Disaffection with the Current Economic Order

Boards are now required to consider externalities they ignored when only considering the narrow financial and legal aspects affecting publicly listed enterprises. Apart from climate change, pollution, congestion, corruption, and tax avoidance where we are “all in it together” whether we like or not, there is also a crisis of trust in institutions created by the failure of the neo-liberal elite to appreciate the pain of “citizens of somewhere,” alienated by the policies of “citizens of nowhere,” articulated forcefully by Theresa May, then British Prime Minister at the Conservative Party Conference in October 2016:

Now don't get me wrong. We applaud success. We want people to get on. But we also value something else: the spirit of citizenship. That spirit that means you respect the bonds and obligations that make our society work. That means a commitment to the men and women who live around you, who work for you, who buy the goods and services you sell. That spirit that means recognising the social contract that says you train up local young people before you take on cheap labour from overseas. That spirit that means you do as others do and pay your fair share of tax.

But today, too many people in position of power behave as though they have more in common with international elites than with the people down the road, the people they employ, the people they pass in the street. But if you believe you are a citizen of the world, you're a citizen of nowhere. You don't understand what the very word “citizenship” means.

So if you're a boss who earns a fortune but doesn't look after your staff… An international company that treats tax laws as an optional extra… A household name that refuses to work with the authorities even to fight terrorism… A director who takes out massive dividends while knowing that the company pension is about to go bust… I'm putting you on warning. This can't go on anymore.¹

Failure to deal with this pain and resentment and its populist reaction undermine the liberty we take for granted and could put free-market capitalism and democracy at risk. In the words of Geoffrey Garrett, dean of Wharton:

I am increasingly convinced of three things:

First, the populist outrage expressed toward all elite institutions (governments, corporations, universities) is not a top-down case of charismatic leaders inflaming a rudderless society. Rather, today's populist leaders are the product of profound societal dissatisfaction with an elite-driven political economy.

Second, the rise of populism is at its core an economic phenomenon—with enormous social and political consequences—driven above all by the deteriorating economic situation of the middle class.

Third, there is negativity toward “the system” including democracy itself. The deep potential support base for populist leaders who want to blow it up—not reform it through the established push and pull of democratic politics—is highest among millennials. We used to think of young adults as being the most idealistic and committed to democracy. No longer.²

Yet dealing with this pain and resentment presents boards with a serious dilemma: On the one hand, they are expected by Milton Friedman³ and shareholders to do what is in the best interests of the organization on whose board they sit, regardless of the cost of the externalities they create for society⁴; while on the other hand, such behavior creates resentment in the general public and leads politicians like Theresa May to threaten them because, in her words, they do not understand what “citizenship” means.

This dilemma is made worse because the individual company decisions they take, ignoring externalities to maximize short-term profitability, when taken collectively by all enterprises, fuels this resentment and dissatisfaction with the current economic order. What may be sensible for one firm can become a recipe for disaster if all firms do the same thing at the same time.

Boards must therefore recognize the collective impact of externalities created by their focusing on short-term profit maximization means no firm is an island and we are still “all in this together.” However, recognizing the fact we are still “all in this together” is made doubly difficult by the populist assertion that we are not, and by the fact boards do not have adequate decision-making tools to reflect the true costs they impose on the environment, economy, and society of the externalities they create through their individual profit-maximizing decisions.

Leading boards recognize shareholder value reflects their effectiveness first in creating value by selecting strategies to create sustainable competitive advantage; second in extracting value by implementing such strategies efficiently; and third in sharing it with investors through dividends, share buybacks, and capital gains. However, that is no longer all they must consider if they are to constrain the rise of populism. There are serious additional issues of distribution at stake—job security, income inequality, and social welfare—which make reconciling long- and short-term time horizons more difficult and which have been largely ignored.

The failure of politicians and companies to consider these additional issues over the past 30 years has helped fuel the rise of populist politics with its volatile mix of nostalgia for imagined past greatness; resentment of elites that have rigged the economic system against those left behind by globalization and technological change; and fear of cultural change brought about by immigration.

