The Golden Passport

by Duff McDonald

  Friedman didn’t shy away from taking alarmist stances. If you want to get noticed in economics, you pretty much have to do so—just ask Paul Krugman. And he proceeded to do just that: “[Speeches] by businessmen on social responsibility . . . may gain them kudos in the short run. But it helps to strengthen the already too prevalent view that the pursuit of profits is wicked and immoral and must be curbed and controlled by external forces. Once this view is adopted, the external forces that curb the market will not be the social consciences, however highly developed, of the pontificating executives; it will be the iron fist of Government bureaucrats.”

  Setting aside the hysterical tone of the above, as well as its exaggeration—the idea that the pursuit of profit is “wicked” has never been “prevalent,” let alone “already too prevalent” in the United States—it was a compelling argument not just to those in whose interests it argued (that is, shareholders) but to a managerial class that was on the verge of a nervous breakdown. Imagine the beleaguered CEO of a major American firm in the 1970s, hectored by everyone from employees to environmentalists to public opinion, all while being besieged by competitive products from Japan that weren’t just better, but also cheaper.

  To that person, the suggestion that they be released from their obligations—contractual or otherwise—to anyone but the shareholder must have seemed like an eleventh-hour reprieve on death row. What Friedman was saying was that it wasn’t American managers’ loss of focus, excessive hubris, or self-congratulation that had brought the country to the brink, but the fact that corporate executives had been trying to do too much for too many people. They’d let their good nature get in the way of getting the job done. And it was time to throw off such naive notions for the good of the country—nay, for capitalism itself.

  “Friedman’s maxim arrived just in time for the era of the hostile takeover and the leveraged buyout, when corporate raiders sold themselves as saviors liberating shareholders from misguided managers who paid too little attention to the stock price,” writes the New York Times’ Eduardo Porter. “Though legally dubious, the argument that it is an executive’s fiduciary duty to maximize the company’s share price became a mantra from the business school to the boardroom. And it was nailed down with money.”2

  It was a remarkable intellectual sleight of hand. Executives who try to act in ways that most of us would consider moral—with an eye to the environment or some other social goal—are, in Friedman’s way of thinking, acting immorally. When Joel Bakan interviewed Friedman for his 2005 book, The Corporation: The Pathological Pursuit of Profit and Power, the economist repeated the same point he’d made nearly forty years before, but with a twist. With corporate social responsibility again on the rise, Friedman conceded that it could be beneficial, but only when it is insincere, when executives espouse social and environmental values as “hypocritical window dressing” that’s really meant to boost corporate image and therefore boost the bottom line. In Friedman’s view, “hypocrisy is virtuous when it serves the bottom line,” Bakan observed, “[whereas] moral virtue is immoral when it does not.”3

  Bakan then found a professor at HBS who was willing to channel Friedman’s “brand of cynicism [that is] old-fashioned, mean-spirited, and out of touch with reality.” According to then–HBS professor Debora Spar, corporations “are not institutions set up to be moral entities . . . they are institutions which really only have one mission, and that is to increase shareholder value.”4

  Says who? Milton Friedman, obviously. But who else? Just a small sample of people who’ve actually “set up” corporations would seem to suggest that such a blanket statement is entirely without merit. Yves Chouinard, the CEO of Patagonia, certainly had a larger mission in mind. John Mackey, who cofounded Whole Foods, wouldn’t agree with that premise. It also seems likely that the founders of Harvard, itself a corporation, wouldn’t have, either.

  To borrow from Friedman’s logic, a corporation can’t have “a mission.” But people certainly can. And not all people who set up corporations have only one mission. But to pick on Spar is akin to picking on a parrot, someone who was mindlessly repeating the battle cry of an investor capitalism that was just a few years away from pushing the global economy off the edge of the cliff—it was 2005 when she spoke—and which by that point had HBS in a pretty tight choke hold. What’s more, Friedman’s argument, which accused do-gooding executives of “analytical looseness and a lack of rigor,” was ironically based on his unsupported claim that “a corporate executive is an employee of the owners of the business,” or the shareholders.

  Again: Says who? The corporate executive is an employee of the organization. But as far as Friedman was concerned, a corporation was “artificial.” Using that logic, he concluded that the corporation’s money was actually the shareholders’ money. Not so. The corporation’s money is the corporation’s money. If you don’t believe that, buy a share of stock in a company and then call its chief financial officer and ask him to send you some of “your” money.

