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Business Groups or The Riddle of the Great Pyramids Randall Morck Globes – Israeli Business Conference, Tel Aviv, December 2010 1.

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Presentation on theme: "Business Groups or The Riddle of the Great Pyramids Randall Morck Globes – Israeli Business Conference, Tel Aviv, December 2010 1."— Presentation transcript:

1 Business Groups or The Riddle of the Great Pyramids Randall Morck Globes – Israeli Business Conference, Tel Aviv, December

2 Business Groups Economics textbooks are about large US & UK firms, which are 1.Widely held – no controlling shareholder 2.Freestanding – listed firms neither control nor are controlled by other listed firms Many (most?) large firms in most other countries belong to business groups, which are 1.Pyramidal 2.Controlled by wealthy families or tycoons 2

3 How LSE Nearly Destroyed the World Rosenstein-Rodan, Paul Problems of Industrialisation of Eastern and South-Eastern Europe. Economic Journal 53(210/1)  Pervasive & huge coordination problems slow growth  A business needs public goods  No single business can pay for education  Needs suppliers & customers  Economies of scale often different  Needs complementary sectors (externalities)  Economies of scale different  Especially for ‘hard to trade’ goods  Hold up problems everywhere  Especially for ‘hard to trade’ goods  Quality control problems  Irrational to produce quality intermediate goods 3

4 Solution: A Big Push  Rosenstein-Rodan, Paul Problems of Industrialisation of Eastern and South-Eastern Europe. Economic Journal 53(210/1)   Central planning is the solution!!  State provides public goods  State captures externalities in taxes  State-owned enterprises formed as needed to fill in economic gaps  Customers, suppliers, & producers & users of complementary goods set up & expanded in proper sequence  Extensive taxes & subsidies  Tax optimally scaled sectors to subsidize needed, but inefficiently scales sectors  The state can supervise quality control 4

5 How LSE Nearly Destroyed the World  Rosenstein-Rodan, Paul Problems of Industrialisation of Eastern and South-Eastern Europe. Economic Journal 53(210/1)   Why the private sector can’t do it  “Financial markets and institutions are inappropriate to the task of industrialization of a whole country.  “They deal with too small units, and do not account for externalities  “Capital goes to individual firms  “There has never been a [private sector] scheme of planned industrialisation comprising a simultaneous planning of several complementary industries” X 5

6 How LSE Nearly Destroyed the World  Rosenstein-Rodan, Paul Problems of Industrialisation of Eastern and South-Eastern Europe. Economic Journal 53(210/1)   How the private sector can do it!  Pyramidal business groups are precisely “a [private sector] scheme of planned industrialisation comprising a simultaneous planning of several complementary industries”  Pyramidal business groups are  Highly diversified  Coordinate the establishment of new firms using capital from existing one  Rife with cross subsidizations  Public goods – e.g. Turkish universities 6

7 A Common Theme … “LG My father and I started a cosmetic cream factory in the late 1940s. At the time, no company could supply us with plastic caps of adequate quality for cream jars, so we had to start a plastics business. Plastic caps alone were not sufficient to run the plastic molding plant, so we added combs, toothbrushes, and soap boxes. This plastic business also led us to manufacture electric fan blades and telephone cases, which in turn led us to manufacture electrical and electronic products and telecommunications equipment. The plastics business also took us into oil refining, which needed a tanker shipping company. The oil refining company alone was paying an insurance premium amounting to more than half the total revenue of the largest insurance company in Korea. Thus, an insurance company was started. This natural step-by-step evolution through related businesses resulted in the Lucky-Goldstar (LG) group as we see it today.” “LG My father and I started a cosmetic cream factory in the late 1940s. At the time, no company could supply us with plastic caps of adequate quality for cream jars, so we had to start a plastics business. Plastic caps alone were not sufficient to run the plastic molding plant, so we added combs, toothbrushes, and soap boxes. This plastic business also led us to manufacture electric fan blades and telephone cases, which in turn led us to manufacture electrical and electronic products and telecommunications equipment. The plastics business also took us into oil refining, which needed a tanker shipping company. The oil refining company alone was paying an insurance premium amounting to more than half the total revenue of the largest insurance company in Korea. Thus, an insurance company was started. This natural step-by-step evolution through related businesses resulted in the Lucky-Goldstar (LG) group as we see it today.” Koo Cha-Kyung, Chair Kim and Lee (2007)

8 American Pyramids 8

9 1930s America Pyramidal business groups prominent in news & on Capitol Hill  Shareholders rights activists fret about vast separation of ownership from control, entrenched insiders, self-dealing  IRS auditors complain of transfer pricing  FTC economists complain of hidden monopolies  Newspapers warn of systemic governance risk  Roosevelt’s “New Dealers” suspicious of concentrated political power, hereditary elites, … 9

10 Worthy of Eternal Life Big Push growth Hereditary governance Tax avoidance Market power Systemic risk Political influence 10

11 Roosevelt’s New Deal ‘35 Securities & Exchange Act enforces transparency, self-dealing exposed Securities & Exchange Act enforces transparency, self-dealing exposed ‘36 Intercorproate dividend tax at 10% of regular rate Intercorproate dividend tax at 10% of regular rate No capital gains tax on property from complete liquidation of a controlled subsidiary No capital gains tax on property from complete liquidation of a controlled subsidiary Public Utilities Holding Co. Act “Death Sentence Clause” bans pyramids > 2 layers high in public utilities industries Public Utilities Holding Co. Act “Death Sentence Clause” bans pyramids > 2 layers high in public utilities industries Bank & Cheffins (2010) dissent, prob. wrongly Bank & Cheffins (2010) dissent, prob. wrongly Sokolinski (2010) is best work on the subject Sokolinski (2010) is best work on the subject ‘37 Intercorproate dividends tax at 15% of regular rate Intercorproate dividends tax at 15% of regular rate No capital gains tax on any assets from complete liquidation of subsidiary No capital gains tax on any assets from complete liquidation of subsidiary ‘40 Investment Companies Act regulates listed companies with extensive shareholdings in other listed companies as investment companies Investment Companies Act regulates listed companies with extensive shareholdings in other listed companies as investment companies Source: Morck (2005). 11

12 Decline of Equity Control Blocks in the US 12

13 What Happened in the UK? ’68  LSE Takeover Rule If you buy 30% of any listed firm, you must buy 100%  Postwar Labour governments capitalized large trade-based pension funds  Their lobbying led to the LSE takeover rule  Active M&A eroded pyramids  Either incumbent control block holder or raiders must buy 100%  Pyramids largely gone by 1970s  Such measures won’t work absent active M&A British reaction to something “not cricket” Source: Tripe Soup, by Andy Farnsworth. Copyright © Google Franks, Meyer, and Rossi (2005) 13

14 Elsewhere  Big Push in effect in “developing” world  Business group firms are star performers in India, Chile, …  Business groups after a Big Push  Dismantled in US & UK (& Japan)  Tied with regulation to various degrees in W. Europe, Canada, Australia …  Failure to launch in Latin America  Repeated “almost successful” aborted economic takeoffs  Just as takeoff imminent, lobbying stalls further development?  Completed development would obviate the advantage of business groups?  Latin America “land of the future, … forever?”  Saving Capitalism from the Capitalists, by Rajan & Zingales  Recent successful Big Push economies  Public policy issue in Hong Kong, Korea, Singapore, Taiwan, Israel … 14

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