As a firm believer in the merits of capitalism, like Ray Dalio, I fear we may see a replay of the 1930s with different actors but the same outcome. Again, in the words of Geoffrey Garrett, dean of Wharton:

My message to our students was that we must all be realistic optimists, not naive ones. For me, that means acknowledging that we must all do whatever we can to navigate and reverse three intersecting geo-economic and geo-political trends:

• After four decades of ever-increasing engagement between China and the United States, the world's two leading powers seem increasingly determined to decouple their economies from each other—making a second Cold War a reality and superpower war more likely.
• Notwithstanding that past technological revolutions have improved both the quality of life and the world of work, the combination of robots and AI threatens to destroy many more jobs than it creates—undermining the foundations of a good life based on a good job.
• While it remains tempting to dismiss the recent rise of anti-establishment politics as an aberration, the roots of populism run much deeper and stronger—weakening the foundations of democracy and increasing the chances of international conflict.⁵

Given the level of dissatisfaction with the current political-economic order, will good modern corporate governance (CG) be sufficient to prevent a “political tragedy of the commons,” caused by boards doing what is in the best interests of their individual organizations without considering the collectively the negative impact of their decisions on society as a whole?

Boards will need to consider not just the sustainability of their organizations, but also the impact on society of externalities they create and their effects on the long-term acceptability of capitalism. This may prove to be challenging and boards may not have the tools and skills to meet the challenge.

Dealing with Symptoms Rather Than Causes

As Ray Dalio points out, capitalism in the past 40 years failed to deliver benefits to enough people for the body politic to continue believing in its merits:

Contrary to what populists of the left and populists of the right are saying, these unacceptable outcomes aren't due to either a) evil rich people doing bad things to poor people or b) lazy poor people and bureaucratic inefficiencies, as much as they are due to how the capitalist system is now working… As a result of this dynamic, the system is producing self-reinforcing spirals up for the haves and down for the have-nots, which are leading to harmful excesses at the top and harmful deprivations at the bottom. More specifically, I believe that:

1. The pursuit of profit and greater efficiencies has led to the invention of new technologies that replace people, which has made companies run more efficiently, rewarded those who invented these technologies, and hurt those who were replaced by them. This force will accelerate over the next several years, and there is no plan to deal with it well.
2. The pursuit of greater profits and greater company efficiencies has also led companies to produce in other countries and to replace American workers with cost-effective foreign workers, which was good for these companies' profits and efficiencies but bad for the American workers' incomes. Of course, this globalization also allowed less expensive and perhaps better quality foreign goods to come into the U.S., which has been good for both the foreign sellers and the American buyers of them and bad for the American companies and workers who compete with them.⁶

As a capitalist who still believes it is the best system known to humankind for creating wealth, I also worry its moral underpinnings may have been fatally undermined by a combination of forces unleashed by financial services, the 24/7 culture we now live in, promoted by instant news and the Internet and the collapse of rational, civilized political discourse.

I believe sustainable capitalism is built on three pillars: deferred gratification (the reason for investing to make the world a better place in the future rather than consuming any surplus immediately); trust (my word is my bond); and mutuality (the same rules for everyone). As these pillars crumble, so does the moral case for global capitalism, helping explain the rise of populism.

The Wrong Neo-liberal Responses

The metropolitan neo-liberal responses to loss of jobs and status made matters worse. Priding themselves on being meritocrats, they have often argued losers deserved to lose because they were undereducated and unable to keep pace with the changes around them. Sometimes, this sense of meritocratic moral superiority was expressed quite openly, merely angering the “losers” further.

Neo-liberals have continued to promote the concept of Ricardian free trade, with its static comparative advantage where capital, land, and labor were fixed geographically and disruptive technology was not a factor. It may have made sense in the nineteenth century, as Ricardo's examples of wine and wool proved. However, in today's world, only land is fixed geographically and technology is designed to overcome even that through global supply chains, whose workings politicians do not seem to understand (hence the dangerous emphasis on a “clean break” with the EU of hard Brexiteers and Trump's declaration of a trade war with China that will be “easy to win”).

Instead of Ricardo's static comparative advantage, we have Yotaro Kobayashi's (a former chairman of Fuji Xerox) concept of dynamic comparative advantage. He argued, as early as 1986 at a conference I attended in Taipei, the Japanese would never have learned to make cars, leaving it to the Americans instead, if Ricardo was correct. He proposed a theory of dynamic comparative advantage where comparative advantages change over time as a result of deliberate government policy choices.

