Contagion and Financial Economics: The Dividend Puzzle as a Case Study
© 2000 by The Institute of Psychology and Markets
Frankfurter, Louisiana State University
Elton G. McGoun, Bucknell University
paper we explore the connection between the theory of thought contagion
and the ways of thinking in financial economics. We argue that financial
economics became what it is today not by coincidence, or a methodically
optimal process in search of some universal truth that is "out there,"
but by an organized campaign to inhibit thinking. We show that much
of financial economic thinking is influenced by the modes in which
this thought control takes place. We use the dividend puzzle, one
of the great enigmas of modern finance, as a case study to demonstrate
the validity of our thesis.
must begin with myths, and with the criticism of myths.
that financial economics became what it is today not by coincidence,
or a methodically optimal process in search of some universal truth
that is "out there," but by an organized campaign to inhibit thinking.
This process of influencing thinking is now formalized in a subfield
of biology referred to as "thought contagion." In the second section
of this paper, we develop the idea of thought contagion, describe
its seven modes, and explain the relation of these modes to financial
of the paper is a case study showing how thought contagion works through
the example of perhaps the greatest riddle of financial economics:
the persistence of firms in paying dividends, often called the dividend
puzzle. Our purpose is not a comprehensive review of the dividend
literature. Rather, we demonstrate what dividends are, how they evolved,
and how thought contagion in financial economics formed the development
of models that explain dividends as an economically rational transfer
of wealth from the firm to the shareholder.
section is a review of the logic of why firms pay dividends. The fourth
section recasts the dividend payment logic in terms of the principles
and nomenclature of the theory of thought contagion. In the fifth
section, we put the dividend phenomenon in evolutionary perspective,
explaining in these terms what dividends really are. Brief
conclusions are offered in the final section.
Theory and Practice
for the Priesthood"
of the idea of thought contagion comes from a relatively new, emerging
subfield of biology called memetics. Lynch  defines memetics
as the study of the processes of "thought contagion":
a software virus in a computer network or a physical virus in a
city, thought contagions proliferate by effectively "programming"
for their own retransmission. Beliefs affect retransmission in so
many ways that they set off a colorful, unplanned growth race among
diverse "epidemics" of ideas. Actively contagious ideas are now
called memes (a word that rhymes with "teams") by students of the
newly emerging science of memetics (p. 2).
meme was coined by Richard Dawkins , who formally recognized
the newly emerging science of thought contagion (TC) in his book,
The Selfish Gene, in which he pointed out the similarities between
biological and cultural contagion (p. 3).
identifies seven modes for retransmitting memes: quantity parental,
efficiency parental, proselytic, preservational, adversative, cognitive,
and motivational. Each of these modes "involves a thought contagional
'carrier,' or host, serving to increase the idea's 'infected' group,
or host population" (p. 3). The first three modes are general in nature.
parental mode is the simple idea that children are influenced
first and foremost in the family (for example, racism is learned first
in the family, unlike a faculty or instinct one is born with). Thus,
the more children of the same parentage, the more the memes are transmitted
parental mode is a safety device to make sure that the memes of
the family are transmitted. A special effort must be made within the
family because quantity alone is no guaranty of continuing influence.
For example, Jews living in the diaspora have for many centuries considered
it to be the greatest of tragedies if their children marry out of
faith. Some take it so far as to sit shiva (the Jewish tradition of
mourning for the dead) for their child if such a marriage takes place.
There is no greater tragedy for a parent than to bury a child; yet
the intermarriage taboo is so strong that parents can consider a living
child to be dead.
proselytic mode, as the name implies, aims to influence society
outside the family by impregnating it with beliefs and values that
are strongly held within the family. Contagion in this mode is far
quicker than that in the family modes, because there is no need to
wait twenty or twenty-five years until a new generation establishes
its own family and transmits its memes to a new set of children. This
mode is very common, and has previously been classified under the
rubric of mass persuasion. Convincing the masses that they are part
of the Pepsi generation, or the more crude form of brainwashing in
the former communist countries, are typical examples of the proselytizing
mode. In many instances, this mode manipulates deeply rooted feelingspatriotism,
for exampleto cover up injustices of society. A prime example
is JFK's famous statement, "Ask not what your country can do for you,
but what you can do for your country."
