Business at a Crossroads Leadership_1 doc

32 BUSINESS AT A CROSSROADS more precious than yours. His salary and emoluments, as stated in the annual accounts, tell you that he is worth 80 times more to your company than you are. His performance bonuses and the options he has recently exercised make his net worth two orders of magnitude greater than yours. He’s from a different planet. Wealthy beyond dreams of avarice, he lives a life of luxury, pampered by personal flunkies, surrounded by courtiers and counselors, and casually running up expenses each month that would keep you in clover for a whole year. The company he keeps, in the rarified CEO atmosphere, also sets him apart. He spends as little time with his company colleagues, as he does with his family. His intimates (the people he talks CEO talk with) are wealthy, external professionals (investment bankers and analysts, lawyers, consultants and so on) dressed in the same tailored suits and hand- made shoes, and wearing the mandatory Swiss watches costing as much as a small car. His social life consists of hobnobbing with politi- cians and journalists at sporting events and playing host to royalty at concerts and charity galas. He is a few years older than you and has a similar background, but his life is as different from yours as the life of a medieval king was different from that of a villein. He seems, somehow, to have found the door to another world where the worth of its inhabitants is measured by different standards. We will explore the justification for and the implications of this striking economic “class system” within large companies later. In this chapter, I will explain why I think it emerged, and why it is (or has been until now) generally accepted as the “natural order.” My explanation is evolutionary. It takes us on a journey back in time to the origins of enterprise, long before the company, as we know it, made its first appearance. Business is natural Business, trade and industry are manifestations of what Adam Smith and the French physiocrats saw as “natural economic laws” embedded in the logic of the human situation; of the need for shelter and suste- nance, of the wish for warmth and convenience, of the ability to manip- ulate and craft, and of differences in skills, aptitudes, experience and environments. They have very little to do with “the company” as we know it today, and for most of human history, they generated economic activity without it. 9780230_230941_04_cha02.indd 32 09/09/2009 10:00 2 A FEUDAL HERITAGE 33 Smith argued that, while animals fend for themselves: Among men … the most dissimilar geniuses are of use to one another; the different products of their respective talents, by the general disposition to truck, barter, and exchange, being brought, as it were, into a common stock, where every man may purchase what- ever part of the produce of other men’s talents he has occasion for. 1 Animals are not as self-sufficient as Smith supposed – we know now that cooperation is quite common in the animal kingdom. But that simply means his economic laws were more profoundly “natural” than Smith knew. The hunger for wealth is more distinctively human, but Max Weber believed it to be just as natural: The impulse to acquisition, pursuit of gain, of money … has in itself nothing to do with capitalism. This impulse exists and has existed among waiters, physicians, coachmen, artists, prostitutes, dishonest officials, soldiers, nobles, crusaders, gamblers and beggars … it has been common to all sorts … of men, at all times and in all countries of the earth, wherever the … possibil ity of it is or has been given. 2 How these “impulses” were first expressed is shrouded in the mists of pre-history, but business is probably as old as society itself, because it is very hard to imagine how mankind could have emerged from the caves without specialization, and the barter of goods and services. (The first providers of professional services might have been the artists who painted pictures of animals on cave walls and were given shares in the kill in exchange). Trade – exchanges of goods or services between, rather than within tribal societies – came later. But it, too, was the consequence of innate human dispositions, and the potential for win–win exchanges between social individuals. Matt Ridley tells the story of the Yir Yoront aboriginals who live at the mouth of the Coleman river, on the York Peninsula, in north Australia. 