David
 James
 Brunner

HBS professors Gary Pisano and Willy Shih have an interesting article (“Restoring American Competitiveness“) in the July 2009 issue of the Harvard Business Review discussing the plight of the American economy.  They argue that American business has lost the capability to innovate in many important high-tech industries by outsourcing production to Asia and decreasing investment in research and development (R&D).  This process has been continuing for several decades, and the damage is reflected by average weekly wages that have been stagnant for almost thirty years, as well as by a trade balance in high-tech products that has been in deficit since 2002.  Pisano and Shih assert that there are strong complementarities between manufacturing capabilities, design capabilities, and innovation.  Consequently, although the strategy of specializing in “high-value-added design and innovation” while outsourcing capital-intensive manufacturing tasks to low-cost providers may be attractive in theory, it proves difficult or impossible in practice.

Pisano and Shih then offer a few proposals for policy-makers and managers about how to improve the situation.  Unfortunately, I find the proposals unconvincing.  With respect to government, they first recommend to “reverse the slide in the funding of basic and applied science”.  It turns out, however, that U.S. federal funding for basic research has almost tripled since 1980, while funding for applied research has nearly doubled.  According to the data that Pisano and Shih provide in the article, funding has declined only slightly since 2003, after a dramatic rise that began in 1998.  Although raising investment in basic and applied science is probably a good idea, it’s hard to understand how this can be a solution to the problems identified in the article, since these problems developed despite dramatic increases in the level of federal research funding (in real dollars).  Next, Pisano and Shih recommend that government “focus resources on solving ‘grand challenge problems’” and “let ailing giants dies” (they refer specifically to auto companies).  I don’t object to either of these proposals, but, again, I find it hard to understand how they will reverse three decades of deterioration in America’s high-tech innovation capabilities.

Pisano and Shih’s recommendations for managers are similarly unsatisfying.  First, they suggest that companies “make capabilities the main pillar of your strategy”.  My colleague Brad Staats explains that a capabilities-oriented approach to management entails recognizing the interdependencies between different parts of the business. If managers understand these interdependencies and incorporate them in strategic decision-making, perhaps they will not outsource activities that are crucial to long-term competitive advantage. It’s a nice idea, but Harvard Business School professors (notably Bob Hayes) have been making similar arguments at least since the 1980s.  It seems to me that we need to dig deeper and consider the factors that have discouraged or prevented managers from following this obviously sound advice.

Next, they recommend managers “stop blaming Wall Street for short-term behavior”, because managers can escape Wall Street’s pressure for short-term results if they send a clear, consistent message that they intend to focus on the long term.  Although it’s nice to think that frequent incantations about long-term focus can keep Wall Street at Bay, I’m skeptical.  A long-term strategy can take ten or twenty years to pay off, and few CEOs are sufficiently secure in their positions to ignore criticism from stock analysts and business journalists obsessed with short-term results.  And activist investors eagerly pounce on companies when their stock prices dip, so CEOs take a long view at their peril.  Even leaving these problems aside, most senior executives will be inclined to pursue strategies that pay off by the exercise date on their multi-million dollar stock option packages.

The other recommendations for managers–”recognize the limits of financial tools”, reinvigorate basic and applied research”, “collaborate”, and “create technology-savvy boards of directors”–all sound like nice ideas, but again it’s unclear why companies that have steadily cut R&D and outsourced the foundations of their innovative capabilities would heed these appeals.  Certainly similar appeals have been made since the problems became apparent in the 1980s.

My take on the problem, informed by the work of professors Mary O’Sullivan (Wharton) and William Lazonick (University of Massachusetts), is that the America’s problems will require major changes in the institutions of American capitalism, as opposed to the relatively minor adjustments proposed by Pisano and Shih.  In an insightful article, O’Sullivan and Lazonick describe the way that the shareholder value maximization ideology has lead companies to shift from retaining earnings and reinvesting them for long-term growth, to downsizing the corporation and distributing profits to shareholders.  The shareholder value ideology is reinforced by executive compensation tied to share price (stock-linked compensation), and by the danger of becoming the target of a hostile acquirer or an activist investor (the “market for corporate control”).  Together, stock-linked compensation and the market for corporate control create strong incentives for managers to focus on short-term shareholder returns: increase the share price and reap multi-million dollar rewards, or let the share price wilt and risk losing one’s job.  Until we change these incentives, I doubt that companies will begin to make the kind of investments that Pisano and Shih advocate.