recent illustration is Ronald Reagan's "window of vulnerability" (a
metaphor that to this day we do not fully understand), which opened
the floodgates of the arms race and justified a $4 trillion increase
in the national debt. Another example is the brilliant slogan, "Support
our troops!" which turned antiwar sentiments around in favor of the
Gulf War by making not supporting the war tantamount to not supporting
the more educated people are, the less effective the first three modes
are as permanent transmitters of memes. This is because the intrafamily
modes lose their grip with higher levels of education, and proselytizing
does not work very well for those who see through the sometimes-crude
sloganeering. For academic communities, however, departments within
universities and schools of thought across groups of universities
perform the same role as families in TC.
and Colander  designed and distributed a survey of thirty-one
questions among the doctoral students of six economics departments
selected out of the top ten according to the ranking by citation by
Davis and Papanek [1984, p. 228]. After analyzing the results, they
conducted intensive interviews with students in four economics departments,
condensing the analysis of the survey and the substance of these interviews
into nine chapters of a monograph.
emerging from their work is astonishing. In general, the overall education
of the new academic cadres is very narrow, and so are their interests
outside economics, mathematics, history, and political science. But
even within the subject of economics, the major fields of interest
are limited to macro- and micro-economics and political economy. Labor,
urban and comparative economics, econometrics, public finance, the
history of thought, and law and economics score 75% to 98% as being
of little or no interest.
revealing is the orthodox indoctrination of students at the University
of Chicago. Fully 97% of the students at Chicago agree either strongly
or moderately that "Neoclassical economics is relevant for the economic
problems of today" (i.e., for making public policy), compared with
76% at Harvard. Also, as students at Chicago are educated over the
four-year term of their studies, they become more rigid and conservative
in their thinking. In contrast, those at MIT, for example, tend to
move in the opposite direction, toward flexibility and liberality.
at Chicago also strongly believe that human behavior, according to
some convention, has no importance; only 31% agree that it might be
important in some areas. This view contrasts with that of students
at MIT, where 18% agree that it is "very important" and 69% agree
that it "is important in some areas." As one fourth-year student at
Chicago succinctly put it, "I feel I have been socialized into the
profession, into its way of thinking" (Klamer and Colander [1990,
p. 28]). Apparently, this "socialization" is the strongest at Chicago.
socialization at school is what the first two modes of TC accomplish
in the family. But it goes beyond that, according to Klamer and Colander.
Consistent with the third mode, the language they acquire becomes
unique and obscure.
graduate school, the rhetoric that people use when they talk about
the economy is organicthe economy is an organism inhabited
by real people who are often involved in a battle between good and
evil: "The US is engaged in a trade war with Japan"; "Investors
panicked on October 19, 1987"; "Consumers lose confidence"; and
"The administration is out of control." Graduate school bans this
organistic, personalistic rhetoric and replaces it with the abstract,
mechanistic, mathematical rhetoric of academic discourse. People
become "optimizers." Trade wars become "exchanges in two-goods,
two-factors-of-production models with constant technology." And
panicky investors become "buyers and sellers who operate under information
constraints in a stochastic environment." In this view of the world,
technological constraints, endowments, and random factors reign.
For many students, learning the academic rhetoric is like learning
a new language. It is painful. ... They are far from sure that they
like the new rhetoric (Klamer and Colander [1990, p. 179]).
Within the Church
sciences, or meta-sciences such as economics, Lynch's other modes
of TC come more into play and are more directly relevant to economic
mode promotes ideas so as to influence their hosts for as long as
possible. It is similar to a church orthodoxy, something that is especially
akin to financial economics. Criticism of the elders of the church
can never be on philosophical grounds, but rather on the grounds of
what the so-called "data" show or do not show. That is why Kuhn's
 ideas of scientific revolutions were accepted with such enthusiasm
by those very few financial economists who cared, to one degree or
another, about the philosophical underpinnings of their trade. He
gave them an explanation of why certain methodologies were anathema
and some hope that there might eventually be some change.
