Citizens are angry. “The body politic is burning up,” we learn from a recent NBC/Esquire survey. “And the anger that courses through our headlines and news feeds… about what they are doing to us—shows no sign of abating.” Insurgent presidential campaigns are making unexpected inroads in challenging establishment candidates in both parties. Why is the electorate angry?
“A common thread,” writes columnist Nicholas Kristoff, “is that this country is no longer working for many ordinary citizens.” The anger is bipartisan, although the lists of suspected villains differ.
Political Villains
Republicans are ticked off at the government, President Obama, Obamacare, immigrants and Republican leaders who abandon conservative principles once in office. Even Donald Trump says “the system” is “broken.”
Democrats are angry too, but their list of villains is different: money in politics, Wall Street and the rich. “People feel like the system is rigged against them,” says Democratic senator Elizabeth Warren, “and here is the painful part, they're right. The system is rigged.” Ordinary citizens can no longer get ahead just by hard work.
The fact that the two lists of villains have little in common indicates that the two groups are projecting their own political preoccupations onto the situation, rather than getting to the root cause of the problem.
Public Institutions
Thoughtful columnists like David Brooks warn there is no single villain. “Americans are beset by complex, intractable problems that don’t have a clear villain: technological change displaces workers; globalization and the rapid movement of people destabilize communities; family structure dissolves; the political order in the Middle East teeters, the Chinese economy craters, inequality rises, the global order frays… There’s no all-controlling Wizard of Oz to slay.”
Yet Brooks himself proposes his own single solution: public institutions. “If we’re to have any hope of addressing big systemic problems we’ll have to repair big institutions and have functioning parties and a functioning Congress. We have to discard the anti-political, anti-institutional mood that is prevalent and rebuild effective democratic power centers.”
It’s The Economy, Stupid
Yet is this plausible? The fact that 60 years ago politicians were able to reach bipartisan agreements on budgets doesn’t mean those politicians were generically wiser and more public-minded than the politicians we have today. The principal difference is that back then, politicians were operating in a world of strong economic growth and widely shared prosperity. So of course it was much easier to find win-win compromises. The underlying reason why public institutions find it difficult to reach agreement today is that the economic pie is not growing fast enough to produce solutions.
With demands increasing and an economy that is barely growing at all in real terms, it’s much more difficult for politicians to reach closure, even if with the best will in the world.
The same line of reasoning can be applied to the current lists of villains from the political parties. Would Republicans be so bothered by immigrants and the government handouts if prosperity was widespread and the economic future was bright?
Would the Democrats be so upset about Wall Street and the rich if there were good jobs for all with growing salaries?
In effect, aren’t all parties confusing cause and effect? The alleged villains are either symptoms or victims of the fact that the economy isn’t generating enough benefits to lead to prosperity for ordinary citizens.
So why isn’t the economy performing better and generating benefits for all? What went wrong? To answer that question, we need to dig a bit deeper into the difference between an economy that is well-functioning and one that isn’t.
A Virtuous Circle Of Prosperity
In the period after World War II, America enjoyed a quarter-century of economic growth and shared prosperity. Firms were generally well managed, at least in terms of the marketplace at the time. Workers became steadily more productive. Customers were satisfied. Firms made more money. The gains in productivity were shared with the managers and the workers who created them.
Increased pay for workers enabled them to spend more on products and services. As they spent more, firms were inclined to invest more. Investments in turn generated more jobs for workers. Workers became more productive and had even more resources to spend. As the economy grew, everyone was better off. The future looked bright. There was a virtuous circle of growing prosperity for all.
A Wrong Turn: The 1970s
Then in the 1970s, something went wrong. It was as if a strange new economic disease began to infect everything. Firms focused more closely on making gains for themselves and stopped passing on gains in productivity to their workers.
Source: Bureau of Labor Statistics
What this chart shows us is that from 1949 through the 1970s, firms shared the gains from productivity improvements with the workers who produced them. Not surprisingly in this period, the economy functioned well and there was widespread prosperity.
