Creative Capitalism: Profit-maximization as the sole goal of a corporation :

By Martin Wolf

What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy? What implications does the answer have for such a company’s freedom to be “creative” in the way Bill Gates uses the term? The classic answer to the first of these questions, repeated often in these discussions, is that its aim is to maximise profits. This statement is not false. But it is vastly too limited. Here are ten points relevant to this theme.

First, one has to distinguish the goal of the firm from its role. The role of companies is to provide valuable goods and services – that is to say, outputs worth more than their inputs. The great insight of market economics is that they will do this job best if they are subject to competition. Profit-maximization (or shareholder value maximization, its more sophisticated modern equivalent) is NOT the role of the firm. It is its goal. The goal of profit-maximization drives the firm to fulfill its role.

Second, by creating a competitive market for corporate control, we more or less force companies to maximize shareholder value, or at least behave in ways that the market believes will lead them to do so. If companies fail to oblige, the company will be put “into play.” Thus, in Anglo-American shareholder-driven capitalism, maximization of shareholder value (as perceived by the market) must perforce be the goal of the company. This is not the case in countries where a market in corporate control does not exist. In such countries, companies must earn a high enough return on capital to survive. But this need not be a shareholder value-maximizing return.

Third, a company is viewed in the Anglo-American world as a bundle of contracts. But companies are also social organisms created by a highly gregarious mammalian species with a unique capacity for large-scale co-operation over time and space. Companies have cultures and histories. For many of those most closely associated with them, they also have (and offer) a certain meaning. Committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living. Indeed, it is impossible to direct most companies solely by the goal of profit-maximization. (Goldman Sachs may be an exception.) They have to be aimed at the intermediate goal of producing and developing goods and services that people want to buy and are worth more in the market than they cost to produce.

Fourth, the idea that a company is an entity that can be freely bought and sold is culturally specific. It is the view, above all, of Anglo-Americans. It is not shared in most of the rest of the world. The reason for this divergence is that, for many cultures, a company is viewed as being an enduring social entity. I once read that, for many Japanese, one can no more sell a company over the heads of its workers than one can sell one’s grandmother. In this view, goods and services can be bought and sold. Companies, like countries (or, as we all now agree, people), must not be.

Fifth, in this perspective, shareholders are not genuine owners. They contribute nothing of value to the competitive strengths of the firm, enjoy the benefits of limited liability and are well able to diversify the risks they run. They are merely an (ever-shifting) group of people with a claim to the residual incomes. Those with the biggest (undiversifiable) investment in the firm—and thus the greatest exposure to firm-specific risks—are not shareholders, but core workers. The interests of the latter are, therefore, paramount.

The salient characteristic of the contracts inside the firm (that is between the company, its employees and, quite often, its suppliers and even distributors) is that they are relational. That is to say, they cannot be written down in any precise form. Companies are hierarchies in which people engage voluntarily. They necessarily work on the basis of trust in what is often a very long-term relationship: I work extra hard to meet a deadline now, in return for consideration when I need to look after my elderly mother later on. For many companies, trustworthiness is an essential ingredient in their long-term success.

Sixth, if companies can be freely bought and sold, relational contracts, which depend on continuing interaction among specific people inside the business, are hardly worth the paper they are (not) written on. Rational employees will act opportunistically, because they will always expect their company to do the same. The longer and more reliable relationships are expected to be, the less likely such opportunistic behaviour is to emerge.

Seventh, accordingly, capital-market arrangements (and associated views of the firm) that enforce shareholder value maximization may (I stress “may”) make companies work less efficiently than otherwise, in terms of their primary role, by precluding (or at least making far more difficult) a range of potentially valuable relational contracts inside the firm. At the least, such restrictions may have powerful effects on comparative advantage, by shifting countries away from those activities in which companies that benefit from long-term relational contracts are likely to be most effective.

Eighth, it is not necessarily even the case that companies which operate under the assumption that they can be bought and sold (like GM) will operate more successfully in terms of maximizing shareholder value than those which do not (such as Toyota). Toyota is a better car company than GM in almost all dimensions. The failure of Japanese capitalism to achieve the highest level of productivity and sustained dynamism may have far more to with repression of domestic competition in many markets for goods and, above all, services, rather than with the absence of an active market for corporate control.

Ninth, consequently the room for enduring divergence in the forms of capitalism is bigger than those working in the Anglo-American intellectual tradition appreciate. In particular, without an active market for corporate control, managements rule companies. It also acts as a trustee for a range of stakeholders, of which core workers are the most important. Because these companies cannot be forced to maximize shareholder value, they can indeed undertake a range of costly “charitable”activities, provided they do not threaten the company’s ability to survive.