adversative mode sabotages or attacks competing ideas, particularly
those that were not spawned by the ideology or methodology of the
orthodoxy. In financial economics, the sabotage or attack is achieved
through the publication and the promotion/tenure processes, where
editors of the nobility press are de facto gatekeepers, under the
disguise of quality control.1 What is not published
by the leading journals of the field, as in a ukase of a monarch,
is not and cannot be "quality." But nothing that challenges the basic
tenets of the ideology or is not substantiated by data will ever appear
in these publications.
cognitive mode exposes as many non-hosts to the basic ideas as
possible. Its aim is to fulfill the folksy maxim: "If you can't beat
'em, join 'em." The seven or eight dominant paradigms of financial
economics were posited by academics at a handful of schools. The bulk
of the published work of their minions overwhelmingly supports these
hypotheses. Empirical evidence to the contrary is declared an "anomaly,"
and pretending that contradictory findings are only anomalies, of
course, guarantees the longevity of the paradigms. Consequently, the
basic paradigms are rarely abandoned, even when the pile of "anomalies"
in the academic dustbin looms over the supportive empirical evidence.
Yet these empirically questionable paradigms dominate the texts used
by all students of the subject. A prime and revealing example of this
mode is the history of the CAPM (see Frankfurter ).
mode is related to the adversative mode. It inspires one to reap the
economic benefits of joining the host by enhancing one's vita, which
brings about promotion to a higher rank, a move to a better academic
position, and, ultimately, the reward of lucrative consulting assignments.
other four modes of TC are part and parcel of regular academic life
in finance departments. They are institutionalized through the publication
process and through the promotion and tenure process that is very
much dependent on it. Evidence is again anecdotal, but they have become
part of the language. One talks about "major hits" and "minor publications,"
which incidentally have nothing to do with content but with the publication
outlet itself, and "R&R," which stands for revise and resubmit to
a "major" journal.
modes of TC make the ruling belief structure virtually impenetrable.
Although it is possible that, over many years, a new set of beliefs
with its own methodology may evolve, it may take a very long time.
Consider the example of heliocentrism and its history from the ancient
Greeks to this century. In May 1514, Copernicus had written and discreetly
circulated a manuscript, a first outline of the arguments eventually
substantiated in De revolutionibus orbium coelestium (On the Revolutions
of the Heavenly Spheres). This classic work challenged the geocentric
cosmology that had been the dogma from the time of Aristotle.
opposition to Aristotle and the second-century astronomer Ptolemy,
who enunciated the details of the geocentric system based on celestial
phenomena, came Copernicus. Copernicus proposed that a rotating earth
revolving with the other planets about a stationary central sun could
account in a simpler way for the same observed phenomena of the daily
rotation of the heavens, the annual movement of the sun through the
ecliptic, and the periodic retrograde motion of the planets.
new theory of the heavens was actually not new at all. It was anticipated
in various aspects first by the Pythagoreans and Aristarchus of Samos
(with whom Copernicus was familiar), and by the Muslim astronomer
Ibn el-Shatir and certain Christian writers of the Middle Ages. It
was not until the second half of the twentieth century, however, that
the Catholic church officially accepted heliocentrism and rejected
as this example of heliocentrism is of how TC works, it is perhaps
misleading in that it suggests that, sooner or later (and, in the
case of helio-centrism, much, much later), truth will win out. The
concept of TC becomes especially useful in disciplines such as financial
economics where, unlike the natural sciences, there is far less likelihood
of some sort of transcendental truth "out there" to be discovered.
When truth is a matter of convention and more akin to ideology than
to physical law, how such ideologies originate, mutate, and propagate
is of considerable interest. In fact, the absence of any sort of externally
verifiable truthdespite the fiction within financial economics that
there is such a thing and that there are empirical methods by which
it can be revealedcan make ideologies quite durable.
that underlies economics, financial or otherwise, is very difficult
to replace because its failures to explain and to dictate social policy
cannot be measured with accurate instruments, as can the speed of
light, the color of stars, or the wavelength of radio signals. Accordingly,
the modes of TC ensure that a Kuhnian revolution is very unlikely
because they nip in the bud all attempts at such a revolution.
well does TC in financial economics really "work" in practice? A direct
answer is almost impossible, but a case study may elucidate some of
the ways in which it has a strong influence within the discipline.