Dramatic examples of this are high-speed rail and smartphones. Twenty years ago, China had no high-speed rail. Japan, France, and Germany led the world in terms of networks and technology. According to Ricardo, China should never have become a global competitor in high-speed rail. Yet today, China has the world's biggest network and aims to reach 38,000 kilometers by 2025. It is competing successfully in third markets against the Japanese, French, and Germans. The same is true of mobile phones and smartphones. Fifty years ago, China was a backward country in telephony. The United States was the most advanced, with landlines managed by AT&T. Today, China has the largest mobile phone market, and in the last five years has become a threat to both Samsung and Apple in smartphones. If Ricardo was correct, Huawei would threaten nobody. I could provide more examples such as Ali Baba, Alipay, TenCent, Baidu, and WeChat in mobile apps and the fact Chinese now hardly use cash, even when paying for fruits and vegetables at street markets. Korean industrialization and its creation of global branded champions is yet another example of the shortcomings of Ricardian analysis.

We must accept that dynamic comparative advantage harnesses the power of disruptive technology to put entire industries at risk, with the ensuing rapid dislocation of employment depending on those industries—for example, Finland and the rise and fall of Nokia. Economists and politicians seem to forget decline is much more rapid and devastating than the rise of replacement jobs of equivalent social and economic status. An unemployed Ohio steelworker will not likely find work at Facebook; the geographical and skills barriers are too great. He may find a job in his local Walmart, but with lower pay and much lower status, becoming a target for populists.

Dynamic comparative advantage combined with globalization undermines the principle of economic mutuality. We are not “all in it together”; there really are zero-sum conditions. Until politicians recognize dynamic comparative advantage works differently from static comparative advantage, they will continue to promise undeliverable benefits from global free trade for those who do not have the ability to adapt quickly enough in a “winner takes all” capitalism that creates ever fewer jobs per dollar of revenue. Moreover global network effects disproportionately benefit the few who own the networks or the stars (authors, entertainers, celebrities, and sportspeople) who feature on the networks, dramatically reinforcing highly visible inequality. The Internet and 24/7 media with their love of celebrities and reality shows sharpens the disconnect between winners and losers.

1. Focusing on Reputation

What is reputation and why does it matter? Reputation is defined as:

The observers' collective judgments of a corporation based on assessments of financial, social and environmental impacts attributed to the corporation over time. [Emphasis mine]⁹

This definition shows there is more to maximizing the value of a company's reputation than just maximizing shareholder value. Boards must reconcile the impact their companies have on the communities within which they work if they are to maximize their “social license to operate.” A good reputation has become a much more valuable business asset over the past 40 years. In 1975, according to The Economist, intangibles represented just 17 percent of stock market cap at US$590 billion. By 2015, the sums involved had risen to US$19.8 trillion and 84 percent. In a world where intangibles represent over 80 percent of market capitalization, reputation matters more than ever. Boards now recognize this, rating reputation risk as their most important risk.

According to the 2017 Reptrak study on the impact of reputation, the positive reasons for focusing on reputation are that an excellent reputation increases growth; makes it easier to recruit and retain the best people; mitigates the downsides of crises; increases trust; and enhances the share price (companies with a good reputation outperformed the S&P 500 by 2.5 times over the period January 2006–January 2017). Compared with companies with poor reputations, companies with excellent reputations have nine times more prospects to buy their products; just over ten times more positive comments and product recommendations; nearly ten times more people trusting the company to do the right thing and welcoming them in the community; and nearly nine times more people willing to invest in the company.

The board's role in strategy setting and review consists of five tasks: defining a sustainable mission; creating a compelling vision; reconciling creation, extraction, and distribution of value; reviewing implementation; and ensuring compliance with regulations. Reputation plays a key role in all of them: first, defining a sustainable mission; second, creating and sustaining a unique and compelling vision to provide a line of sight between the company's mission and the employee's job; and third, reconciling value creation, extraction, and distribution with the needs of the future (investment in R&D and new business models). Focusing on the reputation impact of the resulting trade-offs helps effective reconciliation and enhances the company's sustainability as a result. This need for reconciliation between short-term and long-term objectives with different stakeholder interests has become critically important, as a result of the rise in inequality caused by the doctrine of maximizing shareholder value at the expense of stakeholders who create that value.

Seeking to minimize reputation risk across the company, value and supply chain can help boards find the right balance. As far as the environment is concerned, this means adopting policies of “reduce, reuse, and recycle.” In the case of the community, this means adopting policies of zero tolerance of corruption, obeying laws, paying a fair share of taxes, and avoiding politics. In the case of the workplace, this requires policies based on diversity and inclusion, recruitment and promotion based on merit, transparent pay for performance, respect for human rights, good working conditions, no sexual harassment, and no child labor.

