The Corporation in the 21st Century

The Corporation in the 21st Century- John Kay

PART 1: The Background

1: Love the Product, Hate the Producer

“Some of these billionaire executives are no superstars: individuals such as Philip Green, who extracted nine-figure sums from retailer BHS before selling the company to multiple bankrupt Dominic Chappell for £1, Mike Ashley, the domineering boss of the retailer Sports Direct, and Eddie Lampert, who inflicted similar destruction on Sears, for a century America’s leading store chain. The lifestyle of these executives contrasts with the fate of their businesses. The 90-metre yachts of Green and Lampert make good newspaper pictures. Green’s is moored in the harbour of the tax haven of Monaco, where he is resident, while Lampert’s is named Fountainhead, after Ayn Rand’s turgid paean to individualism.

2. A History of Pharmaceuticals: A Case for Treatment

“‘If there was a company that was selling an Aston Martin at the price of a bicycle, and we buy that company and we ask to charge Toyota prices, I don’t think that that should be a crime.’

Martin Shkreli, CEO of Turing Pharmaceuticals, defending a decision to raise the price of a

62-year-old drug to fight parasitic infection from $13.50 a tablet to $750, 2017

Valeant’s approach found imitators, however. Martin Shkreli adopted an even more extreme strategy of price gouging at Turing Pharmaceuticals, increasing the cost of Daraprim, on the market since 1953, from $13.50 to $750. In 2007 generic drugs producer Mylan acquired the rights of the long-established EpiPen® – used to provide urgent relief to people with severe allergies – and over the next ten years gradually raised the price sixfold. The company paid almost a billion dollars to settle – ‘without admission of liability’ – claims that it had violated antitrust laws and defrauded Medicaid.

The Novo Nordisk Foundation, which owns a controlling stake in the Danish drugmaker, is the largest charitable foundation in the world, and the Wellcome Trust, by far the biggest educational endowment in Britain, as funded British science to remarkable effect. Thus two of the four largest charities globally are the result of the philanthropy of the leaders of the pharmaceutical industry: the Danes August Krogh and Harald Pedersen and the British Henry Wellcome.

This is an important and underappreciated point: there is no shortage of ‘patient capital’ – institutions such as pension funds and university endowments are naturally looking for investments that may only pay off in the long term – but there is a shortage of patient individuals working in the finance sector, an industry remunerated almost entirely by transactions. The result is a constant flurry of financial activity engaging senior executives, investment professionals and advisers which rarely adds to, and often detracts from, the effectiveness and success of the underlying business. The financial pressures that motivated strategy at Merck and Valeant not only damaged the standing of the businesses and their products but also diminished the returns to their shareholders in the long run. In later chapters I will show that these are far from exceptional cases. The history of pharmaceuticals illustrates much that is right and wrong in the relationship between business and society. I have described four problem areas: the motivation and standards of behaviour of leaders of the industry; the interface between business and finance; the difficulty of constructing a regulatory regime that is relevant and effective; and the sometimes too tenuous relationships between prices, costs and values. None of these issues is unique to the pharmaceutical sector: similar questions arise in every kind of business, and the answers are necessarily specific to industry, time and place. But in this book – and another that will follow – I will illustrate principles and directions of travel.

3: Economic Motivation

“Employees, of course, go to work expecting a pay cheque that will fund the groceries and the rent. But in a well-functioning organisation they also look forward to the camaraderie of the workplace. They welcome acknowledgement of their skills and contributions from their colleagues and bosses. Employees take satisfaction from being associated with the creation of fine products and satisfied consumers. The bonus is valued as a symbol of affirmation as well as for its cash value. Even in corrupt environments – whether Mafia clans or among the traders who conspired to fix interest rates at the time of the global financial crisis – there is a need for the approbation of co-workers.

I might leave the last word to Steve Jobs: ‘The only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do.’ As with Guinness, Messi and Messner, Jobs’s career illustrates that high professional skill is often associated with extreme self-absorption. Claudio Abbado, who seems to have been distinguished from most conductors by a degree of personal modesty, explained why he had chosen not to conduct American orchestras: ‘they finish the rehearsal not because the music is finished, but because the time is finished.

In my book Foundations of Corporate Success, published in 1993, I was sympathetic to the ‘nexus of contracts’ approach, believing – as I still do – that the essence of the firm was an assembly of relationships among individuals. But I did not then realise, as I now do, that the advocates of this idea visualised these relationships as transactional rather than social. A central argument of the present book is that by excessive emphasis on the transactional nature of business relationships we have undermined not only the relationship between business and society but also the effectiveness of business, even in transactional terms.

PART 2: A Brief History of Business

4: The Mechanical Firm

“A central thesis of this book is that this transactional account of business is not just repellent but mistaken. It does not describe how successful business works – or could work – in modern society. Individuals do, of course, respond to incentives, but a better description is that individuals tend to behave in line with the behaviours expected in their environment; they are led to do what the community approves, both through praise and material reward. Social aspects of work, including both relationships within the workplace and those between business and society at large, are crucial to both personal productivity and personal fulfilment.

6: The Rise of Corporation

“Guilds and livery companies survive into the twenty-first century as dining and drinking societies, and many support charitable causes. But you would rarely find a practising fishmonger in Fishmongers’ Hall, and the only fish would be the sole meunière served at feasts – although in 2019 a narwhal tusk was pulled from the wall and used to subdue a terrorist who had murdered two people at a conference on offender rehabilitation.

A modern, but less successful, reprise of the gathering under the buttonwood tree played out as American troops stormed into Baghdad in 2003. A twenty-four-year-old real estate salesman, Jay Hellen, followed close behind the invading army. Hellen had been recruited by the Department of Defense to head the immediate establishment of that vital institution of liberal democracy – a modern stock exchange. Hellen’s Republican credentials were impeccable but his financial credentials less so. Once the Coalition Provisional Authority was

disbanded in 2004, Iraqi officials abandoned the attempt to implement electronic trading systems and establish a Securities and Exchange Commission on US lines and resumed the practice of setting the prices of the five quoted stocks on a whiteboard.

