How Business Leaders Turned Into Vampires

By Steve Denning

How did America—a country dedicated to the proposition that all men are created equal—become one of the most unequal countries on the planet? Why do the nation’s leaders now spend so much of their time feeding at the trough and getting ever more for themselves? Why has public-mindedness in our leaders given way in so many instances to limitless greed?

These questions are being raised, not in some anti-capitalist rag from the extreme Left, but in the staid pro-business pages of the Harvard Business Review, in a seminal article by Roger Martin, the former dean of the Rotman School of Business and the academic director of the Martin Prosperity Institute: “The Rise and (Likely) Fall of the Talent Economy.”

One key factor, argues Martin, is a fundamental shift in nature of the economy. Fifty years ago, “72% of the top 50 U.S. companies by market capitalization still owed their positions to the control and exploitation of natural resources.” But in the latter part of the 20^th century, a new kind of organization began to emerge: an organization that prospered not by natural resources but through “the control and exploitation of human talent.”

“By 2013 more than half of the top 50 companies were talent-based, including three of the four biggest: Apple AAPL +0.21%, Microsoft MSFT +0.35%, and Google GOOGL +0.69%. (The other one was ExxonMobil.) Only 10 owed their position on the list to the ownership of resources. Over the past 50 years the U.S. economy has shifted from financing the exploitation of natural resources to making the most of human talent.”

As a result, “the talent” got much richer. “Skilled leaders saw a major boost in income… after it was recognized as the linchpin asset in the modern economy… the vast majority of Forbes billionaires are self-made.”

So, what’s wrong with that? Nothing, you might say: it’s simply part of “the American Dream, in which hard work and the cultivation of talent deserve rewards.”

Not so, says Martin, who asks the tough questions: Is it truly hard work and talent that is leading to these super-sized rewards? And are the rewards deserved? Are the rewards sustainable? His answers are clear: no, no and no. Let’s look at the issues, one by one.

Talent that adds value

Is it truly hard work and the deployment of genuine talent at play here?  The word, “talent” has generally positive connotations, implying that the people involved add real value to society. And certainly the talent economy described by Martin includes categories of such people.

1. Entrepreneurs who take huge risks and generate huge benefits for society and for themselves. Even if most entrepreneurs fail, some succeed: Steve Jobs at Apple, Bill Gates at Microsoft, Larry Page and Sergei Brin at Google and Mark Zuckerberg at Facebook. They contribute in different ways to adding real value to society by giving the world a better products and creating employment. They are part of the Creative Economy.
2. Skilled workers, whose talents and attributes add value for customers. This includes great designers, brilliant software engineers, even sportsmen, movie stars, models and television personalities. In some instances, the attributes are more significant than the skills. For instance, Tom Brady’s wife, Gisele Bundchen, has earned more money in modeling than he has in the NFL at around $300 million, and Kim Kardashian notoriously receives around $30 million a year for doing no more than “being famous for being famous.” They are also part of the Creative Economy.
3. Administrators, who hold positions in bureaucracies, both in the public and the private sector. They oversee systems, processes and practices, following rules and regulations and allocating capital among different categories of action. Administrative CEOs create little in the way of extraordinary new value. They take ongoing enterprises and administer them efficiently. They are solid performers. The jobs require no particular imagination or creativity. Their skills are not unique and they can be easily replaced. They oversee steady and modest improvements. In the public sector and in the private sector, they have been paid moderately—until several decades ago— roughly in proportion to their moderate contributions in terms of value.

Talent that extracts value

Martin’s article focuses mainly on three other categories of ‘talent’ whose pay appears to have lost any connection to their skills or attributes, or to its contribution to society. These are people who, for one reason or another, find themselves in privileged positions and are able to exploit the situation. Some of these roles involve skills, but the skills are deployed in zero-sum games or activities that are socially harmful. They might be called ‘vampire talent’ in the sense that they suck value from their organizations, their customers and from society, rather than creating it. They include:

1. ‘Super-managers’ are people who hold administrative positions in the C-suite of private-sector bureaucracies but are masquerading as entrepreneurs. They are, to use Thomas Piketty’s slyly ironic term, “super-managers.” As such, they have been able to extract extraordinary levels of compensation. They have been lavished with stock and stock options and have been able to “manage” the share price of their firms with massive share buybacks and other financial engineering so that they receive massive bonuses. As Bill Lazonick documented in the September 2014 issue of HBR, the net effect of their activities is to extract value, rather than create value. A prime example is Sam Palmisano’s $225 million payout for his stint at IBM, while systematically extracting value from the firm for himself and the major shareholders over a period of years.

2.  Hedge funds act as gamblers, speculating with other people’s money, for instance in the $700 trillion derivatives market. “Modern market structures enable hedge funds to trade like this by borrowing stock in large amounts, which means they can take short positions as well as long ones. In fact, hedge fund managers don’t care whether companies in their portfolios do well or badly—they just want stock prices to stay volatile. What’s more, they want movement in prices to be large: The more prices move, up or down, the greater the earning potential on their carried interest. They aren’t like their investment management predecessors, long-term investors who wanted companies to succeed.”

