The American version of capitalism has been knocked off its pedestal in the last three years. After the stock market crash and the corporate scandals which followed, the triumphalism inspired by the productivity surge in the second half of the 1990s has been silenced. What John Kay has called the American business model (Prospect, May 2003) is now widely condemned as both immoral and inefficient.
What happened at Enron, WorldCom et al was indeed a shaming episode in the history of US capitalism. Yet the conclusion which some critics have drawn - that the shareholder-based model of corporate governance is flawed and that managers should be answerable, as they are in Germany and Japan, to a wider set of stakeholders, including employees - is wrong. The recent scandals have exposed failings in the way US companies are managed, failings which are now attracting a flurry of reforms. But the scandals have not negated the enormous strengths of the US system as it has evolved over the last 25 years.
During this quarter of a century the system has undergone big changes, the most important of which are a larger role for the stock market in disciplining companies and a stronger emphasis by managers on shareholder value. These changes have enhanced the position of the US as the world's most productive country. Neither Enron nor the bursting of the stock market bubble has undermined American leadership.
The principal US advantage lies in the speed with which new industries and companies are created and old ones dismantled or shrunk. This advantage stems from four forces that first emerged in the 1970s and that became more powerful in the next two decades.
The first was a new relationship between companies and their shareholders. The rise of investing institutions - principally pension funds and mutual funds - as the dominant owners of most publicly quoted companies brought to an end a long period in which managers had been largely free from active oversight by shareholders. These institutions, holding larger stakes in companies than the private shareholders they replaced, had the power and incentive to press poorly managed companies for better performance. At the same time, an array of financial innovations made new sources of funding available to ambitious entrepreneurs. The result was an increase in the number and size of hostile takeovers and in the supply of venture capital for start-up firms.
The second force was international competition. With the entry into world markets of low-cost manufacturers from Japan and other east Asian countries, several US industries, especially those which had lived for years in a state of comfortable oligopoly, found themselves under pressure. A symbolic event was the boardroom upheaval at General Motors in the early 1990s, when the chief executive was sacked and an outsider appointed as chairman for the first time in the company's history. This was a belated response both to import competition and to investor dissatisfaction: GM had wasted billions of dollars in misdirected investment in the previous decade.
Thirdly, deregulation transformed the structure of industries such as telecommunications, airlines and banking. As barriers to new entry came down, former monopolists such as American Telephone and Telegraph came under attack from start-ups. AT&T subsequently broke itself up into separate pieces, and each of these businesses is now operating in highly competitive markets. The airline industry has gone through a similar upheaval with low-cost carriers taking market share away from the incumbents, some of which have been bailed out by the US government.
Finally, advances in information technology created huge opportunities for new companies, some of which - like Cisco, which makes switching equipment for the internet - have become very large businesses. These changes also had a broader impact on the way older companies organised themselves. The general trend was for big companies to "deintegrate," relying on outside suppliers for products or services that used to be provided in-house. Corporate bureaucracies were slimmed down.
The consequence of all this was to put a sharp brake on managerial empire-building. Companies which had paid little attention to shareholder value in earlier decades were forced to use their assets more efficiently. During the 1960s, businessmen such as Harold Geneen at ITT had created large, diversified groups, claiming that their superior managerial skills enabled them to run a variety of disparate activities - ranging, in ITT's case, from hotels and insurance to vehicle components and paper-making. By the end of the 1970s, it was clear that many of the businesses would be better off on their own, or under different ownership. Financial entrepreneurs such as Carl Icahn and T Boone Pickens, and buyout partnerships such as Kohlberg Kravis and Roberts, saw an opportunity to make a great deal of money, both for themselves and for shareholders in the conglomerates, by taking them over and breaking them up. The threat of takeover encouraged other companies to restructure themselves voluntarily, usually by specialising in fewer businesses.
The number of mergers and acquisitions in the US reached a historic peak in the late 1980s; after a lull in the early 1990s, activity resumed at an even higher level in the second half of the decade. There were fewer hostile bids in this later period, partly because of the protective devices which companies had installed in order to deter unwanted bids. But it also reflected the fact that boards of directors had become more attentive to shareholder interests; there were fewer easy pickings for the raiders. Another factor was the shift from cash to stock options in executive pay packages. With their rewards tied more closely to the share price, managers had a strong incentive, not to make their companies bigger (the traditional route to higher pay), but to make them more profitable and hence more highly valued in the stock market.