The reconstruction of Barings after the 1890 debacle involved incorporation as a limited company, although most other London and New York investment banks remained as partnerships for another century. So when Barings failed once more in 1995 (as a result of fraud by ‘rogue trader’ Nick Leeson), the shareholders lost their investment, but the elegant

Georgian Baroque-style mansion in Oxfordshire owned by a later generation of Barings rests in the family still. Across the twentieth century, the notion of personal accountability for failures of financial management became eroded. Dick Fuld, CEO of Lehman, whose failure provoked the 2008 global financial crisis, opened his fresh advisory business less than a year later, its reception adorned with the text ‘That was then, this is now.’ But some may prefer the maxim attributed to legendary investor Sir John Templeton: ‘the four most expensive words in investing are “This time it’s different”.

The European Commission has sought some degree of commonality across the EU and has usefully created the concept of a Public Interest Entity, spelling out the principle that the conduct of large businesses is properly a matter of public interest. But the application of that idea is in the hands of member states, with the consequence that nothing much has happened. A European corporation can now register as a Societas Europaea, and Airbus SE is the archetype of the modern European company, but the fact that it was necessary to resort to Latin for the title is indicative of the difficulty of securing continent-wide solutions, an observation equally true of the United States.

Leslie Hannah, an eminent business historian, has shown how the ‘rationalisation’ of industry, which was favoured by the British Government (represented by the Bank of England), set the stage for the new ‘corporate economy’ which would characterise Britain for decades. The 1920s saw the creation by merger of ICI (chemicals), the Distillers Company (Scotch whisky) and Unilever (soap and margarine). A similar wave of mergers in Germany established IG Farben and Vereinigte Stahlwerke as the dominant chemical and steel producers respectively. (Both these companies were dissolved by the victorious Allies in 1945.)

The nascent industry did not escape the attention of rationalisers and consolidators. Billy Durant took over the Buick company and used it as a base for acquisitions of many competitors and suppliers. In 1909 alone he added the names of Cadillac, Oldsmobile and Pontiac to his stable of brands. Durant’s talents as salesman and dealmaker exceeded his capacity to run a business, and the banks that had financed his acquisition spree took control of the cash-stretched company and sacked Durant.

With the assistance of Bill Knudsen, who could no longer work for the irascible, autocratic Henry Ford, GM overtook its principal rival to become not only America’s leading automobile company but the largest manufacturing corporation in the world.

Both businesspeople and critics of business, then and now, exaggerate the benefits of size. The advantages of scale are technological and appear visible; the disadvantages are mostly human and less immediately apparent. If pricing power is not eroded by competition, as it usually is, regulation will generally follow. Large organisations develop entrenched interests which inhibit the development of collective intelligence and the adoption of new business methods and innovative products. We have Intel and Microsoft, not IBM, to thank for our laptop computers; Apple, not AT&T and Verizon, to thank for our smartphones; and Tesla, not General Motors, for pioneering electric and autonomous automobiles.

7: Changing Fortunes

“”All fortune is good fortune; for it either rewards, disciplines, amends or punishes, and so is either useful or just.”

Boethius, The Consolation of Philosophy, written in 524, while in jail awaiting execution

The business magazine Fortune published a list of the largest 500 US corporations in 1955 and has continued to do so annually ever since. The subsequent fate of the initial top ten provides a powerful rejoinder to the claim that large businesses acquire a scale that leaves them masters of their environment.

With Britain’s ICI and Germany’s IG Farben, DuPont straddled the world market for chemical products. But subsequent events would demonstrate that Chandler was describing the past, not anticipating the future. After decades of indifferent performance and an unsuccessful acquisition of Conoco, another of the successor companies to Standard Oil, in 2015 DuPont merged with Dow, the other leading US chemical producer. The business was then divided into three separate units, one of which retains the DuPont name.

The Fortune 500 list did not include retailers. If companies had been ranked by sales, the list would have then been led by America’s three great shopping giants: Sears Roebuck, Montgomery Ward and JCPenney. Their fate was one of steady decline. In 2000, Montgomery Ward filed for bankruptcy. In 2019 Sears did the same and in 2020 JCPenney followed suit. The disappointing fortunes of these businesses are not the result of being in declining industries. Global demand for automobiles, food, oil, steel, chemical products and particularly electrical goods has continued to grow. Consumers still shop. But none of these 1955 companies is today the dominant firm in its industry. Cars are Toyota and Volkswagen; food is Nestlé; steel is ArcelorMittal, which took over much of the excess capacity located in the former Soviet Empire. Germany’s BASF is the world’s leading chemical company. And electricals – well, it depends on what you mean by electricals but, whoever you regard as market leader, it isn’t GE. Within America, cars are still General Motors – unless you look at market capitalisation and hence to Tesla. But food is PepsiCo and Tyson, steel is Nucor and Pfizer leads in chemicals. Retail is Walmart – and Amazon. Only ExxonMobil and some of the DuPont and GE subsidiaries remain among the global leaders in their fields.

In 2020 the Fortune 500 looks very different. Fortune now includes service businesses, so the two top companies by sales are retailers – as would also have been true in 1955. But the current leaders are retailers that did not exist in 1955: Walmart and Amazon. No fewer than four companies are names that probably mean little to non-US readers – they are intermediaries in the fabulously costly US healthcare system. United Health is an insurer, McKesson and Cencora (previously known as AmerisourceBergen) are distributors of pharmaceutical products and CVS Health is both insurer and retailer.

8: The Decline of Manufacturing

“As Smith noted, the division of labour was limited by the extent of the market, and the growth in the geographical scope of markets has steadily increased the geographical division of labour. Switzerland and Denmark are among the richest countries in the world, but neither produces automobiles.

Contrary to many people’s images of a society focused on tourism and banking secrecy, Switzerland is an outlier in the Global North, with 20 per cent of the working population engaged in manufacturing, particularly speciality chemicals and precision engineering. But little of this manufacturing is of the kind that requires its exhausted workers to wash off the dust and sweat of the day as they return home.

You only got paid for producing goods that people wanted, but it soon became apparent that repairs and priestly services and (later) insurance and cosmetic surgery were among the things people wanted. The earnings from different activities came to reflect the availability or scarcity of the talents needed to undertake them and the position of the actor in the power structure of the tribe. Specialist skill explains why the insurance agents, surgeons and repairmen did well, and hierarchy accounted for the relative prosperity of the political leader and the priest.