3.  Tollkeepers, or what Charlie Munger calls ‘rats in the granary.’ They extract rents or baksheesh, simply by reason of being able to do so. Examples include high speed trading, dark pools and some facets of banking. Martin cites one of the notorious examples: “James Simons, the founder of Renaissance Technologies, ranks fourth on Institutional Investor’s Alpha list of top hedge fund earners for 2013, with $2.2 billion in compensation. He consistently earns at that level by using sophisticated algorithms and servers hardwired to the NYSE servers to take advantage of tiny arbitrage opportunities faster than anybody else. For Renaissance, five minutes is a long holding period for a share.” Simons is hardly an isolated example. Others include:

• Goldman Sach’s efforts to corner the aluminium market and JP Morgan’s effort to do something similar in the copper market.
• Price fixing at LIBOR, in which most of the biggest banks were involved.
• Money laundering by some of the biggest banks for illegal drug money and illegally funneling cash to Iran.
• Facilitation of tax evasion by major Swiss banks.

Vampires only part of the time

Keeping the activities of the “vampire talent” in perspective is complicated by the fact that not everything these characters do is bad. CEOs head organizations that provide real goods and services to the economy. The financial sector, in addition to these questionable activities, serves a useful social function in funding the real economy of goods and services and providing citizens and businesses with financial security. The issue is: where do the “value-adding activities” end and the “value-extracting activities” begin?

“Most of the writing on these subjects,” writes John Lanchester in The New Yorker, “was done either by business journalists who thought that everything about the world of business was great or by furious opponents from the left who thought that everything about it was so terrible that all that was needed was rageful denunciation. Both sides missed the complexities, and therefore the interest, of the story.”

Although there are plenty of grounds for rage against the over-paid executives and wrong-doing in the financial sector, the challenge is to sort out which are the activities that grow the real economy of goods and services, and which are the activities that are zero-sum games or socially harmful.

Since this is difficult, there is a tendency to dismiss the activities of ‘vampire talent’ asde minimis. “That’s capitalism, right? Every man for himself. It’s no big deal if there’s an occasional bad apple in the barrel. The ‘invisible hand’ of capitalism will make everything come out right for society in the end.”

Not so, says Martin. His article documents how the excessive compensation of ‘vampire talent’ is making everything come out very wrong for the organizations involved, for the economy and for society as a whole.

The problem today is that the super-sized executive compensation, the gambling and the toll-keeping of the financial sector aren’t tiny sideshows. They have grown exponentially and are now macro-economic in scale. They have become almost the main game of the financial sector and the main driver of executive behavior in big business. When money becomes the end, not the means, then the result is what analyst Gautam Mukunda calls “excessive financialization” of the economy, in his article, “The Price of Wall Street Power,” in the June 2014 issue of Harvard Business Review.

No trickle down

One “basic grievance” says Martin, “with today’s billionaires is that relatively little of the value they’ve created seems to trickle down to the rest of us… Real wages for the 62% of the U.S. workforce classified as “production and non-supervisory workers” have declined since the mid-1970s… since the mid-1980s inequality has rapidly increased, with the top 1% of the income distribution taking in as much as 80% of the growth in GDP over the past 30 years (estimates vary).”

“Consequently, labour’s earnings have been suppressed and real wages have stopped growing. This has exacerbated income inequality in America, especially between the very rich and everyone else: The differential between 50^th percentile incomes and 90^th(or 99^th or 99.9^th) percentile incomes has widened dramatically since 1980 and shows no signs of stabilizing, let alone narrowing. Meanwhile, the differential between 10^thpercentile and 50^th percentile incomes has changed very little.”

“The move from building value to trading value is bad for economic growth and performance. The increased stock market volatility is bad for retirement accounts and pension funds… talent is being channeled into unproductive activities and egregious behaviours.”

These imbalances cannot endure for long. “The income gap between creativity-intensive talent and routine-intensive labour is bad for social cohesion. … In a democratic capitalist country, it is not sustainable to leave the members of the largest voting bloc out of the economic equation.”

One risk is that the fear of damaging the talent that really does add value to the Creative Economy will defer needed action in dealing with the ‘vampire talent’ that extracts value. That in turn may lead to steady aggravation of the activities of the ‘vampire talent’ until the eventual remedial action is a massive societal spasm that causes unnecessary social and economic havoc.

Negative economic impact

We might argue over a glass of wine whether Gisele Bundchen really deserves $300 million for prancing up and down the fashion runway, or whether Kim Kardashian’s antics warrant $30 million a year. However these “talents” do no further harm to society. It’s all good, relatively clean fun. Pure entertainment — no collateral damage.

Not so with the ‘vampire talent’ whose activities are distinctly unentertaining and causing massive collateral damage for organizations, the economy and society.

The C-suite

The growth of super-sized executive compensation is inversely related to performance. The super-managers are in effect being rewarded for doing the wrong thing. “Across the economy,” writes Martin, “ the return on invested capital, which had been stable for the prior 10 years at about 5%, peaked in 1979 and has been on a steady decline ever since. It is currently below 2% and still dropping as the minders of that capital, whether corporate executives or investment managers, extract ever more for their services.”

Yet even as the members of the C-suite are delivering less and less return on invested capital, it has yet to register in their paychecks. In the period 1978 to 2013, CEO compensation increased by an astonishing 937%, while the typical worker’s compensation have declined. These executives are administrators masquerading as entrepreneurs. As Bill Lazonick has documented in his recent HBR article, these executives are “takers,” while posing as “makers”: they are extracting value, not creating it.

