They were all disloyal capitalists

by John MacBeath Watkins

In the late 1970s, I noticed a strange thing. Companies that had been built by a partnership between management and labor began to make war on their employees. In the mid-1980s, I was working for a newspaper in Texas and had to come back to the Northwest for my grandfather's funeral on Frontier Airlines, part of the empire Frank Lorenzo built from his hostile takeover of Continental Airlines.

The carpet on that aircraft was patched with duct tape. The cabin crew were obviously exhausted, and consequently had a bit of a bad attitude, not for the passengers but for their job. I wondered how tired the pilots were. On the trip back to Texas, the same airline gave me the hardest landing I've ever experienced, in an airliner, in a military aircraft, or in a light plane flown by an amateur. Guess that answered that question.

Frank Lorenzo was a trend-setter. He showed that a clever operator could make a name and a fortune for himself by using loads of debt to buy a company, offloading obligations through use of the legal system, and cashing in on the rapidly increasing CEO pay. His tactics are one example of what Larry Summers and Andrei Schleiferwere were talking about in a 1988 paper Matthew Yglesias brings to our attention, Breach of Trust in Hostile Takeovers.

Yglesias does and admirable job of condensing the Summers and Schleiferwere paper, and I recommend you follow the link above and read the full text of his post.

Essentially, companies exist because free individuals contracting with each other to produce the result the company can produce would require cumbersome and unworkable contractual arrangements. Instead, a group of people get together and work toward a goal, and this allows them to cooperate based on informal obligations and trust that all those in the company understand that they are working for the same goal. How to achieve this is the substance of thousands of management books.

Without that trust, the logic of having a firm breaks down. As Yglesias points out, what Summers and Scheleifwere are talking about is the opportunity for the new management to take advantage of their formal rights to violate implicit agreements and take more of the wealth created by the business for the management. From Breach of Trust in Hostile Takeovers:

One striking fact militating in favor of. the importance of wealth
transfers as opposed to pure efficiency gains is that a significant fraction
ed of hostile acquisitions are initiated and executed by only a few raiders.
It is hard to believe that Carl Icahn has a comparative advantage in
running simultaneously a railcar leasing company (ACF), an airline 
(TWA) and a textile mill (Dan River). It is more plausible that his
comparative advantage is tough bargaining and a willingness to transfer
value away from those who expect to have it. In fact, those who describe 
him (including he himself) point to this as his special skill. The
industrial diversity of many raiders' holdings suggests that their particular
skill is value redistribution rather than value creation.

How does that sort of thing affect employees? Again, from Breach of Trust in Hostile Takeovers:
The virtually universal lesson that interviewees claimed to have learned from their takeover experience was never again to trust a large corporation. One employee remarked that previously he had believed that if he did a good job, he would be appreciated. Now he thinks, "You have to look out for yourself. You really can't hold any loyalty to a corporation." Another offered his view of long.term contracts: "To the average Joe, life in the business world can be compared to walking a tightrope across the Red Sea. It might break at any time, so don't get too comfortable." Many said their loyalty had been killed, and that they developed a more cynical and cautious view of corporate America. As a result, some reversed their prior belief that continued loyalty to a corporation would be rewarded.
Less dramatically, another asked, "How can you go to another company now and give 100 percent of your effort?"

In short, if the firm has no loyalty to its employees, they will have none to the firm. This sort of transfer of wealth away from people who had a great deal to do with creating it destroys the trust on which the logic of the firm's existence is based.

And in the years since this sort of wealth transfer started to happen, the size of firms has declined, Yglesias informs us, with a helpful link to the blog of Evan Soltas, who in turn informs us that:

Another way to think about the secular shift from large firms to small ones is by using Riemann sums to approximate the average size of a nonfarm private firm in the United States. In December 2000, the average firm employed 213 people; in May 2012, the average firm employed 199 people. That amounts to a decrease in average firm size of 6.6 percent.

And the growth in employment since the depth of the recession is substantially greater at firms with less than 500 employees. That is, firms too small to be of interest to companies like Bain Captial. Could it be that the diseconomies of scale this reflects are linked to a lack of trust?

Yglesias again:

The big socialized loss in the case of this kind of "breach of trust" scenario is loss of trust and economy-wide loss of ability of managers and workers to form flexible implicit arrangements with one another. Summers and Shleifer write that it's difficult to assess the systematic impact of this because to do so "we must analyze a world in which people trust each other less, workers are not loay to firms, and spot market transactions are more common than they are at this time." That's a difficult task. But we do know something about what an economy like that looks like. It looks like Greece or Italy where firms are much smaller and less productive in part as a coping mechanism in a low-trust environment.

One of the remarkable things about human beings is that they will cooperate with others who are not blood relatives. That is vanishingly rare in the animal world. It is also a phenomenon that varies substantially between societies. Great societies have something in common with "the Great Society" that Lyndon Johnson wished to create -- they have fellow-feeling for the large number of people in the society. They work together for common goals.

The breach of trust Yglesias brings to our attention from the 1988 paper by that name is difficult to build and easy to destroy. The financial engineers who managed to claim more of the nation's wealth from about 1980 on gave themselves extravagant compliments, calling themselves "masters of the universe," "big swinging dicks," and the like. Managers who found ways to squeeze more from employees flattered themselves that it made them better than those employees. Of course, getting more efficiency is what management is supposed to be about, but a large part of what's happened in the last 30 years has been redistribution of wealth upwards. Efficiency has increased, but the reward for it has not been shared as it once was.

And when someone has the temerity to suggest that no one creates wealth on their own, they are accused of "hating success." Because the greatest threat to those who have been redistributing wealth away from the middle class and toward the top earners is that people might recognize that redistribution is what is happening, that the creation of wealth is a social enterprise to which many contribute, and few are being rewarded.

From the Congressional budget Office:

Shares of Income After Transfers and Federal Taxes, 1979 and 2007
The share of income going to higher-income households rose, while the share going to lower-income households fell.
  • The top fifth of the population saw a 10-percentage-point increase in their share of after-tax income.
  • Most of that growth went to the top 1 percent of the population.
  • All other groups saw their shares decline by 2 to 3 percentage points.


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