Why American Industry Is Where It is.

The blog post linked to below is important.  Very important.  Now I don’t think that the trends here are the sole cause of what’s happened and what is happening, but it’s a big reason for a lot of the issues that I talk about here.

The U.S. computer industry is dying and I’ll tell you exactly who is killing it and why

It’s not even a very old theory, in fact, only dating back to 1976. That’s when Michael Jensen and William Meckling of the University of Rochester published in the Journal of Financial Economics their paper Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.

Their theory, in a nutshell, said there was an inherent conflict in business between owners (shareholders) and managers, that this conflict had to be resolved in favor of the owners, who after all owned the business, and the best way to do that was to find a way to align those interests by linking managerial compensation to owner success. Link executive compensation primarily to the stock price, the economists argued, and this terrible conflict would be resolved, making business somehow, well, better.

There are many problems with this idea, which appears to be more of a solution in search of a problem. If the CEO is driving the company into bankruptcy or spends too much money on his own perks, for example, the previous theory of business (and the company bylaws) say shareholders can vote the bum out. But that’s so mundane, so imprecise for economists who see a chance to elegantly align interests and make the system work smoothly. The only problem is the alignment of interests suggested by Jensen and Meckling works just as well – maybe even better – if management just cooks the books and lies. And so shareholder value maximization gave us companies like Enron (Jeffrey Skilling in prison), Tyco International (Dennis Kozlowski in prison), and WorldCom (Bernie Ebbers in prison).

It’s just a theory, remember.

The Jensen and Meckling paper shook the corporate world because it presented a reason to pay executives more – a lot more – if they made their stock rise. Not if they made a better product, cured a disease, or helped defeat a national enemy – just made the stock go up. Through the 1960s and 1970s, average CEO compensation in America per dollar of corporate earnings had gone down 33 percent as companies became more efficient at making money. But now there was a (dubious) reason for compensation to go up, up, up, which it has done consistently for almost 40 years until now we think this is the way the corporate world is supposed to work – even its raison d’etre. But in that same time real corporate performance has gone down. The average rate of return on invested capital for public companies in the USA is a quarter of what it was in 1965. Sure productivity has gone up, but that can be done through automation or by beating more work out of employees.

Jensen and Meckling created the very problem they purported to solve – a problem that really hadn’t existed in the first place.

Maximizing shareholder return has given us our corporate malaise of today when profits are high (but are they real?) stocks are high, but few investors, managers, or workers are really happy or secure. Maximizing shareholder return is bad policy both for public companies and for our society in general. That’s what Jack Welch told the Financial Times in 2009, once Welch was safely out of the day-to-day earnings grind at General Electric: “On the face of it,” said Welch, “shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers, and your products. Managers and investors should not set share-price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.” 

Now let’s look at what this has meant for the U.S. computer industry. 

First is the lemming effect where several businesses in an industry all follow the same bad management plan and collectively kill themselves.  We saw it in the airline industry in the 1980s and 90s.  They all wanted to blame regulation, then deregulation, then something else. The result was decimation and consolidation of America’s storied airlines and the services of those consolidated companies generally sucks today as a result. Their failings made necessary Southwest, Jet Blue, Virgin America and other lower-cost yet better-service airlines.

The IT services lemming effect has companies promising things that can not be done and still make a profit.  It is more important to book business at any price than it is to deliver what they promise.  In their rush to sign more business the industry is collectively jumping off a cliff. 

This mad rush to send more work offshore (to get costs better aligned) is an act of desperation.  Everyone knows it isn’t working well.  Everyone knows doing it is just going to make the service quality a lot worse.  If you annoy your customer enough they will decide to leave. 

The second issue is you can’t fix a problem by throwing more bodies at it.  USA IT workers make about 10 times the pay and benefits that their counterparts make in India.  I won’t suggest USA workers are 10 times better than anyone, they aren’t.  However they are generally much more experienced and can often do important work much better and faster (and in the same time zone).  The most effective organizations have a diverse workforce with a mix of people, skills, experience, etc. By working side by side these people learn from each other.  They develop team building skills.  In time the less experienced workers become highly effective experienced workers.  The more layoff’s, the more jobs sent off shore, the more these companies erode the effectiveness of their service.  An IT services business is worthless if it does not have the skills and experience to do the job. 

The third problem is how you treat people does matter.  In high performing firms the work force is vested in the success of the business.  They are prepared to put in the extra effort and extra hours needed to help the business — and they are compensated for the results.  They produce value for the business.  When you treat and pay people poorly you lose their ambition and desire to excel, you lose the performance of your work force.  It can now be argued many workers in IT services are no longer providing any value to the business.  This is not because they are bad workers.  It is because they are being treated poorly.  Firms like IBM and HP are treating both their customers and employees poorly.  Their management decisions have consequences and are destroying their businesses.

Mr. Cringley is mostly talking about the IT industry, but the rot has spread across just about every industry.  Certainly I’ve seen it in many different companies that I’ve either worked for or interviewed with.  Perhaps the biggest issue is that once a CEO is tied to the company through stock options it’s assumed that they as dedicated as possible to keeping value at a company.

What happens though is that, for various reasons the stockholders stop paying attention as long as the stock seems to rise and incompetent clowns get put in charge who have all the right credentials and no knowledge of the business. That incompetence bleeds down the management chain.  At least it did at my last employer.

Part of this is the fact that upper management is drawn from the same managerial class of people that are screwing up finance and government. Another part is predominance of corporate ownership by institutional investment funds run by managers who have no real skin in the game.  Add to that the fact they all tend to come from the same sort of schools and have the same sort of thinking. That’s where a lot of the mushy stuff about “diversity” or “good corporate citizenship” comes from.  It’s also the fact that those schools all teach about money in the abstract and not why money exists in the first place.

This is followed up by the fact that once the executives get their MBA’s, the go right into management with no actual experience with the product, company or kind of people they are managing.  Which leads to the problem that a good portion of the people in management are insecure because they feel out of their depth and incompetent and the rest actually are incompetent.

So these people have to pretend.  Pretend constantly that they have clue.  In some areas of a company that actually works, sorta.  Finance, legal and HR seem to have a lot of pretending going on all the time.  You can’t do that in R&D though.

http://thedeclination.com/pretending-to-be-something/

To make R&D work, you have to understand the product, the processes behind it and the technology.  R&D is gamble and all too frequently, it’s not going to pay off. Anybody remember the picturphone?  In R&D failure is a big part of the game. If you don’t have any failures, you’re not trying.

In the social capital world of the modern corporation, failures are something a manager cannot afford.  Unless he can pass the buck to some poor clod, the failure is going to cost the manager plenty in social capital.   In the zero sum social capital environment of the modern corporate culture, social capital is something that no executive can afford to lose.  So R&D gets kicked down to the losers and gets driven by risk adverse strategies.  Projects have to get approval by committee, so that no one person has to take responsibility when they fail.  The projects that do get approved are the ones that are most risk adverse.  So R&D becomes maintenance engineering for ever more mediocre products while the company leadership touts the company vaporware as great innovation.  Along with the company’s great support of the community and commitment to “sustainability.” Great virtue signaling to the PC crowd, but all this doesn’t make the stockholders money.

The problem is that the stockholders have, by and large been separated from the flow of information about the stocks they own. Most stock these days are owned by big mutual funds and other funds rather than individuals. this has been created by a tax and regulatory environment that discourages individual investing and separates the actual owners of the stocks from any influence on their investments. Most investment funds are now managed by the same kind of people that run the big companies.  They come from the same schools, go to the same clubs and frequently going form job to job, are the same people.

In good times this can go on and nobody will notice.  The business will keep running on inertia and everything will look OK, for a while.  The problem is that with no explicit responsibility there’s nobody at the controls.  You can do that when nothing needs to change, but when big changes are needed, things don’t end very well. Ergo, the collapse of just about every major company in the US.

In order to fix the problem people are going to have admit that the rules are going to have to change.  The tax code is going to have to have to be simplified to remove the incentives for malinvestment and the regulations are going to have to removed and people are going to have to acknowledge that no amount of regulation can create a perfect market.  This is going to be hard and a lot of very wealthy and powerful people are vested in the status quo.  We all have to understand though that if we don’t change how we don’t do things, there will soon be no status to quo.

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