Economic Calculation in the Corporate Commonwealth
Introduction. Via Lyndsey Medsker (private email). Former House Majority Leader Dick Armey, now of the corporate "free market" think tank FreedomWorks, (just click on the link, and you'll get the idea pretty quickly ) writes on the political controversy surrounding executive pay:
The vitality of the American economy results from thousands and thousands of ongoing experiments. Entrepreneurs take an idea and test it in the marketplace. Some ideas are about new products or methods for production, sales or marketing. Still other innovations are in the organization of a firm, its management system and even in the ways of measuring, monitoring and compensating its employees. Markets reward successful entrepreneurs and innovations. Just as importantly, however, markets will punish bad ideas and inefficient behavior. Justice for corporate malfeasance is swift and brutal, as was seen in plummeting stock prices for Enron or Tyco once scandal emerged
By contrast, oftentimes efforts by Congress to "protect" shareholders from self-serving corporate executives tend to insulate bad actors from market forces and perpetuate poor performance.
Clearly the top-performing CEOs in corporate America earn every penny of their compensation and then some. They create wealth, and by doing so create shareholder value, increased consumer welfare and higher standards of living.
Publicly held companies are designed to maximize profit to their shareholders. Inevitably, some firms will employ poor managers and occasionally a really bad actor. Unless the firm has a strong system for monitoring the quality of executive decision-making, the market will pass judgment quickly in the form of lower or negative returns on investment.
The problem with a one-size-fits-all approach to executive pay is that it punishes the vast majority of the market — where wealth-generating firms and shareholders reside — in order to get at a handful of bad actors who would otherwise be dealt with through market forces.
There is a healthy dose of arrogance in the idea that another law could beat an entrepreneurial marketplace for determining how to evaluate compensation. Poor executive performance shows up quickly on the bottom line.
I won't even bother telling you what I think of Armey, either as a former economics professor or as a professed friend of "free markets." Suffice it to say that, with such defenders of "free markets," it' s no wonder so much of the Left hates markets on principle and sees free market libertarianism as a disingenuous apologetic for corporate interests. If "free markets" really meant what Armey and his paymasters mean by them, I'd hate them too.
But since this ties in so closely to a line of argument I was already developing in a manuscript article ("Economic Calculation in the Corporate Commonwealth"), I thought I'd use this as the jumping-off point for publishing an excerpt here.
Disclaimer: I shouldn't have to say this, but for the record I do not favor government regulation of executive pay.
"Economic Calculation in the Corporate Commonwealth"
Part II: Hayek vs. Mises on Distributed Knowledge
Mises denied any correlation between bureaucratization and large size in and of itself. Bureaucracy as such, he argued, was a particular rules-based approach to policy-making, as opposed to the profit-driven behavior of the entrepreneur. The point Mises neglected was the extent to which rational profit-driven entrepreneurial behavior becomes impossible because of the information and coordination problems inherent in large size. The large corporation, necessarily, distributes the knowledge relevant to informed entrepreneurial decisions among many departments and sub-departments, until the cost of aggregating them outweighs the benefits of doing so.
Try as he might, Mises could not exempt the capitalist corporation from the problem of bureaucracy. One cannot define bureaucracy out of existence, or overcome the problem of distributed knowledge, simply by using the word "entrepreneur." Mises tried to make the bureacucratic or non-bureaucratic character of an organization a simple matter of its organizational goals, rather than its functioning. In seeking to solve the problem by definition, by making profit-seeking the defining characteristic of the "entrepreneurial" organization as a whole, Mises resembled the collectivists who try to solve agency problems by positing a "new socialist man." The motivation of the corporate employee, from the CEO down to production worker, will be profit-seeking; his will is in harmony with that of the stockholder because he belongs to the stockholder's organization.
By defining organizational goals as "profit-seeking," Mises--like the neoclassicals--treated the internal workings of the organization as a black box. In treating the internal policies of the capitalist corporation as inherently profit-driven, Mises simultaneously treated the entrepreneur as some kind of indivisible actor whose will and perception permeate the entire organization. Although (as we see below) Mises at one point explicitly denied that the entrepreneur was omnipresent, in practice he viewed his entrepreneur as a brooding omnipresence whose influence guided the action of every employee from CEO to janitor.
Mises viewed the separation of ownership and control, and the agency problems resulting from it, as largely non-existent. The invention of double-entry bookkeeping, which made possible the separate calculation of profit and loss in each division of an enterprise, as "reliev[ed] the entrepreneur of involvement in too much detail." The only thing necessary to transform every single employee of a corporation, from CEO on down, into a perfect instrument of his will was the ability to monitor the balance sheet of any division or office and fire the functionary responsible for red ink.
