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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Some investment managers go further, attempting to recruit the interest of corporate raiders in companies in which they have investedSome investment managers go further, attempting to recruit the interest of corporate raiders in companies in which they have invested. It is not that fund managers are particularly greedy. Many are salaried and do not share in profits they make for clients. But they have the same mindset that measures everything in terms of return on investment. Even the most secure and enlightened managers reinforce this mindset. CalPERS, the largest fund manager and one of the most socially conscious, in its Domestic Proxy Voting Guidelines and in meetings with corporate managements, pays lip service to social concerns but makes clear that it does not recognize corporate responsibility to any group other than shareholders. It is this mindset that leads to corporate restructuring, the assumption of heavy debt, the reduction of R&D, the sale of divisions whose selling price exceeds a threshold multiple of cash flow, the termination of “redundant” employees, the adoption of golden parachutes for top management (which heightens any sense of unfairness). More can be said. The highest-paid people in the country are the experts in corporate restructuring. These experts purchase public companies at a premium to the market with funds borrowed from broker-dealers or banks. They play the role of corporate surgeons (butchers?) and do everything possible to reduce overhead, buttress short-term profitability and cash flow, and pay down some of the debt to enhance the attractiveness of the repackaged company to investors. Once the restructuring has been completed, a new IPO (initial public offering) offers the eviscerated remains back to the public, proceeds going to pay down additional debt and reward those who structured the deal, to the tune of as much as hundreds of millions of dollars. It is not coincidence that an MBA is worth far more than any other Masters (or Doctorate) degree, or that a short-term arbitrage mentality has diffused through the corporate psyche. Because investors “own” the company and because the jobs of the most important investors, the fund managers, depend on short-term results, the priorities of corporations increasingly reflect the priorities of their owners and the preeminence of the short term. Aware of the potential danger to their own jobs, should their stock price decline to the point that their company becomes an acquisition target, corporate managers are sensitized to their stock price. Even in the absence of any immediate threat, they take steps to enhance short-term profitability. Because “lean and mean” sounds impressive and also encourages cutting expenses to spur immediate profitability, many upper level executives aspire to such a management style. Despite the catchy slogan, making a company leaner and meaner doesn’t necessarily make it more efficient. The Wall Street Journal (July 7, 1995), in a survey of large corporations that had downsized between 1989 and 1994, reported that only half of them had achieved an increase in operating profits and only onethird had experienced improved productivity (despite a general increase in both corporate profitability and productivity), but that 86% had suffered a decline in employee morale. They may have been leaner and they may have been meaner, but they were hardly more productive. For one thing, morale can affect productivity. In addition, revenues often decline in tandem with expenses. Contrast this to the strategy of Continental Airlines. Facing the danger of their third bankruptcy in three decades, they did not follow the standard formula. They chose a pilot, not an accountant, to be CEO. Instead of reducing expenses by cutting employment, they instituted incentive pay, which raised compensation 25% over four years. Better employee morale reduced turnover 45%. On-the-job injuries and workers’ compensation dropped more than 50%. Lost baggage claims and on-time service improved from near the worst in the industry to near the best. Having lost money for 10 consecutive years, the company became profitable. Despite such evidence, announcements of layoffs are greeted with enthusiasm by the market, which quickly calculates the expected increase in profitability that should follow from reduced employee compensation. The popularity of these easy, but often ineffective, restructuring measures with corporate management stems from the widely accepted view that the market is always right. Top management’s owning stock options and being rewarded by higher prices also encourages playing to the market. The perception of the market, whether or not it is accurate, drives many business decisions of corporate America. The exaggerated significance of short-term market perception contributes to the proclivity of our corporations to select financial engineers as top managers. Companies founded by real engineers, inventors, entrepreneurs have seen control pass to a different breed. Two thirds of America’s CEOs are lawyers, accountants, or advertising executives. By contrast, two thirds of Japan’s CEOs are scientists or engineers. Japanese companies are often willing to sustain losses for years to enter new sectors or gain long-term advantages in their present markets. Toyota introduced robotics into its automobile assembly plants long before such an introduction could be justified in terms of return on investment. Nissan announced that it did not expect to make a profit for five years on its Infiniti. It would be difficult for such a company to survive intact in this country, to resist pressure to maximize short-term profits. It would be an inviting target for corporate raiders seeking to sell the unprofitable parts of the business and milk the profit centers. This is not to deny the propriety — in select cases — of corporate raiding and restructuring. In the 1980s Hanson Industries compiled an impressive track record by targeting companies that were undervalued because they were poorly managed. Hanson engineered unfriendly takeovers, buying these companies at a premium to the market. It then sold parts of these companies for as much as or more than it paid for the entire company — and made record profits with what was left. Such situations, however, are rare. Most takeover targets had not been badly managed, but had generated returns on equity above the corporate average before being acquired. On average, they did not perform as well under their post-acquisition management. Were the Hansen experience common, that would question the competence of American top management, which is very highly compensated. The average American CEO makes more than 400 times the compensation of the average worker, up more than ten-fold since the early 1980s. By contrast, in Japan and Europe top management typically makes from 10 to 25 times the compensation of the average worker. We justify our generosity in compensating top management on the free market grounds that such incentive produces the highest quality management. Again, the free market paradigm is misleading. We have talked ourselves into the dubious view that without limits, the higher the compensation, the greater the incentive, the better the quality. To the contrary, there is little to suggest that American managers, whose rewards are attached to the job title, rather than performance, are more capable than their European or Asian counterparts. An article in The Wall Street Journal (March 17, 1995) reported that the CEO of Eastman Kodak received $1.7 million in bonuses, despite Kodak’s profits falling short of their target. Remarkably, such treatment, lavish reward — incomprehensible to mortal sensibilities — for disappointing performance is not exceptional but has become commonplace. In the final installment of a series of articles looking at the downsizing of U.S. corporations, The New York Times (March 9, 1996) wrote: Often cited is Robert E. Allen, chief executive officer of AT&T. Since 1986, AT&T has cut its work force by 125,000 people, but Mr. Allen’s salary and bonus have increased fourfold, to $3.3 million. His salary and bonus was trimmed by $200,000 last year, but he was also awarded options worth $9.7 million.… AT&T’s board says Mr. Allen is the best man to lead AT&T in the new era of deregulated telecommunication. But his critics point out that he also headed AT&T in 1990, when it bought the big computer company NCR for $7.5 billion. The NCR acquisition, AT&T eventually conceded, was all but a complete failure. This generosity was not an aberration. In 2000 the shares of AT&T fell 70%, largely due to its mis-investment in cable. The company built up AT&T Broadband by spending $100 billion, much of it to acquire MediaOne Group and Tele-Communications Inc. But AT&T was unable to generate satisfactory returns and is now looking to sell AT&T Broadband. It may lose tens of billions of dollars. Whether its failure was with strategy or implementation, responsibility rests with the chairman of the board. Yet in 2000 his compensation was increased sharply, to $27 million. AT&T’s spin-off, Lucent Technologies, fared even worse. It made the disastrous mistake of granting credit to marginal companies so they could purchase Lucent products. In the short term, this made Lucent look good, bolstering revenues and profits. But when the marginal companies defaulted, Lucent was left with staggering losses. The company cut 70% of its employees. It even had to sell its Hamilton Farm Golf Club, on which it had spent $45 million to provide a private golf course for its top officers. Its share value declined 99%. For his work in engineering this disaster, its CEO received a severance package of $12.5 million plus an annual pension of $870,000. Even this is small potatoes compared with Qwest. “Qwest CEO Joe Nacchio took BellSouth to task for reportedly selling its Qwest stock. Nacchio warned BellSouth that if it continues to dump, he’ll move into BellSouth’s region with telecommunications services. Isn’t this a little like Gary Condit chiding Bill Clinton for fondling the interns? Didn’t Joe bag close to $100 million last year for dumping his Qwest shares? And isn’t he scoring a similarly decadent sum this year, despite the plummeting value of Qwest?” (Al Lewis, Denver Post, August 12, 2001.) Qwest stock lost 60% of its value in the 18 months prior to this article (and an additional 90% since). Then there is Liberty Digital. In the first half of 2001 the company lost $89 million. Its stock declined 95%, yet it rewarded its CEO with $140 million in stock and cash. And even this pales in comparison with the $1 billion in stock options Computer Associates had attempted to provide to its top three executives. While the bonus recently given to the CEO of Raytheon was a miserly $900,000, it came after a quarter in which the company lost $181 million and a