For this paper, we have chosen to consider dividend policy, which,
despite five decades of intensive study, remains one of the most prominent
unsolved puzzles of finance. And it may be that this failure is a
result of TC, which has prevented thinking from taking more potentially
fruitful directions toward a solution.
that we are using the dividend puzzle to illustrate the applicability
of thought contagion to the methodology and methods of financial economics.
Our concern is with how dividends have been studied and not with dividends
themselves. Therefore, our explanation of the theories of dividends
is brief, only long enough to support our contention that thought
contagion can explain how we have gone about solving this and all
other puzzles in financial economics.
Firms Pay Dividends
makes the analysis of memes in financial economics especially difficult
is that even for a single issue such as dividends and dividend policy,
there are a number of different "sites" that memes target. In the
case of dividends, the obvious site targeted by successive memes is
the question of why firms pay dividends. And how the answers to this
questionthat is, the memeshave changed over time is a
familiar tale to most financial economists.
are taxable distributions of after-tax, past, and present income of
firms, in the form of a real asset to current shareholders, in proportion
to their ownership.2 Most firms tend to follow a pattern
of stable or slightly increasing dividend payments, even in the face
of weak current income. This, of course, means paying out a higher
proportion of earnings, or borrowing cash for maintaining their dividend
pattern. When earnings are higher than expected, higher dividends
will be paid only when management is convinced that the higher level
of dividends is sustainable in the future. Lintner , who observed
this behavior first, is perhaps the most famous (and possibly only)
example of grounded field research in finance (Bettner et al. ).
"dividend puzzle" (Black ; Bernstein ) deals with the
double-edged enigma of why individuals like dividends and why this
method of income distribution persists in light of quite burdensome
double taxation (Crockett and Friend ). If earnings are retained
in the corporation, personal income taxes on those earnings are deferred
for shareholders. If earnings are distributed in the form of share
repurchases rather than dividends, personal income taxes are deferred
for those shareholders who do not tender their shares, and are assessed
at the lower capital gains rate that prevailed during most of the
last four decades for shareholders in need of the liquidity (Modigliani
explanation for the dividend puzzle was that for some shareholders,
whose personal tax liability was insignificant, there was little or
no double taxation and therefore no cost to be offset. If this is
so, corporations should have shareholder clienteles whose personal
tax positions match the corporations' dividend policiesâ€¹separating
themselves into ownership classes of high-, low-, or no-dividend-paying
firms according to their marginal tax brackets. There is mixed information
concerning such clienteles (Blume et al. ; Blume and Friend
recent explanations, based on asymmetricity of information flows,
claim to have found the economic rationale for dividend payments.
One explanation is based on the reasonable assumption that managers
know more about the prospects of the firm than outsiders (Bhattacharya
). If the prospects are favorable, managers want to alert the
investment community (albeit without divulging proprietary competitive
information) in order to raise the corporation's stock price, thereby
raising the value of their own shareholdings and enhancing their managerial
reputations. These models assume that false informationi.e.,
signaling better prospects through increases of dividend payments
when, in fact, no such prospects are anticipatedare "punished"
severely by the know-all, see-all markets.
to this tale, the dividend increase becomes a reliable signal of higher
future earnings. The markets, in turn, properly impound this signal
into the price of the stock, thereby offsetting the dissipative tax
liability with a higher share value. Managers who increase dividends
without the prospect of higher future earnings would pay for their
deception later when the implied earnings did not materialize.
however, has noted that the double taxation of dividends is quite
expensive and that there are less expensive ways to affirm the veracity
of announcements of favorable prospects (Crockett and Friend ).
Another concern regarding this meme, which does not receive much attention
in the literature, is that managers are aware that dividend decisions
are subject to interpretation by the investment community, but they
do not agree on this interpretation (Crockett and Friend ).