Former health care executive Wendell Potter has been calling attention to how health insurance companies increase shareholder value at the expense of their customers and the broader public interest.  Potter left an executive post at CIGNA to become a senior fellow at the Center for Media and Democracy.  His descriptions of how insurance firms short-change their customers and cynically manipulate the political process to serve there masters on Wall Street are a powerful indictment of the shareholder value maximization ideology.  Potter’s interview with Bill Moyers, below, is well worth watching.

From a Public Interest Capitalism perspective, one of the most interesting characteristics of the interview is that neither Moyers nor Potter ever questions the ideology of shareholder value maximization–Milton Friedman’s doctrine that a company exists only to make as much money as possible for its shareholders.  So we have only two choices: healthcare managed by greedy corporations who will (metaphorically) throw their customers under the bus to boost profits, or healthcare managed by the government.  Although I have nothing against healthcare managed by the government, my research on Public Interest Capitalism suggests another possibility: restructuring capitalism so that corporations seek to balance private profits and the public interest.

The idea of such enlightened corporate management may seem far-fetched, and it is far-fetched when economic institutions create overwhelming incentives for management to increase shareholder value regardless at any social cost.  But these incentives can be changed.  We could start by prohibiting compensation linked to share price (stock options and stock grants) in publicly traded companies.  Capping executive compensation at a multiple of the compensation of the lowest-paid employee–perhaps forty times–would probably help, too, by limiting the ability of senior executives to profit personally from abusive tactics.  Then limit dividends and voting rights to shareholders who have owned shares for at least five years, thereby reducing the influence of activist investors and hedge funds while protecting the legitimate interests of long-term shareholders.  Requiring that insurance companies disclose, in a standard and easy-to-understand format, performance metrics related to patient satisfaction, recision rates, and so forth would help the public identify abusive firms.

In light of our shareholder-oriented corporate governance institutions, it’s easy to understand why health insurance companies behave the way they do.  Institutions determine whether we can cooperate productively, or whether we slip into wasteful and socially injurious redistributive conflicts, as in the case of the American health insurance industry.  But just because we have developed pathological institutions doesn’t mean that managers necessarily want to behave this way–Potter obviously did not–or that we have to stand idly by as these institutions wreak havoc on our healthcare system and our government.  As Nobel-prize-winning economist Douglass North points out in his book Institutions, Institutional Change, and Economic Performance, institutions are “humanly devised constraints that shape human interaction”.  Humans devised them, and humans can change them.

In my research on Public Interest Capitalism, I argue that markets and self interest do not necessarily serve the public interest.  This research draws on theoretical work by the respected economist Douglass North, who argues that institutions (i.e., values, social norms, and regulations) determine whether economic actors engage in wasteful redistributive activities, or productive value-creating activities.  When resources are squandered on redistributive activities, societies decline.  Recently, similar concerns have been echoed by Yukio Hatoyama, Japan’s prime minister to be.  Today, the Telegraph reports on a remarkable speech by Stephen Green, the chairman of HSBC.  The following are quotes from his speech, as reported by the Telegraph.

At their worst, financial markets can be engines of destructive excess. In recent years, banks have chased short-term profits by introducing complex products of no real use to humanity.

capitalism generally, and banking specifically, needs to reaffirm its commitment to contributing to social and economic development

There is no question that the markets – in the form of investors and traders – have often put pressure on boards to pursue short-term strategies and profits.

The results of that pressure are now plain to see in the broken businesses and weakened economies around the world. This was the basic failure of corporate governance.

Legislation is not and can not be sufficient without a culture of values in our industry

If this crisis leads to a genuine reassessment of the role of business and banking in market economies, it may come to rank as one of the great turning points in history of the modern world.

These points closely parallel the arguments that my colleagues and I make in our research on Public Interest Capitalism, so it’s encouraging to see these views articulated by a senior bank executive.  North would surely applaud Green, too, for recognizing that values are an essential complement to legislation (see also my discussion of Why Greed is Bad).  Finally, I think that Green could be right about the potential historical significance of reassessing the role of business in society: if businesses seek to profit through contributing to the general welfare, instead of seeking to profit at its expense, we may enjoy more equitable, sustainable, satisfying, and rapid economic growth.

I doubt that Green or any of his close associates will stumble across this blog, but I invite anyone at HSBC to contact me to discuss Public Interest Capitalism.

Yukio Hatoyama, slated to be the next prime minister of Japan, has an op-ed piece in the New York Times criticizing the excesses of globalization and American free-market fundamentalism.  His comments on both topics are right on target. To begin with, Hatoyama calls for an

end to unrestrained market fundamentalism and financial capitalism, that are void of morals or moderation, in order to protect the finances and livelihoods of our citizens

He is right to do so.  During the past few decades, the behavior of many American companies and the teachings of influential American economists have certainly been “void of morals or moderation”.  If this seems extreme, read about health insurance companies and nursing homes operated by private equity companies.  And recall that Milton Friedman published a well-known article in the New York Times Magazine titled “The Social Responsibility of Business is to Increase its Profits”.

With respect to globalization, Hatoyama says:

globalism has progressed without any regard for non-economic values, or for environmental issues or problems of resource restriction.

If we look back on the changes in Japanese society since the end of the Cold War, I believe it is no exaggeration to say that the global economy has damaged traditional economic activities and destroyed local communities.

…

Under the principle of fraternity, we would not implement policies that leave areas relating to human lives and safety — such as agriculture, the environment and medicine — to the mercy of globalism.

Hatoyama might be interested to read my good friend David Grewal’s book Network Power, which provides carefully reasoned support for these positions.

The New York Times has also published a response to Hatoyama’s article, in the form of an article by Hiroko Tabuchi.  The article is generally critical in tone.  Tabuchi writes that:

many economists here [Japan] say Japan may need more American-style deregulation and market-led growth, not less, to invigorate its stagnant economy.

Of course, that’s hardly surprising: there are few maladies for which mainstream economists do not prescribe “deregulation and market-led growth”.  The article is framed to support this position, making it read more like an opinion piece than like a journal article.  Tabuchi goes on to say:

Japan may be famous for its ruthlessly efficient, competitive manufacturing industries — like Toyota’s just-in-time production, in which parts are delivered just before assembly to keep inventory low. But its domestic service sector, which makes up 70 percent of the economy, is an overregulated, inefficient mess, businessmen and economists say.

Tabuchi is parroting a fairly standard, biased description of the Japanese economy.  She gives no statistics to support the extreme claim that the “domestic service sector … is an overregulated, inefficient mess”.  Indeed, casual observation suggests that she is dead wrong.  Health care is arguably the most important service industry of them all, and Japan’s health care system certainly is not an inefficient mess, though the government plays a major role.  Here are the statistics, from PBS Frontline: Japan spends 8% of GDP on healthcare, versus 15.3% for the U.S.; Japan’s life expectancy is 82 years, versus 77 for the U.S., and Japan’s infant mortality rate is 2.8, versus 6.8 for the U.S.

How about finance, another important service industry?  Japan’s financial industry certainly is not as innovative as America’s, but financial innovation probably does not have much social value anyway.  Certainly Japanese finance did not bring the world to the bring of economic collapse.  Though I do not have the data on hand, I am reasonably certain the Japanese financial sector does not account for 40% of corporate profits.

My personal experiences with the Japanese railway, retail, restaurant, air travel, health care, professional services, and hotel industries contrast sharply with Tabuchi’s characterization of the domestic service sector.  Indeed, Tabuchi’s only evidence for Japan’s service sector being an “overregulated, inefficient mess” is that a new airline has had difficulty getting a license for international flights, and that Japanese businesses employ more people than necessary.  These are both spurious.