3 Until the 19th century, they were still Stone Age hunter- gatherers with no crops, no writing, no money, no science and no systems of government or law. (Or so it seemed to the white colonists who first encountered them. As Karl-Erik Sveiby and Tex Skuthorpe showed in their book, Treading Lightly – The Hidden Wisdom of the World’s Oldest People, 4 Australian aboriginals developed very sophisti- cated systems of government, law and leadership 60,000 or so years 9780230_230941_04_cha02.indd 33 09/09/2009 10:00 34 BUSINESS AT A CROSSROADS ago. They have not been recognized as such, because they are very different from their Western counterparts but, as we shall see later, they may have much to teach us.) The Yir Yoront used axes, with stone heads and wooden handles, for cutting wood, digging, hunting and fishing, but lived 400 miles or so from the nearest quarries. They could have walked south for the stone, but there was no need. Plenty of axe heads reached them from the tribes that lived near the quarries, through a line of trading partners who passed them north, in exchange for spears tipped with stingray barbs passed south through the same hands. The trade developed, not because of a plan to make spears and swap them for axes, but because of differences in price. A Yir Yoront could exchange y axe heads from a neighboring southern tribe for x spears, and sell y axe heads to a northern neighbor for more than x spears. Because there was profit in the arbitrage, the axe heads moved north and the spears moved south automatically. The trade emerged spon- taneously from the “natural economic law” named, by the 19th century economist David Ricardo, the “Law of Comparative Advantage.” No human gene codes for trade. The potential for trade exists when different people value tradable goods differently, have different abilities, and command different resources. The potential will be realized when beings smart enough to see profit in the differences begin experi- menting. When mutually profitable trades were seen to have occurred, the trade “meme” (a term coined by the evolutionist Richard Dawkins to denote a unit of memory 5 ) spread all over the world. Early trade 6 Salt and stone may have been the first “traded” goods. The Chinese are thought to have boiled brine in small pans of saline soil from desert basins more than 4,000 years ago. Obsidian (a dark volcanic glass formed when molten rock reaches the surface and hardens too quickly to crys t allize) is a unique indicator of trade, because it was widely used by early peoples for weapons and cutting tools and contains trace elements that identify its origins. Recent studies have shown it was being traded by hunter- gatherers during the late glacial period 15,000 years ago. The Mayas were still using it in the 16th century. David Landes says that when the Spanish invaders first encountered them in the Yucatán the Mayas “did not know hard metal … but they had weapons – slings, poison darts, clubs set with razor-sharp pieces of obsidian.” 7 9780230_230941_04_cha02.indd 34 09/09/2009 10:00 2 A FEUDAL HERITAGE 35 By 3000 bc the Euphrates river was a busy trade route transporting semi-precious stones, baskets and carpets between Iraq and Egypt. Sargon of Akkad, conqueror of the Sumerian city-states, spoke of ships laden with goods moored outside his capital in 2370 bc. The Canaan- ites, the indigenous people of the Levant, were trading with Egypt in the early Bronze Age, using donkey caravans. As the civilizations of Sumer, Assur, Nineveh and Babylon rose and fell, new markets in slaves, food, wine, wool, livestock, metal and wood developed in Iraqi ports, the organization of donkey caravans improved and trading ships steadily increased in size. The precursors of companies As a legal form, the company can be traced back to Roman times and company-like bodies were often used to organize monasteries, craft guilds and universities in the Middle Ages. But, as R. H. Tawney noted, “pecuniary transactions were a fringe on a world of natural economy” in medieval times, and “there was very little large-scale organization.” The typical craftsman was a “master,” employing two or three jour- neymen and apprentices. 8 The craft guilds, the immediate precursors of companies, were not much admired, either then or later. “They were first and foremost, monop- olists,” according to Tawney, “and the cases in which their vested interests came into collision with the consumer were not a few.” John Wyclif, the 14th century religious reformer, did not mince his words: “all new fraterni- ties and guilds made of men seem openly” to conspire “to bear up each other … and oppress other men in their right by their wit and power.” Wyclif’s invective against corporations and guilds had a religious and an economic rationale. He claimed associations for mutual aid were in the first place unnecessary, because people were already obliged by God’s commandments to help each other, and in the second place were a conspiracy against the public. Such criticism has haunted the company ever since. It was used in the 16th century as an argument for state control of industry and commerce and, with the market’s “invisible hand” substituting for “God’s commandment,” by Adam Smith and others as an argument for free competition. Trade declined after the Roman Empire fell, but resumed its growth in the Middle Ages. It was further stimulated by the appearance of much larger ocean-going ships in the 15th and 16th centuries. New sea 9780230_230941_04_cha02.indd 35 09/09/2009 10:00 36 BUSINESS AT A CROSSROADS routes between Europe and the East reduced the prices of Asian imports and merchantmen gradually replaced caravans. The discovery of the Americas led to trade in tobacco and wood and Spain’s imports of gold, silver and precious stones from Mexico and Peru stimulated trade in the other direction, by giving Europe commod- ities in demand in the Far East. As long-distance trade grew, merchants began to experiment with new forms of organization. In Holland it became common after 1500 for “shareholders,” rather than captains to own ships, because owning “shares” in several ships allowed them to divide their goods among vessels bound for different ports. But it was not until the great voyages of discovery in the 16th and 17th centuries that an obviously corporate organizational form made its appearance, and even then these proto-companies were barely recog- nizable as the forerunners of modern companies. They were profit- seeking, to be sure, but they were also the creatures and servants of states, and states would later become their executioners. They emerged from a new kind of commercial rivalry between nations that developed in the 15th and 16th centuries, known as mercantilism, in which competing states assumed such sovereign rights over trade as they could secure through diplomacy and force. But such rights were worthless until attempts were made to exploit them. In the early 17th century European states privatized them by dividing the globe into areas and selling exploitation rights, or “char- ters,” to companies of merchants. The new chartered companies took their original form from the medieval fraternities and guilds Wyclif had railed against. There were two main types. In regulated companies, the members had their own stock and traded at their own risk. In joint stock companies, the members held a joint stock and earned profits (or incurred losses) in proportion to their shares. The regulated company became extinct as a corporate form, although one can see a remnant in the highly regulated utility companies of the present day. The joint stock company, however, was eventually to evolve into the most dominant form of business organization the world has ever seen. The trade of a joint stock company was managed by “directors,” who were subject to the control of a general court of proprietors (the modern general meeting). But as Adam Smith pointed out: the greater part of those proprietors seldom pretend to understand anything of the business of the company; and when the spirit of 9780230_230941_04_cha02.indd 36 09/09/2009 10:00 2 A FEUDAL HERITAGE 37 faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such … dividends as the directors think proper to make them. This … exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in a private co-partnery. Such companies, therefore, commonly draw to them- selves much greater stocks [capital] than any private co-partnery can boast of. (This quality of the joint stock company would be characterized by Berle and Means 200 years after Smith described it, and after the insti- tution had become ubiquitous and dominant, as the “divorce of owner- ship and control” – see Note 12, Chapter 3.) Smith conceded that the joint stock company had a role to play in trades such as banking, insurance and water engineering, where the operations can be “reduced to what is called a routine, or to such a uniformity of method as admits of little or no variation.” It didn’t seem to occur to him that the “division of labor” he advocated would greatly extend the variety of trades in which the operations could be “reduced” in this way. But that was much later. It would take another three centuries for the joint stock company to achieve the dominant position it enjoys today and it would acquire, during this long apprenticeship, some char- acteristics that have become liabilities in our own time. THE ENGLISH EAST INDIA COMPANY In December 1600 England’s Queen Elizabeth I granted a charter to “The Governor and Company of Merchants of London Trading into the East Indies,” conferring a trading monopoly in Asia, Africa and America, the only restriction on which was that the company should not contest the existing trading rights of “any Christian prince.” The new company was managed by a governor and 24 directors, chosen from its wealthy, aristocratic stockholders. In its early voyages it ventured as far as Japan, but established its first “factories” (trading posts, run by “factors”) in Madras and Bombay in 1610 and 1611. Having absorbed several rivals and acquired more rights from the crown, the English East India Company (EEIC) established itself as a major power in India at the end of the 17th century. 