Ideas
Gautam Mukunda

Gautam Mukunda, HBS professor, on the dangers of managing companies for shareholders. Taking Business Back from Wall Street

Burgess COMMENTARY

Peter Burgess

HBR Blog Network Taking Business Back from Wall Street Comments (3) TRANSCRIPT SARAH GREEN: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Sarah Green. I’m here today with Gautam Mukunda, Harvard Business School professor and author of the new article “The Price of Wall Street’s Power.” Gautam, thanks so much for coming in today. GAUTAM MUKUNDA: Oh, it’s a pleasure to be here, Sarah. Thank you. SARAH GREEN: Now you have described the financialization of the US economy as the American economy having an enlarged heart. Explain what you mean by that metaphor. GAUTAM MUKUNDA: It’s common to criticize the financial sector in the wake of the financial crisis of 2008. And what we always say when we talk about the sectors, it’s important to remember that capital flow is the blood supply of an economy. You cannot have a functioning modern economy without banks. You cannot have a functioning economy without capital flowing through the system. And if the financial system’s the circulatory system of the economy, then the large banks that we think of when we think of the centers of financial power are the heart of the system. The problem is if they are the heart of the system is that hearts are good up to a certain point. But the fact that something is a heart does not mean that it has an infinite claim on how big it can be. It does not mean that it can get eternally larger and eternally more powerful. And we know this from our own bodies, right? There’s a medical condition we call an enlarged heart. So when you look at the financial system in the United States today, what you see is that over the last generation, since deregulation in the 1980s, it has become larger and larger and larger, and more and more and more profitable, and it’s taking up a larger and larger fraction of GDP. And for all the good things that it does, these enormous increases in its size and profitability have not been matched in any way that we can detect by equal increases in things that it contributes. SARAH GREEN: So if this vector does have this kind of intense gravitational pull that’s distorting things, how does that affect companies like Ford, Sara Lee, GE, companies that go out and make things? GAUTAM MUKUNDA: So let’s start at this from the corporate perspective first, right? So there are a few ways, and it’s common to hear senior executives talk about the fact that they are doing things in order to meet Wall Street’s expectations, often things that they themselves do not want to do. Palmisano of IBM talks about the fact that he just refuses to do earnings calls. He says nope, it’s a waste my time, essentially. I’m not going to do that. And that Jeff Immelt at GE has said the same– that he would like to do that, but he can’t. That’s a pretty striking thing, right? The CEO of one of the largest, most powerful corporations in the world can’t do something as simple as not take earnings calls that we all know are basically just a Baroque piece of performance art. But this is pretty trivial, right? But let’s– much more broader critique is the fact that we have evidence, for example, that publicly held companies invest substantially less than highly similar companies that are privately held. When we ask why is this so, this seems to be that those publicly held companies are driven by a focus on short-term stock market returns, what my colleagues term managerial myopia. And what they’ve said is that– what the executives believe– and the amazing thing is this might not even be true. This is something that executives of publicly held companies often believe. Whether or not that it’s true, it still governs their actions– that the less they invest in assets, the more they will be rewarded by Wall Street for their performance, and the higher their stock price will go up. And so these executives decide we will, to the greatest extent possible, minimize our investments in assets in order to maximize the ratios that they feel that Wall Street is evaluating their performance on. And for any individual company, this might work, right? Sara Lee, for example. Its CEO said that we got out of manufacturing food, and we moved into brand management because that meant that we could take all the assets that were involved in making things and outsource them to other companies, and we get the profits or brand management. That’s right. Apple, right, outsources almost all of its manufacturing to China. Dell basically, at this point, makes nothing except the name plates, I think, that it slaps on its computers. Again, research by Willy Shih and Gary Pisano, my colleagues, demonstrated that innovation and manufacturing are intrinsically linked. If you separate out these roles in a company, for a little while you would do well. But eventually, the people you are outsourcing to will learn how to do all the things that you know how to do better than you do it, and they will eat you for breakfast. So in the short-term, this might be great for your company, but for the long-term, it’s probably disastrous. SARAH GREEN: I’ve heard parts of this argument before, like, “Oh, short-term isn’t bad.” But then you had this stat in your article that, really, I thought– it surprised me by the extent of how harmful this could be. And I’m just going to read the line from the article. You wrote “the financial sector’s influence on management has become so powerful that a recent survey of chief financial officers showed that 78% would give up economic value, and 55% would cancel a project with a net positive value, to meet Wall Street’s targets.” Why are people willing to harm their companies just to meet this kind