Tenth, one of the most interesting questions over the next generation is whether the Anglo-American form of capitalism, which gives primary direction of companies to capital markets, will flourish and expand, or not. Some of the evidence on the (in)effectiveness of takeovers and the recent sad experiences in financial markets rather suggests not.

This is not to deny that such active financial markets bring big benefits, particularly in financing new companies and enforcing greater discipline on badly run businesses.

Anyway, the more “Anglo-American” capitalism becomes and so the more shareholder driven, the less “creative,” in Bill Gates’s sense, it is likely to be. Or, at the least, the less concerned with wider social results it is likely to be.

FT.com : The Accountancy Column:

By promoting the fallacy that an increase in the value of an asset necessarily makes its owner better off, it has repercussions throughout the economy.

The housing market is an obvious casualty. The amount homeowners can afford to borrow depends on their ability to service the loan – normally out of income. The fair value fallacy encourages the mistaken belief that it is safe to borrow or lend, provided the loan is covered by the market value of the property. The result is a spiral of ever-increasing loans pushing up property values, which make possible ever-increasing loans. Pyramid schemes are normally against the law. Pyramid lending, however, has been made respectable by a fundamental error in accounting theory.

More sabre-rattling in Iran | Economist.com : Israel worries that, even if Tehran does not yet have enough fissile material for a bomb, every month that passes adds to its knowledge. The next American president may be less tough on Iran than the current one. If military action has to be taken, Israel may calculate, better to do it before the new man takes over. Moreover, if Israel intends to bomb the Russian-built nuclear reactor at Bushehr, it would be better to do so before it is loaded with fuel, probably before October. Israel might also prefer to act before Iran deploys its new generation of air-defence missiles, which may happen early next year.

Via Gas Buddy:

Via Economist.com

In his 30s Mr Fossett had typed out a list of things to do that included, rather than putting up shelves or going to the gym, doing all the World Loppet cross-country skiing marathons, swimming the English Channel and climbing the highest mountain on each continent. He did them all, except for climbing Everest, for which he found he did not have the patience. But he also took part in the Le Mans 24-hour car race, the Boston Marathon and the Iditarod dog-sled race in Alaska. He performed the fastest sail circumnavigation, the fastest sail transatlantic crossing and the highest flight in a glider, nine miles (15.5km) above the Andes. By sea or by air he set 116 records, of which 60 still stand, sewing them up (ever the keen Eagle Scout) like badges on his arm.

Via Zero Beta

This merger was equivalent to the marriage of a somewhat hot thirty-something bachelorette (who is unsecure nervous that all her friends were getting married and she would never be a bride) marrying the 60 year old rich guy (who never got to have that hot girl earlier in life but now that he has money, he can make up for it) – it was a GREAT marriage. Both people got what they wanted.

For as long as I can remember, I have read Art Buchwald’s syndicated column. The column used to appear in ‘The Hindu’, one of the main newspapers in India and I read it daily before going to school in the morning

Later, after I moved to the USA, I got my hands onto his books; ‘I’ll always have Paris’ is my favorite.

Art passed away today. The
New York Times has an article and a video on him.

Tax Report – WSJ.com

Taxing reading: A handy new publication with an overview of the federal tax system is available free on the Web site of Congress’s Joint Committee on Taxation, or JCT (www.house.gov/jct/x-2-07.pdf). ... A separate JCT publication lists tax provisions scheduled to expire through the year 2020.

Via The New Yorker:

....one of the critical clues about Enron’s condition lay in the fact that it paid no income tax in four of its last five years. Enron’s use of mark-to-market accounting and S.P.E.s was an accounting game that made the company look as though it were earning far more money than it was. But the I.R.S. doesn’t accept mark-to-market accounting; you pay tax on income when you actually receive that income. And, from the I.R.S.’s perspective, all of Enron’s fantastically complex maneuvering around its S.P.E.s was, as Fleischer puts it, “a non-event”: until the partnership actually sells the asset—and makes either a profit or a loss—an S.P.E. is just an accounting fiction. Enron wasn’t paying any taxes because, in the eyes of the I.R.S., Enron wasn’t making any money.

If you looked at Enron from the perspective of the tax code, that is, you would have seen a very different picture of the company than if you had looked through the more traditional lens of the accounting profession. But in order to do that you would have to be trained in the tax code and be familiar with its particular conventions and intricacies, and know what questions to ask. “The fact of the gap between [Enron’s] accounting income and taxable income was easily observed,” Fleischer notes, but not the source of the gap. “The tax code requires special training.”