The airline industry has very high fixed costs and low marginal costs, so free competition will drive prices below average cost, reducing profits to the point where firms cannot service the debt taken on to finance fixed investments.  The result, as we know here in the U.S., is one bankruptcy after another, often together with layoffs and broken promises to employees.  Small wonder that Japanese airlines have better service.  That a prospective entrant could not get a license may well be evidence of appropriate regulation and dynamic efficiency, though careful analysis would be necessary to say so with any confidence.

As for Japanese businesses employing more people than necessary, this does not necessarily indicate overregulation or inefficiency.  Indeed, as Tabuchi points out:

Japan’s jobless rate is at a record high of 5.7 percent, and it could be as high as 12 percent if not for a government subsidy program that encourages companies to keep surplus workers

So firms should fire their excess employees and leave them feeling betrayed and worthless, and without income?  That certainly would not contribute to economic growth or the general welfare.  Why not keep people employed, where at least they have income, some sense of purpose and belonging, and maybe even a chance of being useful?

Carrying the absurdity a bit further, Tabuchi continues:

Now, with a rapidly aging population and almost no immigration, Japan must increase its productivity, economists say.

Of course, if 12% of the labor force might as well be unemployed, there can be no shortage of labor.  If growth picks up, surplus labor will flow to the sectors that are willing to pay a premium for it (and the government will probably cut employment subsidies).

Perhaps Tabuchi should consider performing her own analysis rather than relying on what “economists say”.  They often get it wrong anyway.

More on balancing exploration and exploitation, this time from a Science article reviewed by the New York Times.  I have not read the original article, but here’s an excerpt from the New York Times review, entitled “Brain Is a Co-Conspirator in a Vicious Stress Loop“:

Nuno Sousa of the Life and Health Sciences Research Institute at the University of Minho in Portugal and his colleagues described experiments in which chronically stressed rats lost their elastic rat cunning and instead fell back on familiar routines and rote responses …

… regions of the brain associated with executive decision-making and goal-directed behaviors had shriveled, while, conversely, brain sectors linked to habit formation had bloomed.

In other words, the rodents were now cognitively predisposed to keep doing the same things over and over, to run laps in the same dead-ended rat race rather than seek a pipeline to greener sewers. “Behaviors become habitual faster in stressed animals than in the controls, and worse, the stressed animals can’t shift back to goal-directed behaviors when that would be the better approach,” Dr. Sousa said. “I call this a vicious circle.”

This could turn out to be a very vicious circle, since those conditions that seem likely to cause stress–environmental turbulence, deteriorating performance, anticipated threats–are exactly those conditions that require exploratory, adaptive responses.  In fact, my colleagues and I argue that deliberately stressing and destabilizing processes (“deliberate perturbation“) may be necessary to sustain exploration in mature organizations.

Nelson and Winter’s respected volume An Evolutionary Theory of Economic Change makes a significant contribution to the development of an algorithmic, symbol system model of economic behavior.  One of my favorite lines from the book:

the idea that “individuals are complex organizations too” has considerable power. (1982: 72)

Minsky provides one interpretation of the individual-organization duality in Society of Mind.  Another perspective surfaced in a recent op-ed piece titled “Your Baby is Smarter than you think” in the New York Times.  The article hints that the dynamics of exploration, exploitation, learning, and maturation, which my colleague Brad Staats and I study in the context of organizations, may also apply to human beings.  From the article:

Adults focus on objects that will be most useful to them. But as the lever study demonstrated, children play with the objects that will teach them the most. In our study, 4-year-olds imagined new possibilities based on just a little data. Adults rely more on what they already know. Babies aren’t trying to learn one particular skill or set of facts; instead, they are drawn to anything new, unexpected or informative.