  In a June 2014 piece for the Harvard Business Review, Roger Martin ventured an opinion for why Friedman’s argument held sway for the better part of half a century. “Friedman has won the way a great debater wins,” he wrote, “by cleverly framing the terms of the debate, not by brilliantly arguing the logic of the debate once it has been framed. Because Friedman was so inflammatory in his call for a 100 percent versus zero percent handling of the trade-off, his entire opposition for the entire time since 1970 has focused on making arguments for a number lower than 100 percent for shareholders. In doing so, they implicitly—and I would argue, fully—accepted Friedman’s premise that there is a fundamental trade-off between the interests of shareholders on the one hand and other societal actors such as customers, employees and communities on the other hand.5

  “Had the opposition been cleverer,” Martin continued, “it would have attacked the premise from the very beginning by asking: what is the proof that there is a trade-off at all? Had they done so, they would have found out that Friedman had not a shred of proof that a trade-off existed prior to 1970. And they would have found out that there still isn’t a single shred of empirical evidence that 100% focus on shareholder value to the exclusion of other societal factors actually produces measurably higher value for shareholders.”

  What’s truly unfortunate is that if one considers the work of midcentury thinkers at HBS such as Kenneth Andrews and C. Roland Christensen, the faculty of HBS had stood firmly on the side of the argument that enlightened business policy did have a social aspect to it, as well as an idiosyncratic one. Each situation was different, the thinking went, and while the rest of the business school academy tilted heavily toward the belief that everything could be programmed, analyzed, and fed through an algorithm, HBS stood almost alone in insisting that character had a part to play in management. Until it decided to hire the man who thought that managers had no character at all.

  42

  The Murder of Managerialism

  By the late 1970s, after nearly three-quarters of a century of existence, Harvard Business School had carved out a nice little niche in the management universe. It had proved itself a dependable supplier of prescreened and highly motivated graduates to big business. It had shown itself ready and willing to put the high gloss on the management myth of the day, whether that was through refining managerial claims to moral leadership or putting a stamp of approval on the rationale for the conglomerate era. And while the School had also come to think of itself as a generator of new and influential management technique, the fact of the matter is that the business world really didn’t need the likes of HBS to tell it how to do what it did. The rare instances in which an idea was born at HBS and proceeded to catch on in the real world were not for the how but for the why—when the School provided a new or improved justification for something managers were already doing.

  In the 1980s, HBS’s role stayed pretty much the same, except for being entirely different. The School still proved itself a
dependable supplier of prescreened and highly motivated graduates, but they weren’t going to big business anymore. They were headed to Wall Street and consulting. It also continued to be ready and willing to put the high gloss on the myth of the day, but those myths were increasingly finance related, in particular the merits of shareholder capitalism. And it continued to deliver pseudointellectual capital that practitioners could use to justify their decisions, although those practitioners weren’t managers of big companies but rather managers of big portfolios. In the 1980s, HBS turned on a dime, abandoned its three-quarter-century mission of trying to educate an enlightened managerial class, and threw its lot in with Wall Street as it went about dismantling the edifice of American industry that HBS had helped build. HBS had nurtured the professional manager from the moment of his birth, and then it helped to kill him.

  The main way it did so was by endorsing the innocuously named “principal-agent theory.” If much of the faculty of HBS was still trying to figure out how to help American management resurrect its reputation and its fortunes as the 1980s began, Michael Jensen, a professor at the University of Rochester’s business school steeped in the University of Chicago’s free-market tradition, was working in the opposite direction, making sure that managers’ good name stayed dead. Along with William Meckling, the dean of Rochester’s business school, also from Chicago, where he had been a graduate student of Friedman, Jensen wrote a 1976 paper that would change everything, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” In it he laid the groundwork for the most radical change in the hierarchy of power in corporate America since the robber barons had given way to professional managers.

  Something had to give. On the one side were the “reformists,” as Rakesh Khurana describes them, the traditionalists who thought that managerial capitalism simply needed a little fine-tuning. On the other side were the likes of Jensen, Meckling, and Friedman, who thought it needed to be replaced. “[The] second camp . . . implicated American managers as the source of many of the nation’s economic woes,” writes Khurana, “but did so in the context of a sweeping critique of relationship capitalism itself.”1

  They had a point. The debacle of the conglomerate era showed a marked lack of managerial restraint during the good times. And as for the bad, consider the following: If it were in the best interests of shareholders that a company simply shut itself down, pay off its obligations, and then return what was left to shareholders, is it likely that a CEO would go ahead and do so? Of course not. Friedman had argued that it was an executive’s job to maximize profits; Jensen was focused on figuring out ways to make sure that they did so.

  Arguing that managers had become too entrenched and lacked discipline and accountability, Jensen and Meckling posited that investors were more trustworthy than managers as custodians of the American corporation. Managers weren’t going to voluntarily reform, their thinking went, so the system had to be adjusted so that they would be forced to do so. No longer would they be their own judge or be judged by a jury they had picked themselves, that is, their board. The market was henceforth to be judge, jury, and executioner, all at once.

