AN OPINION: What caused the credit crisis, and what is the solution?
On June 17, 2009, President Obama announced sweeping new regulations as an additional remedy to the credit crisis.
In order to analyze whether the various steps his administration has taken will solve the problem or not, we must first analyze what the problem is.
In my lectures and books, I claim that all problems stem from disintegration, which is caused by change.
In the case of the credit crisis, what changed? What was the nature of the disintegration?
Here is my opinion.
The capitalist system is based on the principle that capital creates value and gives a return to the investor. People who contribute capital do not need to literally work. They invest their capital and let the capital work for them. In exchange for that investment, they get a return. It makes sense, then, that owners should be able to control the company in which they have invested.
This system worked well in the early stages of capitalism – early, meaning back when owners were also the managers. The major shift from early to advanced capitalism occurred when ownership became separated from management, through the stock market.
In advanced capitalism, many companies are owned by the public, through shares purchased on the stock market. But these shareholders, who are the owners, do not de facto control the company they own, nor do they necessarily know a lot about the company. They buy shares because they believe that the stock will go up, and in chasing the best returns they will move their ownership from one company to another in a heartbeat.
The effect of the stock market was to bifurcate ownership of the company from control of the company.
But what about the board of directors? Is it not supposed to represent the owners? Don’t the owners continue to control the company, and thus their investment, through the board?
True, the board was designed to be the link that puts owners in control of their company by representing shareholders and supervising management. But it does not function that way. It should, but it does not. In reality, most boards are selected by management and presented to the stockholders for a vote. Except during a fight for control of the company, the managers’ choices are approved by shareholders.
Admittedly, my exposure to the issue has been experiential rather than through scientific research; still, I suggest that the boards are controlled by management rather than vice versa. Management chooses both the board’s agenda and the information to which it is given access.
How about when the board wants to represent – or even is – the majority owner? Does it control management actions then?
I do not think so. Today, businesses are too complex to be well understood by boards that meet once a month for a day or so. Most external boards hardly know what is happening in the company. In making their decisions, board members rely mostly on what management tells them. Realistically, all the board can do is review the company’s financial statements, study the recommendations of top management, and be a sounding board.
What the board does care about is what it can supposedly control: reviewing the actuals and controlling the budgets and, through them, the earnings per share. In fact, under the existing system, the one interest that unites owners, managers, and board members is seeing to it that the price of the stock goes up. When the stock price goes up, the shareholders are happy because their bet worked out. The boards are happy because they have met the needs of the shareholders, and also because the value of their own compensation, usually given in the form of stock options, has risen. Finally, management is happy, because the board appreciates them instead of putting pressure on them to perform better, and also because their take-home income increases, through bonuses and in the value of their stock options.
Both MBA schools and the business trade and academic literature legitimize this common interest. In fact, it is their mantra: “The goal of management is to increase stockholders’ value, ie., the capitalization of the company.”
But in this system, who controls the decisions a company(ie., management) makes?
The stockholders don’t, nor does the board. So who does? It is the ratio of earnings per share that directs the decision-making of management. The price of shares has to decline drastically and substantially, to crisis proportions, before a board will act to replace management.
It should come as no surprise that public companies focus on earnings per share as the goal to be maximized by management. And it is not strange – in fact it should have been predicted – that financial institutions, in order to increase their performance, took the risk of giving sub prime loans – mortgages: the risk to default was in the distant future and transferred to buyers of securitized mortgages, while the benefit to the Profit and Loss statement was imminent.. Any bankers who would not do that would have achieved a smaller earnings per share result than their competition, and probably would have been pressured or even warned by the board to improve performance or else..
I suggest, then, that the disintegration caused by change was the bifurcation of ownership from control of the company. This disintegration meant that now, those who make the investment and take the risk, the owners, are no longer the ones who control the decision-making. And workers, who risk losing their jobs if the wrong decisions are made, have no say in the decision-making process, either. But management, which does control the decisions, does not take the risks: With their golden parachutes and severance pay, managers can end up very well off even if they’re fired.
Let me repeat, for emphasis, where the disintegration occurred: Those who took the risk had no control over decisions; and those who controlled the decisions took no risk.
Many analysts blame the crisis on greed. I do not believe greed is the real culprit. Greed per se is a locomoting force. It motivates people to work hard. The problem is that the greed was not controlled. The uncontrolled greedy managers took risks, and did not have to suffer from the consequences. On the contrary, they gave themselves obscene bonuses even as their companies were going bankrupt. And those who should have controlled the risk, could not, and paid dearly for it.
This was not always the case.
When companies were privately owned and controlled by their manager/owners, the situation was different. The owners were building something for their descendants. The family name was on the door. They took pride in what they did. Companies were much smaller,and owner/managers knew every detail in the company, and owner/managers contributed to the local community, whose residents they both employed and served. If a company did well, the recognition and appreciation of the community followed. If it failed, its owner/manager would feel ashamed in front of the community. Firing your workers was like firing your own family. The community was where you earned either respect or scorn.
If the banks were privately owned and managed – if they were managed and thus controlled by their owners, who actually knew the people they were lending to – do you really think the banks would have taken the risks that got us into this crisis? Now, companies are enormous, spread worldwide. Clients are mere statistics in a market research report, and workers are another statistic, represented by labor costs and sales-per-employee indicators.