That is, there is no verification that the "signal" is unequivocally
understood by both the signalee and the signaler, and there is no
testamentary evidence that an important reason for increases in dividend
payments is the deliberate decision to signal.
these models, too numerous to mention, suffer from a lack of possibility
of accurately measuring, or even confidently proxying for, their key
variables. Thus, they fail at the outset the Friedmanian requirement
for "reasonably good" predictive ability, or Popper's precondition
of verifiability, which deems such models ad hoc.3
variant of the asymmetric information explanation is based on the
firm's executives' (agents') intention of self-interestedly managing
the corporation for their own benefit, rather than for the benefit
of its shareholders (owners) (Easterbrook ). Managers tend to
want to undertake projects with safe but insufficient returns in order
to protect their positions and perquisites, rather than riskier projects
that could generate higher returns for the shareholders. In this scenario,
the shareholders' interest is to force firms to pay out all the income
as dividends so that managers are compelled to face the discipline
of the market in their procurement of investment funds and are not
able to acquire them virtually unnoticed and largely unchecked in
the form of retained earnings.
brief summary of the dividend fables appears to tell us many things.
Lintner  noted that many firms follow a similar dividend policy,
and subsequent researchers have attempted to explain why. The whole
process certainly looks to be consistent with Popper's  prescription
of conjecture and refutation as the correct path of scientific progress.
It does not seem to have anything to do with memes, which, as we have
argued, have more to do with intellectual fashion than with scientific
truth. But telling the tale a bit differently (putting it in a larger
context of methodological trends in finance), the memetic nature of
the process becomes much clearer.
to Explain Why Firms Pay Dividends
grounded field research into dividend policy was one of the last gasps
of a qualitative approach to finance, which sought to discover what
it was that finance practitioners actually did by observing them and
then perhaps to extract from these observations (especially observations
of the more successful practitioners) normative prescriptions as to
how they might do it better. It was a last gasp in that seeds for
a more technical quantitative approach to finance and for its philosophical
justification had recently been planted by Markowitz , Friedman
, and Modigliani and Miller . More precisely, Markowitz,
Friedman, and Modigliani and Miller were the agents by which memes
were introduced into finance from economics.4
work of Markowitz and Modigliani and Miller was actually the tail
end of a much larger process of meme transmission in which emigre
mathematicians and physicists had introduced apparently rigorous quantitative
methods into economics in the 1930s and 1940s (McGoun ). Friedman's
"contribution" was the resuscitation of the positivist/instrumentalist
philosophy (which had been dying in the philosophy of science), which
found a new life in economics. Instrumentalism was then infused with
the ideology of the radical individualism of Adam Smith as interpreted
and modified by Friedman.5
the beginning, the search for answers to why firms pay dividends was
less a dispassionate quest for scientific explanations for Lintner's
observations than the necessary outcome of methodological memes that
dictated a new approach to finance to supplant that of Lintner. Ironically,
however, Miller and Modigliani  were the first who pointed out
the irrelevance of dividends under conditions of no taxes. And although
rejecting the notion that, ceteris paribus, dividend-paying firms
should sell for a higher price than non-dividend-paying firms, Miller
and Modigliani argued that, if that were true, it would point to a
systematic irrationality of the marketplace.
method, or methods, of TC caused this to happen? Within finance, Markowitz
would not have had anything to gain from the introduction of a complicated
and at that time decidedly suspect meme (Bernstein ). Within
economics, where philosophy was not then and is not now an important
concern, Friedman would not have had anything to gain from the introduction
of a quite unfashionable meme, other than the dissemination of his
own ideological beliefs (eventually to rule all economic thinking).
How, then, did the contagion spread so rapidly?
likely it was a combination of two modes. Within operations management
and the philosophy of science, the proselytic mode was operating,
in which the purpose is to dominate society outside the family by
impregnating it with beliefs and values that are strongly held within
the family. Markowitz's methods were indeed in healthy ascendency
in operations management, but in the philosophy of science Friedman's
instrumentalism was actually waning and needed fertile ground elsewhere
in order to survive. This explains the "push" of the meme, but what
about the "pull," bearing in mind that disciplines are clearly resistant
to infection by foreign memes?
it may sound somewhat strange, the motivational mode probably played
an important role. At the time, finance and economics were already
undergoing change and were searching for intellectual respectability.