Many of the biggest mergers took place in industries which were going through a period of turbulence as a result of regulatory or technological change. Although some deals worked out badly, the resulting reallocation of resources almost certainly contributed to the strength of the US economy during those years. Recent research by two American economists, Gregor Andrade and Erik Stafford, suggests that, taken overall, the mergers of the 1980s and 1990s served to increase productivity. Mergers can be an efficient means of dealing with excess capacity in declining industries, while in rising industries they allow well run companies to grow faster.
Despite the mega-mergers, moreover, the level of concentration in the US - the share of industrial output accounted for by the largest corporations - has been stable or declining over the last 15 years. This is due partly to spinoffs and divestments by large companies, and partly to the growth of new companies. In the chemical industry, for example, new entrants, sometimes created through management buyouts, have taken over activities that had previously been part of long-established groups such as DuPont and Dow. Much of the heavy end of the industry - the production of low-value commodities such as petrochemicals and plastics - is now in the hands of companies which did not exist ten or 15 years ago.
The shareholder value revolution, linked to innovation in financial markets, has made US industry more flexible and productive. To the extent that Britain moved in a US direction during this period - and it did so to a much greater extent than other European countries - the results were also beneficial. Unwieldy conglomerates were broken up, and companies were quicker to close loss-making businesses. Deregulation allowed new entrants to prosper, Vodafone being a spectacular example. And an expanding venture capital industry supported many business start-ups in new areas such as biotechnology.
Some critics say that the privileging of shareholder interests above those of other stakeholders, together with the widespread use of stock options, leads to an unhealthy preoccupation with the share price. Managers look for ways of impressing the stock market - and making themselves rich - through deal-making rather than long-term business-building. This infection, so the argument runs, spread to Britain during the 1990s, causing once-great companies such as ICI and Marconi to be sacrificed on the altar of shareholder value and financial engineering. There are, indeed, dangers with the shareholder value approach, but the examples of ICI and Marconi do not support the case for the prosecution.
In the 1980s, ICI was a diversified chemical group which was losing ground in several of its businesses. However, it owned a profitable pharmaceutical subsidiary, which at the end of the decade was worth more than the rest of the company put together. This attracted the attention of James Hanson, the well known corporate raider; he started buying shares in ICI in 1991, apparently with a view to taking over the company and breaking it up. Although Hanson did not in the end make a bid, the episode made it clear to the ICI directors that they could not rely on the passivity of investors to maintain the company in its existing form. The response, little more than a year after Hanson's withdrawal, was to split the company in two, hiving off the pharmaceutical subsidiary as an independently quoted company, called Zeneca.
The demerger was good for ICI shareholders, and made industrial sense; Zeneca (now AstraZeneca) has become one of the world's most successful pharmaceutical companies. But the separation left ICI with a collection of largely unrelated businesses, some of which were barely profitable. In 1997, ICI sought to solve this problem with a giant acquisition, the ?5bn purchase of a group of speciality chemical businesses owned by Unilever; the idea was to shift ICI from bulk chemicals into the lighter, higher margin end of the industry. However, the operation depended on financing the purchase through the sale of ICI's unwanted businesses, and this took much longer than expected. Heavy indebtedness, together with poor results in some of the acquired businesses, put ICI in a very difficult financial situation from which it is only now beginning to emerge.
No doubt ICI made mistakes, both before and after the Zeneca demerger, but it was not alone among the global chemical groups in thinking that a shake-up was needed. Hoechst, which as a German company was less vulnerable to the threat of takeover, adopted an even more radical approach than ICI. During the 1990s it transformed itself from a broadly based chemical group to a pure pharmaceutical company, now known as Aventis; this included divestment of all its non-pharmaceutical interests and a merger with a large French company. Aventis appears to be performing well. The fact that the second stage of ICI's restructuring worked less well has more to do with poor implementation than with stock options or an obsession with shareholder value.
Marconi is a rather different story. In the early 1990s, when General Electric Company (GEC), as the company was then called, was still dominated by its long-serving managing director, Arnold Weinstock, its finances were strong, but, with the possible exception of defence electronics, it had few businesses that looked capable of sustained profits growth. Weinstock retired in 1996. His successors, led by George Simpson, believed, probably rightly, that the group was too diversified, and that too many of its assets were tied up in joint ventures which GEC did not control. One option was to concentrate on defence, but Simpson and his colleagues thought that, in an industry which was consolidating into a handful of global giants, this subsidiary needed to be part of a larger group. This was achieved by demerging it into British Aerospace, enabling GEC shareholders to acquire a stake in what is now one of the world's largest defence contractors, BAE Systems.
