Part three of an ongoing series
Harvard Business School professor Michael Jensen has vivid childhood memories of southern Minnesota grain elevators. For him, these countryside skyscrapers represent the clash of capital interests that has rocked Wall Street and the financial markets and is now spilling over on rural America.
Early on, the Minneapolis native explains, a logical way for a local grain company to assure supply and price of grain would be to own the farms around the community. That wasn’t an efficient or politically acceptable approach to agriculture.
Instead, farmers pooled resources to own most of the elevators, or local grain companies, in their communities, he recalls, citing his mother’s home area around Minnesota Lake as an example. “That system has worked,” he said.
Jensen never studied agriculture. He went to Macalester College (Minnesota 2020 is affiliated with Macalester College) in St. Paul before beginning a storied career in academia that landed him at Harvard. Current problems with different investors in ethanol plants in his home state serve as fresh reminders of organizational problems he sees across industry and investment sectors nationwide.
Jensen teamed with the late William Meckling of the University of Rochester in 1976 to create agency theory, incorporating concepts from other economists, business professors and philosophers (see References below). In short, it identifies problems that arise over behavior of owners or investors (“principals” or shareholders) and managers (“agents”), when their interests are not compatible.
The Jensen-Meckling theory is being given a brief look here as the third part of a series keyed to Minnesota ethanol plants and economic development issues. The plants are not unique for agency theory conflict; rather, they are the most visible of new economic development efforts throughout rural Minnesota. As such, they are representative of challenges facing economic development strategies as we seek ways to recover from the current recession and stimulate the economy.
The first part of the series, “Economic Development Lessons from Ethanol: Markets Work, but Not for All Investors,” was published online on April 2. A second part, “Study Shows a Billion Reasons Why Minnesota Farmers Invest in Ethanol,” was published April 20. That installment included a research paper by Aparna Bhasin, “Adding Value the Minnesota Farmers’ Way,” and showed why ethanol development makes sense for farmers if not other investors.
A forthcoming, final installment in the series will look at ways to shape community economic development projects and public policy to avoid agency theory problems to the extent possible. But first, let’s look at the expanding ethanol industry that is showing signs of internal strain.
Some Minnesota ethanol plants are currently closed. Others are being sold, consolidated and liquidated in industry realignments and bankruptcies. Minnesota wants the plants up and running for what they contribute to farm income, rural jobs, local economic activity and the general rural economy.
This puts the hired managers (agents) in an extremely difficult situation. While they don’t have control over either input supply or output demand markets, they must try to manage profitable plants to meet goals of different classes of investors and creditors.
The Jensen-Meckling work led to a large number of studies examining costs of the conflict between owners and managers, and then to a second agency conflict between stockholders and creditors, or bondholders. This stretches to include a number of stakeholders who also have interests in the health and longevity of the firm.
Inevitably, the strains of such conflicts lead to questions of ethics. What Jensen calls “the sorry state of affairs” in the finance industry has him currently working on ethics curricula for business schools (see below).
Like most theories that survive the test of time, agency theory has been adapted to wider uses and is constantly evolving. Beginning in the mid-1980s, scholars at Michigan State University, Wageningen University (The Netherlands), Swedish Agricultural University at Uppsala, University of Missouri, University of Saskatchewan and Western Illinois University, among others, adapted the theory to cooperative enterprises and, by extension, various forms of community-based enterprises.
We are seeing it come home to roost with the obvious capital clash over investments in ethanol plants. Outside investors have different objectives than the farmers who are also investors. The passive investors want high rates of return on their investments (ROI). The farm investors want a combination of returns, from higher valued corn crops as well as plant profits. Managers have their own short-term and long-term objectives, but the different classes of owners are defining their “success” differently.
This battle of interests hangs over economic development projects in rural communities that would add value to locally produced commodities or goods. It also applies in urban areas where workers and community investors are exploring ways to resuscitate troubled industries and companies.
This plays out at the local level while on the broader, national scene, managers of financial firms have taken dangerous risks, managers have been awarded excessive compensation for taking risks, and shareholders have been victimized. Conversely, some groups of investors have severely damaged enterprises through investment banking practices that only look at short-term gains from leveraged buyouts and sales of assets.
“Is this the worst of agency theory playing out on Wall Street?” Jensen was asked in a recent interview.
“Actually, the best example,” he corrected, noting that agency theory highlights the problems built into ownership, governance and management conflicts of modern firms.
The self interests of different groups within a modern business organization are great enough before greed and plunder run amuck. That has Jensen working on elevating ethics into business school curricula.
The Bernie Madoff scandal, for instance, has him asking “for what?” Ill-gotten gains won’t do him much good if he spends the rest of his life in prison, Jensen said.
“What has he gained? He ruined his life, his reputation. He ruined his family. He ruined his firm. For what?”
That question is germane to numerous headline stories in the business press today. It is also germane, and should be studied in advance, as we move forward with state and local supported economic development projects as well.
For what? For whom? Good answers to those questions would help investors, managers and stakeholders alike. It would define reasonable objectives for economic development projects.
A short list of reference materials is offered here for people wishing to learn more about agency theory and its impact on economic development strategies. Serious students of economics and business management would already be schooled in the theory, but that doesn’t include most people involved with community development and public policies aimed at encouraging economic development.
For understanding agency theory, see:
Jensen, Michael C. and William H. Meckling. “Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics. (October 1976), 305-360.
Encyclopedia of Business. “Agency Theory.” This useful summary can be found at www.enotes.com/biz-encyclopedia/agency-theory.
For a discussion of how agency theory has been adapted to cooperatives and community-based enterprises, see:
Egerstrom, Lee. “Obstacles to Cooperation.” Merrett, Christopher D. and Norman Walzer. Cooperatives and Local Development: Theory and Applications for the 21st Century. M.E. Sharp Inc., 2004.
And for a look at current efforts to develop ethics in business curricula, see two works in progress online at:
Erhard, Werner, Michael C. Jensen and Steve Zaffron. “Integrity: A Positive Model that Incorporates the Normative Phenomena of Morality, Ethics and Legality.” Social Science Research Network, April 25, 2008. It can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=920625, and
Jensen, Michael C. “A New Model of Integrity: An Actionable Pathway to Trust, Productivity and Value.” It can be accessed at http://ssrn.com/abstract=932255.
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