological Transition, Wage Inequality, and Economic Growth,” Quarterly Journal of Economics 115, no. 2 (May 2000): 469–97, https://doi.org/10.1162/003355300554827.

  household debt and dependency: See Safeway Stores, Incorporated, 1975 Annual Report, 2.

  “In 1919 I had never seen”: See Safeway Stores, Incorporated, 1970 Annual Report, 9.

  “Drive the Safeway; Buy the Safeway”: See Olive Gray, “Seelig’s Chain Is Now Safeway,” Los Angeles Times, March 15, 1925, B8 (“The adopted slogan of the old-new organization—old in fact and in tested operation but new in name—is an admonition and an invitation: ‘Drive the Safeway; Buy the Safeway.’”).

  “Safeway Offers Security”: See Susan Faludi, “The Reckoning: Safeway LBO Yields Vast Profits but Exacts a Heavy Human Toll,” Wall Street Journal, May 16, 1990. Hereafter cited as Faludi, “The Reckoning.” The firm had other mottos also. Annual reports indicate that at least from 1929 to 1932 the motto was “Distribution Without Waste.” See Safeway Stores, Incorporated, 1929 Annual Report, 1; Safeway Stores, Incorporated, 1930 Annual Report, 1; Safeway Stores, Incorporated, 1931 Annual Report, 1; Safeway Stores, Incorporated, 1932 Annual Report, 1.

  “a simple formula for success”: “Safeway Stores, Inc.,” Fortune, vol. 26, October 1940, 60. Hereafter cited as “Safeway Stores, Inc.,” Fortune.

  to fire any of its employees: See Safeway Stores, Incorporated, 1939 Annual Report, “Personnel,” 5; Safeway Stores, Incorporated, 1940 Annual Report, “Personnel,” 5; Safeway Stores, Incorporated, 1941 Annual Report, “Personnel,” 5. Such attitudes persisted. The 1955 Annual Report, for example, declared that Safeway “desires to be a part of each community in which it does business. It strives to carry its share of community charity and welfare costs and to pay its fair share of local and state taxes.” Safeway Stores, Incorporated, 1955 Annual Report, 9.

  In 1968, Safeway worked: See Safeway Stores, Incorporated, 1975 Annual Report, 13, and Safeway Stores, Incorporated, 1968 Annual Report, 16–17. Asked why a business should be interested in helping to solve the problems of society, the 1968 Annual Report observes, “We have answered that in our opinion it is not only good citizenship, but is necessary for a good business environment and perhaps even for the survival of private enterprise itself.” Safeway Stores, Incorporated, 1968 Annual Report, 17.

  “social responsiveness and accountability”: See “How Consumer Organizations Rate Corporations,” Business and Society Review, no. 3 (September 1972): 94.

  underprivileged minority workers: Safeway Stores, Incorporated, 1975 Annual Report, 13.

  working his way up to lead the firm: See Safeway Stores, Incorporated, 1965 Annual Report, 8.

  “We live and preach people development”: See Safeway Stores, Incorporated, 1972 Annual Report, “Young Managers Move Up,” 4.

  as a bakery helper: See “Safeway Stores, Inc.,” Fortune, 128.

  half the pay of the CEO: See “Safeway Stores, Inc.,” Fortune, 128.

  roughly $1.2 million in 2018 dollars: See Safeway Stores, Incorporated, 1965 Proxy Statement (Form DEF 14A), 9.

  “Safeway has rationalized”: See “Safeway Stores, Inc.,” Fortune, 134.

  performing basic management tasks: See Goldin and Katz, The Race Between Education and Technology, 19–22.

  returning them to shareholders or creditors: Roughly 70 percent. See Fraser, Every Man a Speculator, 488.

  raised on the capital markets: Over 90 percent. See Fraser, Every Man a Speculator, 488.

  raise operating capital by borrowing: Indeed, U.S. nonfinancial corporations have, in aggregate, issued negative net equity since 1980, devoting some of the funds raised by issuing new debt to buying back old equity. Net equity was negative not just over the longer period but also in almost every individual year, with only a few exceptions in the early 1990s. See Board of Governors of the Federal Reserve System, “Flow of Funds Accounts of the United States, Annual Flows and Outstanding,” Tables F2 and F4, 1985–1994, 1995–2004, 2005–2010. See also Thomas I. Palley, “Financialization: What It Is and Why It Matters,” Levy Economics Institute Working Paper no. 525, December 2007, 19–20, Figure 4, “Nonfinancial corporation net equity issuance and new borrowing, 1959–2006.”