Much more questionable was the decision to concentrate what was left of the group on telecommunications equipment. GEC had a telecommunications subsidiary known as GPT, small by international standards, in which Siemens of Germany had a 40 per cent stake. Simpson tried to sell the other 60 per cent to Siemens, but the price which the Germans offered was deemed to be too low. GEC then chose to buy out the Siemens holding in GPT and to expand the business through acquisitions, including two large ones in the US. It was a risky strategy which was some way from completion in mid-2001, when the company (by then renamed Marconi) was knocked sideways by the unexpected collapse of telecommunications markets. By the end of that year falling sales and heavy indebtedness arising from the acquisitions brought on a financial crisis.
With hindsight, it is clear that the telecommunications strategy was too ambitious, although few people thought so at the time. (At the end of 1999 the Financial Times hailed the reshaping of GEC as a triumph for Simpson and his deputy, the former banker John Mayo.) GEC also probably paid too much for one of the US companies. But can these errors be blamed on an Anglo-American fixation with shareholder value? Certainly the new team wanted to improve GEC's stock market rating, and one of the attractions of telecommunications was that it was more highly valued than defence. But Marconi's view of telecommunications was widely shared - witness the vast sums paid, by continental as well as British operators, for the third-generation mobile telephone licences, and for takeovers in the US.
Large-scale acquisitions are risky, but that does not mean they should never be undertaken. Other British companies have used takeover strategies just as aggressively as ICI and Marconi, with rather better results. BP bought two large American companies, Amoco and Atlantic Richfield, in the late 1990s; the rationale for these deals seems to have been sound, and post-merger integration has been handled well. The same is true of Glaxo's 1995 takeover of Wellcome. (It is too early to judge the subsequent merger between GlaxoWellcome and SmithKline Beecham.)
Acquisitions can succeed or fail for a variety of reasons, most of which are hard to assess in advance. What the record shows, however, and here the critics of excessive deal-making are on stronger ground, is that the incidence of mistakes tends to be greater during a raging bull market. In the late 1990s, euphoria over new technology drove prices of internet and telecommunications companies - including some which had no early prospect of making a profit - to absurd levels. A mood of irrational exuberance took hold, affecting managers and shareholders.
In these circumstances, companies whose shares are riding high are tempted to use those shares to buy other companies - an apparently easy way of maintaining the momentum of growth and feeding the appetite of analysts and bankers, who are urging them to do more deals. Sometimes the gamble comes off, as it did with Vodafone, which made two huge share-based acquisitions in the US and Germany at the end of the 1990s - although the long-term impact of these deals remains to be seen. At the other extreme, the acquisition of Time Warner, the media group, by America Online (AOL), the internet company, has been a disaster. This came at the start of 2000, when the internet boom was at its height and AOL shares had soared. The subsequent performance of the merged company has been poor; the hoped-for synergies have proved illusory.
Whether stock options contributed directly to unwise acquisitions is not certain, but there were, in any case, other reasons for questioning the effectiveness of this form of remuneration. When they were introduced in the 1980s, their purpose was to align the interests of managers with those of shareholders. The subsequent escalation in top managers' pay could be defended on the grounds that companies, operating in a more competitive environment than in the past, now depended to a greater degree on exceptionally talented managers, and those managers were in short supply. (Tenure of top executive posts was also becoming shorter and more precarious - hence the generous "golden parachutes" in the event of forced departure.) By the second half of the 1990s, however, it was clear that some companies had been far too lavish with their stock option awards. The stock market boom allowed them to cash in their options at very high prices, even though these prices might have owed little or nothing to their own efforts. More seriously, as Edward Chancellor has shown (Prospect, June 2002), poorly designed option schemes with short payout periods created an incentive for unscrupulous managers to inflate reported profits by dubious or illegal means.
A reappraisal of executive remuneration is now under way, in Britain as well as the US. There are moves to lengthen the period before options can be exercised, or to replace them, as Microsoft has done, with other ways of enabling managers to acquire and retain ordinary shares in the business. Companies may also be forced to disclose the cost of stock options when they are granted. One of the reasons why stock options were so popular in the US was their favourable tax and accounting treatment, which made them appear less expensive for the employer than straight salary or other forms of share-based remuneration; that now seems certain to change.