9780230_230941_04_cha02.indd 37 09/09/2009 10:00 38 BUSINESS AT A CROSSROADS After the victories of EEIC officer Robert Clive, over the French at Arcot in 1751, and Bengali prince Suraj-ud-Dowlah (perpetrator of the Black Hole of Calcutta massacre), at Plassey in 1757, the EEIC became the dominant power in India. All European challenge to its rule ended with Clive’s defeat of the French at Pondicherry in 1761. But military prowess was no defense against the consequence of the EEIC’s position as the chartered holder of sovereign rights. Its charter was renewed several times during the 18th century, but each time it was obliged to make financial concessions to the crown. In 1773 the govern- ment appointed Warren Hastings the governor-general of India and greatly reduced the company’s administrative role. An India Depart- ment of the British government was created by the 1784 India Act, to assume political, military and financial control of the EEIC’s affairs, and the company’s monopolies of the Indian and Chinese trades were removed in 1813 and 1833 respectively. The company continued to play a significant administrative role in India until the Sepoy Mutiny of 1857–58, but the Act for the Better Government of India of 1858 transferred its governmental duties to the Crown and absorbed its 24,000 troops into the British army. On January 1 1874 the company was finally dissolved by the East India Stock Dividend Redemption Act. It’s not known whether EEIC shareholders resented the govern- ment’s withdrawal of powers from and dissolution of their company, but it seems unlikely that senior EEIC “officers” raised objections. Many became so fabulously rich, during their tours of Indian duty, that they acquired the nickname “nabobs” (the English version of the Indian nawab). Robert (later Lord) Clive, victor of Plassey, had amassed a personal fortune by his 35th birthday probably unmatched by an indi- vidual until our own time. His share of reparations for the Black Hole of Calcutta massacre extracted after the battle of Plassey, was some £90 million in today’s money and that wasn’t the half of his wealth. The “nabobs” exemplified a weakness of these early companies which survives until this day – too much of the value they created ended up in the pockets of the officers. Clive only became a signifi- cant shareholder in the EEIC after he had amassed a huge fortune as its employee. In modern parlance, EEIC officers imposed heavy “agency costs” on shareholders, partly because the company was operating too far away for shareholders to control its managers, and partly because there was and there remains to this day a conflict between the interests of the shareholders of a joint stock company and the interests of its managers. 9780230_230941_04_cha02.indd 38 09/09/2009 10:00 2 A FEUDAL HERITAGE 39 The Abbé Morellet, a contemporary of Smith, counted 55 joint stock companies for foreign trade formed in Europe since 1600, which had failed, due to mismanagement, despite monopoly privileges. Smith, the most perceptive economic observer of his age, regarded the new species as a pernicious evil; a creature of the dark side of human nature; a system for indulging in the sin of avarice by distorting the free inter- play of market activity in ways that benefited the incorporators, at the expense of potential competitors and society at large. From mercantilism to capitalism The early companies were the agents of mercantilist states, rather than independent businesses, and most failed because politics too often compromised their economics. But, although mismanagement and nationalization took a heavy toll of the early joint stock trading compa- nies in the 17th and 18th centuries, there were some survivors; the Hudson’s Bay Company, for instance, and the joint stock system itself. A brief history of the impressively adaptable Hudson’s Bay Company (now owned by a U.S. private equity firm) will be found at the end of this chapter. Adam Smith would have been astonished by its longevity, but he was aware that it was different from the general breed of joint stock trading companies that he so heartily despised. He approved of its small size and modest ambitions: a joint stock company, consisting of a small number of proprietors with a moderate capital approaches very nearly to the nature of a private co-partnery, and may be capable of nearly the same degree of vigilance and attention. He was referring to his famous and still relevant criticism of the joint stock company, namely that its directors: being the managers … of other people’s money … it cannot well be expected that they should watch over it with the same anxious vigi- lance with which the partners in a private co-partnery frequently watch over their own. These remnants of mercantilism lived to see the emergence of a new economic order in which the joint stock company would eventually, long after the Industrial Revolution was complete and, as we shall see, more because of good luck than any inherent merit, find a new role. 9780230_230941_04_cha02.indd 39 09/09/2009 10:00 40 BUSINESS AT A CROSSROADS Although not named by its arch-enemy, Karl Marx, until the mid- 19th century, the origins of modern capitalism date back