Companies leave themselves open to accusations that share buybacks are socially irresponsible behavior, robbing workers of well-deserved pay increases and society of investment in future jobs and new improved products, just to satisfy short-term shareholders and to inflate the remuneration of overpaid CEOs:

Between 2015 and 2017, U.S. publicly traded companies across all industries spent three-fifths of their profits on buybacks. The low-wage restaurant, retail, and food manufacturing industries spent 137%, 79%, and 58%, respectively. The restaurant industry borrowed money or used cash on its balance sheet to exceed the amount of its bottom line.

These actions disproportionately favor senior management and direct funds away from more productive purposes, such as corporate investment, job creation, or increased worker pay.

Lowe's, CVS and Home Depot could have provided each of their workers a raise of $18,000 a year… Starbucks could have given each of its employees $7,000 a year, and McDonald's could have given $4,000 to each of its nearly 2 million employees. [Emphases mine]¹⁰

This accusation damages the reputation of companies practicing buybacks and it undermines the moral case for capitalism.

2. Treating People as Assets Rather Than Costs

Something is wrong with how “people” are discussed at the board. If directors truly believed what they say about the importance of “people” as assets, they would put their “people,” summarized in payroll costs, on the balance sheet as well as in the P&L as an asset to be invested in, upgraded, and protected from obsolescence. They would charge depreciation against the sum allocated based on the rate at which skills and competencies become outdated. They would treat payroll how they treat plant, machinery, and goodwill, as an aggregated financial sum, not treated solely as a cost, but also as an asset. They might also regard people as a long-term obligation rather than as a variable cost to be disposed of when no longer needed.

The financials only show “people” as a cost, never as an asset. I suspect this difference in accounting treatment has unconscious psychological implications on how boards look at people. There is always subconscious and conscious pressure to minimize these costs in order to maximize shareholder returns. This pressure can be taken to extremes, as exemplified by Amazon's past treatment of some of its workers in the United States, where despite benefiting from generous tax breaks to set up warehouses in communities, it also relied in part on foodstamps provided by the supplemental nutrition assistance program (SNAP) to subsidize its part-time workers who did not get paid enough to buy their groceries.

I wonder if Jeff Bezos really believed the people who work for his company were its assets, he would treat them this way? Instead it seems as though he viewed them as costs to be minimized or externalized in whatever way the law permits. As a result of being targeted by Senator Bernie Sanders, who proposed the BEZOS Act to stop him underpaying workers, Jeff Bezos announced, on October 2, 2018, Amazon would raise minimum wages to US$15.00 per hour in the United States from November 1, 2018, and to £10.50 ($13.60) in the UK for the London area and £9.50 in the rest of the UK rather than taking several years to do this. This at a time when the U.S. minimum wage was still $7.25, turning Amazon from villain into almost a hero on pay. Maybe Jeff Bezos had a change of heart. The reputation gains and improvement in Amazon's image as an employer justify the affordable extra cost.

As long as financial accounts do not record “people” on the balance sheet as assets, the underlying assumption they are costs to be minimized or externalized will continue. In some types of employment, the “psychic income” afforded by following a vocation, doing “national service,” or working for an NGO or charity has justified underpaying people.

The Internet and gig economy have made matters worse with skilled labor in developed economies competing with workers from emerging markets, reinforcing the assumption workers are a cost to be minimized in a global “race to the bottom.” This encourages boards to think people are disposable—an attitude most prevalent in the “Anglosphere” economies. However, “Rhenish” capitalist countries have adopted a different approach, building long-term loyalty through effective apprenticeship programs to develop long-term skills in export-based activities. They have created better-paying jobs in export-oriented industries, lower inequality, and longer life expectancy than in the United States, where life expectancy is falling. The Anglosphere approach only seems to be superior in delivering short-term GDP growth—a defective measure of the overall well-being of an economy in any case.