year in which its stock price plummeted more than 70%. One could go on and on. These examples illustrate the irrelevance of the performance of our top executives to their compensation. They are supported by surveys showing that most large corporations do not recognize, or even try to assess, differences between excellence and mediocrity in their top-level managers. This makes it is clear that the astronomic compensation offered to American CEOs is not a function of objective measures of their actual performance. It is not even a function of their track record. A front page Wall Street Journal article (March 31, 1995) entitled “Failure Doesn’t Always Damage the Careers of Top Executives,” focused on individuals who became CEOs of major corporations despite previous failures in that, or a similar, position. A more biting article in Financial World (March 28, 1995) began, “Are you indecisive, stubborn? Do you have lots of friends in high places to shield you from your blunders? Then you could be the next CEO of ...” We claim to pay CEOs so much more than our trading partners do because this pay scale attracts the best talent. But our rewarding top management independent of objective measures of their previous track record or their present performance belies this claim. Given that extraordinary benefits are attached to the position of CEO, rather than to performance in that position, and given the overly collegial means of choosing and rewarding CEOs, there is little wonder that American corporations have failed to blow away the competition. It may be valuable to reflect how such a critical aspect of industry has evaded the discipline of the free market. It epitomizes a slogan coined by John Kenneth Galbraith: “Socialism for the rich; free enterprise for the poor.” Trade Trade issues present an important, if controversial, interface between economics and politics. While economists agree that trade is beneficial, increasing the quantity and variety of goods available, the devil is in the details. How much trade is ideal? Here, too, laissez faire gets it wrong. At the extreme of zero trade, everyone would produce everything he consumes. But it makes little sense for Alaskans to grow citrus fruits and coffee when they could buy such products in exchange for their oil, fish and minerals. No serious economists have recommended autarky. At the other extreme, laissez faire recommends that the division of labor be extended to countries: each country should restrict its output to only those items it produces with the greatest relative efficiency and should trade for everything else. Economists argue: (i) because of economies of scale, each country’s specializing in a narrow range of products and trading those for other products will provide the greatest quantity of goods, and/or (ii) one can maximize total production if each country will concentrate on those products it can produce with the greatest relative efficiency. These arguments sound impressive — until you consider the real world. On one hand, modern technology has done much to reduce economies of scale, and the business community is reveling in its discovery of the value of smaller size and greater flexibility. On the other, it is doubtful that there are substantial inherent long-term differences in relative efficiencies. Nor do actual patterns of trade fit this picture of specialization. Most trade takes place among developed countries, and between any two countries much occurs in items they both produce. Electric machinery and parts, vehicles, and office and data processing machines are three of our four largest categories merchandise exports. They are also three of our four largest categories of merchandise imports. More important, arguments for specialization, flawed as they may be, appear best against a static and sheltered background. These arguments are even less attractive in a dynamic environment, one in which industries come into existence, thrive, mature, and are made obsolete and replaced by newer technologies or tastes. For one thing, specialization increases risk, and not just from technological obsolescence. As developing countries have discovered, painfully, specializing in any single agricultural commodity subjects one’s economy to enormous and unpredictable boom-bust cycles. A more diversified economic base makes a country less susceptible to such shocks. In addition, there is often synergy among different industries. Advances in robotics have improved productivity in the auto industry. Complementing this, the auto industry has stimulated and funded advances in robotics. The relegation of industries to different countries on the basis of initial efficiency would abort cross-fertilization. Problems with free trade would not surprise a historian. Free trade has never been universally beneficial, but has always had its winners and losers. Certain products have been profitable while others have been marginal. In Ricardo’s day, England sold finished textiles and industrial goods to Portugal in return for low-margined wine. This was clearly good for England, but hardly of mutual benefit. This explains the popularity of mercantilism. For centuries, powerful countries struggled to dominate the most profitable sectors. They even fought wars to establish and maintain their dominance. If free trade were good for everyone, it would not have been necessary to fight. The mercantilists were not stupid. This also explains why it was Ricardo, the Englishman, rather than a Portuguese, who