Thus between 2003 and 2012, publicly-listed firms in the S&P 500 used a colossal amount of their earnings—54% or $2.4 trillion—to buy back their own stock. These firms are engaged, Bill Lazonick’s article showed, in “what is effectively stock-price manipulation.” The consequences of these share buybacks are an economic and social disaster: net disinvestment, loss of shareholder value, crippled capacity to innovate, destruction of jobs, exploitation of workers, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation.

Hedge funds

The situation is even worse with hedge funds. “Over the past 13 years,” writes Martin, “the number of hedge fund managers, by far the fastest-growing category, has skyrocketed from four to 31 on the list [of the 400 richest people], second only to computer hardware and software entrepreneurs (with 39) in possessing the greatest fortunes in America. If the LBO fund managers on the list are included, it becomes clear that far and away the best method of getting rich in America now is managing other people’s money and charge them 2 and 20. As Steven Kaplan, of the University of Chicago, and Joshua Rauh, of Stanford, have pointed out in a recent paper, the top 25 hedge fund managers in 2010 raked in four times the earnings of all the CEOs of the Fortune 500 combined.”

Hedge funds operate as a kind of speculator’s paradise: no-risk gambling. The standard fee is “2 and 20”; that is, each year the managers charge two per cent of the money invested in the fund, and also twenty per cent of any profit above an agreed-upon benchmark. So if you can put together a fund of $100 million, you make at least $2 million a year even if you generate no profits, or even lose a lot of your capital. Nice work if you can get it. It doesn’t really matter if you fail.

Indeed, “most hedge funds fail,” writes John Lanchester in The New Yorker. “Their average life span is about five years. Out of an estimated 7,200 hedge funds in existence at the end of 2010, 775 failed or closed in 2011, as did 873 in 2012, and 904 in 2013. This implies that, within three years, around a third of all funds disappeared. The over-all number did not decrease, however, because hope springs eternal, and new funds are constantly being launched.”

Once upon a time, hedge funds earned their outsize compensation by truly hedging investments. This risk-mitigation strategy reduced the gains when markets were up but avoided some of the losses when markets were down.

Today, most hedge funds are aggressive, highly-leveraged, speculative vehicles that are desperately chasing returns to outperform their benchmarks. They make huge returns for the managers regardless of the fund’s performance and generally end up transferring wealth from investors to hedge fund managers.

Objectively, hedge fund performance is poor. Hedge funds have failed to keep up with regular markets. According to HFRX Global Hedge Fund Index:

• Hedge funds returned a mere 3.5% in 2012, while the S&P 500-stock index gained 16%.
• Over the past five years, the hedge fund index lost 13.6%, while the indices added 8.6%.
• In 2013, most hedge funds fell even further behind, gaining 5.4% vs. the market’s rally of 15.4%.

That’s even before we get to the question of fees. The industry standard fee of “2 and 20” is outrageous compared to average mutual fund fees of 1.44% and under 0.25% for an index ETF. To add insult to injury, hedge fund managers get a special tax break that enables them to claim that their “2 and 20″ fees are capital gains.

The fee arrangements are a wealth-transference mechanism, systematically moving money from investors to hedge-fund managers. Some of the statistics cited in Simon Lack’s The Hedge Fund Mirage (2012) are astounding:

• From 1998 to 2010, hedge fund managers earned $379 billion in fees. The investors of their funds earned only $70 billion in investing gains.
• Managers kept 84% of investment profits, while investors netted only 16%.
• One-third of hedge funds are funded through feeder funds and/or fund of funds, which tack on yet another layer of fees. This brings the industry fee total to $440 billion. That’s 98% of all the investing gains, leaving the people whose capital is at risk with only 2%, or $9 billion.

Moreover it can be hard to get your money out of a hedge fund. Many hedge funds are “gated” with only small windows when you can withdraw your money.

Given these facts, why would any investor, let alone a supposedly-savvy institutional investor, hand over money over to a hedge fund? As Barry Ritholz explains in the Washington Post, it’s driven by greed and the swagger of the supposedly-superstar manager. The illusion of the guy who might make you fabulously wealthy attracts capital. Investing in hedge funds makes as much sense as trying to become a billionaire by gambling big money in Las Vegas.

A typical example is John Paulson, who got publicity when he became a billionaire in 2005-06 and so money flowed in. As a result of a couple of lucky bets, he was hailed as a financial genius and was soon managing some $36 billion. But lo and behold, shortly afterwards, he suffered massive losses: 52% in one fund and 35% in another.

Only a small percentage of funds have significantly outperformed the markets; an even smaller percentage have done so after fees are taken into account. And no one has the slightest clue which if any funds will outperform markets over the next decade. As Ritholtz notes, “Every fund in the world warns that past performance is no guarantee of future results. It is too bad that investors refuse to believe it.”

The rational conclusion is obvious: if you want to become fabulously rich, become a hedge fund manager, not a hedge fund investor.

Aggravating volatility

The problem is not just that the hedge funds and executives are getting rich. They actively cause damage to the whole economy by undermining what the real economy needs—economic stability. Hedge funds and executive behavior generate price volatility.