The need to rethink stock options, while retaining the link between rewards and shareholder value, is one of several lessons that have come out of the stock market boom and bust. Another is the need for auditing reform. While Enron was an extreme case, the practice of manipulating quarterly earnings statements in order to keep investors happy was by no means confined to "new economy" companies. To some extent these lapses may be self-correcting as investors and managers learn from their mistakes. But there is clearly a case for stronger regulation to ensure the integrity of financial reporting, and to prevent auditors from being "captured" by their clients, as Andersen was by Enron.
It is probably healthy, too, that institutional investors are taking a stronger line over practices, such as over-generous executive rewards, which they regard as a damaging to the interests of shareholders. In Britain this greater activism may be partly due to pressure from the government: New Labour is now more interested in making the shareholder-based system work well than in shifting to the stakeholder model. There will always be room for argument, as in the recent ousting of Michael Green from the chairmanship of the Carlton/Granada group, over whether institutional investors or boards of directors know best - and it is a mistake to put too much faith in shareholder activism as a cure for underperformance. Nevertheless, as owners, the big institutions have a responsibility to be vigilant, and to intervene when things are going wrong.
A regulatory response to Enron was necessary, but it would be wrong to overreact. The benefits of stricter rules on corporate governance need to be set against the potential costs, not least in deterring companies from going public. After all, the US economy has come through the stock market crash and its recession in decent shape, with business productivity growing at 3.5 per cent a year since 2000, much faster than in the eurozone. The events of the last three years do not undermine the case for well developed and demanding financial markets, nor do they cancel out the gains that stem from the shareholder value revolution. Indeed, the bursting of the bubble should strengthen the US system if, as seems likely, it helps to re-establish what shareholder value really means.
The definition has to start from the purpose of the corporation, which is to create wealth. Its success in doing so is shown by its profitability - its ability to provide goods and services at a price which more than covers the costs it has incurred. If the corporation achieves this in a competitive market, there is a reasonable presumption that it is using its resources efficiently, and thus contributing to social welfare.
Shareholders are interested in expected as well as current profitability, and share prices should reflect the market's estimate of what future earnings will be; it is a signal to managers of how well they are doing. But from time to time the stock market can fall out of line with reality, and, as Harvard business professor Michael Jensen has remarked, an overvalued share price can be as dangerous to a company as an undervalued one: it can tempt managers to do foolish things to keep it up. Recent experience (not just at Enron) has shown that a focus on boosting the share price in the short term can lead to the long-term destruction of value on a massive scale. The proper task for managers is to create wealth over the long term, it is for them to decide what the appropriate time frame should be and to explain to investors how their decisions contribute to that objective. (That is not the same as doing whatever investors tell them to do.)
This is a different goal from that of promoting the survival and growth of the company. Most senior managers are loyal to their company and want it to prosper. But it may happen that the sector in which they are competing enters a period of maturity or decline. (The chemical industry found itself in that situation during the 1980s and 1990s.) The appropriate response is to get smaller, to demerge or sell off parts of the business and to return cash to shareholders. In that sense the interests of shareholders - and by extension those of society as a whole - take precedence over those of other stakeholders, including senior managers, in the enterprise.
This does not imply a lack of concern for employees and local communities. A loyal workforce and a reputation for fair dealing are assets which should contribute to long-term value creation. But to give these other constituencies equal weight with shareholders, as urged by some advocates of stakeholder or "Rhineland" capitalism, is a recipe for confused accountability - in effect, giving managers the freedom to set and pursue their own objectives.
These disadvantages are less serious as long as the market in which stakeholder-based companies are operating is competitive. The postwar success of Germany and Japan owed more to the vigour of internal competition than to those countries' distinctive corporate governance arrangements. It would also be wrong to exaggerate the link between the creation of shareholder value and the threat of hostile takeover; after all, Toyota has done far better for its shareholders in recent years than any US car maker and Hoechst transformed itself without the threat of takeover. Nevertheless, financial markets of the sort which have taken shape in the US over the past two decades are a powerful instrument for constraining the power of incumbent management and promoting the growth of new enterprises. The absence of such markets provides greater stability for employees and a cosier life for managers, but it makes adjustment to change more difficult. Those concerned about the productivity gap between Britain and the US, such as Gordon Brown, should embrace the pursuit of shareholder value as part of the solution.