The automobile plants of Detroit and the steelworks of Pittsburgh once defined their towns, but few service activities are undertaken at similarly large facilities. There are some exceptions, such as hospitals and universities. These institutions have shown more permanence than the firms that built assembly lines; Oxford University is seven centuries old, but the Oxford plant of Morris Motors, which opened in 1922, closed seven decades later and was demolished in 2002. The founding of Oxford’s Radcliffe Infirmary in 1770 is almost contemporaneous with the beginning of production at the Carron Works. But the Carron Works is shuttered while the modern John Radcliffe Hospital employs 11,000 people. Rochester, once synonymous with Kodak and Xerox, is now known for its university and the Eastman School of Music (a leading conservatory).

The manufacturing obsession has no economic basis but considerable social and political significance. Many of the roots of the white working-class resentment which in the US supports Donald Trump and in the UK voted for Brexit are to be found in the disappearance of traditionally masculine jobs in the Global North as a result of economic globalisation. It would be an absurd response to look nostalgically at pictures of men whose bare torsos were covered in sweat as they worked in the light and heat of rivers of molten iron, or who heaved coal as they spent their day working underground; these may have been ‘real jobs’, but they were awful jobs, and our society is better off for no longer needing them. But their very awfulness generated solidarity and stability that have been lost. Martin Wolf has written powerfully on the social and political consequences of that loss, which are reflected in the fragility of today’s political order, while recognising the vast gains that globalisation has brought.

New Product

Date Developed

Price per kg at 2020 prices

Carronade

1776

£2

SA80A2 Rifle

2000

£200

Model T Ford

1908

£27

Airbus A380

2007

£1,250

Empire State Building

1931

£1,40

Burj Khalifa

2010

£2,70

DynaTAC mobile phone

1984

£10,000

iPhone 15 Pro Max

2023

£5,000

Pin

Prince from 1821

£11

Pfizer Covid-19 Vaccine

2020

£500,000

As former Federal Reserve chairman Alan Greenspan observed in the remark that began this chapter, modern economic growth in developed economies is largely about better and more complex rather than bigger and more.

My critique of GDP measurement in practice relates to its inability to report sufficiently accurately what it is intended to measure: the value of economic output. And pronouncements based on such data about long-run trends in income or the rate of increase of productivity should be taken with a grain of salt – or several. When pundits fret over whether the latest figure for GDP growth is an annual rate of 1.8 per cent or 1.9 per cent, they are fussing over differences that are insignificant in relation to the fundamental and inescapable uncertainties in the data they are citing.

Failure to recognise that economic growth is mostly better rather than more is why the sages who have repeatedly predicted that growth must end because we will run out of – first it was wood, then it was coal, then nitrates and then oil – have always been wrong. We haven’t run out of arable land and our progress will not be halted by a shortage of lithium. All physical resources have finite limits, but human ingenuity does not.

PART 3: The Secret of Our Success

9: Better at Everything

“Abrahams employed a personal coach, Sam Mussabini, before his 1924 Olympic victory. This was regarded as almost tantamount to cheating, but today even club runners benefit from extensive coaching, better diet and nutritional guidance, and from the advice of friendly competitors. Bolt runs 10 per cent faster and Kipchoge 50 per cent faster than the earlier winners in their events. These improvements in productivity have been observed in an activity whose essential character has remained unchanged for thousands of years. Mussabini could train Abrahams to win Olympic gold but could never have run the race himself; Abrahams could run faster than any man alive but had no understanding of sports mechanics. The combination was more powerful than either alone. The power of combinations of capabilities is the secret of our modern athletic prowess. And of our opulence.

Some of these complementary supporting capabilities originate in individual talents, but combining individual skills with more mundane complementary resources builds the distinctive capabilities of teams, and these assemble into combinations which represent the distinctive capabilities of organisations.

Runners’ times have also fallen because the pool of talent from which elite athletes are drawn has widened. The athletes against whom Abrahams competed in 1924 were white men who had received a university education in Britain or the United States. Strikingly, today most short-distance and extreme-distance champions are, respectively, of West African and East African descent. Inclusivity – which allowed people from diverse nationalities and social classes to compete for gold – together with sports engineering, the scientific analysis of the determinants of performance, nutritional advance and systematised training protocols, gave us sub-ten-second sprints and sub-two-hour marathons.

We run faster because of the accumulation of collective knowledge about sports engineering and nutrition. With the aid of coaches this knowledge becomes collective intelligence – know that becomes know how. We eat better apples because plant species were carried across the world and because of the accumulation of collective knowledge of techniques of cross-breeding. The collaboration of Sam Mussabini and Harold Abrahams won an Olympic gold medal, and the collaboration of botanists at Washington State University, local growers and breeders and marketing and branding agencies produced the Cosmic Crisp. By accumulating collective knowledge, applying collective intelligence and practising the division of labour on a global and inclusive basis, humans have become better at ... almost everything.

The psychologist Cecilia Heyes has written of ‘cognitive gadgets’ to emphasise the key role of culturally developed cognitive capabilities: the ability to assemble disparate and developing components of human knowledge into problem-solving capabilities.

It is common, and natural, to tell the history of innovation through the exploits of men of genius, such as Edison and Tesla, and pioneers such as Berners-Lee and the Wright brothers. But if the Wright brothers had not flown in 1903, someone else would have done something very similar in some other location. Collective intelligence develops when the accumulation of collective knowledge reaches a point at which talented people identify problems that this shared knowledge can be employed to solve. And it is also common, and natural, to describe the history of innovation through the introduction of new gadgets, from aeroplanes to iPhones. I have taken running and apples as examples to emphasise that the

growth of collective intelligence has a range and applicability that extends well beyond technology.

We are distinguished from other animals by our capacity for social learning – gaining knowledge not just from our own experience but from the experience of others – and the acquisition of such learning is immeasurably enhanced by our ability to communicate.

The unprecedented prosperity of the modern world is the result of the growth of our collective intelligence.

11: Value

“Business is embedded in a social, political and cultural environment, and we cannot understand its outcomes without understanding these interrelationships. Nor seriously maintain that the outcome of market allocation is a distribution of resources based on desert – the moral rather than the sandy kind.