“The real problem for the economy,” says Martin, “is that hedge fund talent and executive talent both have an incentive to promote volatility, which works against the interests of capital and is damaging to the cause of labor…. stock-based compensation motivates executives to focus on managing the expectations of market participants, not on enhancing the real performance of the company.”

What to do?

Martin suggests three categories of action:

1. “Talent must show self-restraint… Perceived greed of this magnitude will encourage retributive action. If top financial and executive talent wants to avoid that, they need to scale back their financial demands.”

2. “Investors must prioritize value creation.” Institutional investors in particular must stop three practices that facilitate abuse by talent: (a) They supply large amounts of capital for hedge funds. (b) They lend stock to hedge funds and (c) They support stock-based compensation.”

3. “Government should intervene,” including (a) Regulating the relationship between hedge funds and pension funds. (b) Taxing carried interest as ordinary income. (c) Taxing trades. (d) Revising the overall tax structure.

Martin himself is sceptical whether government action is likely. “Unfortunately, political gridlock in the United States makes it unlikely that government can implement such reforms.”

Similarly, it isn’t easy to imagine self-restraint being practiced by characters like hedge fund manager Steven A. Cohen, the principal formerly of SAC Capital Advisors (which pled guilty to insider trading and paid a $1.8 billion fine). It’s like imagining hungry wolves lying down with lambs and not satisfying their appetite. It’s not in the nature of a hedge fund manager to exercise restraint.

A wider set of issues for society

It’s possible that institutional investors will awaken from their delusions about hedge fund performance and refocus their investments on creating long-term real value. But this is only likely to happen if it is part of a much wider societal transformation.

The current situation is one of fundamental institutional failure across the whole of society. The behavioural breakdown is mutually reinforcing. Hedge funds are gambling risk-free with other people’s money. ‘Rats in the granary’ are raking in baksheesh in massive amounts. CEOs are extracting value from their firms, rather than creating it. CFOs are systematically enforcing earnings-per-share thinking in decisions throughout their organizations. Business schools are teaching these people how to do it. Institutional shareholders are complicit in what the CEOs and CFOs are doing. Regulators pursue individuals but remain indifferent to systemic failure. Rating agencies reward malfeasance. Analysts applaud short-term gains and ignore obvious long-term rot. Politicians stand by and watch. In a great betrayal, the very leaders who should be fixing the system are complicit in its continuance. Unless our society as a whole reverses course, it is heading for a cataclysm.

Thus change in behaviour is needed in a whole set of institutions and actors: CEOs, CFOs, investors, legislators, regulators, rating agencies, politicians, analysts, thought leaders and business schools—all need to think and act differently.

The intellectual foundation of all this behaviour is the notion that the purpose of a firm is to maximize shareholder value. Unless we do something about this intellectual foundation, the problem will remain. Changes in a few regulations or the tax code won’t make much difference. ‘Vampire talent’ will find ways around them.

Nor will change happen merely by pointing out that shareholder primacy is a very bad idea. Bad ideas don’t die just because they are bad. They hang around until a consensus forms around another idea that is better.

A different way of managing

Fortunately, a consensus is emerging around a better idea. The idea isn’t new. It’s Peter Drucker’s foundational insight of 1973: the only valid purpose of a firm is to create a customer. It’s through providing value to customers that firms justify their existence. Profits and share price increases are the result, not the goal of a firm’s activities

In the last few years, more than a score of books have been written about this better idea, including notably Roger Martin’s own book, Fixing The Game. The language, terminology and emphases differ somewhat from book to book, but there is a great deal of common ground on the overall direction of change.

Moreover in a recent report from the Aspen Institute, which convened a cross-section of business thought leaders, including both executives and academics, the most important finding is that a majority of the thought leaders who participated in the study, particularly corporate executives, agreed that “the primary purpose of the corporation is to serve customers’ interests.” In effect, the best way to serve shareholders’ interests is to deliver value to customers.

CEOs, institutional investors, legislators, regulators, politicians, analysts and particularly business schools must join in the effort to focus organizations on their true purpose. To be sure, there is still plenty of room for substantive debate on the details of implementation but the emerging consensus of the way forward is now becoming clear. What is needed is the courage and wisdom to pursue it.

A vast societal drama

We are thus about to witness a vast societal drama play out. That’s because we have reached that key theatrical moment, which Aristotle famously called “anagnorisis” or “recognition.”  This is the moment in a drama when ignorance shifts to knowledge. Just as King Lear in Shakespeare’s play eventually recognized that his apparently virtuous daughters, Goneril and Regan, were a rather bad lot, and that his apparently disrespectful daughter, Cordelia, truly loved him, so society is learning that much of ‘the talent’ it thought was adding value have in fact been extracting value for themselves.

As usual with anagnorisis and the shock of recognition at a disturbing, previously-hidden truth, there is a disquieting sense that the accepted coordinates of knowledge have somehow gone awry and the universe has come out of whack. This can lead to denial and a delay in action, even though the facts are staring us in the face.

If the recognition of our error comes too late, as in Shakespeare’s Lear, the result will be terrible tragedy. If the recognition comes soon enough, the drama can still have a happy ending. We are about to find out in our case which it is to be.

