GUEST POST from Greg Satell
“Not everything that can be counted counts and not everything that counts can be counted,” is a quote often attributed to Albert Einstein, which I think aptly sums up the past 40 years. Since the 80s, we’ve been laser-focused on numbers and missed the underlying math. We’ve become finance-obsessed but lost track of economics.
Consider Jack Welch, who Fortune magazine named “Manager of the Century.” In the article explaining why he deserved such an honor, it lauded the CEO’s ability to increase the stock price and deliver consistent earnings growth, but nowhere did it refer to a breakthrough product or impact on society.
There’s a good reason for that. As NY Times columnist David Gelles explains in, The Man Who Broke Capitalism, Welch increased profits largely by firing workers, cutting investment and ‘financializing’ the firm. During his 20 year reign, innovation faltered and the company produced less, not more. Clearly, we need to reevaluate what we consider valuable.
What’s The Purpose Of A Company?
In a famous 1937 paper, Ronald Coase argued that the economic function of a firm was to minimize transaction costs, especially information costs. For example, it makes sense to keep employees on staff, even if you might not need them today, so that you don’t need to search for people tomorrow when important work needs to be done..
In 1976, Michael Jensen and William Meckling built on Coase’s work in their groundbreaking paper entitled The Theory of The Firm, which asserted that the purpose of the firm was to make money for its owners. They further argued that there is a fundamental principal-agency problem between managers and owners because their interests are not perfectly aligned.
These were brilliant works of economic theory, but as reflections of reality they are somewhat absurd. People start businesses for all sorts of reasons, profits being just one motivation. That’s why we have public benefit corporations and socially responsible investment funds. Heirs such as Abigail Disney have spoken out strongly against corporate greed.
There is simply no basis for the notion that owners of businesses care only about profits, much less the stock price over a given period. Yet during the 1970s and 1980s there was a growing conservative intellectual movement that argued that managers had a moral responsibility to increase shareholder value at the expense of pretty much everything else.
Today, many portray the conservative movement behind the nation of shareholder value as evil and greedy. Most of the evidence indicates that its leaders thought they were doing the right thing. It seems that there were more fundamental errors at play.
Management By Algorithm
In the 1920s , a group of intellectuals in Berlin and Vienna, became enamored by an idea that came to be known as logical positivism, that human affairs should be subjected to the same logical rigor as physical sciences. It failed miserably and, when Kurt Gödel published his incompleteness theorems in 1931, it was completely discredited.
Yet the strain of thought that arose in the 1970s that gave rise to Jack Welch’s brand of capitalism was essentially the same thing. It was, in effect, management by algorithm, in which human agency was eschewed and decisions were boiled down to a single variable to be optimized. Pretty much everything else could be blissfully ignored.
Does a particular action further the mission of the enterprise? It doesn’t matter as long as the stock price goes up. Will a merger of two companies undermine market forces and restrain trade? Unless regulators can prove that prices will go up, they have no right to step in. What should govern relations between nations? They should simply pursue their interests.
These ideas failed for the same reason that the original theory of logical positivism did. The world is a messy place, with lots going on. You can’t simply boil complex problems down to a single variable—or even a limited set—and not lose important information in the process. The notion that you could was naive and reckless.
The Cost Of Carelessness
To understand why the Welch era went so badly, let’s look at one common practice that took hold in the 1980s and 90s: Offshoring. From a shareholder value perspective, it has an intuitive logic. You move your factory from high wage countries such as the US to low wage countries such as China and pocket the savings. You lower costs and increase profits, at least in the short-term.
Yet that analysis omits some important factors. First of all, it undermines trust among employees, suppliers and other partners when relationships are treated as purely transactions. Also, a Harvard study found that moving the factory floor thousands of miles away from R&D reduces knowledge transfer and has a negative effect on innovation.
Looking back, it’s easy to see how this played out at GE. The company became more profitable, but less productive. For decades, it failed to innovate. Its last major invention was the CT scanner, which came out in the 1970s, before Jack Welch took the helm. Today the company is worth about $60 billion, roughly the same as back in the 90s.
The results for society are just as clear. Our economy has become markedly less productive, less competitive and less dynamic. Purchasing power for most people has stagnated. Life expectancy in the US has decreased in a number of years over the past decade. Anxiety and depression, which have been rising for a while, accelerated during the pandemic.
Creating Mission-Driven Organizations
The statistician George Box famously said, “All models are wrong, but some are useful” and that’s especially true of economic models. When Ronald Coase argued that the “nature of a firm” was to reduce transaction costs, he didn’t mean that was the only purpose of an enterprise. To argue that there is a principal-agent problem between owners and managers should not imply that it only applies to profits.
In fact, as Andrew Winston and Paul Polman explain in their book Net Positive, many practices that aren’t sustainable depress profits in the long run. Running an enterprise that dismisses the interests of customers, partners and communities is destined for trouble. Sooner or later, there will be a reckoning.
In the final analysis, the purpose of an enterprise is its mission. When we think of great founders such as Henry Ford, Sam Walton and Steve Jobs, they had vastly different purposes in mind, but it was fulfilling that purpose that drove profits. Ford was passionate about the power of transportation. Walton was fanatical about serving the customer. Can you imagine what Steve Jobs would have said about an ugly product that could make him a lot of money?
That’s what we’ve gotten wrong over the last 50 years. We’ve been counting the wrong things. Economics should serve people, not the other way around. The success of a society needs to be measured by the well-being of those who live in it. If companies profit, but our people are impoverished, our air and water are more polluted, our children less educated, we live unhappy lives and die deaths of despair, what have we really gained?
— Article courtesy of the Digital Tonto blog
— Image credit: Unsplash
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