Management has lost both pride and shame as controlling forces. What has taken its place is an idol to worship – in the form of a faceless earnings-per-share formula.
We need to re-engineer the system. Specifically, we need to re-evaluate who controls the large corporations – in reality, not on paper.
Let me say right away that I cannot imagine, nor do I recommend, that we limit the size and the geographical presence of companies, or that companies must be owner-managed. Ridiculous. There is no way back from where we are.
So what, then?
One answer we see happening is that the government is getting more involved – by, for instance, taking equity in companies it is trying to save. And which ones is it trying to save? Those that are so enormous that their failure can bring down the whole economy
But will these companies be better controlled because the government now owns a piece of them? Do we really believe that government ownership will cause companies to take fewer or wiser risks?
President Obama said clearly that he does not intend to manage the companies now owned by the government. Thus, government will be just like any other absentee owners. It will appoint some members of the board. But why should we believe that the government can appoint better board members than we have had in the past?
Furthermore, this solution does not provide the paradigm shift that the system requires. If you accept my analysis of the problem, then you can see that the problem remains the same: We expect boards. representing absent capital, to do the supervision – even though the crisis is proof that they have not done an adequate job up to now. Why, then, would we believe the boards as composed can prevent the next crisis?
Will there be another one? Yes, I believe so. After all, this is not the first crisis:Remember the saving and loan crisis?
Let me repeat: The system is broken, and I do not mean the financial system. I mean the capitalist system. It was not built for governance in the complex world we live in today. Our world is globally interdependent. And if each component in this highly interdependent system seeks the maximization of its own interests, it is hardly strange that the totality can get messed up.
We need more regulations, then – and that is the other solution that President Obama is providing, as announced today.
But is it a good solution? Did the Sarbanes Oxley legislation improve accountability and thus the quality of decisions that management makes – or did it just burden companies with an additional amount of stifling bureaucracy and endless paperwork?
More regulation is just more of the same. Again, there is no paradigm shift apparent in the thinking here.
We do not need more of the same of anything. We need a different solution. We need to re -engineer the system.
So we are right back to the question: Who should control management?
Who do you think knows best how well a company is run? The government? Some wise old men and women who meet for a few hours once a month at most? Do new regulations or the government appointment of boards, or supervisory councils, solve the problem of bifurcation: that those who take the risk do not make the decisions, and those who make the decisions do not take the risks? No, they don’t.
But that is the essence of the problem!
Now. who is taking the risk of losing their jobs if the company fails? Who, beyond the stockholders, worries most about the company’s well-being?
Yes, it is the employees. They take the risks. They should be part of the governance of the company.
This is exactly how many professional organizations, such as consulting, legal, or accounting firms, are run. And in the aftermath of this crisis, many unions are now exchanging their benefits packages for a package of ownership in the company. In other words, we are on our way to seeing that happen.
But is it just membership on the board that is needed? Germany has union representatives sit on corporate boards;how well does that work? Actually, not well, if the union representatives are isolated from the workers on the line. If they are professional union leaders, all they really know how to do is negotiate hard for the workers.
What we really need is to move away from such adversary relations, into cooperative relations. And a whole system of governance should be established from the bottom up, from the shift level to the plant and corporate level.
There is a name for the kind of system I just described: “industrial democracy.” Industrial democracy was a fad of the 1960s, and I am well aware of its complexities: I have written two books on the subject. Nevertheless, I think it is time we dust it off the shelf and re-examine the subject.
In industrial democracy, it is the employees who elect to the boards and select their leadership. It is a democracy because the people who are going to be led elect those who will lead them, and management than is controlled by a board composed of both capital and labor.
Democracy should not be applied only to macro systems. It should start from the ground up.
Communism negated the role of capital in creating value and gave no representation to capital in company governance. Capitalism, by and large, does the opposite: it gives labor no power to govern the company. Capitalism and communism, oddly enough, are mirror images of each other, each one rejecting what the other worships.
One more point: the open market mechanism is based on legitimate adversarial relations. That is good for creating competition, which promotes excellence and economic efficiency; but why bring adversarial relations into the company?
We should leave the adversary relations to the market, and restructure governance and a nurture a corporate culture where management workers and capital can be on the same side of the street. The more we integrate, the less disintegration there is, the better off we will be.
And for a global economy, we need global institutions that represent the globe – not institutions that are an accumulation of individual state interests, like the United Nations.
These global institutions should not be focused only on economic issues, as the World Bank and IMF are. Economic-social-political sub-systems are interdependent and becoming increasingly so: Economic issues impact social issues, which impact political issues, etc. You cannot deal with one sub-system and expect to solve a systemic problem.
Systemic problems require systemic solutions. We need global institutions to oversee global issues – for the sake of the globe. We need a new Bretton Woods system that looks beyond economics.
Unfortunately, I am not optimistic that we will make this or any other strategic paradigm shift. Even the current credit crisis is probably not painful enough to spur the drastic changes the system needs. To really change our system, we need to change our values system and our political philosophy, and slay some sacred cows. But to accomplish so fundamental a change, it appears we need an even bigger crisis.
We have had the savings and loan crisis, followed by the real estate crisis; now we have the credit markets crisis with all its ramifications. Each crisis is worse and more all-encompassing than the one before it and will continue to be so, till we get the courage to change the value system that has been driving our decisions so far.
Dr. Ichak Kalderon Adizes