As income inequality steadily deteriorates, and President Biden explores one-time fixes like increasing corporate taxes, more durable solutions are needed to deal the root cause of growing inequality: the goal of big business. That, in turn, would require understanding how most business remains committed to extracting value from the economy, rather than the more profitable, more productive, more worthwhile path of value creation.
Few people today know that in the period, 1945-1970, productivity gains were equally shared between firms and their workers, as shown in Figure 1.
This was one result of the seminal book by economists Adolf Berle and Gardiner Means, The Modern Corporation and Private Property, which laid the basis for stakeholder capitalism: the job of professional managers was to balance the claims all the stakeholders— shareholders, workers, partners, customers and society. (Before that, it was usually assumed that firms pursued their own self-interest, subject only to forces of competition and regulation.)
However this approach also led to “garbage can” firms in which goals were unclear and firms became confused as shown in Figure 2.
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Two Divergent Paths
The actions taken to deal with this problem led to two divergent paths that have determined the fate of firms and their economies for the past half century. One path was that proposed by Peter Drucker in his book, The Practice of Management (Harper & Brothers, 1954): “There is only valid purpose of a firm, to create a customer.” Firms created customers by generating value for them. Customers returned the favor by creating value for companies: making money was the result, not the goal, of the firm.
The Path Of Value Extraction
The opposite path was that of value extraction. Economists Milton Friedman (1970) and Michael Jensen and William Meckling (1976) proposed maximizing shareholder value as the purpose of a firm and recommended executives compensating themselves with stock to align their interests with those of its shareholders. Put more bluntly: the firm’s goal is to extract value from customers. Over the next half-century, that became the goal of big business, particularly in the U.S. It led directly to rampant short-termism and increasing income inequality.
It was accelerated by the SEC rule 10B-18 introduced in 1982 under President Reagan, which allowed firms to buy back their own shares, and so boost the firm’s stock price, without executives having to worry about being accused of corruption or self-dealing.
It was given rocket fuel by a 1990 Harvard Business Review article by Michael Jensen recommending that the executives should compensate themselves handsomely with stock in order to encourage entrepreneurial action. Boards were happy to comply with the compensation. The result however was the opposite of what was intended: executives focused even more on the short-term goal of boosting the stock price. Extraction of value for the shareholders—and themselves—became a central preoccupation of big business.
The path of value extraction was given further help by Michael Jensen in 2002 when he proposed the-re-labeling of the goal of maximizing shareholder value as “long-term value maximization”. Firms supposedly took into account of all the stakeholders, but customers were still no more than the means of making money for the shareholders. “At the end of the day,” as IBM CEO Ginni Rometty explained, “this is about returning value to shareholders.” Ironically, the effect on shareholders was the opposite. A focus on shareholder value systematically lost shareholder value.
The self-interested approach of value-extraction at the expense of the rest of society came under increasingly intense criticism. Even Jack Welch called maximizing shareholder value, “the dumbest idea in the world”. The meager financial returns of firms pursuing shareholder value added fuel to the fire.
Criticism of big business became so intense that in August 2019 major corporations issued a declaration through the Business Round Table that maximizing shareholder value was no longer the goal of business and vowed to help all stakeholders.
However, in the period since the BRT declaration was issued, Harvard Law Professor Lucian Bebchuk and his colleagues have not detected significant change in corporate behavior. Few of the signatory CEOs obtained the approval of their boards to sign the announcement. Massive share buybacks that benefit shareholders, particularly executives, continue to flourish, even where there has been a collapse in profits. Bebchuk concludes that the BRT statement was “mostly for show.”.
The Value Creation Path
The customer value creation path signaled by Peter Drucker in 1954 had very different consequences. For many years, his dictum was ignored. Eventually, it was embraced by Agile software teams driven by the first principle of the Agile Manifesto of 2001. In due course, customer-first thinking spread to whole firms.
The next step was to apply customer-first thinking to the creation of new businesses, which had extraordinary success at serial innovators like Apple, Amazon, Haier Group, and SRI International. These firms demonstrated the extraordinary gains that came from creating new businesses with new customers, one after the other.
Those gains have now been extended by the development of customer-value-creating platforms in which firms establish partnerships with firms to provide an even wider array of products and services than they themselves can deliver.
Even more gains for customers are generated when the platform becomes an ecosystem in which the customers themselves become active partners in determining what value is to be generated.
The Role Of Public Policy In Corporate Purpose
While the public sector should not, in a healthy economy, be dictating to the private firms what their goals should be, the public sector should at least avoid actions and policies that aid and abet value extraction. Here are three things that President Biden should do.
One is to use the power of the bully-pulpit of the U.S. presidency to expose what’s going on in big business and reveal the hypocrisy of firms that portray value extraction as value creation.
A second, more specific action is for the SEC to repeal SEC Rule 10B-18 which gives blanket legal cover to firms that are using share buybacks in self-dealing schemes aimed at boosting C-suite pay. Government would leave it to the courts to decide whether any particular schemes are legitimate or corrupt—a review that Rule 10B-18 currently prevents.
The third is to upgrade the capability of the Federal government from bureaucracy to become a nimbler exponent value-creating management in its supervisory role
In taking these actions, the government would be doing a favor to firms and their shareholders by pointing them to the path of their own long-term profitability as well as the good of society.
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