to long before Adam Smith’s description of its main principles in An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Defined as a self-regulating system in which both land and capital are privately owned, economic activity is coordinated through the inter- actions between buyers and sellers (markets), and the owners of land and capital and suppliers of labor (workers) are all free to pursue their own interests, “capitalism” existed in a primitive form in a number of ancient societies. It is, in a real sense, the natural system. Full-blooded, industrial capitalism, which in our time has all but vanquished its only serious challenger, communism, as a system for coordinating economic activity is of European and particularly of English origin. It was an adaptation of the mercantile capitalism (mercantilism), which flourished between the 15th and 18th centuries, to the opportunities and problems presented by industrialization. Mercantilism embraced the principles of private property, and used markets to coordinate economic activity, but, unlike capitalism, its focus was the interests of the sovereign or state, rather than the individual owners of economic resources. The concern of states in the mercantilist era was to accumulate wealth in the form of gold and silver and, since most nations lacked a natural abundance of such metals, the only way to acquire them was through trade. State governments controlled production and exchange and favored low wages to discourage imports, encourage exports and so generate trade surpluses with other states that would be paid for in gold. Trade was fundamental to mercantilism and ships, from the “stately Spanish galleon” of the second verse of Masefield’s poem, right up to their final, mercantilist incarnation in the speedy and elegant tea clippers of the late 19th century, were mercantilism’s primary instruments. Under capitalism, ships assumed a humbler role as the servants of industry. States abandoned mercantilism and embraced the new capitalism when they realized that the real wealth of any nation was not its hoard of gold, but its ability to produce goods and services. The relationship between wealth and production, rather than wealth and trade, was first explored by the physiocrats in France. In his Tableau Économique (1758), François Quesnay traced a natural flow of money and goods through an economy consisting of three classes: a productive class (engaged in agriculture, fishing and mining), a proprietorial class (land- owners and their dependants) and what he regarded as a sterile artisan class, who merely “transformed” and circulated the output of the productive class. 9780230_230941_04_cha02.indd 40 09/09/2009 10:00 2 A FEUDAL HERITAGE 41 Quesnay and the other physiocrats, including Pierre Samuel du Pont de Nemours and Victor Riqueti, also argued that there were natural economic laws with which the state should not interfere. The physiocrats’ attacks on the state interference associated with mercantilism were later developed by Adam Smith into a rout of the entire mercantilist system. Smith explained how the combination of self-interest, private property and competition leads “as if by an invis- ible hand” to an unintended end; the well-being of society. He shared the physiocrats’ belief in a natural economic order that works best when the state does not interfere, but took issue with them on their assertion that only agriculture, fishing and mining created wealth. Au contraire, he saw, in the transforming activity of Quesnay’s “artisan” class, the division of their labor and the coordinating power of free markets, infinite potential for wealth creation. Thomas de Quincey, a friend of Wordsworth and Coleridge and author of Confessions of an English Opium-Eater, identified two kinds of literature: the “literature of knowledge” and the “literature of power.” 9 “The function of the first is to teach; the function of the second is to move: the first is a rudder, the second an oar or a sail.” An Inquiry into the Nature and Causes of the Wealth of Nations was an example, perhaps even the exemplar, of the literature of power. Its illumina- tion of the inherent dynamics of industry and commerce began to influence government policy throughout Europe as soon as it was published. Apart from what seem in retrospect to have been brief, 20th century flirtations with modified forms of mercantilism (communism and socialism) advo- cated by Karl Marx who gave capitalism its name, Smith’s descriptions of natural economic forces have remained unchallenged and his policy prescrip- tions have been generally heeded by Western governments ever since. Smith had no time for the joint stock company, and would have been amazed by the role it has come to play in the system he described. But he, more than any other writer, established the philosophical rationale the company needed if it was to transcend its origins as the instrument of mercantilism and become the dominant institution of industrial capitalism. The Industrial Revolution At the start of the Industrial Revolution the company was equipped with two valuable and distinctive qualities – the ability to trade on joint stock, and the beginnings of bureaucratic organization. 