12: Stanley Matthews Changes Trains

“Organisations create economic rents because they enjoy distinctive capabilities or distinctive combinations of capabilities. A successful organisation is one whose capabilities are appropriable and sustainable – they can be deployed for the benefit of the organisation and its stakeholders on a continuing basis. These differentiated firms, which earn substantial economic rents, are the focus of this book.

PART 4: The Age of Individualism

14: Or Perhaps It can: The Modern Theory of Firm

“But the recollection came more often when someone approached me with a question like ‘What will the dollar–sterling exchange rate be ten years from now?’ My response – and I strongly believe the only appropriate response – was along the lines of ‘If you tell me why you are asking that, I will try to help you formulate a more sensible question which it may be possible to answer. But that reply was not often well received. Frequently the problem was that the individual concerned had been asked the question by their boss, who – like Sir Denys– had to be placated. Or they were building a spreadsheet and this number was required to fill a vacant cell. Or my interlocutor might observe that, if I could not give them an answer, there was someone else – probably at an investment bank – who would. And ring off.

Friedrich Hayek described the issues well in his 1974 Nobel Prize lecture, which he delivered under the title ‘The Pretence of Knowledge’. Hayek observed:

I regard it in fact as the great advantage of the mathematical technique that it allows us to describe, by means of algebraic equations, the general character of a pattern even where we are ignorant of the numerical values which will determine its particular manifestation. ... It has led to the illusion, however, that we can use this technique for the determination and prediction of the numerical values of those magnitudes; and this has led to a vain search for quantitative or numerical constants.

He continued:

compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.

Real businesspeople operate in ‘large worlds’, in which problems are ill defined and there are no objectively correct answers. Moreover, the ‘right’ answer will often not be apparent, even in retrospect. Effective decision-makers in large worlds are not maximising; they do not have and never can have the information needed to make the relevant calculations. They confront radical uncertainty. Often they not only do not know what will happen but do not even know the kinds of things that might happen. Although we must abandon ‘the pretence of knowledge’, individuals, institutions and businesspeople need to act in the face of uncertainties.

The world is radically uncertain. Information is imperfect. No contract can anticipate all possible contingencies. Not only do we not know what will happen – we often have only limited insight into the range of things that might happen. Unforeseen events will require adaptation. But by the time such adaptation is required, both parties to the contract will have committed to the relationship.

Thus we encounter the paradox that the thesis put forward by Jensen and Meckling from the Midwest of America in the 1970s is broadly consistent with the Marxist view of the capitalist firm proposed in Western Europe by Karl Marx and Friedrich Engels in their Communist Manifesto of 1848. It is also consistent with the account of Ayn Rand, whose libertarian rants inspired yacht-owning Eddie Lampert, whom we shall meet again at the destruction of Sears, Roebuck and Co. Left and right often agree when both are wrong.

Thus Meyer, Milgrom and Roberts write ‘although delegating authority to those with the information needed to make good decisions is an important part of good organisation design, it is of little use unless the decision makers share the organisation’s objectives. We have already mentioned incentives as a way to align individual and organisational objectives ... incentives and delegated authority are complements: each makes the other more valuable’. Their solution to the principal–agent problem is to create incentives such that the individual (with local knowledge unavailable to persons more senior in the hierarchy) will act as if the objectives of the organisation were his or her own. The principal–agent problem seeks solutions that will induce subordinates to pursue the objectives of the organisation. But what are the objectives of the organisation, and who identifies them?

15: The Myth of Ownership

“‘You are undone if you once forget that the fruits of the earth belong to us all, and the earth itself to nobody.’

Jean-Jacques Rousseau, Discourse on the Origin of Inequality, 1761

In 2021 the newly formed investment fund Engine No. 1 secured the election of environmentalist Andy Karsner to the Exxon Mobil board. Sometimes corporate activists are active in both senses, as with Icahn’s attempts to engage with McDonald’s over animal welfare.

So who does own Amazon or Apple? The answer is that no one does, any more than anyone ‘owns’ the Mississippi River, the Theory of Relativity, the Royal Economic Society or the air we breathe. A thing or – in Lord Millett’s erudite terminology – a res can exist without being owned by anyone. There are many different kinds of claims, contracts and obligations in modern economies, and only occasionally are these well described by the term ‘ownership’. The differences between the modern corporation and my umbrella are so wide-ranging that it is hardly likely that my relationship with them could usefully be described in the same way.

16: Must Companies Maximise Profits?

“Organisations have distinctive cultures and collective intelligences, and it is through these differentiating characteristics that they contribute to our economy and society.

German law is clear and adopts a stakeholder perspective. American law on corporate obligations is not at all clear; scholarly debate is extensive and continuing, but veers towards shareholder primacy. Britain is, as on so many issues, somewhere in between. But clarification of the legal issue is much less important than it may appear to be at first sight. All three jurisdictions have sensibly framed their law, and the practice of their courts, to make it hard to challenge honestly made business decisions. As a result, managers are left with considerable discretion in practice in balancing the claims of different stake-holders. The manner in which they resolve these questions owes far more to the business climate and the expectations of society than to the precise definition of legal duties. Businesses are social organisations and operate within a particular society.

18: The Dumbest Idea in the World

“Any idea that the market knows more about the corporation’s future than its management knows – or could or should know – represents the triumph of an abstract theory over common sense.

Successful bidders for objects whose true value is unknown routinely turn out to have paid too much: they won because they were the most optimistic. When there are few publicly held shares in small companies whose success or failure is hard to predict, these shares are more likely to be held by people who overestimate their value than by people who underestimate it. Most such investments fail, but the losses might, though need not, be offset by occasional spectacular gains. The market value of a security is often a poor guide to the value likely to be created in the business over the long run.

Intrinsic rather than instrumental motivation is required at all levels of the successful business and is a hallmark of such businesses. Disney employees are not told to go and make money for Disney. They are told to make sure the guests have fun. They feel they are part of a great business. The result makes a great deal of money for the Disney Corporation. It is all that way around.

