Why capitalism must reform or die

PUBLISHED : Wednesday, 09 March, 2011, 12:00am
UPDATED : Wednesday, 09 March, 2011, 12:00am

Leading business executives must get rid of their stock market-driven fixation with short-term results and institute deep and far-reaching reforms if they want to ensure the survival of capitalism. This plea comes not from an isolated academic in an ivory tower but from the top executive of the McKinsey consultancy group writing in the flagship journal, the Harvard Business Review.

Dominic Barton, global managing director of McKinsey, warns that business is failing in key areas and that friction between business and society may reach a tipping point that could threaten capitalism.

Unfortunately, though he raises the important issues, his solutions are wishy-washy or tentative and unlikely to gain traction.

McKinsey itself has recently come under fire after the United States Securities and Exchange Commission charged its former managing director Rajat Gupta with insider trading. Some critics claim the global consultancy group is a sinister power. Barry Ritholtz, in his influential Big Picture blog, asked whether McKinsey was the root of all evil and claimed,: 'Where ever there has been a financial disaster in the world, if you look around, somewhere in the background, McKinsey and Co is nearby.'

But on the question of capitalism, Barton raises the right concerns, not least because the 2008 recession and its aftermath of cutbacks and high unemployment have increased public antagonism towards business. Barton steers away from how to restart growth, and offers a root and branch examination of capitalism itself. He calls for a 'shift from what I call quarterly capitalism to what might be referred to as long-term capitalism.'

Barton says the fundamental question is 'about rewiring the fundamental ways we govern, manage and lead corporations. It's also about changing how we view the value of business and its role in society.'

He lays out what he calls the three essential elements of the shift in attitudes. 'First, business and finance must jettison their short-term orientation and revamp incentives and structures in order to focus their organisations on the long term.

'Second, executives must infuse their organisations with the perspective that serving the interests of all major stakeholders - employees, suppliers, customers, creditors, communities, the environment - is not at odds with the goal of maximising corporate value; on the contrary, it's essential to achieving that goal.

'Third, public companies must cure the ills stemming from dispersed and disengaged ownership by bolstering boards' ability to govern like owners.'

Barton says the challenge is urgent. The choice is to undertake reforms or face the wrath of government driven by an angry public. He believes that reforms will also strengthen capitalism. 'They will unleash the innovation needed to tackle the world's grand challenges, pave the way for a new era of shared prosperity, and restore public faith in business.'

Bravo, bravely put, but hold the applause. Much of what Barton advocates makes eminent sense. His world view is informed by broad experience of advising business, public sector companies and non-profit organisations over 25 years. He has the advantage of being a Canadian who has lived in Toronto, Sydney, Seoul, Shanghai and, now, London. The problem, of course, is that making the prescription is relatively easy; taking the medicine and getting it to work is more difficult.

The tyranny of short-termism is well established, but still rules. Barton points out that companies like Toyota and Hyundai took years and went through many teething problems to establish their ascendancy.

Indeed, Toyota's rise took decades. Early Toyota vehicles had so many problems that a Japanese cartoon described a stalled truck as being 'in Zen meditation'.

Even in the West, Intel took the bold but 'wrenching' decision to abandon its core business of making memory chips to start producing microprocessors, and became leader of the multibillion dollar industry. Apple's iPod also had a tough first year, when only 400,000 units were sold (out of 275 million to date) and its share price fell by 25 per cent.

Back in the 1970s the average holding period for US equities was seven years; today it is seven months. Moreover, hyperspeed traders, who may hold shares for only a few seconds, now account for 70 per cent of US equities trading. Says Barton: 'If the vast majority of most firms' value depends on results more than three years from now, but management is preoccupied with what's reportable three months from now, then capitalism has a problem.'

Yet markets twitch and typically respond almost to every passing breeze of rumour. BBC World's business correspondents visibly cheer when stock markets go up and look glum when they go down, taking a child's mind view of markets.

Barton pleads with the major providers of capital, pension funds, insurance companies, mutual funds and sovereign wealth funds, which together hold US$65 trillion or 35 per cent of the world's financial assets, to pursue their obvious interest in long-term value creation and eschew shortsighted practices.

His second imperative is to disseminate the idea that serving stakeholders is essential to maximising corporate value. Too often, Barton says, a false choice is offered - are you a champion of shareholder value or a fan of the stakeholders?

By 'stakeholders' he means employees, suppliers, customers and creditors, and also the communities in which the companies work and the health of the environment.

McKinsey's own surveys of executives and investors show that a majority believe that taking care of the environment and having good social and governance practices enhance corporate value.

Barton's third prescription is for renewed corporate governance. Lessons from successful family-owned companies, he says, suggest that: 'The most effective ownership structure tends to combine some exposure in the public markets (for the discipline and capital access that exposure helps provide) with a significant, committed, long-term owner. Most large public companies, however, have extremely dispersed ownership, and boards rarely perform the single-owner-proxy role.

As a result, CEOs too often listen to the investors (and members of the media) who make the most noise. Unfortunately, these parties tend to be the most nearsighted ones. And so the tyranny of the short term is reinforced.'

He offers three prescriptions for better ownership-based governance: more effective boards whose members will take their jobs more seriously, and spend 30 to 36 days a year on their work, not the current 12-20 days, to serve as the agents of long-term value creation; more sensible pay for CEOs to reward them for their achievements in adding to long-term value; and redefining shareholder democracy.

The last idea, and his suggestion it is time for new rules to counterbalance high churn rates, perhaps following practice at some French companies of giving two votes to shares held for more than a year, shows the gap between his sensible ideas and harsher reality. Would differently weighted shares be accepted? Would they work?

Pay of CEOs continues to rise astronomically above that of ordinary workers, and sacking of a boss, even after evident failure, still gets him a multimillion-dollar pay-off. High unemployment in the US today is coinciding with record corporate profits and a corporate cash glut.

And Barton does not tackle the harmful influence of the big financial conglomerates and the way they took the world close to financial meltdown. Even the governor of the Bank of England has just complained big financial companies felt free to gamble with other people's money.

But business should beware and be aware: trust in business in the US and Britain is only 45 per cent, slightly up from all-time lows. Trust is higher in China at 61 per cent, in India (70 per cent) and Brazil (81 per cent).

Days of reckoning may be at hand if business does not reform itself.