9780230_230941_04_cha02.indd 41 09/09/2009 10:00 [...]... led to a period of organizational innovation in the U.S railroads, from which the “divisional line-and-staff” organization emerged as the standard The line-and-staff organization adds to the simple line management system a staff department that supports and advises line managers In theory it has two separate hierarchies: departments in the line hierarchy (manufacturing, selling and so on) generate revenue,... efficiency had led to the creation of a managerial hierarchy, whose duties were carefully defined in organi51 52 Business at a Crossroads zational manuals and charts Middle and top managers supervised, coordinated, and evaluated the work of lower level managers who were directly responsible for the day-to-day operations Chandler called the new organizational form a “multi-unit business enterprise” (MuBE) and... a “boundedly rational,” rather than a purely rational way.4 Williamson acknowledged that the reduction in transaction costs in an integrated organization must be set against the growing “agency costs” of management – the imperfect matching of supply and demand and the tendency of managers to pursue their own ends (as did the English East India Company’s nabobs – see Chapter 2) at the expense of shareholders... of authority and communication for the railroad’s administration, maintenance and operation.” The distinguished business historian, Alfred Chandler, argued that the implementation of the committee recommendations created “the first modern, carefully defined, internal organizational structure used by an American business enterprise,” and in the process “the first [company] … to operate through a formal... that gave the MuBE its crucial competitive advantage over small, traditional enterprises, it’s hard to deny that the relative competitiveness of the MuBE has been eroded in the past 30 years Advances in information technology (IT) have reduced transaction and information costs in general, and greatly increased the efficiency of markets, and thus the potential efficiency of inter-firm coordination That... rewards of partners rise as the ratio of partners to associates (professionals who are not yet partners) falls Partners favour growth, because it allows them to reduce their partner/associate ratios, and so increase the proportion of value added they share out among themselves As a prescription for motivating employees, “tournament theory” is not compelling for several reasons It encourages back-stabbing... it was a response that carried a lot of baggage; a “quirky mass of imperfections” accumulated over three centuries Its bureaucracy was designed for monopoly-farming, rather than for innovation Its structure was a hierarchy based on the military class system where power was concentrated at the top Its distribution of value added bore the marks of a feudal world, where fabulous wealth co-existed with... central function of modern business o enterprise.” In this he took issue with Ronald Coase, who had suggested 3 the steam-age corporation 53 40 years before The Visible Hand was published that the reason why integrated organizations had evolved was that, by suppressing the internal price system, they saved the “transaction costs” that arose when markets balanced supply and demand.2 Coase’s ideas were... were later developed into a broad theory of the firm by his student, Oliver Williamson He suggested that: “The modern corporation is mainly to be understood as the product of a series of organizational innovations that have had the purpose and effect of economizing on transaction costs.”3 Williamson argued that transaction costs can be large, because people are opportunistic, but not omniscient, and act... Journal of Political Economy, October, 1981 Personnel Economics for Managers, John Wiley, 1998 3 The steam-age corporation We have seen how the idea of trade and the dynamics of comparative advantage emerged from the economic logic of the human situation Trade was a fire that, once lit, was sure to spread Moreover, the trade idea brought with it other ideas, such as “price,” “exchange rate,” “profit” and . early voyages it ventured as far as Japan, but established its first “factories” (trading posts, run by “factors”) in Madras and Bombay in 16 10 and 16 11. Having absorbed several rivals and acquired. at Arcot in 17 51, and Bengali prince Suraj-ud-Dowlah (perpetrator of the Black Hole of Calcutta massacre), at Plassey in 17 57, the EEIC became the dominant power in India. All European challenge. mercantilist era was to accumulate wealth in the form of gold and silver and, since most nations lacked a natural abundance of such metals, the only way to acquire them was through trade. State governments