It is the system of double-entry bookkeeping that makes the functioning of the managerial system possible. Thanks to it, the entrepreneur is in a position to separate the calculation of each part of his total enterprise in such a way that he can determine the role it plays within his whole enterprise. Thus he can look at each section as if it were a separate entity and can appraise it according to the share it contributes to the success of the total enterprise. Within this system of business calculation each section of a firm represents an integral entity, a hypothetical independent business, as it were. It is assumed that this section "owns" a definite part of the whole capital employed in the enterprise, that it buys from other sections and sells to them, that it has its own expenses and its own revenues, that its dealings result either in a profit or in a loss which is imputed to its own conduct of affairs as distinguished from the result of the other sections. Thus the entrepreneur can asign to each section's management a great deal of independence. The only directive he gives to a man whom he entrusts with the management of a circumscribed job is to make as much profit as possible. An examination of the accounts shows how successful or unsuccessful the managers were in executing this directive. Every manager and submanager is responsible for the working of his section or subsection. It is to his credit if the accounts show a profit, and it is to his disadvantage if they show a loss. His own interests impel him toward the utmost care and exertion in the conduct of his section's affairs. If he incurs losses, he will be replaced by a man whom the entrepreneur expects to be more successful, or the whole section will be discontinued. At any rate, the manager will lose his job. If he succeeds in making profits, his income will be increased, or at least he will not be in danger of losing it. [Human Action, p. 305]
Mises also identified outside capital markets as a control mechanism limiting managerial discretion. Of the popular conception of stockholders as passive rentiers, and of managerial control, he wrote:
This doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the "market," plays in the direction of corporate business.... In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation's business; it creates a state of affairs to which the managers must adjust their operations in detail. [Human Action, pp. 306-07]
Mises' naivete is almost breathtaking. One can hardly imagine the most hubristic of state socialist central planners taking a more optimistic view of the utopian potential of numbers-crunching.
Peter Klein, in his excellent study of economic calculation arguments as they affect firm size, ["Economic Calculation and the Limits of Organization," The Review of Austrian Economics Vol. 9, No. 2 (1996): 3-28] argues that Mises foreshadowed Henry Manne's treatment of the mechanism by which entrepreneurs maintain control of corporate management. So long as there is a market for control of corporations, the discretion of management will be limited by the threat of hostile takeover. Although management possesses a fair degree of administrative autonomy, any significant deviation from profit-maximization will lower stock prices and bring the corporation into danger of outside takeover. ["Mergers and the Market for Corporate Control," Journal of Political Economy 73 (April 1965) 110-20; however, Klein cites the argument by Williamson, in Markets and Hierarchies, that the internal structure of the M-form corporation is more effective than external control devices like the capital market; see also Roberta Romano's "A Guide to Takeovers: Theory, Evidence, and Regulation," Yale Journal on Regulation 9 (1992): 119-80, for a survey of the debate on the effectiveness of the takeover threat.]
The question is whether those making investment decisions--whether senior management allocating capital among divisions of a corporation, or outside finance capitalists--even possess the information needed to assess the internal workings of firms and make appropriate decisions.
How far the real-world process of internal allocation of finance differs from Mises picture, is suggested by Robert Jackall's account of the actual workings of a corporation (especially the notorious practices of "starving" or "milking" an organization in order to inflate its apparent profit in the short-term). Whether an apparent profit is sustainable, or an illusory side-effect of eating the seed corn, is often a judgment best made by those directly involved in production. The purely money calculations of those at the top do not suffice for a valid assessment of such questions.
One big problem with Mises' model of entrepreneurial central planning by double-entry bookkeeping: it is often the constraints of the "general plan," as refined at each level of the hierarchy, that result in red ink at lower levels. Those at lower levels have their hands tied by the irrational constraints imposed from above. But those above them in the hierarchy refuse to acknowledge the double-bind they put their subordinates in. "Plausible deniability," the downward flow of responsibility and upward flow of credit, and the practice of shooting the messenger for bad news, are what lubricate the wheels of any large organization.
As for outside investors, participants in the capital markets are even further removed than corporate management from the data needed to evaluate the efficiency of factor use within the "black box." In practice, hostile takeovers tend to gravitate toward firms with low debt loads and apparently low short-term profit margins. The corporate raiders are more likely to "smell blood" when there is the possibility of loading up an acquisition with new debt and "milking" it (stripping it of assets) for short-term returns. The best way to avoid a hostile takeover, on the other hand, is to load an organization with debt, and inflate the short-term returns by milking its long-term productivity.
