Capitalism is a great technology and a mediocre philosophy.
– Reid Hoffman
This week I passed by an article in the Wall Street Journal about how pay regulations are back on the table for big banks. Although the rule was mandated by Dodd-Frank, a decade later the pay restrictions and clawbacks are not in place (seriously?). At the same time, I started reading Duff McDonald’s epic takedown of MBAs, The Golden Passport.
I haven’t read the full thing yet so don’t want to give a review, but it’s definitely getting my attention. Mainly I’m drawn in by McDonald’s provocative writing and crux-finding. In the earliest chapters, he lays out the root of all MBA evil: profits. Telling the story of Frederick Taylor, the founder of Taylorism and an early management science pioneer, McDonald throws down and calls out Taylor as a traitor to workers and glorified bean-counter. When discussing the “original case study”, McDonald criticizes Taylor’s self-aggrandizement and attempts to science-ize management:
Frederick Taylor generalized a step too far. In arguing that his methods revealed a universal science of management, Taylor engaged in metonymy–confusing just one part of management (that is, quantitative analysis) for the whole. Efficiency–and its close relative, profitability–is just one possible goal of management. Others include customer satisfaction, community relations, and quality. In Taylorism, one could argue, lie the seeds of American industry’s eventual comeuppance at the hands of the Germans and the Japanese…[H]e was implicitly sanctioning the idea that a company can be judged by a single metric. Today’s even more pernicious version of such: shareholder value. Writes Stewart: “The modern-day CEOs who sacrifice the long-term viability of their corporations for the sake of short-term boosts in their quarterly earnings reports are direct descendants of the pig-iron managers who undermined their work team’s morale in order to achieve temporary productivity targets.”
McDonald is not subtle, to say the least. But, ignoring European dissatisfaction with their more socialist system and Japan’s anemic growth over the last decade, McDonald also gets one crucial thing wrong in my opinion: that profits, shareholder value, efficiency, or whatever you want to call it, are the wrong metric. In my opinion they are the right metric, but the markets that are developing in America are no longer fully free and fair.
Profits represent a very simple metric: revenues minus costs. Revenues are also a very simple metric: the value to the person buying the good or service. And cost, you guessed it, is a simple metric: the value that was expended in producing the good or service. So, at its core profits represent the purest definition of value creation, the difference between what value was expended to produce a good or service and what the consumer values that good or service at.
My argument is that Friedman was right and there is no better way for a society to operate than to have corporations attempt to maximize profits. By only taking into account value created (revenue) and value destroyed (cost), all of the hardest questions are boiled down into “value”. It’s a nebulous term, but with a free and fair market, it forms the motive that self-interested humans need to participate without relying on political connections, committing fraud, or more. In a free and fair market, you have to create value, or you go out of business.
But surely, there are problems. In America today, there is income inequality, monopolization, fraud, Wall Street short-termism, and more. These are real problems that are infecting our society and becoming more visible with each passing year. So do they exist because MBAs have tricked the world into sacrificing the common good on the altar of profit-driven capitalism? No. Increasingly, consumers lack the ability to take their dollars elsewhere. In repeat transactions, consumers have no choice because America’s markets are getting less free and less fair. Some examples:
- Transactional in Nature. When corporations have a one-and-done interaction with you, why bother having good customer relationships, support, or quality? Examples: car salesmen (who are not linked to service), realtors.
- Private Equity Leveraged Buyouts. If you’re definitely going to exit an investment in 7-10 years, does it make sense to plan for longer? Certainly a private equity firm that does will have a lower IRR, and therefore not look as good to future investors. Examples: RJR Nabisco, Toys R’ Us.
- Monopoly. When every repeat transaction is guaranteed to go to your platform, why bother doing anything right? Customers can’t switch, so they won’t. Examples: Cable companies, landline phones, employer health insurance.
Compare that with some of the best examples of customer satisfaction, quality, and community relations.
- Amazon. Online retail is cut-throat, single-digit margin business with insanely low switching costs. Bezos knew from the outset that good customer service could be a huge competitive advantage. People value convenience and purchase consumer-packaged goods every few days, so by having the best customer service Amazon keeps its customers wanting more.
- Rolex. When your good is a commodity, how can you stand out from the crowd? Make your watch impeccable quality, ornately adorned, and a status symbol. The business model here makes sense from a profit perspective: don’t compromise on quality, and your customers will more than make up in the difference of your costs.
- Mom-and-Pop Shops. When your reputation is on display daily because all of your clients are neighbors, you often behave with community relations in mind. According to a recent study, small businesses donate 250% more than larger businesses to non-profits and community causes.
So how to address the problems of our day if not by throwing out the concept of shareholder value?
- Executive Compensation Periods. Deferring the compensation for longer than the current 5-year standard and enabling clawbacks is absolutely crucial to ensuring that, say, 10 years into a toxic mortgage the executives are not retired and fully vested while the rest of the economy melts. The WSJ article is a salient reminder of the urgency of this.
- Expansion of Small Business Loans and Incentives. If Amazon can get billions of dollars in incentives for building HQ2, why can’t other businesses? To New York’s credit, the majority of what Amazon was leveraging were programs that already existed for other businesses. For some municipalities though this is not the case. We should be encouraging small upstarts to take on incumbents and build in the communities they serve.
- Incorporation of Full Cost into the Production of Goods. Coal-powered energy brought almost 1 billion people out of poverty in China at the turn of the 21st Century. There is real evidence that the climate is changing, but at what benefit? Let’s assign a dollar value to carbon, modify it frequently, and levy it on large industrial companies. This will help address externalities within the framework of the profit-seeking motive.
- Aggressive Monopoly-Busting. I am firmly on the side of more vigorous antitrust enforcement. Modern business has gotten basically a free pass to vertically integrate thanks to Bork’s precedents and a focus on an actually bad single metric (HHI). Makan Delrahim took a step in the right direction, but the courts need to break precedent and change with the times.
Culture is important. Greed is not always good. But show me a better technology than profit-based incentives for capitalism before you say we should throw the baby out with the bathwater.
 The original case study was, not surprisingly, about steel and railroads. In 1899, the Bethlehem steel company found themselves in possession of a surplus of two million pounds of pig-iron bars. They needed to figure out the most efficient way to load them into railcars for transport, and Taylor stepped in. Whether counting, efficiency, or science, McDonald considers this the original sin of HBS.
 What type of profits? Economic profits. There are adjustments, tax considerations, etc. etc. in the real world I understand, but I am simply using the most basic definition of profit available. This might even be part of McDonald’s argument: that such an analysis is too simplistic. But I would argue there’s nothing wrong with establishing that gravity is 9.8 m/s^2 of acceleration, even if there’s always air resistance on Earth. As is often said, “the difference between theory and practice is, in theory small, but in practice much larger.”