of financial, maybe even imaginary financial target? GAUTAM MUKUNDA: So this is quite shocking, right? And it’s one of the, I think, two most shocking single statistics in the paper. And I want to sort of qualify that. You will often hear people familiar with that statistic defend it by saying, “Well, they’re not actually harming their companies.” What Wall Street people will tell you is the thing is that earnings management is such a fundamental skill that if you can’t do that, you can’t do anything. So there are two problems with that argument. One is, of course, that what you’re really saying, therefore, is that what we want executives to do is be good enough at lying to us that they can slide through the numbers, right? So if you train people to be deceptive, don’t be surprised when they’re deceptive. So we see this constant stream of financial scandals and earnings management, things like that. It is very easy, once you start down that path. They’ll keep walking down path. The second issue, of course, is that earnings management has no economic value whatsoever. So every second that a company is spending doing that is a second that it is not spending actually doing what it is supposed to be doing, which is creating value. This is why I keep saying drive back to power. Think about power, because power shapes the way we think about the world in profound way, in ways that we are often unaware of. And it shapes both the powerful and the people who are the objects of that power. So what we see here is that people in the rest of the economy– the power of the financial sector– is shifting the way they think. They think that, “OK, if what these guys want me to do is what I should do.” The broader term for what we see of the kind is called financialization, where everything becomes viewed through a financial lens. It started out with Milton Friedman– a column in the New York Times saying that executives have a fiduciary responsibility to maximize shareholder value. That’s the term you hear. I hear it from my students quite frequently. Now whatever you think about an executive’s responsibility to shareholders, a fiduciary responsibility implies a specific type of obligation under American law. And there is no fiduciary responsibility to maximize shareholder returns. As a point of American law, of uncontested American law, this responsibility does not exist. So this is a myth. It is a myth. Why do we all believe it? Well, we believe it because we have been financialized, because we believe that this is, in fact, how we’re supposed to work. And so when you think about this in this context– so what do you do if you have a financial view of the company that is nothing but a locus of contracts, and the only job of the executive is to maximize shareholder value? Well, then, of course, it’s obvious, right? You compensate executives as if they are shareholders. And so they, of course, have every incentive to manage only for short-term shareholder value because one, that’s what they’re being paid to do, and two, that’s what we tell them to do. So again, this is not a case of anyone doing anything wrong. Everybody is doing exactly what they’re supposed to do. But the system only works if it is in balance. And the problem with the American economy right now is that it is not in balance. SARAH GREEN: What I find myself wondering is if we accept that the system’s out of balance and that there are these negative impacts, is it realistic to think that we can somehow get it back into balance? GAUTAM MUKUNDA: It’s completely realistic, and the reason is because we did it before. This is the wonderful thing is that this is a problem that Americans know how to solve. And the reason we know we know how to solve it is because we have solved it in the past. If you look at the American economy before the Great Depression, it was, in fact, well, not almost as financialized as the economy we have today. It looked a lot like the economy today. So we have seen this in the past. We have every reason to believe that when you regulate the financial sector in certain, specific ways, this is completely controlled. And it goes back, and we allow the sector to do what we desperately need it to do, which is help the other parts of the economy create value. These regulations are actually not that difficult. There are ones about breaking up the largest financial institutions, the ones that we think of as being too big to fail. What’s stopping us from doing that? Well, of course, what’s stopping us from doing that is the financial power of the banks themselves who use enormous sums of money, sums of money that boggle the mind, that swamp any other interest group that’s trying to lobby the government to say that, well, you can’t do this. But that being said, of course they don’t want us to do that. I totally understand that they don’t want us to create these regulatory limits. But the rest of American business needs to get involved. The American economy is vast. And yes, the financial sector is an enormously powerful interest group, but it is not a more powerful interest group than the rest of the economy combined. And that is the thing where people really, really need to understand, that this is a profound issue that is affecting the competitiveness of every American company. And so we need to take that just as seriously as they would take environmental regulations or labor regulations that American companies think are hindering their competitiveness. This is just as important, and it’s just as serious, and it’s something that you need to focus just as much attention on. SARAH GREEN: Gautam, thanks again for talking with us today. GAUTAM MUKUNDA: Thank you so much. SARAH GREEN: That was HBS professor Gautam Mukunda. For more, including his article, visit HBR.org.