The rise in inequality resulting from the view shareholders come first and employees last, demonstrated by companies buying back shares while real wages stagnate or decline for blue-collar and lower-white-collar workers may lead to a political tragedy of the commons where what makes economic sense for one individual board does not make political sense when all boards follow suit. Brexit, the election of Donald Trump, and the rise of populists in Europe are all early warning signals of a political pushback boards may yet come to regret. It has already started in the UK, demonstrated in the report of a leading UK thinktank cited by The Guardian on September 5, 2018:

A radical overhaul of Britain's economy as far-reaching as Labour's post-war reforms and the Thatcherite revolution in the 1980s is needed to address the UK's chronic failure to raise the standard of living of millions of workers since the 2008 financial crash, according to a major report…

…Although Britain is experiencing record levels of employment, low wage growth and persistent inequality have been widely cited as reasons for the Brexit vote. [Emphasis mine]

3. Rethinking Processes

The modern definition of CG recognizes the importance of processes and tries to provide a framework boards should apply, including recognizing the collective needs of stakeholders outside the firm. It is an important first step in getting boards to reconcile mitigating their individual (microprudential) risks with minimizing collective (macroprudential) economic and political risks created by their collective actions.

Much more needs to be done, however, if a political tragedy of the commons is to be averted. Boards need to rethink their processes and how they measure performance and set key performance indicators (KPIs) if they are to reconcile the dilemma between doing what is best for their organization and what is best for society as a whole. This requires abandoning Milton Friedman's doctrine that the purpose of business is to maximize shareholder value. Boards should recognize once again Peter Drucker's argument that the real purpose of business is “to create and maintain satisfied customers,” best exemplified in Johnson & Johnson's Credo, which puts customers first, employees second, communities and the environment third, and shareholders last, only requiring they receive a fair return on their investment rather than a maximum return. Or as Jack Ma, the Chinese founder of Alibaba, put it:

Customer number 1, employee number 2, shareholder number 3. If the customer is happy, the business is happy, and the shareholders are happy.¹¹

If recognizing the correct hierarchy of needs to be satisfied is the first board process change, the second is to put the process impact on reputation at the heart of every decision. If all decisions, at all levels, are measured by their positive or negative impact on reputation, boards will have gone a long way to rebuilding trust in their individual companies and in business in general.

This means embedding ethical considerations into deciding what kind of customers they wish to serve, what kinds of products and services they will offer, how they will do business, and how they will treat their employees and the communities within which they operate. This in turn requires developing precisely articulated values, translated into required observable, measurable behavior, forming the basis of transparent employee performance reviews, reinforced by written, trained, and attested codes of conduct, enforced regardless of position and short-term impact on the bottom line. The third step is to ensure KPIs are revised to reflect the first two steps, ensuring how results are achieved is as important as achieving them.

Such rethinking of processes must cover strategic planning, budgeting, and financial reporting, and board-approved policies and procedures, regularly inspected by internal audit, reporting to the audit committee on lapses and loopholes and the corrective action being taken. It also must include all forms of internal formal and informal feedback mechanisms, covering recognition, reward, remuneration, and appraisal systems; the setting and review of KPIs and scorecards; as well as training and personal development schemes; career development and talent management; and appropriate documentation of standard operating procedures (SOPs) and service level agreements (SLAs)

As part of this rethinking, it is essential rewards are redesigned to be distributed fairly both within the organization itself and sustainably within society as a whole. Currently, this is not the case, as argued by Senator Elizabeth Warren:

For much of U.S. history, … corporations sought to succeed in the marketplace, but they also recognized their obligations to employees, customers and the community. As recently as 1981, the Business Roundtable—which represents large U.S. companies—stated that corporations “have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy.” This approach worked. American companies and workers thrived.

Late in the 20th century, the dynamic changed. Building on work by conservative economist Milton Friedman, a new theory emerged that corporate directors had only one obligation: to maximize shareholder returns. By 1997 the Business Roundtable declared that the “principal objective of a business enterprise is to generate economic returns to its owners.”

That shift has had a tremendous effect on the economy. In the early 1980s, large American companies sent less than half their earnings to shareholders, spending the rest on their employees and other priorities. But between 2007 and 2016, large American companies dedicated 93% of their earnings to shareholders. Because the wealthiest 10% of U.S. households own 84% of American-held shares, the obsession with maximizing shareholder returns effectively means America's biggest companies have dedicated themselves to making the rich even richer…

Before “shareholder value maximization” ideology took hold, wages and productivity grew at roughly the same rate. But since the early 1980s, real wages have stagnated even as productivity has continued to rise. Workers aren't getting what they've earned.

Companies also are setting themselves up to fail. Retained earnings were once the foundation for long-term investments. But from 1990 to 2015, nonfinancial U.S. companies invested trillions less than projected, funnelling earnings to shareholders instead. This underinvestment handcuffs U.S. enterprise and bestows an advantage on foreign competitors. [Emphases mine]¹²