PART 5: How It All Worked Out

“It is not a coincidence that the emphasis on financial metrics in business occurred at the same time as explosive growth in the size and remuneration of the financial sector. There were useful innovations, such as the emergence of venture capital as a means of financing start-up businesses. But the financial sector is primarily rewarded by fees from facilitating

transactions, not for the consequences of these transactions. Corporate executives engaged in a frenzy of dealmaking, buying and selling existing businesses; incentive plans encouraged actions that generated immediate revenues or cost savings, mostly with unmeasured consequences for the business in the long run. The result was the destruction of many of the great businesses which an earlier generation of less well-rewarded managers had created.

21: Not a Pretty Picture

“The finance sector, and its associated legal and accounting advisers, is rewarded for making a transaction happen, not for the commercial success of that transaction. The ‘advice’ expensively provided is not primarily about the merits of the deal, but principally about how to get the deal done. Bruce Wasserstein, architect of KKR’s takeover of RJR Nabisco, was the doyen of Wall Street M&A advisers for more than two decades before his death in 2009. Wasserstein became known as ‘bid-em-up Bruce’ for his role in encouraging his clients to pay whatever was necessary to get the deal done. The ‘dare to be great’ speech with which he massaged the egos of corporate executives became famous. While the businesses concerned paid his fees, his real client was the ambitious executive teams.

Oreo cookies are an American icon. The product was introduced in 1912 by the National Biscuit company (Nabisco). Today annual sales worldwide exceed $40 billion. Oreos continued to be a Nabisco product until the merger which created RJR Nabisco in 1985. Three years later came the KKR takeover of RJR Nabisco. In 2000 the cookie division was sold to another tobacco company, Philip Morris, and incorporated into that company’s Kraft subsidiary. In 2007 Philip Morris (now renamed Altria) divested Kraft, and in 2012 Kraft in turn divested the division which bakes Oreos into a new company, Mondelez. The biscuit filling has undergone minor changes and the top pattern has been redesigned, but otherwise America’s favourite cookie has evolved little over the century. Only the ownership of the brand has changed. Repeatedly. ‘What did it have to do with doing business?’, Bryan Burrough and John Helyar asked in the final sentence of their study of the KKR transaction, referring to the changes in corporate structure. It is an appropriate note on which to end this chapter.

22: The Fall of the Icons

“Black left ICI not long after the successful launch of beta-blockers and joined another British pharmaceutical company, SmithKline, where he discovered Tagamet, an anti-ulcer medication. This breakthrough led Glaxo, a smaller company, to refocus its research and the outcome was Zantac, a similar therapy which became for a time the world’s best-selling drug. Directly and indirectly, Black probably created more shareholder value than any other person in Britain.

I interviewed Black to discuss his departure from ICI. He told me:

“I used to tell my colleagues [at ICI] that if they wanted to make money, there were many easier ways to do it than drug research. How wrong could I have been! In business as in science, it seems that you are often most successful in achieving something when you are trying to do something else. I think of it as the principle of ‘obliquity’.”

In that exchange, Black gave me inspiration – and a title – for my 2010 book Obliquity.

A new management team and its advisers devised an all too common 1990s business strategy: to sell off boring bits to fund exciting acquisitions. But, like other companies, ICI found it easier to overpay for new businesses than to make rewarding disposals of old ones. Burdened with debt and finding growth elusive, the stock price was only a fraction of what it had been a decade earlier. What remained of Britain’s leading industrial company of the twentieth century was acquired in 2007 by the Dutch company AkzoNobel. Blair resigned the premiership in the same year.

23: The Finance Curse

“But between 1981, when Welch took control at GE, and 2005, when Lampert took control of Sears, a new approach to business developed. Managers like Sir Denys Henderson and Simon Marks, Alfred Sloan and Owen Young, had seen themselves as public figures with associated responsibilities to a wide range of constituencies. The generation that succeeded them had a narrower conception of their role. A successor generation of corporate executives paid close attention to quarterly reporting and the stock price.

If you had invested in these household names in the 1990s era of shareholder value, you would have lost all your money in GEC and Sears and most of it in the others. Your least bad bet would have been on ICI, whose shares were acquired in 2007 for about one-third of their price a decade earlier. Both GE and Marks and Spencer subsequently lost more than 80 per cent of their peak value. Almost all financial advisers would have agreed in 1995 that a portfolio that consisted of these stocks was a safe and conservative, if unexciting, choice. And that advice would have been spectacularly wrong.

In every case, the activities that analysts and investment bankers applauded diverted attention from the central issues facing the operating businesses, and this diversion was the source of the long-term decline of the corporation. All of these companies cut costs and raised prices in ways that reduced the long-term attractiveness of the business, as exemplified by Marks & Spencer. They engaged in earnings management, effectively borrowing money from the future to enhance reported profits now. As in GE’s financial services businesses. They adopted accounting practices that accelerated the recognition of profits that might be earned in the future but often were not. As at Enron. They were enthusiastic dealmakers, engaging in activities that excited the investment community but which rarely created value and frequently destroyed it. As exemplified by GE. In each case, the short-term boost to the share price was followed by a lengthy – or, in the case of GEC, abrupt – decline. The leaks from the pipes became a flood. Some companies were able to resist the demands of share-holder value. Notable among these stand-outs were some of the leading producers of fast-moving consumer goods (FMCG): corporations such as Proctor and Gamble, Colgate–Palmolive, Coca-Cola, Unilever and Nestlé. The culture of these businesses was and still is dominated by marketing people, for whom responsiveness to the needs of customers is a preoccupation. And that responsiveness is the key to the durability of these companies.

When I joined the board in 1991, ‘the Halifax’ was the largest mortgage lender in the world. Its head office was still in the modest Yorkshire town of Halifax (which it now dominated), and most of the people who worked there had been born and brought up locally. The organisation – like the Marks & Spencer of that time – was a powerful illustration of how strong systems and culture can enable otherwise unremarkable people to do remarkable things. The contrast with Oxford University, which relied on the services of remarkable people but as an organisation was remarkable only for its ineptitude, was striking. I could not help noticing that even the most junior teller in the Halifax would use the pronoun ‘we’ in talking about the organisation, while in Oxford even the vice-chancellor would talk about ‘the University’ as though it were an organisation over which he had little real influence – which was perhaps true.

For an economist who taught that profit could be sustained only as a result of competitive advantage, this diversification raised a simple question. And some businessmen on the board, accustomed to a world in which profit is earned only by meeting customer needs, encountered the same difficulty.

A report on the HBOS failure by the regulators the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) took the view that the board ‘lacked non-executives with sufficient experience and knowledge of banking, particularly corporate banking’. While this may have been true, I believe it is also important to have non-executives with little experience and knowledge of an industry who can offer challenge to the conventional wisdom of those who have spent their working lives in it. Diversity of thought and perspective is necessary, and not the same as the appointment of ‘diverse persons’.

The finance curse is the elevation of the achievement of financial metrics over satisfaction of the needs of stakeholders – a priority that has often worked to the long-run detriment of all stakeholders, including shareholders themselves. Neither quarterly earnings management nor merger and acquisition activity is a source of sustainable competitive advantage. And it is sustainable competitive advantage – which all the companies described in this chapter and the preceding one once enjoyed – that is the basis of business success. And the only long-term source of shareholder value.

PART 6: The Corporation in the 21st Century

24: Combinations and Capabilities

“The modern firm is a community, rather than an office or a factory. It is defined not by its plant and machinery but by its capabilities. The successful business is characterised by the distinctive nature of its collection of capabilities and the match between these capabilities and the needs of its customers – and other stakeholders. The claim that George W. Bush told Tony Blair that ‘the problem with the French is that they don’t have a word for entrepreneur’ is, sadly, apocryphal.

Online retailing and the personal computer revolution would have happened even if Bezos,

Gates and Jobs had never been born. These developments occurred around the end of the twentieth century because all the necessary pieces of collective knowledge and collective intelligence were then developed. These individuals and their associates pieced together relevant capabilities. When innovative firms succeed, as Amazon, Microsoft and Apple did but most new firms do not, it is because of the distinctive character of the capabilities of their organisation and the combinations they put together.

A central theme of this book is that The History of Business is not the Biography of Great Men, although many business biographers and especially autobiographers might seek to tell us otherwise. Economists might reasonably reciprocate Carlyle’s contempt. His contemporary, the novelist Samuel Butler, wrote that ‘It was very good of God to let Carlyle and Mrs Carlyle marry one another and so make only two people miserable instead of

four.

For Penrose, the firm was defined not by the assets it owned or the contracts it made but by its capabilities and its ability to deploy those capabilities in productive services: ‘All the evidence we have indicates that the growth of firms is connected with the attempts of a particular group of people to do something.’ Perhaps that seems obvious. But her emphasis

on ‘the group’ recognises the centrally cooperative nature of business activity, and her identification of purpose – ‘to do something’ – establishes its problem-related focus.

The critical resource for a firm lies in its distinctive capabilities or distinctive combinations of capabilities.

Distinctive capabilities, such as those of Apple’s design team, are those characteristics of a firm that cannot be replicated by competitors or can only be replicated with great difficulty, even after these competitors realise the benefits which they yield for the originating company. That distinctiveness could never be true of the hierarchical organisation run in the spirit of Frederick Taylor or as a cascade of principal–agent problems formulated by reference to the solutions in leading economic journals.

25: A Letter from Arnold Weinstock

““If you want to hire great people and have them stay, you have to be run by ideas, not hierarchy. The best ideas have to win.”

Steve Jobs, 2010

In 1944 the US Office for Strategic Services (the precursor of the CIA) produced a ‘sabotage manual’ to advise people in occupied European states on how to obstruct the conduct of the war with little personal risk. Suggestions included:

• Insist on doing everything through ‘channels’. Never permit short-cuts to be taken in order to expedite decisions.

• Make ‘speeches’. Talk as frequently as possible, and at great length. Illustrate your ‘points’ by long anecdotes and accounts of personal experiences.

• When possible, refer all matters to committees, for ‘further study and consideration’. Attempt to make the committee as large as possible – never less than five.

• Bring up irrelevant issues as frequently as possible.

• Haggle over precise wordings of communications, minutes, resolutions.

• Refer back to matters decided upon at the last meeting and attempt to re-open the question of the advisability of that decision.

• Advocate ‘caution’. Be ‘reasonable’ and urge your fellow-conferees to be ‘reasonable’ and avoid haste which might result in embarrassments or difficulties later on.

Many readers, especially academic ones, will be able to testify to the continuing effectiveness of these techniques even in peacetime.

The most common device for diluting or deflecting responsibility is the meeting – better still, the committee. If many people are associated with a decision, then no one is really responsible for it. The form and the check box are common means of creating the appearance of accountability without the reality. Meetings, form-filling and box-ticking take time – often a lot of time. That is how bureaucracies come to waste resources while making bad decisions.

The most powerful military machine the world had ever seen was defeated in Vietnam and Afghanistan and failed in Iraq. It is hard to imagine a more compelling demonstration that the scale of an organisation is less important than the match between the capabilities of the organisation and the problems it is asked to solve. And the most powerful manufacturing organisation the world had ever seen was defeated in global automobile markets when Asian businesses successfully challenged the hegemony of General Motors. Toyota famously introduced the Andon cord, which enabled individual workers to stop the production line if they identified a defect or a problem. The system restored personal initiative and encouraged workers to take pride in their work.

The monarch, and the position of the monarch, is unique. But an orchestra has a conductor, and a sports team has both a captain and a coach. The players do not, to any large degree, do things because they are the things the conductor, captain or coach has told them to do. The violinist follows the score; the footballer uses his talent and experience to move into position, to pass or to shoot. The music and the game would continue even if the conductor dropped his baton and the coach fell asleep. The great conductor, captain or coach will be a source of inspiration and imagination to his colleagues. But if these leaders understand their responsibilities they never assume the role of Big Boss or The Man Who Knows.

A successful management team in a business strikes a balance with which most stakeholders are content. Investors are satisfied with their dividend (or now more usually share price appreciation); employees are happy with their jobs; customers and suppliers believe they are getting a good deal. So staff turn-over is low, customers and suppliers remain loyal and the share price remains buoyant. And so does the business. In a market economy exit may be a more important and effective mechanism of imposing accountability – and expressing one’s opinion of the quality of the decisions of the executives of the business – than voice. But voice and exit operate in parallel. Exit is the remedy of those who feel their ideas or needs are ignored. The voice that matters to most people in organisations is not loud. It is the internal voice that says that people in this organisation care about me, and care about what I do, and about what I think. That sense of engagement does not require, and is often inconsistent with, formal processes of consultation, such as town hall meetings or, particularly, worker representation on the board. A common feature of these

processes is that the people who take an active part in them are unrepresentative by virtue of the very fact of being there. Most people have other things to do, and hesitate to express themselves publicly; participants in consultations are often present simply because they are particularly opinionated.