Why Is Corporate America Eating Itself Alive?

Steve Denning

“There is a rare type of organism that eats itself alive,” writes Dennis Berman in the Wall Street Journal. The short-tailed cricket, for instance, eats its own wings. The sea squirt digests its own brain after attaching itself to a rock. And the North American rat snake has been known to consume two-thirds of its entire body.

Another organism that is currently practicing self-cannibalism, Mr. Berman writes, is Corporate America.

The 100 largest companies in the S&P, writes Mr. Berman, have spent around $1 trillion on share buybacks since 2008. And the pace is increasing. “In the 12 months ending in September,” writes David Hall also in the Wall Street Journal, “the total dollar amount of all corporate buybacks increased by 15 percent from a year earlier.” (Mr. Berman cites one major firm that has, over the last twenty years, bought back more than half its own shares. If it were to continue at this pace, by the year 2034, it would have no publicly traded shares at all.)

The practice of share buybacks, which is facilitated by cheap money from the Fed, is worrying for several reasons:

“Those buybacks have been substituting for substantive future investment, be it software engineers, new products, or extra marketing. This has two effects: It stymies the economic growth originally intended by the Fed. And it could eventually leave businesses ill-equipped to adapt to changes in their industries.”

If only one or two firms were doing this, it might not matter much. But when most large firms are spending massive amounts on buying back their own shares, the implications are macro-economic. The national economy remains stagnant, even as share prices are soaring. The rising stock market reflects financial gadgetry more than growth of the real economy.

Shying away from investment

• ·   Honeywell International [HON] has been making about 4 percent on its share buybacks, compared to 13 percent on business assets.

• ·  Oracle [ORCL] is spending half its cash flow in share buybacks, when the return on buybacks has been around 5 percent, compared to around 32 percent on past investments.

 Decisions “by rote and by fear”
Still the world’s dumbest idea: maximizing shareholder value
There is another way: the Creative Economy

Is this shying away from investment based on low returns from investment? Not so, says Mr. Berman. In collaboration with hedge fund manager Jim Chanos, one of Wall Street’s legendary short sellers, Mr. Berman concludes that the returns on “net business assets” i.e. “actual stuff used in actual business,” have historically been much higher than share buybacks. For instance:

Is this seemingly irrational pursuit of lower returns by Corporate America based on a shrewd assessment of an abrupt decline in investment opportunities? That’s hardly plausible, given the immense possibilities being unleashed by new technology and the Internet, as whole sectors of the economy are systematically transformed. It could be argued that there has never been a better time to be an entrepreneur. But entrepreneurship is not what’s driving this corporate behaviour.

Instead, Messrs Berman and Chanos suggest that the decisions are made “by rote and by fear”, driven by the C-suite’s perception that they are under “the threat from shareholder activists, who now patrol the market like prison guards with billy clubs. Overspend and get whacked.”

C-suite compensation also plays a role. Given that the current extraordinary levels of executive compensation are directly linked to movements in the short-term share price, amid faster executive turnover, we should hardly be surprised that the C-suite is more focused on actions that can move the share price in positive directions, and less on investments that will only pay off in the medium term. As Upton Sinclair once pointed out, “it is difficult to get a man to understand something when his salary depends on not understanding it.”

The decision-making thus appears to be yet another disastrous consequence of what Jack Welch has called “the world’s dumbest idea”: maximizing shareholder value.

A brilliant study by economists from the Stern School of Business and Harvard Business School, Alexander Ljungqvist, Joan Farre-Mensa, and John Asker, entitled “Corporate Investment and Stock Market Listing: A Puzzle,“ offers confirmation. The study compares the investment patterns of public companies and privately held firms. It turns out that the lag in investment is a phenomenon peculiar to public companies.

Thus in standard economic theory, it makes no sense that net investment by public firms is a meagre 4 per cent of output since the meltdown of 2008, when pre-tax corporate profits are now at record highs – more than 12 per cent of GDP. When profits go up, companies should be seizing investment opportunities to lay the groundwork for even more profits in future. In turn, that investment should create jobs, generate more capital goods and lead to higher wages. That’s how capitalism is meant to work. So why isn’t it happening?

The study finds that “ keeping company size and industry constant, private US companies invest nearly twice as much as those listed on the stock market: 6.8 per cent of total assets versus just 3.7 per cent.”

In other words, firms that perceive themselves to be at the mercy of shareholder activists pursuing the maximization of shareholder value invest roughly half as much as those private firms that are relatively free from such pressures.

As Matthew Yglesias at Slate writes:

“On this account we are reaping the bitter fruits of the ‘shareholder value’ revolution. Executives at publicly traded companies are paid to generate higher share prices, which is done by hitting quarterly earnings targets. This leads to underinvestment relative to the behaviour of managers of privately held firms. Not because managers of private firms are indifferent to the interests of shareholders, but because there’s less need for creating the shareholder value link via a simplistic relationship between compensation, share price, and quarterly earnings.”

As Robin Harding in the Financial Times concludes, it is “time to stop thinking about corporate governance and executive pay as matters of equity and to regard them instead as a macroeconomic problem of the first rank.”

There is of course another way to run organizations, as illustrated by Amazon [AMZN] and other companies that embody the Creative Economy. Their goal is not short-term profits or meeting quarterly targets, but rather adding value for customers through investment in continuous innovation. The returns from this different approach are extraordinary.