extolled the benefit of free trade. The one-sidedness of free trade was well appreciated by William Pitt the Younger in his remarks to Parliament about the Eden Treaty. This treaty, signed by England and France in 1786, reduced tariffs and other obstacles to trade. It was a major step in the direction of free trade between the two countries. After its signing, Pitt proclaimed the treaty was “…true revenge for the peace treaty of Versailles” that had been signed three years earlier to end the American Revolutionary War. (The French renounced the Eden Treaty in 1793.) It is not just that free trade has historically benefited strong countries at the expense of weaker ones. Even now, free trade increases economic disparity. It prevents less advanced countries from developing high-margined modern industry. Without protection, domestic industries that need to progress along the learning curve cannot survive competition with foreign imports. Independently, free trade encourages corporations to reduce expenses by locating facilities in low-wage, low-tax, low-regulation countries. This redistributes income upwards from the working middle class to the rich large shareholders. In our present economic environment, characterized by excessive disparity between the rich and the rest, this may be the most dangerous aspect of free trade. FREE TRADE VS. MERCANTILISM A laissez faire system would be hard pressed to compete with an economy run according to mercantilist principles. By holding selling prices at a point such that other countries could not justify capital investment in a sector, a predatory country could eventually dominate that sector. Our strict adherence to the free market and the constraints imposed by short-term profitability have contributed to the erosion of our technological leadership and market share in industries targeted by our competitors. Many examples fit a common pattern, sketched in Adam Smith’s The Roaring 80s: Japan has a network of networks. There is not only MITI, there is the Industrial Structure Council, the Telecommunications Council, and similar councils, all of which study key industries. The councils have leaders not just from business and government but from consumer groups, labor unions, the press, and universities.… The result is to socialize the risk, to take it from the individual firm and spread it, which makes it easier to have long-term goals. The long-term goal can be to have a dominant position in an industry. One example cited frequently is supercomputers. The American side of the story is a familiar one, the genius inventor and the better mousetrap. In this case the genius inventor is Seymour Cray, who left Control Data to start his own firm in the 1970s. No one else could come close to the Cray machines for speed and price, and with no Japanese supercomputers on the market, Cray sold two machines to the Japanese. But in 1981, MITI announced a program to develop a supercomputer. Cray’s prospective customers in Japan seemed to disappear instantly.…Two years later the Japanese had their supercomputers ready and the makers of supercomputers began an export drive by cutting prices dramatically. (p. 140-1.) Free market economists would argue that this is perfectly acceptable. If competing countries wish to subsidize their exports to us, that is to our benefit. The more they subsidize their exports, the less we have to pay for our imports. That is good for us, not for them. Such a response misses the point. Predatory pricing is hardly the result of a charitable desire to subsidize consumers. Rather, its aim is to price competitors out of the market, at which point the survivor can exact monopolistic prices. Monopolistic profits will outweigh the losses suffered during predatory pricing. Ultimately the consumer will pay more. The standard reply has been that any attempt to raise prices to excessive levels would create a price umbrella, allowing new competition to enter the market. But this, too, misses the point, for it assumes an ease of entry that fails to reflect reality. CEOs of semiconductor producers have estimated it would cost at least $1 billion for a new company to enter the semiconductor industry. Even that may understate the cost of entry into a technology intensive sector. For technology is a moving target, and by the time one has paid the entry price to develop staff, supply networks, production facilities, and marketing, the state of the art may have advanced. If one is not already at the cutting edge of technology, it is difficult to discern the direction of its movement. This increases the risk of focusing one’s investment in the wrong area, targeting yesterday’s most profitable sectors rather than tomorrow’s. In short, a significant technological lead — and most targeted industries are technology intensive — may be insurmountable. So even if we were to acquiesce to the assumption that free trade is the best possible system — provided everyone would adhere to it — a laissez faire country may be at a disadvantage if others adopt predatory policies. And others might well adopt such policies. Even if mercantilism were to lower global output, enlightened selfinterest might drive a country to seek a larger share at the expense of others. Alternatively, in a world of uncertain political and economic alliances, a country may decide to retain production capability in vital sectors, even if that requires violating free market precepts. |
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