Michael Lewis (the author of Moneyball) says:

Where I have encountered greatness, there is an ability to go a different direction from everyone else while behaving with confidence and assurance as if you’re just doing it the way things should be done. It’s now very fashionable to be an innovator and to be a change maker. You get lots of people throwing the terms around. People think they are more unusual than they are. Whenever you see someone say, “I like to think outside the box,” you know that they are so deeply in the box that they’ll never get out.

He has a real ability, like a really gifted trader, to act on his own judgments. This is painful for most people to do, because they face ridicule and ostracism. I think intelligence is overrated as a quality central to this kind of innovation. It’s a kind of nerve. It’s the ability to take a risk.

On Wall Street everybody says he’s a contrarian, and nobody is. It is so hard to recognize the moment when you are caving to conventional behavior. I’ve seen over and again in my subjects – and there is greatness in this – a trigger that goes off in their mind, a switch that flips when they sense that everyone is going one way, and it’s stupid. And they take pleasure in taking a bloody-minded stance against it.

Law Blog » Issue Spotting: Larry Sonsini’s Email Exchange
Regardless of the legalities, HP’s board is comprised of intelligent, accomplished individuals and therefore they should be held to a high standard of behavior. Exactly how does a board member expect a private investigator to obtain confidential information without operating in a gray area of ethical behavior?

American businesses operate all too often under the misguided idea that media exposure and “spin” are an acceptable impetus of behavior. While recognizing that one’s reputation is valuable and should be jealously guarded, one should also realize that our actions speak more clearly than our words. That anyone’s reputation can be damaged by others should prompt us to focus on what we can control instead of what we cannot.

Eventually HP’s business will be rated by its performance in the market place. Revelations of confidential “squabbles” between board members or their intended business strategy should be, at most, a temporary concern. Does this board really think the revelation of HP’s turnaround strategy is truly that important? Or does the board recognize not only it’s own failure at HP, but also the failure of most boards to act decisively. Their fear of culpability is exaggerated in the recognition of their inability to incur the necessary changes required to lead a large corporation.

Clearly, Keyworth did not like the results of the board’s performance. Perhaps he recognized that he was powerless to change things inside the board room? Although violating his confidentiality agreement doesn’t seem to be the best solution, it appears he thought differently and took the course of action which allowed him to exercise power and meet his obligations as a director.

Perhaps a truly diligent director recognizes the implicit conflict in retaining responsibility while not being able to effectively delegate one’s authority. If in fact board members have any authority to delegate in the first place. Which in turn begs the question if one has no authority how can one be responsible?

It is beyond my imagination as to how anyone can authorize access to private and personal telephone records of a company’s board number, to investigate a purely business issue. Patricia Dunn, the chairwoman of HP should resign. Infact, I think every one of HP’s board should’ve resigned the minute they were informed of the above breach of privacy. It just goes on to show that stupidity and arrogance knows no boundaries. I’ve known stupid and arrogant PhDs when I was in academia. Now real-life board of directors are no better either. More on Calif. Investigates Legality of HP Probe

Dunn’s consultants weren’t actually listening in on the calls—all they had to do was look for a pattern of contacts. Dunn acted without informing the rest of the board.

Perkins co-founder of Menlo Park-based venture firm Kleiner Perkins Caufield & Byers complained to other executives and journalists about the investigation’s ethical implications.

His attorney, Viet Dinh, a former assistant U.S. attorney general, says he discovered that one of HP’s private investigators also obtained the last four digits of Perkins’ social security number.

The investigator used that information to open an online account with AT&T, Dinh said. The investigator then called the telephone provider and impersonated Perkins, offering up his social security digits as proof of identity and asking AT&T to send a record of phone calls to and from his house in December 2005 and January 2006 to a free, Web-based e-mail account.

I am currently reading The True Believer: Thoughts on the Nature of Mass Movements by Eric Hoffer. It was written more than fifty years ago. But it is still very relevant. Eric writes from real-world experience, not from the confines of ivory-towers. I first heard about this book from Paul Kedrosky.

I had always been fascinated by mass psychology (the madness of crowds if you will). I have been astonished by seemingly logical people falling prey to religious and political cults and Godmen’s sleight of hands. The above link to Sundar Iyer’s website points to a number of links displaying the madness of cults.

In capital markets, this is equally visible. Mass psychology makes one understand how we never really evolved from colonies of Ants. Ok, maybe that is a overstatement. But a substantial part of humanity finds solace in going with the crowd, letting other people think for them instead of using their own brain, and finding depth and meaning in an outside cause.