Then firms began acting very differently on a consistent basis over several decades. From 1980 onwards, firms didn’t share the benefits of productivity gains with their employees. Instead they kept the gains for themselves. Not surprisingly in this period, the incomes of most citizens stagnated.
Here we have the “smoking gun” that explains why ordinary citizens are angry because the country is no longer working for them. When firms are consistently keeping the gains from productivity improvements for themselves, rather than sharing them with the workers who produce those gains, naturally citizens are upset. In effect, firms have hijacked the benefits of growth that the workers have produced. Naturally workers are angry when their incomes stagnate, even as the economy grows.
But it gets worse. When workers' incomes stagnate, this starts affecting economic growth itself. As the workers don’t have more money to spend on products and services, firms perceive a lack of demand for new products and services. As a result, firms are increasingly disinclined to invest in new products and services. Real economic growth slows. The virtuous circle of growth is broken. Instead we enter a vicious cycle of decline.
Why did firms start acting so differently in the period after the 1970s, as compared to the prior several decades? The answer is not hard to find. The villain isn’t a set of individuals or institutions. It’s an idea.
The Villain Is An Idea
In the 1970s, a strange idea—almost unnoticed—came to dominate the way our public enterprises work. The idea is still taught in business schools, presumed in daily financial news reporting, accepted as a go-to for any executive of a large public company, the modus operandi of investors and activist hedge funds, endorsed by regulators, institutional investors, analysts and politicians, and often cited as obvious “common sense.”
What is this strange idea? In the 1970s, the largest enterprises—the publicly owned corporations—began adopting a notion that even Jack Welch has called “the dumbest idea in the world.” In an effort to offset declining performance and profits due to increased competition, these companies embraced the notion that the very purpose of a corporation is to maximize shareholder value as reflected in the current stock price. The focus of these firms turned inward towards singlemindedly extracting value for the company’s shareholders, ahead of delivering value to customers. Executives were compensated in stock so that they would focus on the goal of increasing the stock price.
Where did this strange idea come from? Few people today know that the origin of the idea is quite recent. As John Maynard Keynes once said, “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
This particular idea was put forward in the 1970s by a trio of academic economists—Friedman, Meckling and Jensen—as a way of solving a narrow problem—the so-called “agency” problem of executives feathering their own nests at the expense of the shareholders and the corporation. Their idea was brilliantly successful in the sense that it became the gospel of American business and an entire society embraced it.
Yet the idea was unsuccessful in the sense that it not only aggravated the narrow problem it was introduced to solve—the “agency” problem. It also generated horrendous unintended financial, economic and social consequences: short-term decision-making, relentless cost cutting, staff reductions, squeezed operations, lower investment, crippled innovation, a dispirited workforce, reduced benefits and pensions for employees, mindless mergers, closed factories, off-shoring of production, increased debt, reduced ability to compete, declining rates of return on assets, rampant illegality in the financial sector, excessive financialization of the economy, and ultimately secular economic stagnation.
Just look at this chart. It's from the Shift Index by Deloitte's Center for the Edge, available here. It shows the result of a study of 20,000 U.S. organizations—the largest U.S. firms—from 1965 to 2011 and it shows the steady decline in the rate of return on assets and the rate of return on invested capital. In short, it’s a disaster.
Around 1965, those rates were around 5% or 6%. And now they are down around 1% and 2%. That’s a 75% decline. What that means is that overall, US firms are becoming steadily less productive.
Other studies show that the life expectancy of firms in the Fortune 500, which used to be around 75 years, is now only 10 years.
These declines are also reflected in overall economic growth rates. For several decades after World War II, GDP rose by about 4% a year. In the last fifteen years, GDP has on average fallen below two per cent and many economists believe that it will stay there, or fall even further. After allowing for population growth, the economy on a per capita basis is hardly growing at all. The phrase of the day among economists is “secular economic stagnation.”
Potemkin Prosperity
To hide the underlying decline in real economic performance, firms took steps to bolster their share price by other means and create an appearance of financial prosperity. The C-suite talked up the share price by providing optimistic guidance on the firm’s projected earnings. They switched to more aggressive accounting practices to make the company’s real performance look better than it was. They devised ingenious tax strategies, including shifting the legal location of their headquarters to foreign countries. And corporations spent an astonishing amount—some $3.4 trillion in the last ten years—on share buybacks, mostly at the top of the market, aimed at increasing the stock price and in effect engaging in illegal stock price manipulation.
That’s bad enough. But here’s the horrifying part. Everyone climbed on board. Not just business execs. Boards of directors, Wall Street, brokers, regulators, politicians, pension funds and investors all joined in. Companies scrambled to find ways to keep their current share price rising, by whatever means necessary, both legal and illegal. Huge corporate contributions to political campaigns helped maintain the status quo and stem any regulatory action to redress the situation.
Republican Illusions
Against this background, we can see why Republicans in the marketplace looking for good work might think that immigrants have stolen their jobs. Good jobs are hard to find because corporations have been keeping the benefits of productivity gains for themselves. Don’t blame immigrants. When firms are run this way, there simply aren’t enough good jobs to go around.
We can also see why it appears to Republicans that the government has gotten involved in too many handouts for people in need. It’s not because government has lost its way. It’s because private sector corporations aren’t sharing the benefits of the economy with ordinary citizens in the way that they used to, and as a result, many more citizens need more help from the government just to get by.
We can also understand why Conservative leaders might abandon their plans to do something about immigration and government handouts once they get into office. The proposed actions don’t gain traction, not only because they are unpopular: they don’t solve the underlying problem.
Democratic Illusions
Democrats are somewhat closer to the truth with their particular list of villains: money in politics, Wall Street and the rich. Yes, it’s true: the system is rigged. We do live in a world in which corporations take the gains from productivity improvements, and so yes, the deck of cards is stacked against ordinary citizens.
Where Democrats go wrong is in thinking that the problem can be solved by “taxing the rich” or “printing money.” Merely shifting assets from the top 1% to the middle class won’t solve the problem of stagnating incomes. So long as private sector corporations keep retaining the benefits of productivity gains for their shareholders and their executives, the problem will continue. It can’t be solved by government action. Instead, we need to go deeper and change the way these private sector corporations are run. Fortunately, we now know how to do that.
The Illusion Of Mind-Boggling Complexity
We can also see now why David Brooks is mesmerized by many complex, intractable problems. Once we distinguish the disease from its symptoms, we can see that many apparently separate problems have a single root cause. If we try to deal separately with each of the problems that the “world’s dumbest idea” has generated, we will get nowhere:
Short-term decision-making, relentless cost cutting, staff reductions, squeezed operations, lower investment, crippled innovation, a dispirited workforce, reduced benefits and pensions for employees, mindless mergers, closed factories, off-shoring of production, increased debt, reduced ability to compete, declining rates of return on assets, rampant illegality in the financial sector, excessive financialization of the economy—the list goes on.
Tackling all of these problems separately would amount, as Henry David Thoreau once wrote, to “hacking at a thousand branches of evil.” Instead we need to “strike at the root”—the idea that is driving all those apparently different kinds of asocial behavior: the dumbest idea in the world.
There Is Another Way
The good news is that we know how to do this. Some organizations did not embrace “the dumbest idea in the world.” They took a different path. They pursued Peter Drucker’s insight of 1954 that the only valid purpose of an enterprise is to create a customer, and they adopted the management practices needed to make that happen—a kind of Copernican revolution in management. With this different goal and these different management practices, these organizations became radically more productive and are steadily putting traditionally managed firms out of business.
The experience of these firms shows that there is a way forward. Scores of books have been written about this different way of running organizations that is good for those doing the work, good for those for whom the work is done, good for the organizations themselves, and, ultimately, good for society as a whole.
It is becoming clearer that the stagnation of incomes of average citizens, the decline in real returns of traditionally managed organizations, secular economic stagnation and the resulting anger in the electorate are all the consequences of obsolete management practices.
