Thus far this week (see here, here, and here), we have reviewed Adam Smith’s tedious and painstaking reconstruction of the rise and fall of the East India Company. What lessons can we learn from this epic episode in the history of mercantilism? As it happens, two of the next three paragraphs of Smith’s 1784 pamphlet (namely, paragraphs 27 & 29) move from the specific (the East India Co.) to the general: how to align the interests of the East India Company’s “servants and dependants” (i.e. employees) with those of the proprietors” (shareholders). In paragraph 27, Smith writes:

“It might be more agreeable to the company that their own servants and dependants [i.e. the employees of the corporation] should have either the pleasure of wasting or the profit of embezzling whatever surplus might remain after paying the proposed dividend of eight per cent than that it should come into the hands of a set of people with whom those resolutions could scarce fail to set them, in some measure, at variance. The interest of those servants and dependants might so far predominate in the court of proprietors [i.e. the shareholders who have a controlling interest in the corporation] as sometimes to dispose it to support the authors of depredations which had been committed in direct violation of its own authority. With the majority of proprietors, the support even of the authority of their own court might sometimes be a matter of less consequence than the support of those who had set that authority at defiance.” (Smith 1784, p. 73)

Smith thus anticipates what economists today call “the principal-agent problem”: why would the employees of a corporation ever act in the best financial interest of the shareholders? Moreover, Smith explains two paragraphs down (para. 29) why this problem is especially problematic in the case of the East India Company:

“With the right of possessing forts and garrisons in distant and barbarous countries is necessarily connected the right of making peace and war in those countries. The joint stock companies which have had the one right have constantly exercised the other, and have frequently had it expressly conferred upon them. How unjustly, how capriciously, how cruelly they have commonly exercised it, is too well known from recent experience.” (Smith 1784, p. 74)

In other words, the principal-agent problem is not just a matter of dollars and cents, of maximizing shareholder value. It’s a matter of justice. That is why trade should be free and open, not controlled by state-sanctioned mercantile monopolies. Because when a firm like the East India Company acts as both a merchant and a ruler, an even deeper conflict of interest or principal-agent problem emerges, for the agents of the company only care about their own personal gain or, at most, the profits of the company. They do not care at all about the well-being of the local people they rule.

But what about “the regulations of 1773” — i.e. the two major changes in the East India Company’s corporate governance made by Parliament in 1773 that Smith highlights towards the end of his “very long paragraph” (see here)? Alas, Smith tells us in the next paragraph (para. 28) that “[t]he regulations of 1773 … did not put an end to the disorders of the company’s government in India.” (Smith 1784, p. 73) Why not? Because of the general “principal-agent problem” that bedevils joint stock companies with large numbers of shareholders.

Even though the East India Co. had “during a momentary fit of good conduct” amassed “more than three millions sterling” and had access to “a vast accession of some of the richest and most fertile countries in India”, Smith reports that “all was wasted and destroyed”:

“… during a momentary fit of good conduct, they had at one time collected into the treasury of Calcutta more than three millions sterling; notwithstanding that they had afterwards extended, either their dominion, or their depredations, over a vast accession of some of the richest and most fertile countries in India, all was wasted and destroyed. They found themselves altogether unprepared to stop or resist the incursion of Hyder Ali; and, in consequence of those disorders, the company is now (1784) in greater distress than ever; and, in order to prevent immediate bankruptcy, is once more reduced to supplicate the assistance of government.” (Smith 1784, pp. 73-74)

Smith then closes this paragraph (para. 28) on a pessimistic note. After observing that “[d]ifferent plans have been proposed by the different parties in Parliament for the better management of its [the East India Co.’s] affairs,” Smith highlights what all these proposals have in common:

“And all those plans seem to agree in supposing, what was indeed always abundantly evident, that it is altogether unfit to govern its territorial possessions. Even the company itself seems to be convinced of its own incapacity so far, and seems, upon that account, willing to give them up to government.” (Smith 1784, p. 74)

Smith wraps up his scathing indictment of the English East India Company in paragraph 30 of the last part of his 1784 pamphlet. Although paragraph 30 is not as protracted as Smith’s “very long paragraph” (para. 26), it’s still pretty long: it contains over 500 words and 10 sentences — the lengthiest of which consists of 119 words and the second-longest, 82 words). I will turn to Smith’s closing East India Co. paragraph in my next post. (To be continued …)