While I believe altruism is alive and well, and necessary for humanity’s welfare, the line between individual altruism and a mass movement towards a religious, political cause is very wide indeed. Most adherents to mass movements mistake these two.

Eric Hoffer’s book is a must read for anyone who wishes to understand the contemporary events in the world.

An amusing tit-bit about Ian Fleming’s inspiration for the James Bond novels. A recent Economist’s article implies that one of the ramifications of the Suez crisis from half a century ago is reflected in fiction. Read The Suez Crisis on Economist.com

The major lesson of Suez for the British was that the country would never be able to act independently of America again. Unlike the French, who have sought to lead Europe, most British politicians have been content to play second fiddle to America.

Eden recuperated from the crisis in Ian Fleming’s house, Goldeneye, in Jamaica. It was an appropriate choice, as it was Fleming who was to mythologise the new relationship in his James Bond novels. The first, “Casino Royale”, was published to little attention in 1953, but the series took off in the years after the Suez crisis, offering some sort of literary consolation to a country coming to terms with its new, humbler status. The partnership between Bond and Felix Leiter, a CIA agent, reflected the way the British now liked to see things, the one suave, smart and endlessly resourceful, the other with a lot of money and a slightly plodding manner.

I just finished an extraordinary book, ‘Against the Gods: The Remarkable Story of Risk’ by Peter Bernstein.

I had always believed that the story of civilization is a story of human’s conquest of risk, or atleast a reduction in the most banal forms of risk. Unlike cavemen, we don’t worry about being eaten by wild animals. The vagaries of the weather seldom have life-threatening implications for the general populace. Every human activity, in commerce and in every day life is oriented towards minimizing unknown risks and eliminating known risks.

Bernstein’s book serves to teach you the history of how we came to understand risk, measure it and then proceed to try to eliminate it. While we have reduced risk in many natural spheres, we have created more in the process. Humans have learnt to conquer the risks caused by nature (for the most part) but how about the conquest of risks caused by the actions of fellow human beings?

Volatility is a consequence of irrationality (pause to think about this statement).

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

– G.K. Chesterton

Apple Investigates Allegations Of Poor Work Conditions in China

The Cupertino, Calif.-based company was responding to a report by a British newspaper, the Mail on Sunday, that alleged workers at an unnamed iPod factory were paid as little as £27 (US$50) a month to work 15-hour shifts making the music players.

Apple’s iconic iPod players are made abroad, mainly in China. The company has sold more than 50 million of the devices since its debut in 2001.

I enjoyed reading the book ‘Nation of Rebels: Why Counterculture became Consumer Culture’. The following is a summary from the last chapter in the book. I am inclined to believe that there is definitely a lot of truth in the authors’ thesis.

“...countercultural theorists routinely take concrete social problems and trace them back, in one way or another, to a gigantic “technocratic” apparatus of conformity and repression. For example, environmentalists take straightfowards problems like pollution and blame them on some deep structure of Western rationality (as opposed to an incompleteness of the system of propoerty rights) Antiglobalization activists take the homogenizing effects of trade and blame them on an emerging “Empire” of capital, while ignoring the fact that these same tendencies have been manifest in trade relations since beginning of history. Consumer activists look at the obnoxiously depressing spectacle of brand-consciousness in our society and blame it on a fundamental requirement of the mass production system, rather than simply on the exploitation of a preexisting competition for distinction among consumers.”

The authors cite lively examples to prove the above points. A very thorough debunking of activist progressive left.

Earth Hurtles Toward 6.5 Billion:

Here is an insightful slashdotter
on SUV bashing:

It’s nothing more than guilt-ridden scapegoating.

Even the most ecologically correct American liberal lives a life of unparalleled luxury and ease, fueled by cheap energy, and uses up the Earth’s resources by orders of magnitude more than an African villager.

Can you imagine how comical it would seem to a man who has never ridden in a motor vehicle, to see Volvo and Prius owners looking down their noses at Hummer owners? The guy in Birkenstocks, whose footprint on nature is fifty times bigger than the villager’s, sneers at the guy in cowboy boots whose footprint is sixty times greater.

Same goes for Europe vs. America. If the American way of life is unsustainable, so is the European, differing only by a relatively minor degree. It may help the bien-pensant European Left feel better about its own hypocrisy by saying “Look! The Amis are worse!” But it hardly solves the problem.

Unless you are already living off the grid, growing all your own food, and never traveling farther from your home than you can walk, you have no moral standing to criticize my choice of vehicles.