  Corporate filings made in relation to share buybacks display the connection between repurchasing and new borrowing. For a sample of filings from 1994 to 2012, for example, in close to 40 percent of the cases in which the source of financing was disclosed, the firm said it expected to use some form of debt to fund the share repurchases. See Zicheng Lei and Chendi Zhang, “Leveraged Buybacks,” Journal of Corporate Finance 39
(2016): 244.

  from past profits: They retain just about 12 percent of earnings and fund only 60 percent of their new expenditures and only 27 percent of “major” expenditures from past profits, a share that falls to just 15 percent when acquisitions are included.

  The retained earnings figure reflects retained earnings over net income. Data are for the S&P 500 for the period between 2005 and 2014. William Lazonick, “How Stock Buybacks Make Americans Vulnerable to Globalization,” Institute for New Economic Thinking, Working Paper 8 (March 1, 2016). Prior eras of intensive financialization produced similar patterns, so that, for example, U.S. firms reinvested only 30 percent of their profits in 1929. See Fraser, Every Man a Speculator, 488.

  The data on financing new investments come from Ralf Elsas, Mark J. Flannery, and Jon A. Garfinkel, “Financing Major Investments: Information About Capital Structure Decisions,” Review of Finance 18, no. 4 (2014).

  prefer owners over other stakeholders: See Michael C. Jensen, “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76, no. 2 (May 1986): 323–29. A review of the many complementary factors that favor debt-financed buybacks (including the connections to shareholder activism to restraints on managerial inclinations to serve other stakeholders) appears in Joan Farre-Mensa, Roni Michaely, and Martin C. Schmalz, “Financing Payouts,” Ross School of Business Paper No. 1263 (December 2016), 31–37.

  “separation of ownership and control”: See Adolph Berle and Gardiner Means, The Modern Corporation and Private Property (New York: Macmillan, 1932).

  maximize shareholder value: The term “shareholder value” was introduced by the lawyer-economist Henry Manne in his classic article “Mergers and the Market for Corporate Control.” See Henry Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy 73, no. 2 (April 1965): 110. Note that the date of publication comes at the twilight of the Great Compression.

  incumbent managers: As with the purely financial innovations discussed earlier, the leveraged buyout was conceived in the 1950s but did not become practically consequential until the 1980s, when a sufficient supply of super-skilled labor capable of deploying the innovation at scale first became available. The first leveraged buyout may have been the purchase of Waterman Steamship Corporation in 1955 by McLean Industries, Inc. McLean issued $7 million in preferred stock and took out $42 million in bank loans to purchase Waterman. Marc Levinson, The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger (Princeton, NJ: Princeton University Press, 2016), 49.

  activist investing on a massive scale: See Robert Teitelman, Bloodsport: When Ruthless Dealmakers, Shrewd Ideologues, and Brawling Lawyers Toppled the Corporate Establishment (New York: Perseus, 2016), 66–72; Moira Johnston, Takeover: The New Wall Street Warriors; The Men, the Money, the Impact (New York: Arbor House, 1986), 34. Hereafter cited as Johnston, Takeover; and Bruce Wasserstein, Big Deal: Mergers and Acquisitions in the Digital Age (New York: Warner Business Books, 2001), 548. Hereafter cited as Wasserstein, Big Deal. Wachtell is also famous for helping firms resist takeovers, including on account of having invented the poison pill defense. See Johnston, Takeover, 36; Wasserstein, Big Deal, 552.

  (similar years in the business cycle): See IDD Enterprises, M&A Almanac (May–June 1992); Houlihan Lokey Howard & Zukin, Mergerstat Review (Los Angeles: Mergerstat, 1988), 1.

  between 1988 and 1999: See W. T. Grimm & Co., Mergerstat Review (Schaumburg, IL: Merrill Lynch Business Brokerage and Valuation, 1988), 3; Houlihan Lokey Howard & Zukin, Mergerstat Review (Los Angeles: Mergerstat, 1999), 1.

  implement anti-takeover defenses: See Ho, Liquidated, 133; Marina Whitman, New World, New Rules: The Changing Role of the American Corporation (Boston: Harvard Business School Press, 1999), 9; and Michael Useem, Investor Capitalism: How Money Managers Are Changing the Face of Corporate America (New York: Basic Books, 1996), 2.

  Private equity firms, for their part, today hold over $2.4 trillion in capital at the ready to target firms that they regard as badly run and to replace inefficient managers, a threat that disciplines management even where no takeover materializes. See Preqin, 2016 Preqin Global Private Equity & Venture Capital Report, www.preqin.com/docs/samples/2016-Preqin-Global-Private-Equity-and-Venture-Capital-Report-Sample_Pages.pdf.

  change in the corporate workplace: The new ideology also produced changes adjacent to the corporation. Managers at mid-century served many stakeholders—including the local communities in which a firm did business, the firm’s customers, and (especially importantly) its employees. Moreover, midcentury managers often literally lived with a corporation’s workforce, and this gave them an incentive to support local employment and civic life and to pay their neighbors good wages.

  rather than being managers themselves: Top managers might monitor lower-level workers, but the distance between the tasks that these workers perform and the firm’s share price makes it difficult to incentivize them directly to promote shareholder value.

  (stock- and option-based pay packages): Rising CEO compensation has been accompanied by a shift away from fixed pay to compensation packages that tie pay to stock performance. Indeed, between 1990 and 2015, the non-equity component of income among CEOs of the S&P 1500 barely increased (from roughly $1.2 million to roughly $1.5 million, on average), even as the equity component more than tripled (from $800,000 to over $2.5 million, on average). See Cremers, Masconale, and Sepe, “CEO Pay Redux,” 240. The authors exclude from their data set on CEO pay managers of firms that have dual-class stock and firms in regulated industries. These comprise a little less than 10 percent of all firms in the S&P 1500.

  (the threat of being ousted): By the turn of the twenty-first century, a downgrade in stock analysts’ investment recommendations—from “buy” to “hold” or from “hold” to “sell”—increased by half the chance that the downgraded firm’s CEO would be fired within six months. Indeed, performance-related firings of the CEOs of the world’s twenty-five hundred largest firms quadrupled between just 1995 and 2005. See Reich, Supercapitalism, 76, citing Chuck Lucier, Paul Kocourek, and Rolf Habbel, The Crest of the Wave (New York: Booz Allen Hamilton, 2006).

  if properly incentivized, as a benefit: See Charles J. Whalen, “Money-Manager Capitalism and the End of Shared Prosperity,” Journal of Economic Issues 31, no. 2 (June 1997): 522; and David A. Zalewski and Charles J. Whalen, “Financialization and Income Inequality,” Journal of Economic Issues 44, no. 3 (2010): 762. Employers, moreover, increasingly oppose unionization and prosecute their opposition increasingly aggressively: the share of union elections to receive employer consent fell by four-fifths between 1962 and 1977, and according to the National Labor Relations Board, the rate at which employers used illegal firings to try to deter unionization increased fivefold between the early 1950s and 1990. Reich, Supercapitalism, 80–81.

  in favor of meritocratic hierarchy: They also—because managers are socially isolated not just from communities and employees but also from shareholders—empowered managers to bargain hard to capture from shareholders whatever incomes their skills can sustain.

  management has itself become financialized: See David Carey and John E. Morris, King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone (New York: Random House, 2012), 100. See also Gerald Davis, Managed by the Markets: How Finance Reshaped America (Oxford: Oxford University Press, 2009).

  incumbent firms then still deployed: The connections between meritocracy and mergers-and-acquisitions practice run very deep: the overwhelmingly Protestant white-shoe firms that dominated midcentury legal practice shunned litigation, bankruptcy, and takeover law, on the grounds that these were unseemly practice areas and became necessary only where a lawyer had failed in his primary role. Wachtell and Skadden were both open to Jews who had been excluded from Protestant firms—indeed, Wachtell’s founders were all Jewish—and made their busine
sses in areas that white-shoe firms avoided. Wachtell’s success, and older firms’ imitative aspirations, testify to meritocracy’s rising dominance in elite legal practice. See Eli Wald, “The Rise and Fall of the WASP and Jewish Law Firms,” Stanford Law Review 60 (April 2008): 1803–66.

  very top graduates from the very best schools: The cutoffs are chosen because these are the numbers of schools that, with ties, regularly appear in the U.S. News & World Report rankings of top-ten and top-five schools.

  the same legal talent: In 2016, the top tier of M&A firms (besides Wachtell and Skadden) were Cravath Swaine & Moore; Kirkland & Ellis; Paul, Weiss, Latham & Watkins; Simpson Thacher & Bartlett; Sullivan & Cromwell; and Weil, Gotshal. Each hires not just principally but overwhelmingly from the very most elite law schools. See “The Legal 500 Rankings of M&A Litigation,” The Legal 500, www.legal500.com/c/united-states/dispute-resolution/manda-litigation-defense.

  inside their firms: See Dirk Zorn, “Here a Chief, There a Chief: The Rise of the CFO in the American Firm,” American Sociological Review 69 (June 2004): 345–64.