And it becomes clearer why brilliant macro-economists like Larry Summers and Ben Bernanke aren’t much help in solving the problem of secular economic stagnation. They are looking in the wrong place. The problem isn’t a macroeconomic problem, in the sense of a misguided interest rate or an inadequate fiscal stimulus or a savings glut. The root cause of the problem is running organizations in an obsolete fashion. Solving the macro-economic problem requires solving the management problem—a subject with which most macro-economists have little interest, background or understanding.
Many organizations are still in denial. They are puzzled by the ongoing disruption in the marketplace and the stagnation of the economy. Executives find it difficult to accept that the management practices which worked so well in the 20th century and on which people have based entire careers have become steadily less viable. It is natural to hope that more strenuous pursuit of those practices will eventually be successful. In effect organizations continue to pursue short-term profits and executive bonuses while tolerating a dispirited workforce, declining margins and real economic decline.
Those who work in these corporations are also puzzled as to why so many talented people are working so hard with such large resources with such unproductive and frustrating results. Analysts, regulators, and central bankers are equally concerned that the economy doesn’t experience real growth the way it used to. And those at the bottom of the economic ladder find good jobs ever harder to find. Politicians search for villains who can be blamed for the failure.
Society Is Part Of The Problem
The alarming part of our current situation is not only that powerful leaders and enterprises have been pursuing unproductive business practices and undermining prosperity for all. The deeper problem, as Gautam Mukunda assistant professor of organizational behavior at Harvard Business School points out, is that they have changed the way that we as a society think.
We as a society have come to tolerate that that extracting value from public corporations is given precedence to creating value; that financial gains from productivity improvements are not passed on to workers who generated them; that executives award themselves extraordinary bonuses for objectively poor performance; that many boards of directors have degenerated into a formalized mutual support system; that illegal stock price manipulation on a gargantuan scale is standard practice; and that economic stagnation and decline has come to be seen as, if not acceptable, inevitable. The fact that we as a society tolerate this situation means that we, too, have become a part of the problem.
Not Just A Management Problem
We need therefore to recognize that we are not just dealing with a narrow business issue or a management practice that must be fixed. The issue does have management aspects, but it has become a societal problem. It’s not just executives who have to change their ways. The situation requires action across the whole of society.
Yes, the C-suite must stop giving priority to extracting value from firms. But boards of directors must also stop giving them incentives to do so. Business schools must stop teaching them how to do it. Institutional shareholders must end their complicity in what CEOs are doing. Regulators must go beyond searching for individual wrongdoers, and address overall systemic failure. Central bankers must recognize that they are indirectly funding the operation and open their eyes to the economic consequences of their actions. Pension funds and even small investors must end their support of the extraction of value. The leaders who should be fixing the system must end their complicity in malfeasance.
Such a vast set of societal changes will obviously not be easy. Shareholder value thinking and share buybacks are now deeply entrenched in many institutions and bold actions from many players are needed to fix them. The situation cannot be resolved by single individuals acting alone. Action by an entire society is needed.
Although such a challenge is daunting, we should keep in mind that we have solved huge societal problems before: slavery, cigarettes, industrial poisoning, and the hole in the ozone layer, to name just a few. It would be wrong to underestimate America’s capacity for reinvention.
The Upside Of Electorate Anger
The anger now apparent in the electorate today is both a wake-up call and an opportunity. If that anger can be channeled into efforts aimed at fixing the real problem and replacing “the dumbest idea in the world” with modern management practices, we will make genuine progress.
If the anger is used to pursue illusory villains (immigrants, Obamacare) or illusory solutions (taxing the rich, printing money, public institutions), the problem will only get worse.
We are now at an “emperor has no clothes” moment. We now know that aggressive value extraction masquerading as creating shareholder value is in fact leading to systematic value destruction and an economy that doesn't work for ordinary citizens. We need strong leadership from many actors across society to get on a better path.
And read also:
How CEOs Became Takers, Not Makers
World’s Dumbest Idea: Shareholder Value
Capitalism’s Future Is Already Here
Why The World’s Dumbest Idea Is Finally Dying
The Best Management Article of 2014
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Follow Steve Denning on Twitter at @stevedenning