The exacting formulation and methods of Markowitz and of Modigliani
and Miller provided the sophisticated modernity; Friedman's philosophy
provided the intellectual respectability demanded by finance and economics
departments so that they could hold their heads high among the other
university departments. Although the memes may not have initially
offered much competitive advantage within the fields, they promised
vast competitive advantage within the larger academic community and
were eagerly seized upon.
of Markowitz's, Modigliani and Miller's, and Friedman's memes transformed
the world-view of finance in several ways. Because this world-view
had become quite quantitative, everything had to be calculable and
measurable. Those who made dividend decisions within corporations
did so on the basis of rational calculations, and their actions were
best assessed through the statistical analysis of aggregate market
data. Because the worldview was now positivist, everything was as
it ought to be, and the proper test of an explanation for why corporations
paid dividends was whether corporations in fact paid dividends for
that reason. There was no room for any normative considerations of
how they might do it better, because inefficient dividend policies
must have already been killed off by the natural selection of the
competitive market, a rather Darwinian view.
all the explanations of why corporations pay dividends had to fit
the mold of a cost benefit calculation; that is, double taxation was
a palpable cost, so for dividends to be paid, there must be some larger,
more than offsetting, benefit. Actually, the first explanation, the
clientele theory, did not propose a benefit to offset the cost; rather,
it argued that, for certain investors, there was no cost.
modern explanations for dividends are variations of the information
theory, signaling theory, and agency theory memes that have infected
all parts of finance, at first perhaps via the cognitive mode. These
newer memes all wrap rather simple ideas in the essential quantitative/positivist
garb of their ancestor memes. Information theory simply identifies
who knows what and what matters. Signaling theory implies that someone
may want to subtly let someone else know what they know. And agency
theory conjectures that someone may know something more than someone
else and use it to his or her own benefit ("me-first" rules) and to
the other's detriment. Of course, none of these phenomena will come
as a surprise to anyone, even those whose education has not been so
comprehensive as to include these theories. But without their fashionable
raiments, no one would recognize them as worthy of concern.
has happened in all these so-called theories (which are, in fact,
memes) is that human interactions have been commodified, all exchanges
are undertaken as the result of rational cost benefit calculations,
and all explanations of why firms pay dividends that are not cast
in these terms are proscribed. There is no mystery concerning the
TC of information theory, signaling theory, and agency theory, for
by now all seven of the modes of transmission have come into play
in order to ensure their perpetuation. And even if their influence
should begin to wane, because novelty is a staple of academic life
(after all, doctoral dissertations must make an original contribution
to knowledge), their successors will be virtually indistinguishable
in all essential attributes.
tales of why firms pay dividends, why shareholders like it, and why
the market "rewards" dividend-paying firms are not really honest attempts
in the saga of a Popperian search for truth, but the history of a
disease resulting from the infection of finance by methodological
memes. What matters is not whether an explanation has any real value
from the standpoint of knowledge and understanding, but whether it
is consistent with current intellectual fashion. Methodological memes,
however, are not the only memes at work with regard to dividends.
The concept of value itself, of which dividend policy is a component,
has been shaped by a number of memes over the course of modern history.
it is as if we take the notion of value for granted. It seems obvious
that the value of a corporation is in (or comes from) the cash flows
it generates, and we pay a price for shares in the corporation now
in order to receive the benefits of these cash flows in the future.
Either we receive these cash flows directly in the form of dividends,
or indirectly by selling our shares and receiving from someone else
the discounted value of the dividends. When a corporation retains
and reinvests its earnings rather than paying them out as current
dividends, we believe that these reinvested earnings will eventually
reappear as greater future dividends.
has not always been what investors have been buying when they bought
the shares of a firm. There has been yet another set of memes at work
in finance that have concerned the basis of value, and these have
influenced the question of why firms pay dividends for a far longer
time than the methodological memes discussed in the preceding section.
the turn of the century, the function of dividends in the United States
and Great Britain was to make equity look like debt.6 With
debt's contractually specified payments, one could easily compute
its value, and, as much as possible with any risky venture, debtholders
could depend on receiving a return on their investment. Being a residual
claim on the corporation entitled to no guaranteed periodic cash flows,
it was much more difficult for investors to compute the value of equity,
as it still is. Before accounting standards and external audits, reported
retained earnings were unreliable evidence that shareholders were
receiving any return on their investment.7
the nineteenth-century transportation and industrial expansion, during
which considerable external financing in the form of both debt and
equity was required, was the era of the so-called "robber barons,"
and investors were justifiably skeptical of the entrepreneurial promoters/owners/managers
of a corporation in which they were solicited to invest. There were
numerous examples of fraud by such owners, and an investor had to
wonder why wealthy entrepreneurs would raise external funds for a
promising venture rather than relying on their own funds and those
of their friends.