  Until Jensen came along, executive pay was largely tied to company size. The highest-paid CEOs were those who ran the largest companies. But the unproductive diversification of the conglomerate era had resulted in excess capacity, flat or declining profits, and stagnant share prices. The Dow Jones Industrial Average was basically flat from the mid-1960s through the early 1980s. That excess capacity played a large part in what Jensen called the “capital market restructuring revolution of the 1980s.”2 Companies sitting on large piles of cash—and there were many, as before the 1980s, executives were loath to return money to shareholders—suddenly became the target of hostile acquirers. The age of investor capitalism had begun, and its heroes were not CEOs but corporate raiders like Carl Icahn and T. Boone Pickens.

  A wave of deregulation then created the active market for corporate control that critics of managerialism were calling for, with the new logic of shareholder primacy absolving managers of responsibility to any “stakeholder”—employees, communities, society itself—except shareholders. The bottom line was what mattered. In a remarkable irony, observes Khurana, this revolution in the definition of corporate and managerial purpose was wholeheartedly embraced by the very business schools that had been preaching something very different since their founding days.3

  Agency theory wasn’t new. But Jensen’s resurrected form of it provided academic justification for the takeover movement, and HBS provided the revolutionary soldiers themselves. A course grounded in agency theory that Jensen developed at HBS—The Coordination and Control of Markets and Organizations—was designed with the explicit intention of making students more “tough-minded” and shifting them away from the “stakeholder model” of organizational purpose. It became one of the most popular electives at the school.

  In a 1994 paper he wrote with Meckling, “The Nature of Man,” Jensen cited the story of George Bernard Shaw asking an actress if she would sleep with him for a million dollars. When she agreed, he changed his offer to ten dollars, to which she responded with outrage, asking him what kind of woman he thought she was. His reply: “We’ve already established that. Now we’re just haggling about the price.” The authors then concluded that we’re all whores in the end. “Like it or not, individuals are willing to sacrifice a little of almost anything we care to name, even reputation or morality, for a sufficiently large quantity of other desired things,”4 they wrote.

  The solution they offered was premised on this pessimistic view of man and, having started from the assumption that we are all whores, they naturally ended up with prescriptions on how to try to make us well-behaved whores. “Unlike theories in the physical sciences,” wrote the late business professor Sumantra Ghoshal (DBA, ’86), a professor at the London Business School, in his 2005 paper, “Bad Management Theories Are Destroying Good Management Practice,” “theories in the social sciences tend to be self-fulfilling . . . this is precisely what has happened over the last several decades, converting our collective pessimism about managers into realized pathologies in management behaviors.”5

  In other words, if everybody is just going to assume you’re a whore from the get-go, you might as well grab as much money as possible while you’re still in demand. “[By] propagating ideologically inspired amoral theories, business schools have actively freed their students from any sense of moral responsibility,” concluded Ghoshal. Or, to be more precise, by hiring Michael Jensen, HBS threw its lot in with the pessimists. Managers were not to be trusted. Shareholders were. It stands as one of the most remarkable about-faces in the history of education.

  Graduates of HBS had always been drawn to finance, but in the 1980s they began heading to Wall Street and private equity firms in droves. Whereas in 1965 only 11 percent of HBS MBAs entered the fields of consulting or investment banking, by 1985 the two fields took in 41 percent of the school’s graduating class. And many of them would play a significant role in downsizing—that is to say, gutting—the traditional manufacturing and product firms that previous HBS graduates had helped to build in the first place.

  The shift is indicative of the MBA’s nose for power—whereas pre-1970s increases in retained earnings had lessened the dependence of major corporations on financial institutions, the evaporation of those retained earnings in the 1970s and subsequent emergence of the capital markets as wielders of new power over corporate executives meant that the pendulum had swung back in the financial sector’s favor. In a capitalist economy, power equals money, and that shift was also evident. Between 1983 and 1992, the proportion of professional managers in the nation’s top 1 percent of household wealth holders showed a marked decline while that of people working in finance spiked.6 And so that’s where the MBAs went.

  “For most of the 20th century, social organization in the United States orbited around the large corporation like moons around a planet,” wri
tes Jerry Davis in “Corporate Power in the 21st Century.” But by the time Jensen was through, “any lingering doubt about the purpose of the corporation, or its commitment to various stakeholders, had been resolved. The corporation existed to create shareholder value; other commitments were means to that end.”7 “Business educators legitimized the notion that good management might mean dissolving the firm to improve shareholder return,” writes J.-C. Spender, “without concern for the social costs to employees who lost their jobs or to communities that lost employers.”8

  Ah, yes: all that nonsense about the social responsibility of business. It turned out that was all just posturing, because when the going got tough, as it did in the 1970s, it was suddenly every man for himself. “Employers were increasingly enthusiastic about hiring business school students, [but] they seemed to care very little about whether students had been inculcated with such professional attitudes as communalism, disinterestedness, and a social orientation,” writes Khurana, “norms that had been central to the rationale for creating university-based business schools in the first place.”9 Recent studies by the Aspen Institute show that when students enter business school, they believe that the purpose of a corporation is to produce goods and services for the benefit of society. When they graduate, they believe that it is to maximize shareholder value.