Mediating hierarchy is necessary for any organisation based on collective intelligence to be cohesive and effective. An organisation based on trust and respect rather than obligation and contract.

26: The Macneil Returns to Barra

“Exchange is embedded in a social context, and that context determines the commercial reality.

Cooperation – whether it is between a team of workers driving an engine, a board of directors planning a new line or many individual savers providing capital to the business – requires trust. Successful collective action requires that you believe what others tell you and that you can expect others to do what they say they will do. Trust begins in personal relations; humans are strongly predisposed to trust family members and to form friendship

groups.

Selfishness of motive, narrowness of objective and instrumentality of behaviour are corrosive of collaborative and cooperative activities such as parenthood or education or scientific research.

The relationships with others essential to activities such as parenthood, education and research are valued for themselves, not just for their consequences. Most humans are good at detecting instrumentality – the false bonhomie of the used car salesman, the cynical hypocrisy of the vote-seeking politician – and are repelled by it. There is a difference between the firm that promotes the welfare of its employees because its executives care, and the firm that promotes the welfare of its employees because its finance department has calculated the net present value of reduced staff turnover. And employees can usually tell which is which.

27: The Hollow Corporation

“Business is better understood by reference to the stage of industrialisation, which differs across the United States, China and Bangladesh, than it is through the language of capitalism and socialism.

Everyone knows how the story evolved. The franchising model Kroc implemented involved a process of rigorous standardisation which gave the customer a predictable product. Today you can enjoy, or at least buy, an almost identical Big Mac in familiar surroundings in thousands of outlets in more than a hundred countries. The formula also enabled inexperienced individuals to establish their own businesses with modest capital and a high probability of success.

These hollow corporations share the characteristic that the activities of the business have been pared down to the single link in the chain of production at which the corporation holds a distinctive capability and enjoys a competitive advantage. Richard Langlois, a business historian, identifies this as a key reason for the change in the corporate landscape, enabled by the growth of ‘market-supporting institutions’ which enabled entrepreneurs to easily access support for business functions where they didn’t have a comparative advantage. If the assembly line was the defining innovation in business method of twentieth-century manufacturing activity, the hollow corporation may be the defining innovation in business method of twenty-first-century digital activity.

PART 7: Capitals in the Twenty-First Century

28: Capital as a Service

“And it would be foolish to think that, if one went out to buy the quantities of capital and labour that Apple purchases, one would be able to produce iPhones and MacBooks – any more than one could do so by purchasing appropriate quantities of silicon and glass. The ingredients list is not the recipe. Thomas Thwaites laboriously demonstrated the fallacy of this mechanistic analysis of production through his efforts to make a far simpler item. Capital and labour, silicon and glass: all these factors of production are necessary but no physical description is ever sufficient, or even close to sufficient.

Today the hallmark of successful business is access to collective intelligence that is not common property.

29: Capital and Wealth

“I read with interest a Harvard Business School case in which a senior Morgan Stanley executive recounted the company’s response to the incident. I anticipated at least a mention of Rick Rescorla, the head of security for that company, who ordered evacuation in defiance of the Port Authority’s advice to occupants to stay put, with the result that only thirteen of Morgan Stanley’s 3,700 employees in the towers died. They included Rescorla himself, who returned to the South Tower to ensure that no one remained inside the wrecked structure, and who is now buried in the Cornish village where he was born. There was no such mention, but considerable self-congratulation for the contingency planning which enabled trading to resume less than an hour after the first plane hit the North Tower. Such are the priorities of modern financiers.

In 1921 the British government forced the amalgamation of all railways into four companies of which the Great Western Railway was one; nationalisation followed in 1948, and a complex restructuring, described as privatisation, was effected in 1995. At the time of writing, GWR is operated under an 800-page franchise agreement between the British government and FirstGroup, which is principally a bus company. The trains are owned by specialist rolling stock leasing companies Angel Trains and Porterbrook. The track is owned and maintained by Network Rail, a state-owned company formed after the failure of Railtrack, a company that had been listed on the London Stock Exchange. If the GWR franchise is not renewed– and it won’t be, since the government has announced yet another reorganisation of the structure of Britain’s railways – then the agreement provides for most of the few rail assets that First-Group does own to be transferred to a new operator. Who are Angel Trains and Porterbrook? The two largest shareholders of Angel Trains are Allianz, the German insurance company, and AIMCo, each with 30 per cent of the stock of the company. AIMCo was established in 2008 by the government of the Canadian province of Alberta. It manages funds on behalf of various provincial pension funds and invests the reserves of that oil-rich province. Fifty-five per cent of the stock of Porterbrook is held by AMP, an Australian financial services business (formerly Australian Mutual Provident) now mainly engaged in the management of ‘super funds’ (Australian for individual and collective pension funds).

The nearest approximation I have found is Li Ka-shing, a refugee from China who is now Hong Kong’s richest man. Li left school at the age of fifteen and set up a small business manufacturing plastic flowers. From these modest beginnings he developed the massive Hutchison Whampoa group, of which Eversholt, another rail rolling stock leasing company, is a subsidiary. None of the, admittedly small, sample of railway employees I interviewed had ever heard of Li, far less experienced resentment at his oppression or exploitation. If they did express resentment, it was – appropriately – directed at the management of First-Group and most of all at the Department for Transport. Li is svelte, noted for his relatively modest habits and second only to Bill Gates for the scale of his global philanthropy.

As the economic historian Deirdre McCloskey has pointed out, we do not talk about waterism, essential though running water is to our personal and commercial lives. Or power-ism, although the new availability of first steam and then electric power may have been a more important contributor to the modernity of economic life than any change in the availability of capital. If the managers of a modern business do not want to succumb to the demands of their capital supplier, they can buy their capital services elsewhere. In fact, it is often rather easier for them to exercise that choice than it is to change their water or electricity provider. That these points seem novel, even disturbing, is a measure of the extent to which outdated rhetoric developed to describe the Carron Works and the plant at the River Rouge continues to frame our thought.