originally, were not a signal that prospects for future income were
favorable, as in "signaling theory," but that current income was,
indeed, there. Earnings from which to pay dividends were considered
the sole source of value underlying common stock. There was no concern
with the ownership of the firm's income-producing assets, or for the
potential to accumulate future cash flows from undistributed income.
Dividends were used the same way as interest was used to value debt,
with the par value of equity substituting for the face value of debt
(Ripley ). There was strong pressure on managers by shareholders
to pay hefty dividends. For example, to their future detriment, railroads
often deferred essential maintenance in order to pay dividends (Cleveland
and Powell ).
accounting standards circumscribed the ability of managers to manipulate
their accounts, it was not uncommon to decide how much of a dividend
should be paid and then make the necessary adjustments (in depreciation,
for example) to ensure that the right amount of earnings were available
(Withers ), or even to use "creative" accounting to make earnings
appear out of thin air (Dewing [1921a]). Investors were not concerned
that agents would invest retained earnings in insufficiently risky
investments, as in "agency theory," but that they would be invested
in too-risky investments or misappropriated and not invested at all.
were even paid out when there were no earnings. Some railroads under
construction paid dividends out of their capital (Morgan and Thomas
). This would have presented even more of a puzzle for finance
theory than double taxation presents for it today. But it is not so
puzzling if we recognize that dividends were seen as an indication
of the trustworthiness of management and as evidence of a sound investment.
Of course, promoters and managers did not fail to take advantage of
this perceptionattractive dividends made for an active secondary
market in a corporation's shares. The original shareholders could
sell out very profitably and/or the corporation could raise additional
capital on favorable terms (Dewing ).
not hard to see how, under these conditions, the pattern of no-dividend
reductions would arise. For most investors, dividends were the sole
tangible evidence of the value of their investment. In fact, a concern
for steady dividends was supposed to differentiate an investor from
a speculator (Lyon ; Dewing [1921b]). A dividend reduction,
even by a rapidly growing company, would have been interpreted as
a suspicious impairment of value. A finance text from the 1920s recommends
in no uncertain terms the dividend behavior we still observe today:
principle of greatest importance is that regularity in the dividend
rate is highly desirable.... This rate of dividends in a really
stable and conservatively managed corporation never varies except
when it is increased. And it is not increased until after the directors
have assured themselves that in all human probability a later decrease
will not become necessary. There is a much stronger demand for these
shares than for those which are paying irregular dividends. It is
coming to be more and more widely recognized by bankers, investors,
and the public at large, that the ability of a company to maintain
regular rates is a better test of its soundness than is its ability
to pay high but irregular dividends (Lough [1922, p. 440]).
the value of a corporation came from its current dividend, and that
was the reason dividends were paid. Without the dividend, there was
no value. As long as this meme concerning value was dominant, there
was certainly no dividend puzzle.
subsequently, in the 1920s stock prices began to become detached from
dividends and seemed to have nothing to do with yield. At this point,
value was thought to reside in the assets of the corporation; that
is, when you bought shares, you bought a physical piece of the corporation,
and as long as those assets were there, the value was there. We suspect
that if anyone thought about dividends at all during this time, they
were considered something of an anachronism.
returned again to dividends, albeit briefly, after the stock market
crash of 1929. But then it began to shift to cash flows, perhaps under
the influence of rising stock prices and greater faith in accounting
standards or the blue sky laws. This is the origin of the dividend
puzzle. Today, we also see the value of a corporation residing in
its ability to control cash flows, and not just in the cash flows
themselves, as in the ascendance of the so-called "market for corporate
might be another source of value, however, even newer than what we
have mentioned so far. Stocks became a storage of value (primarily
for retirement funds) as a result of social convention, much the same
as paper money. In fact, one of the reasons that the October 1997
"stock market crash that never was" never was, was because panicking
investors could not liquidate in a few days their 401K or 403B investment
portfolios. Miraculously, the market recovered!
latter meme seems to be emerging in the business press, but has not
made it yet to the academic press. It probably will not surface until
it can be forced into the straightjacket of the existing methodological
Black , who originally drew attention to the "dividend puzzle,"
had this to say in an editorial in the Financial Analysts Journal
do firms pay dividends? I think investors simply like dividends.
