Archived — Discussion Paper Number 3: Canadian Corporate Governance Policy Options

by Ronald J. Daniels, Faculty of Law, University of Toronto and Randall Morck, Faculty of Business, University of Alberta, March 1996

1. Globalization: The Economics Behind the Scenes

No crystal ball is required to predict that, in the coming decades, the Canadian economy will increasingly be subjected to the phenomenon the popular press has labelled "globalization". Some key effects of globalization on Canada are already evident. One of them is that consumers now have greater choice because products from all over the world are available in Canada at affordable prices. Another is that globalization constrains government in new ways. Investors, entrepreneurs and businesses who do not like Canadian government policy are free, as never before, to take their business elsewhere. Globalization has also opened world markets to Canadian businesses while at the same time subjecting many Canadian companies to competition from parts of the world almost unheard of a decade ago. In Canada, the combined effects of globalization have forced a rapid rationalization of the economy, which has disrupted the status quo. People of different ideological persuasions may view these effects in different lights, but there is no longer any doubt that the effects are real.

The purpose of this paper is to examine corporate decision-making in Canada and to clarify the factors that, in the past, have sometimes led to less than optimal corporate governance. In this context, poor corporate governance practices that might have been tolerable even recently are now untenable. Our ultimate goal is to clarify government policy options that are realistic in the new global economic environment and also likely to improve Canadian corporate governance.

In 1930 the Austrian economist, Joseph Schumpeter, proposed that a process he termed "creative destruction" underlies the success of capitalism. Capitalism hugely, some would say obscenely, rewards people who create innovations that improve efficiency or better meet consumer demand. Capitalism also destroys firms, sometimes brutally, that fail in these dimensions. Creative destruction, Schumpeter argues, leads to unmatched improvements in both production efficiency and living standards. Increasingly, mainstream economists are accepting Schumpeter's ideas, and now widely agree that giving free reign to capitalist creativity is more important than avoiding transitory monopoly pricing or other economic distortions.

Over the last several decades, the role of markets has increased steadily in both the industrialized and developing world. In large part, this growth of market importance, and the consequent premium on competitiveness, is related to the global integration of product, capital, and labour markets. The source of this integration has been thoroughly canvassed elsewhere and is mainly the results of reductions in domestic trade-protection barriers, technological innovation, and the liberalization of the command-based economies. The premium on international competitiveness has been felt more acutely in Canada than in other countries, owing to this country's relative openness to foreign competition. Compared to other OECD countries, the Canadian economy exhibits high levels of export dependency and import penetration. Canada's export sector, for instance, constitutes 25.2 percent of the domestic economy — second only to Germany's among the G-7 countries in terms of the importance of export trade to the overall economy. Likewise, in 1970 Canada's import penetration rate was more than five times that of the United States, and was three times the U.S. rate in 1985. Another indication of Canada's dependence on external markets is the high level of foreign direct investment. In 1990 for instance, Canda received 5 percent of the total foreign direct investment inflows to larger industrialized countries, whereas the United States, with an economy roughly 10 times as large, received on 29 percent.

The increasing openness of industrialized economies to the pressures of external markets has spawned a number of different effects. One of the most important is a sharp increase in the pace of innovation. In 1992, 1 87 200 patent applications were filed in the United States, up from 105 300 in 1972 and 68 384 in 1952. There were also 3 107 new product introductions in the United States in 1992, up from 1762 in 1982. When less tangible innovations are included in areas such as human resources management, marketing strategy, etc., the rate of creativity may well be even greater. Continual innovation is expensive, so innovative firms need to be able to reach large numbers of customers quickly in order to earn maximum returns on their creativity. Access to global markets is therefore essential for Canada, and that means granting foreign firms reciprocal access to Canadian markets.

This stepped-up pace of innovation means firms that lag behind can be pushed into obsolescence, and their work forces left high and dry. An innovative new competitor from a remote corner of the world can grab market share with little warning. The bankruptcy rate tracks the downside of this creativity explosion. In 1993 in the United States, 85 982 businesses failed; in 1952 there were 8 862 business failures. Of course, bankruptcy laws and practices have changed over the years, as has the distribution of company failures across industries. Also, the employees of failed companies do not always lose their jobs. Often in bankruptcy, the creditors sell off the assets of the defunct firm as a unit and the buyer retains many or most of the predecessor firm's employees. Nonetheless, this increased pace of bankruptcy has substantial social costs.

In Canada there appears to be a clear national interest in fostering innovation, in encouraging Canadian firms to get ahead and stay ahead, and in cushioning firms that fall behind. Yet, the globalization of the economy constrains government in new ways too.

Traditional government policies based on taxes and subsidies are in disrepute. Government subsidies and tax credits for R&D are perhaps more likely to foster innovative "mining" of the government than true innovation. Government industrial policies that have sought to pick winners and subsidize their growth have seldom succeeded. Even the one previously notable exception, Japan, is now known to be no exception at all. Beason and Weinstein (1994) collected hard data on how much money the Japanese industrial policy directed at whom; and show convincingly that subsidies in the country were directed mainly at losers. The recipients of the biggest subsidies in Japan were weak firms whose collective performance actually declined subsequently. Indeed, taxing winners to subsidize losers, or even potential winners, is particularly unwise in a global economy where individual nations must compete for mobile capital and, especially, for information (etc., people with expertise). Both capital and people can go elsewhere if they are too heavily taxed. In this new environment, taxing winners heavily to cushion losers is likely to lead in short order to a country of losers.

In short, government itself has become a competitive business in the new global economy. In the past, governments were monopolies. Businesses and people who did not like the government of the day could work to change it, but rarely could they simply take there business elsewhere. Today they can, and do. Governments are therefore under pressure themselves to become "competitive". Competitive government is not necessarily small government; rather, it is government that provides services most people and businesses want at tax rates they are willing to pay. Understandably, selective subsidies financed by taxes levied on everyone are seldom seen to fit these categories.

How then is government, robbed of its traditional policy tools, to promote the public interest in this new economic reality? We devote the final study in this volume to a list of viable options. A central thrust of our analysis is that governments should focus on framework policy. That is to say, the state should focus on providing the legal and institutional environment in which markets and firms are able to thrive. As Michael Porter has observed

…[g]overnment's proper role is as a pusher and challenger. There is a vital role for pressure even adversity in the process of creating national competitive advantage … Sound government policy seeks to provide the tools necessary to compete, through active efforts to bolster factor creation, while ensuring a certain discomfort and strong competitive pressure.

In our view, a core feature of an effective framework for competition is the nature and quality of the corporate governance system that obtains in a given country. Here, we refer to the legal and market institutions that make up a country's corporate governance system. Nevertheless, before we begin to think about the precise nature of an optimal corporate governance system, there is great need to sort out where exactly the public interest lies in issues of corporate governance.

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