Thus while many companies consume themselves with share buybacks, “Amazon [AMZN] continues to pour in big dollars into actual technology. It grew its capital spending 14-fold since 2008, and R&D spending fivefold.”

The argument offered by executives that “Wall Street made us do it” has the same legitimacy as “the dog ate my homework” when public companies like Amazon [AMZN], Whole Foods [WFM] and Costco [COST] have been successfully pursuing customer value, with broad applause from Wall Street.

So isn’t it time we stop according extraordinary compensation to Corporate America’s leaders for meeting their quarterly numbers through the short-sighted tactic of self-cannibalism, and instead focus business on its true goal of adding value to customers with investments and innovation in real products and services?

And read also:

The origin of the world’s dumbest idea: Milton Friedman

How modern economics is built on the world’s dumbest idea

When will the world’s dumbest idea die?

Leadership in the Creative Economy

The five surprises of radical management

Why Most Of What We Know About Management Is Plain, Flat, Dead Wrong

By Steve Denning

The first two sessions of the eight-week Radical Management Book Club sponsored by IBM took place yesterday. These were my opening remarks for the discussions.

These conversations are going to be very practical and down to earth, about the nitty gritty of what it takes to get things done today at an operational level.

But let’s start by looking at the overall context in which this is taking place. Why is so much of what we thought we knew about the economy and the workplace and the principles of management now so different? Why is much of what we thought we knew about management now just plain, flat, dead wrong?

The fundamental reason is that we are going through an amazing set of economic and social changes. The world has changed, but management hasn’t. As a result, what used to work doesn’t work anymore.

We are in fact at the beginning of a set of gigantic changes in society, in which everything we do is being re-invented — how we live, how we work, how we play, how we communicate, even how we think and how we feel. At the heart of these changes is of course the Internet and its related technologies. We have already seen big changes. But the implications of it have only just begun.

I was at a meeting earlier this week in Washington DC with some distinguished thinkers and they concluded after some discussion that the Internet and its related technologies will be the most significant invention in human existence, ever, bigger even than the wheel. We can discuss that conclusion. Some people, I know, have different views. But one thing is clear: this change is big.

In one sense, this makes it a fabulous time to be an entrepreneur. If you have a little imagination, everywhere you look, you can see vast possibilities for doing things “better, faster, cheaper, smaller, lighter, more convenient and more personalized.” Now it’s true that we as human beings continue to act the way we do. We are creatures of habit. But when someone comes along and shows us how we can do something “better, faster, cheaper, smaller, lighter, more convenient and more personalized,” we tend to say, “Hey! Yes! I want that! And not only do I want it. I want it now! In fact, not only do I want it now. “I’ve got to have it now!”

So in one sense, it’s a great time to be an entrepreneur because if you are able to come up with one these ideas to do things “better, faster, cheaper, smaller, lighter, more convenient and more personalized,” you can make a great deal of money very quickly. We are seeing more instant billionaires being created in shorter periods of time than at any other time in history.

At the same time, there’s never been a scarier time to be in business. That’s because the risk of your business being disrupted is that much greater. Disruption—or what Clayton Christensen has called the innovator’s dilemma—is an often fatal disease for any business, but it used to happen  at a slow pace as some upstart would make inroads at the low end of your business in one geographical area, with clients you didn’t really care about anyway. It would steadily eat away at your client base, step by step. It happened relentlessly and it was generally fatal if you didn’t do something about it, but it happened slowly. If you kept your eyes open, you could spot it and take action and defend against it.

But now customers are coming to expect “better, faster, cheaper, smaller, lighter, more convenient and more personalized” as the norm. And there are lots of entrepreneurs out there, all around the world, dreaming up ways to do that and then actually delivering it very rapidly, not just in one location, but instantly all at once, all around the entire planet. The Internet becomes an instant delivery mechanism that anyone can access. When that happens, we begin to see the disruption of solid, established businesses happening faster and on a larger scale than was ever before imaginable. “Big bang disruption” is one expressive term used by Larry Downes and Paul Nunes in their book of that name to describe this phenomenon.

For customers, this is fun. Hey, wonderful new stuff! Wow! Amazing!

But for producers, it can be very big and very quick and very scary and very lethal.

As a result, much of what we thought we knew about the economy doesn’t make sense any more. When we listen to discussions on CNBC or the Wall Street Journal, the talk is usually in terms of, How’s the economy doing? Is it up? Or is it down? Why is the economic recovery so weak? Whatever happened to jobs?

The reason why the discussion doesn’t make sense is that there is no such thing as “the economy” any more. No such thing. Today there are two different economies going at different speeds and on different trajectories.

One economy is what I call the Traditional Economy. It’s the economy that we inherited from the 20^th Century. It’s a world of factories, and command and control, and economies of scale and big hierarchical bureaucracies pushing out products and services, through established delivery systems, and getting people to buy them through sales campaigns and advertising.

This economy is still the larger of the two economies. It’s been in steady decline for a number of decades. It doesn’t generate new jobs. It’s not very agile. It’s becoming steadily more efficient. But it’s not good at innovation. It’s less and less able to capture the gains of its efficiencies. In fact, it is harder and harder to make profits by operating in this mode. It’s still a big part of what’s going on in the world. But it doesn’t have much of a future.

The other economy is the Creative Economy. This is an economy of continuous innovation and transformation. This is the economy of firms and entrepreneurs that are delivering to customers what they are coming to expect, namely, “better, faster, cheaper, smaller, lighter, more convenient, and more personalized.” This is an economy where the winners are those who are able to delight customers by continuously adding new value. Success in this economy requires a number of things. For one thing, it requires agility: you have to be quick and nimble, as change is happening much faster than ever before.

But it requires more than agility. It requires an agility that is tightly linked to empathy and a responsiveness to what customers want and need. That’s because the technology has not only empowered producers and entrepreneurs and given them more possibilities in terms of what they can produce, but has also empowered customers. Globalization gave customers choices. The Internet gives customers instant access to reliable information as to what those choices are and an ability to communicate with other customers and mobilize support for what they collectively want.

So suddenly power in the marketplace has shifted from seller to buyer. Suddenly the customer is in charge. The customer is now collectively the boss. This is an epic social and economic development.

This second economy, which I and others have called the Creative Economy, is growing rapidly. It’s still relatively small. But it is highly profitable. It doesn’t just make money. It makes humongous amounts of money. This is the economy of the future.

It’s important to understand the money thing. The Creative Economy, and its mode of operating — radical management — make a great deal of money. Paradoxically its goal isn’t to make money. That’s because if you set out to make money, you end up doing a lot of things that customers don’t want, and you don’t make as much money as you do when you focus on giving customers what they really want. To be precise, making money is the result, not the goal.

The kind of management you need to succeed in this Creative Economy, or what I have called Radical Management, has other advantages too. It has the potential to create more meaningful workplaces — more challenging, with different skills, but also profoundly more satisfying.  It tends to be more environmentally sustainable. Overall, it is more people-friendly.

But for our purposes today, the main thing that it has going for it is that it makes an awful lot more money. This is what makes its advance inexorable. This is what ensures that it will be the economy of the future. It’s not a question of whether it’s going to happen. It’s a question of when. Will the transition from the Traditional Economy to the Creative Economy be quick and elegant and intelligent? Or will it be slow and ugly with a whole lot of unnecessary liquidations and job losses. That’s the choice.

As we look out across the world, we can see some firms operating almost totally in one economy or the other. We see some big old industrial firms operating in the mode of the Traditional Economy. And we see firms in Silicon Valley for instance operating almost entirely in the mode of the Creative Economy.

But we also see a lot of hybrids. Many of the large firms like GE and IBM have both aspects of the two economies going on simultaneously.

• You see some parts of them operating with the traditional management of hierarchical bureaucracy, grinding out their traditional products, and focused on making money for the shareholders.
• And you see some parts, like DevOps in IBM or health care in GE, increasingly operating in the mode of the Creative Economy, with a focus on Agile management and understanding customers and delivering continuous innovation to them.

Part of the stress and tension that people experience in doing Agile software development in a large firm like GE or IBM derives from the tension between the two management modes.

Much of the discussion here will focus on what’s involved in being successful in the Creative Economy. What sort of radical management practices does it take? But some of that discussion will also be about resolving the tensions between the part of the firm still operating in the mode of the Creative Economy and the part of the firm still operating in the mode of Traditional Economy, and what to do about that.

It helps to see that these stresses and tensions are not just the problems of IBM or the problems of GE. They relate to the epic development that the corporation is no longer the centre of the economic universe: the customer is in charge. As a result of this epic transition, some of the fundamental principles on which organizations have been structured and run for the last hundred years have become defunct.

Those organizations that figure out what’s going on and take advantage of it will flourish. Those that don’t will become extinct. The future is that thrilling and that grim.

The management principles of the Creative Economy

So corporations cannot now prosper for long, as they did in the 20^th Century, merely by becoming more efficient at delivering products and services and pushing them at passive consumers through sales campaigns and advertising. Now firms must understand, anticipate and meet the needs, wants and whims of customers who are well-informed, empowered and interacting among each other.

They must learn to do what the 20^th Century corporation was constitutionally incapable of accomplishing: delighting the people who use their products and services through continuous, disciplined, transformational innovation. They must continuously deliver “better, faster, cheaper, smaller, lighter, more convenient and more personalized.”

The good news is that we know how to do this. The practices are becoming increasingly well established. There is a constellation of principles that has been articulated in what I have called a canon of radical management literature. There are different terms in use. I call it radical management. Haydn Shaughnessy calls “the elastic enterprise”. Dan Pontefract calls it “the flat army”. John Seely Brown and John Hagel call it “the power of pull”. There are more than a score of recently published books that talk about it, often using different labels but basically talking about the same set of phenomena. And the literature is growing by the day. If you analyze these books in depth, you can see that they describe five simultaneous shifts now underway.

• These shifts affect the goals of the organization
• They affect the structure of work within the organization
• They affect the way work is coordinated
• They affect the values of the firm
• They affect the way people communicate.