Part of the explanation for these differing approaches can be found in the brain. The young brain is remarkably plastic and flexible. Brains work because neurons are connected to one another, allowing them to communicate. Baby brains have many more neural connections than adult brains. But they are much less efficient. Over time, we prune away the connections we don’t use, and the remaining ones become faster and more automatic. Moreover, the prefrontal cortex, the part of the brain that controls the directed, planned, focused kind of intelligence, is exceptionally late to mature, and may not take its final shape until our early 20s.

So perhaps individuals also face a “productivity dilemma“?

William Lazonick makes the case against stock buybacks in the latest issue of BusinessWeek.  In his article “The Buyback Boondoggle“, He argues that companies spend huge sums of money on buybacks that they could have invested in innovation and employment.  From the article:

The amount of money spent on buybacks is staggering. From 1997 through last year, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on them. In 2007, as profits soared, the average buyback bill for each was about $1.2 billion—a record amount. And faced with a dramatic drop in their combined net income in 2008, these companies trimmed buyback spending, but not proportionately: The buyback-to-profit ratio, which was already unprecedented in 2007, more than tripled in 2008, from 0.90 to 2.80.

He further observes that buybacks helped weaken major American firms to the point that they required government bailouts when the economy deteriorated:

If bailed-out General Motors (GM) had banked the $20.4 billion distributed to shareholders as buybacks from 1986 through 2002 (with a 2.5% aftertax annual return), it would have had $35 billion in 2009 to stave off bankruptcy and respond to global competition.

And the bailed-out banks? Eight of the biggest spent a total of $182 billion on buybacks from 2000 to 2007. That reduced their ability to cover their bets on derivatives, exacerbating the crisis they created in the first place.

At the heart of the issue is the conflict of interest between shareholders and management, on one hand, and other corporate stakeholders such as employees, customers, suppliers, local communities, and nations, on the other.  Shareholders have limited liability, so they can profit by extracting as much money from companies as possible during good times, even to the point of taking on debt to pay dividends–a common private equity practice.  If the companies subsequently go bankrupt, the shareholders have already pocketed their profits.  The greater the likelihood of bankruptcy, the greater the incentive for shareholders to take money out.

A more subtle problem is that shareholders have difficulty quantifying and verifying the value of long-term investments, so they prefer short-term investments or cash distributions.  Thus managing for shareholder value becomes managing for the short term, leading to underinvestment in innovation, human capital, and organizational capital.

As Lazonick points out, executive compensation in the form of stock shares and options create incentives for senior managers to buy back shares, since buybacks both distribute cash to shareholders and increase demand for shares.

In the article, Lazonick proposes banning share buybacks, but this won’t solve the problem of short-termist incentives embedded in executive compensation linked to stock price.  So how about limiting the value of stock grants and options to 5% of base salary for employees of publicly traded companies?

I’ve been puzzling for some time over how California–home to arguably the most innovative and dynamic economic ecosystem on the planet–can be experiencing fiscal meltdown.  The usual suspects are excessive social spending and political institutions that render the state “ungovernable”, but I haven’t seen evidence sufficiently compelling to convict them.  A recent analysis by the San Jose Mercury News suggests that the problems may be more serious: it appears that the social fabric of the state is fraying, with costly consequences.  From the article:

Republican Gov. Arnold Schwarzenegger … and the Democratic-controlled Legislature have spent money well beyond the rate of inflation and California’s population growth — $10.2 billion more.  California’s general fund … has grown 34.9 percent … over that same period, population growth and inflation together grew by only 21.5 percent.  If state spending had grown only at that rate, it would have reached $92.7 billion last year. Instead, Schwarzenegger and the Legislature spent $10.2 billion more.

… where did that “extra” $10.2 billion of state spending above the rate of inflation and population growth go?  The Mercury News found:

The state prison system received the biggest share, about $4.1 billion of it. Corrections spending has increased fivefold since 1994. At $13 billion last year, it now exceeds spending on higher education. Tough laws and voter-approved ballot measures have increased the prison population 82 percent over the past 20 years. Meanwhile, former Gov. Gray Davis gave the powerful prison guards union a 30 percent raise from 2003 to 2008, increasing payroll costs.