30: Who are the Capitalists Now?

“But while people like Bezos, Gates and Musk top the modern ‘rich list’ and capture the public imagination, most large corporations are controlled by men in suits, if no longer in ties, whose careers have been spent ascending corporate bureaucracies. Of the ten largest companies in the Fortune list discussed in Chapter 7, none was founder-controlled.

Doug McMillon is boss to more people than any other business executive but not well known even to Walmart shoppers – or to many Walmart employees. While Françoise Bettencourt plays piano, the business in which she is the principal stockholder is in the charge of Nicolas Hieronimus (CEO of L’Oréal). (Yes, I had to look it up too.)

Wealth is not equally, or even equitably, distributed, but it is more broadly distributed than in the past. To see a modern capitalist, perhaps you should go to the mirror in the home you own.

31: In Search of Capital

“Companies such as Apple and Amazon have market capitalisations far in excess of their tangible assets. One common explanation of this difference is the scale of their ‘intangible assets’. But unless one can be specific about what these intangible assets are, this statement provides no additional explanation or insight. The two sources of intangible assets most frequently cited are research & development and brand value.

When executives deliver that routine cliché of modern management – ‘Our people are our greatest asset’ – the commercial value of the collective intelligence developed within the corporation is probably what they have in mind. The asset is the capability of individuals and teams within the business to solve problems, to devise and deliver new products and to win

the commitment of suppliers and the trust of customers. Collective intelligence is the basis of the competitive advantage of most successful corporations, and it is enshrined in its people.

PART 8: The Best of Times, The Worst of Times

32: Ambiguity is a Feature, Not a Bug

“Adaptation with selection, the basic mechanism of evolution, is the process through which collective intelligence develops and the means by which successful firms find products and business processes appropriate to the needs of their customers. Disciplined pluralism, which allows freedom to experiment but is quick to end unsuccessful experiment, is inseparable from economic progress.

The economies and societies that emerged from the scientific revolution advanced through

disciplined pluralism. Pluralism is the freedom to try new ideas or new ways of doing old things or promoting new products. A society with freedom of speech and a vibrant research community enjoys a surfeit of claims to new knowledge. Likewise, a competitive business environment stimulates the adoption of new business processes and the offer of new goods and services. An economy characterised by disciplined pluralism will applaud these novelties but weed out those not worth pursuing from those that are. In these ways humans navigate radical uncertainty – and prosper from it. Economic advance through disciplined pluralism is an evolutionary process, resembling natural selection.

And when centralised organisations finally adopt new approaches, they tend to deploy them on too large a scale. State agencies are slow to acknowledge failure and prone to cover it up or even to proclaim that failure is success. The same is true of large corporate organisations, which is why disruptive innovation most often comes from outside.

I believe it is appropriate – indeed necessary – to view the business organisation in the same way. The proper goal of corporate activity is the flourishing of the multiple stakeholders of the corporation: employees, investors, suppliers and customers, the communities in which it operates and the corporation itself. For the corporation to flourish, it must contribute to the flourishing of the society in which it operates. And ‘the doctrine of the mean’ is as relevant to the business organisation as it is to the individual. The directors and executives of a flourishing company operate within a mediating hierarchy, which meets the needs of all its stakeholders, gives them an opportunity for voice and protects the business from the adverse consequences of stakeholder exit.

Some economists declare that a ‘recession’ is two consecutive quarters of negative GDP growth. And as I write this book there is endless speculation in the economic press as to whether there is, or will be, a recession. But the answer to that question is not what businesspeople or policymakers want to know – or ought to want to know. They want the answer to a question less specific but more pertinent to their decisions. ‘What is going on here?’ That formulation sounds trite. But we live in a world of radical uncertainty, and every situation, every point of decision, is unique. And in that world, the question ‘What is going on here?’ needs to be posed again and again.

There is today substantive philosophical literature on the topic of vagueness – the necessary deployment of terms that are useful in narrative description but are not susceptible to precise definition. Ambiguity and vagueness are, in the language of today’s digitised world, a feature, not a bug; they reflect the inescapable complexity of reality rather than our incompetence at describing that reality.

In writing this book, I have been repeatedly struck by the frequency with which discussion is clouded, not illuminated, by the imposition of false binaries where no clear-cut distinction actually exists. Just as there is no usefully sharp distinction between heap and not heap, between dry and wet, so there is no sharp distinction between market and hierarchy, between public and private sectors, between profit and not-for-profit organisations, even – and critically – no sharp distinction between capital and labour. The concept of ownership is often complicated, and the ‘badges of ownership’ may be divided among several agents so that the ‘owner’ is hard to identify. Binaries are the natural currency of both lawyers and economists because, for different but related reasons, both law and mathematics demand precision.

33: After Capitalism

“Materials constitute a negligible proportion of the cost of these products. What you are paying for is the collective intelligence within these companies which is incorporated in the product design, rather than the transformation of raw materials into finished goods. This dematerialisation of the value of product is associated with dematerialisation of the means of production. Twenty-first-century business needs little capital, mostly does not own the capital it uses and is not controlled by the people who provide that capital. A modern firm buys capital services just as it buys water, electricity and transport – and as it purchases the services of workers, accountants, executives and suppliers.

The focus on the firm as a collection of capabilities gives a different and more illuminating perspective for understanding the extraordinary diversity of business organisations and of businesspeople over geographies and over time. The core ideas in this book – collective intelligence, radical uncertainty, disciplined pluralism, relational contracts and the mediating hierarchy – have been extensively developed and discussed by earlier writers, though much of that work has been outside the context of business organisation. The relevance of each to the argument of this book arises from a belief that in the modern world successful commercial relationships are not simply instrumental and transactional; they are social and are embedded in a wider framework of communities and teams. That transactional view was both incorrect and unattractive. This book is written in the hope that a better account of how business and its stakeholders flourish will point the way not just to a better understanding of business but to the better conduct of business itself. In a successor volume I will try to explain some of the implications of that understanding for both business policy and public

Policy.

Appendix:

Grove’s 1983 book High Output Management deserves the cult status it achieved in Silicon Valley.

Mayer, C., Capitalism and Crises