In the end, these shifts affect pretty much everything. They constitute a new canon of management. Let me summarize quickly the five main principles

• First the organizational goal: What’s the purpose of the firm? Here we are seeing a shift from an inward-looking goal of making money and maximizing shareholder value to an outward-looking goal of profitably delighting customers. Innovation and transformation are no longer options: they are now imperatives. The firm must orient everyone in the organization and everything it does to profitably delivering “better, faster, cheaper, smaller, lighter, more convenient and more personalized.” This must become the obsession of everyone in the firm.
• Second, the organizational structure: we are looking at a shift from a world where managers are controlling individuals to a world where the manager’s role becomes that of enabling collaboration among diverse self-organizing teams, networks and ecosystems. The reason for this shift is that when you have managers controlling individuals, you can’t unleash the creativity that you need from the workforce to deliver “better, faster, cheaper, smaller, lighter, more convenient and more personalized.” So you have to structure work differently so you can unleash this talent and initiative. Firms that don’t make this shift simply won’t be able to innovate quickly enough.
• Third, how work is coordinated: Here we are looking at a shift from coordinating work by hierarchical bureaucracy with its roles, its rules, its plans and its reports to dynamic linking, that is, a world where work is coordinated with iterative approaches to development and direct feedback and interaction with customers, networks and ecosystems.  In the first instance this kind of coordination happens within the team itself. But then it spreads to whole networks and even ecosystems outside the firm. This is the world of Agile, Lean, Kanban and so on. It’s a world that is increasingly familiar to software developers but it is still largely a secret for general managers. I believe for instance that there has never been a single article in Harvard Business Review devoted to it. And yet it’s the way of the future. It’s a different way of coordinating work and for various reasons, it’s very hard for traditional managers to understand.
• Fourth, values: We are looking at a shift from a single-minded preoccupation with efficiency and predictability to an embrace of values that will grow the firm and the accompanying ecosystems, particularly radical transparency, continuous improvement and sustainability. Hierarchical bureaucracies can be very efficient and very predictable. But they are not very transparent. There are a lot of reports going up and down the chain, but it can be hard to figure out what’s going on, particularly in a world of rapid change. Those reports are often about what people want to hear, not what people need to know. That’s not good enough for a firm that is desperately trying to deliver “better, faster, cheaper, smaller, lighter, more convenient and more personalized.” And they are delivering that to customers who are unpredictable and inscrutable and who don’t know what they themselves want or need. Radical transparency suddenly becomes something not just nice to have, but a requirement of survival.
• Finally, communications: We are looking at a shift from top-down directives to multi-directional conversations. Instead of telling people what to do, leaders need to be able to inspire people to work together on common goals, even across organizational boundaries, even beyond the firm, in related networks and ecosystems. Telling people what to do doesn’t get the job done anymore. In part that’s because the managers aren’t in control, because people are outside their organization boundaries. Control isn’t possible. In part it’s because managers don’t have “the answer.” Managers can’t tell people what to do because they just don’t know. Nor do the workers. Or even the customers themselves. The answers lie in the interaction between networks and ecosystems of customers, workers and managers. This is not like an equation puzzle to be solved, or an algorithm to be applied: it’s more like unravelling a mystery or a voyage of mutual discovery. So to succeed, communications have to become much more multi-dimensional and interactive than in Traditional Management.

When you look at these five shifts or principles, none of them individually is new. What is new is implementing all of the principles together as a system in a coherent and consistent way.

The core principles fit together as an interacting set of organizational possibilities. Implementing only one or two of the principles is not sustainable: the organization will slide back into the old mode.

This is a step change in organizational capability. It goes beyond merely becoming better at what is currently done, or acquiring different management tools, techniques, systems or processes, or following a new set of rules. Just as dinosaurs became birds, not by becoming better at crawling or walking, but by sprouting feathers and learning to fly, so organizations have to become different kinds of animals, with different mindsets, attitudes, values and capabilities. It means different ways of thinking, speaking and acting in the workplace. It means change at the level of the firm’s DNA.

The phase change is as fundamental as the Copernican revolution in astronomy—a shift from the view that the sun revolves around the earth to a view that the earth revolves around the sun.  Initially that discovery didn’t appear very significant. Copernicus’s discovery appeared to be no more than a better way of calculating the movements of the planets and the stars. It was just a discovery in an obscure subject – astronomy – of little general interest to society at large. No big deal. Copernicus even received an award from the Roman Catholic Church.

But once people grasped that the earth was not the centre of the universe, they began thinking the unthinkable. They began questioning fundamental societal assumptions like the role of the Pope and the power of organized religion and the divine right of kings and more. Almost a century after Copernicus, the Pope put Galileo under house arrest for even talking about it. But resistance was futile. In time, the change in theoretical perspective led to vast practical changes for politics, religion and society.

Similarly, the current economic phase change, with the shift in power from seller to buyer, might appear at first sight as an insignificant conceptual shift in obscure aspect of management theory. But as in astronomy, once people grasp that corporations are no longer at the centre of the economic universe, they are beginning to think the unthinkable. They are beginning to question fundamental assumptions as to how organizations are structured and run and their role in society. In time, it too will have similarly far-reaching economic, social and behavioural changes.

So this is a new world that is emerging. It’s undergoing a phase change that is enabled by technology but it is driven by economics. Those firms that get it and master it, will prosper. Firms that don’t, won’t. It’s as simple, as grim and as thrilling, as that.