Another problem, from the perspective of those at the top, is determining the significance of red ink--or of black ink, for that matter. How does the large-scale investor distinguish red ink that results from senior management's gaming of the system in its own interest at the expense of the productivity of the organization, from red ink that results from the normal effects of the business cycle? And the "gaming" might be purely defensive, a way of deflecting pressure from those above whose only concern is to maximize apparent profits without regard to how short-term savings might result in long-term loss. The practices of "starving" and "milking" organizations that Jackall made so much of--deferring needed maintenance costs, letting plant and equipment run down, and the like, in order to inflate the quarterly balance sheet--resulted from just such pressure, as irrational as the pressures Soviet enterprise managers faced from Gosplan.
The problem is complicated when the same organizational culture--determined by the needs of the managerial system itself--is shared by all the corporations in an oligopoly industry, so that the same pattern of red ink appears industry-wide. It's complicated still further when the general atmosphere of state capitalism enables the corporations in a cartelized industry to operate in the black, despite excessive size and dysfunctional internal culture. It becomes impossible to make a valid assessment of why the corporation is profitable at all: does the black ink result from efficiency, or from some degree of protection against the competitive penalty for inefficiency? If the decisions of MBA types to engage in asset-stripping and milking, in the interest of short-term profitability, result in long-term harm to the health of the enterprise, they are more apt to be reinforced than censured by investors and higher-ups. After all, they acted according to the conventional wisdom in the Big MBA Handbook, so it couldn't have been that that caused them to go in the tank. Must've been sunspots or something.
In fact, the conventional wisdom in the financial community sometimes results in censuring transgressions against the norms of corporate culture, even when they are quite successful by conventional measures. Costco's stock actually fell in value, in response to adverse publicity in the business community about its above-average wages. Despite Costco's having outperformed Wal-Mart in profit, Deutsche Bank analyist Bill Dreher snidely remarked "At Costco, it's better to be an employee or a customer than a shareholder." Nevertheless, in the world of faith-based investment, Wal-Mart "remains the darling of the Street, which, like Wal-Mart and many other companies, believes that shareholders are best served if employers do all they can to hold down costs, including the cost of labor." [Stanley Holmes and Wendy Zellner, "The Costco Way: Higher wages mean higher profits. But try telling Wall Street" Business Week Online April 12, 2004]
On the other hand, senior management may be handsomely rewarded for running a corporation into the ground, so long as they are perceived to be doing everything right according to the norms of corporate culture. In a story which Digg aptly titled "Home Depot CEO Gets $210M Severance for Sucking at Job," [the original, more prosaicly titled article appeared in the New York Times January 3, 2007] departing Home Depot Robert Nardelli received an enormous severance package despite abysmal performance. It's a good thing he didn't raise employee wages too high, though, or he'd probably be eating in a soup kitchen by now.
As you might expect, the usual suspects stepped in to defend Mr. Nardelli's honor. An Allan Murray article at The Wall Street Journal noted that he had "more than doubled [Home Depot's] earnings." And a cover story in the January 15 issue of Business Week sympathetically quoted Nardelli's complaint that "share price is the one measure of company performance that he can’t control." T. Blumer of BizzyBlog made quick work of these arguments. He mentioned, among other inconvenient facts, the ways in which Nardelli doubled those earnings:
* His consolidation of purchasing and many other functions to Atlanta from several regions caused buyers to lose touch with their vendors.....
* Firing knowledgeable and experienced people in favor of uninformed newbies and part-timers greatly reduced payroll and benefits costs, but has eventually driven customers away, and given the company a richly-deserved reputation for mediocre service. [BizzyBlog, January 8, 2007]
As for stock price being the one factor Nardelli couldn't control, Blumer observed:
Substitute “control”... with “manipulate.” Nardelli and his minions played every accounting, acquisition, and quick-fix angle they could to keep the numbers looking good, while letting the business deteriorate. The market is not stupid; HD’s poor share-price performance shows that investors have known for quite a while that the HD-Nardelli “success” story has not been genuine. The manipulation can make the numbers look good, and it takes some time for the chickens to come home to roost. [BizzyBlog January 8, 2007]
In fact, Nardelli's mismanagement goes further. Since I originally posted this, T. Blumer provided this additional bit of information: