Tuesday, January 24, 2012

Return on Equity and Competition: Outmoded Economic Incentives?

Christopher Meyer and Julia Kirby provide an interesting perspective on modern capitalism in an article in the Harvard Business Review. They contribute the provocative title, Runaway Capitalism, and this lede:

"When the wrong measures of success drive decisions, strengths can mutate into serious liabilities. Just look at the peacock."

The authors use the peacock as an example of a species that can commit "biological suicide" when demands of natural selection and sexual selection become misaligned. The analogy with capitalism is that incentives can develop that appear to be rewarding, but in the long term are detrimental to the health of the system. The false incentives noted are the metric of return on equity (ROE) and the concept of competition between economic units.

The focus on ROE emerged from the industrial revolution where the accumulation of scarce capital had to be efficiently allocated to the massive factories required for large-scale production.

"Investors, playing the role of peahens and determining which enterprises would continue to the next generation, needed a proxy variable with which to quickly and objectively size up their options for financial mates, and ROE filled the bill very well. Thus was born the feedback loop that to this day drives the mania for managing quarterly earnings to meet investor expectations."

The incentive to maximize ROE is compared to the peacock’s tail: it works up to a point, but when the tail becomes excessive, it threatens the life of the species. The peacock is in a runaway condition where its survival depends on human intervention. The authors consider capitalism to be in a similar runaway situation. While a big tail will ensure the individual peacock will enjoy a mate, the species as a whole is suffering. The focus on a corporation’s bottom line, to the exclusion of all else, is similarly a system-wide danger to the health of the species.

The authors claim that the health of society—and the business community—requires the adoption of a broader-based metric. They contribute this somewhat revolutionary remark in discussing the early emergence of ROE:

"This doesn’t mean that ROE was the point of business—the overall objective of commerce in society was then, like now, to better people’s welfare."

The authors’ bottom line is that businesses’ incentives must be switched to a broader metric that is consistent with the health (survival) of the species as a whole. The runaway focus on individual ROE can lead to the same population crash that biological species endure when poorly incentivized. Corporations can only thrive, long term, when they are imbedded in healthy societies. They can no longer separate their individual goals from those of society.

The authors go on to describe the notion that competition is a means of creating innovation as a fundamentally flawed premise.

"....vitality comes from innovation. And what gives rise to innovation? If you think the answer is "competition"—full stop—you are part of capitalism’s second dangerous runaway."

Capitalism creates wealth, and wealthy companies abhor competition. What they desire is a stable environment in which they can control their future.

"In the U.S. economy today, the curious effect of advocating ‘free markets’—free that is from regulation—is to strengthen the ability of companies that already possess market power to pursue even more of it....no firm actually wants to compete. Individually, all firms seek a so-called sustainable advantage, which is to say the kind of relief from competitive pressure that allows for ample margins, innovation on their own schedule...."

Since one firm is not allowed to dominate, major industries tend to be dominated by a few firms that will look a lot alike and end up with a non-threatening stability.

"....in our competition-obsessed business culture, the way to defend an oligopoly is to spend money to deter entry by new competitors. Innovation only suffers as a result. In classic runaway fashion, mistaking competition for a reliable proxy for vitality leads to choices that undercut that vitality."

For the authors, the answer is in focusing on collaboration as a source of innovation and thus vitality.

"As industry after industry becomes concentrated to the point of oligopoly, fixating on the preservation of competition loses its meaning. It also leads to a failure to notice—and to cultivate and preserve—an equally rich source of innovation in our newly connected world: collaboration."

Encouragingly, the authors point to instances where major corporations are beginning to loosen their hold on proprietary property as a means of hastening and improving product development.

The authors conclude that the world has changed and the manner in which capitalism is organized must change also. Rather than try to predict a path forward, they point to emerging economies where growth is large and there is more opportunity and more motivation to try new approaches.

"The importance of the emerging economies for capitalism, then, turns out not to be that they are a source of lower-cost labor for global firms, or even that they are exciting markets in which those forms can grow revenues. It is that they will reveal what kind of economy is suitable for an information technology world."

If the emerging economies are going to provide guidance on how to proceed, it is interesting to note that they seem to be leaning heavily towards greater state participation in business. There will be more on that soon.

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