I’m not an expert on crime, but clearly such a dramatic increase in the prison population–to the point where state spending on the prison system exceeds investments in higher education–indicates a sick society.  Further, the Mercury News analysis helps exonerate one of the usual suspects:

general fund spending on K-12 schools and social services, like welfare, actually grew less than the rate of inflation and population growth.

Needless to say, an elevated prison population also incurs indirect costs: prisoners are more or less removed from the labor force and the tax base, and resources expended on caring for and securing them could be invested in productive assets instead.  It’s not clear how this problem can be solved.

When I visit Tokyo, I teach an ad hoc, voluntary seminar to Japanese university students.  Each time, we meet for three hours and discuss an assigned text.  The students read the text in Japanese, I read it in English, and we discuss in Japanese.  Last year, we met three times and worked our way through John Kenneth Galbraith’s Affluent Society.  This year, we have been reading Douglass North’s excellent book Institutions, Institutional Change and Economic Performance.  We had our second meeting of the year this afternoon.

During our discussion today, I was particularly struck by North’s conclusions regarding third-party enforcement of contracts and property rights.  He posits capacity for effective third-party enforcement to be a necessary condition for a sophisticated market economy.  This turns out to be problematic:

Third-party enforcement means the development of the state as a coercive force able to monitor property rights and enforce contracts effectively, but no one at this stage in our knowledge knows how to create such an entity.  Indeed, with a strictly wealth-maximizing behavioral assumption it is hard even to create such a model abstractly.  Put simply, if the state has coercive force, then those who run the state will use that force in their own interest at the expense of the rest of the society.  (North, 1990: 59)

North identifies an important limitation of neoclassical economic theory.  In a sophisticated market economy, competition by self-interested agents yields efficient outcomes only given effective third-party enforcement.  Conveniently, the theory assumes both self-interested agents and effective third-party enforcement.  However, North argues that self interest undermines effective third-party enforcement.  If so, then the assumptions of neoclassical theory are mutually contradictory.

To explain the economies of the advanced nations, North suggests that the theory must take into account non-wealth-maximizing human motivations including values and ideologies.  Such internal restraints on self interest appear to be an essential ingredient in the even-handed third-party enforcement that makes possible sophisticated market economies.  With respect to the successful development of third-party enforcement in England during the seventeenth century, North says:

although that story describes a successful outcome, it does not give a definitive answer to the question of how it was achieved.  It was surely a mixture of formal and informal constraints.  Both respect of the law and the honesty and integrity of judges are an important part of this success story.  They are self-enforcing standards of conduct, and I believe that they are important. (North, 1990: 60)

Though the importance of non-wealth-maximizing motivations may seem obvious, they are ignored by most of mainstream economics.  (Sometimes the utility function is said to incorporate non-wealth-maximizing motivations, but this is disingenuous: they are implicitly excluded by the structure of most mainstream models.)

These passages are deeply disconcerting, because they indicate how poorly we understand the foundations of our prosperity.   Moreover, by teaching models that legitimate the pursuit of self interest without regard for social consequences, mainstream neoclassical economics may be weakening those foundations.

A new version of my paper with Brad Staats, Mike Tushman, and Dave Upton on how deliberate perturbation can sustain innovation in mature organizations is available for download from SSRN.  Here is the abstract:

Organizations struggle to balance simultaneous imperatives to exploit and explore, yet theorists differ as to whether exploitation undermines or enhances exploration. The debate reflects a gap: the missing theoretical mechanism by which organizations break free of old routines and discover new ones. We propose that the missing link is perturbation: novel stimuli that disrupt the execution of specialized routines. Perturbation creates opportunities for organizations to invoke exploratory, general-purpose problem-solving routines. In mature organizations, exogenous perturbations become increasingly scarce to the point that exploration is stifled and inertia sets in. We theorize that mature organizations can sustain exploration by deliberately inducing perturbations in their own processes. Our theory yields testable hypotheses about the relationships between exploitation, perturbation, and exploration. We provide illustrations from The Toyota Motor Company to show how deliberate perturbation enables efficient exploration in the midst of intense exploitation.