They believe that dividends enhance stock value (given the firm's
prospects), and they regard dividends as a more ready source of
wealth (p. 5).
in the same editorial:
if investors were neutral toward dividends? Investment advisers
would tell clients to spend indifferently from income or capital
gains and, if taxable, to avoid income. Financial analysts would
ignore dividends in valuing stock. Economists would treat stock
prices and the discounted value of dividends as equal, even when
stocks are mispriced. A firm would apologize to its taxable investors
when forced by an accumulated earnings tax to pay dividends (p.
is quite a different view from the time when Black discovered the
puzzle. Of course, in 1976, Black was still an academic following
the party line. By 1990, he was a senior partner at Goldman Sachs
Asset Management, and, as such, he dealt day in and day out with reality.
Also, the fairy-tale explanation of signaling with dividends, or Jensen's
 free cash flow hypothesis,8 would have been ridiculed
by most of the clients of Goldman Sachs. In fact, Black  does
not miss a beat to ridicule the latter.
are still on the top of the list of many investment advisers, and
generally misunderstood by shareholders and managers alike. In his
1995 "Letter from the Chairman," Michael Eisner, Disney's CEO, had
this to say:
years ago I took, and since then I have taken and retaken again, a
crash course in financial management from Gary Wilson and Sid Bass.
I learned and reviewed every year the following:
management (meaning me and our senior executives) must use excess
cash flow in at least one of four different ways...
invest that cash in extensions of our current business...
repurchase our own shares from time to time when market conditions
seem appropriate. Disney has done that effectively over the years.
can distribute excess cash by paying out a large one-time-only dividend
to our shareholders in addition to our regularly scheduled dividends
that have grown 20% per year. This we have not done because our shareholders
have expressed the desire that we use the company and its assets to
gain higher return on cash than individuals can ordinarily achieve.
we can make an acquisition ...
Whatever the crash course Mr. Eisner took in financial management
might have been, it was not directed to the basic understanding of
the difference between shoveling out cash at a clip of 20% growth
per year and meeting the shareholders' desire to reinvest in the company
because of the spectacular returns of Disney. And if Mr. Eisner and
his tutors had difficulties understanding the similarities between
dividends and share repurchases, and the difference between investing
in profitable opportunities and partial liquidation of the firm, then
what can one expect from ordinary shareholders? The myth of dividends
is still a myth out there. Only education can change investors' attitudes.
This is not happening, and will not happen in the near future, in
spite of Black's  prophesy, "Dividends that remain taxable will
gradually vanish." The TC in academia will make sure that the dividend
puzzle remains a puzzle. This is because the modes of TC are so strong
as to provide an impenetrable phalanx of antibodies, the better to
withstand any possible infection from alternative memes.
1. Robert Merton (pÃ¨re) referred to the academic publication process
as "organized skepticism." It might be that in a cognitive sense.
It is hardly that normatively.
2. This definition separates dividends from stock dividends and stock
splits (because they are not in the form of a real asset), share repurchases
and greenmail (because they are not in proportion to ownership), and
from other means of income distribution.
3. Ad hoc models, according to Popper and common sense, cannot contribute
to the growth of scientific knowledge, because they cannot be falsified.
4. Soon thereafter finance started to be referred to customarily as
5. For a detailed documentation of how Adam Smith's philosophy was
reinterpreted by Friedman, see Collison and Frankfurter .
6. Much of the discussion in this section was inspired by Baskin .
Readers interested in the historical development of dividends should
consult this paper.
7. In that era of corporate secrecy, some corporations reported no
financial information other than their capitalization and dividend
record (Hawkins ).
8. According to this phantasmagoria, shareholders should siphon off
"free cash" through dividends from the managers of the firm, who would
otherwise squander it by flagrant spending on perquisites.
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