Will Rapid-Fire Finance Self-Destruct the Economy?

Businessweek has a interesting article written by Lawrence Mitchell that claims our obsession with finance over operations has put us on a dangerous economic course.

Fueled by headlines about top managers such as Home Depot (HD ) CEO Robert Nardelli, who received stratospheric pay even as his company's stock price stalled, shareholder activists this year took aim at executive compensation. Unfortunately, they should not expect much from those efforts, even if every corporation in the U.S. adopts "say on pay"measures that allow shareholders to vote on pay deals. That's because such proposals treat only a symptom, not a cause, of a more dangerous trend within American capitalism.

The real culprit is the growing preeminence of finance over operations. It causes stock market considerations to trump those that improve the actual workings of a business. And the quicker the stock payoff can be engineered, the better. Until that changes, don't expect CEOs to stop gaming the system.

This reward bias toward finance has been with us since the creation of the giant public corporation in the late 19th century. Almost overnight, U.S. business was transformed from making money by controlling costs and increasing productive efficiency, the way John D. Rockefeller and Andrew Carnegie did, to reaping instant riches from stock sales-such as the $1.5 billion stock fee (in 2006 dollars) that the J.P Morgan (JPM ) syndicate earned in 1901 putting together the factories that created U.S. Steel (X ).

I love this discussion, and Mitchell's analysis, but I think his solutions are short-sighted. Changing capital gains tax structures to a sliding scale that severely penalizes day traders seems like it would have many second order effects (like less liquidity). The traders don't bother me so much as the CFOs who patronize them. The problem is with the CFOs – giving quarterly earnings targets, using accounting tricks to smooth out earnings, and generally managing with a next quarter focus instead of a long-term focus. Not only that, but finance now encounters the same dilemma as production – it's more about marketing than it is about substance. In a world full of noise, it's hard to get your signal out, and that's true whether you are talking about a new product or an earnings release. It's a shame, but it's the way the game is played.

  • This is absolutely true, but it isn’t exactly new news. Economists have been writing about this sort of thing since at least the late 1980s, when the Japanese started to make serious inroads into the United States economy.

    I’m glad to see that the racist arguments that Japan possessed a unique “hive mentality” are gone, but I can’t understand why Mitchell’s argument hasn’t gained more traction than it has – and a lot sooner.

    Doing my best to keep my partisan political beliefs to myself, I just don’t see how anyone can objectively look at the United States allowing so much of its industrial capacity to move offshore – to a relatively hostile and theoretically communist country no less! – and not worry about the future of the U.S. middle class.

    The reason I left the automotive consulting industry is because I watched first-hand how America’s premier manufacturers would invest whatever savings or new revenue they could earn by streamlining their processes and creating new products.

    The money wasn’t reinvested in the company; it was spent on CEO perks, media campaigns, and shareholder dividends. White collar mid-management was forced out to make way for consultants like myself, usually employed by large body-shops that have no incentive to actually help their customers; rather they have every incentive to help themselves to all the paid overtime their employees can get away with. When the inevitable crunch came, there was no one left who really understood how the company functioned that had any long-term incentive to help it react in a cost-effective, strategic manner.

    Finally there’s the issue of what’s happening to America’s skilled trades people. Even the most virulent anti-union business person can’t ignore the reality of basic economics, so eloquently summed-up by Henry Ford (himself no lover of labor):

    “There is one rule for the industrialist and that is: Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible.”

    What’s happening to America’s businesses today is a perversion of this axiom, and it’s a shame. The new rule appears to be:

    “There is one rule for the capitalist (industrialists are *so* 20th Century!) and that is: Make the lowest quality of goods that are PASSABLE at the lowest cost possible, paying the LOWEST wages possible, and OMIT BENEFITS whenever you can get away with it.”

    You reap what you sow; this is all going to come back to bite us one day.