Tales of a New America

by Robert B. Reich

  A year later, the executive is delighted to discover that his prediction was dead right. After figuring out how to make the component, the firm’s workers are far more knowledgeable about this area of technology. They can see all sorts of ways to apply their hard-won expertise to new products and improvements to existing product lines.

  But there is a problem. The workers know that they are now more valuable to the firm than they were before—about $1,500 per employee more valuable. When it comes time for salary talks, each worker demands a raise worth, say, $1,499. If the company won’t deliver, the workers announce they will simply go to work for a competitor who will pay what the workers are now undeniably worth. Triumphant Individuals are not bound by ties of loyalty; they strike out on their own. Our enlightened executive has no choice but to accede to their demands, even though it wipes out the gain from his investment. But he sadly vows that from now on he’ll buy advanced components from Japan.

  Investments in knowledge cannot be protected like investments in real estate or machinery. Investors can assert and defend their stakes in tangible assets, but not in value that resides in people’s minds. They cannot require workers to stay with the firm; the Thirteenth Amendment to the United States Constitution, after all, bars involuntary servitude. Patents are no answer when the learning cannot—like Big Ideas—be reduced to technical specifications in a patent application, but rather takes the form of increased intuition and judgment that yield a stream of future innovations.

  This dilemma explains, in part, the rise of the Japanese-American corporation, which I referred to earlier. For many American firms, buying complex parts from the Japanese was more economical than training their own employees to make them precisely because firms could not guarantee themselves any harvest from investing in experience. Why go to the expense of giving your design and production engineers such valuable experience if almost half of them would leave the firm within two years to become Triumphant Individuals on their own?3 In Japan such an investment was worth its price because engineers could be expected to spend their lifetimes with the firm.4 There, the myth of the Triumphant Individual was less rooted than that of the Loyal Teammate. Thus when the Sperry Corporation announced in 1985 that it would stop making its own small computers and begin to rely on Hitachi for the computers it sold under the Sperry name, investment analysts welcomed the news. They noted that Sperry would save tens of millions of dollars that it otherwise would have to spend on developing technologies for its next generation of machines—an investment that it could not be sure it would ever recoup.5 Some critics charged that the stock market was forcing a shortsighted view on Sperry. But both the market and Sperry were behaving rationally, in terms of the anticipated return to Sperry’s shareholders. The decision was irrational only from the standpoint of the American economy as a whole, which otherwise would have benefited if more scientists, engineers, technicians, and production workers were trained in the next generation of small-computer technology.

  By the 1980s this disjuncture between the private and social returns of investment in people was widespread. When Guardian Industries wanted to get into the fiberglass insulation business, it simply hired away six Manville Corporation employees, who knew all about how to produce the material. Manville had spent $9 million over seven years to gain that expertise; Guardian was selling its own brand in just eighteen months. Next time, Manville (and others like it) would be more reluctant to make such large investments.6

  American companies were energetically but seldom successfully suing former workers for walking off with hard-won expertise. In the mid-1980s even California’s famed Silicon Valley was embroiled in such litigation. It was not uncommon to throw a good-bye dinner for a key employee one night and then serve legal papers on him the next morning. When Steven Jobs, co-founder of Apple Computer, left the firm to start another—taking with him his cumulative experience and that of several other engineers whom he brought along—the action reverberated throughout Santa Clara County. What would become of Apple’s shareholders and other employees who had relied on the expertise of Jobs and the defecting engineers? All over the Valley, the entrepreneurs who had founded the major high-technology companies were being succeeded by second and third generations of entrepreneurs who wanted to found their own. In 1985, one out of three of the Valley’s skilled engineers left their companies. As each successive group peeled off from the former—carrying away the experience necessary for devising future products—it became ever more difficult to reap full rewards on the initial investments. This in turn caused investors to be more wary. And as fewer investments were made, Silicon Valley began to falter.7

  5

  The risk of exploitation runs the other way as well. Consider a company that makes die castings for automobiles, appliances, and factory machines. The market for standard castings is shrinking, as ever more of these end products are produced abroad. The future lies in doing precision casts for computer parts and missile components, a process requiring substantial collective investment. Suppose the firm’s chief executive asks his material supplier to develop an unusual blend of aluminum and silicon, which will be easier to cast into small sizes and intricate shapes. He asks his employees to forego wage increases for the next two years, so that the firm has enough cash to pay for the new molds and computers it will need. He asks the towns and cities where the firm’s factories are located to reduce the firm’s tax bill to free up funds for the retooling. His reputation for solid investments earns the firm’s bonds a good rating, and creditors buy up a new issue despite its unspectacular interest rate. The implicit promise made to all these parties is that, once the transition is complete, the firm will survive and prosper, and all who depend on it will be better off. Suppliers, workers, creditors, and city officials go along.

  Two years later, the new precision die casting operation earns gratifying returns and is relatively safe from foreign competition. The future looks so bright, in fact, that the firm is acquired by a group of investors who offer the firm’s shareholders a hefty premium over the current market price of their shares. The new group of investors pays for these shares with money borrowed from pension funds and savings and loan companies at relatively high interest rates. These loans are secured by the value of the firm’s assets.

  The chief executive who orchestrated the retooling promptly resigns, and the new group takes over the management of the firm. They inform the firm’s employees that they are expected to continue working at the low wages to which they agreed two years before. They announce that because the firm is now so much more efficient, some of the employees will be let go. The new management demands a price cut for the hybrid material its suppliers developed; otherwise, it will contract with another supplier at the same price. The city gets a similar message: more tax abatements, or the firm decamps to another city. The company’s creditors got the news via the bond market: The firm’s additional indebtedness has substantially increased the risk of eventual default and reduced the value of the bonds.

  No party reaps the return it anticipated when it made its investment; none has any certain recourse in contract law. All would have done better by cutting their losses in the first place and refusing to cooperate in the firm’s renewal. The new owners have, in effect, expropriated the benefits that were to go to these parties under the tacit agreements made with the former chief executive.8

  Three years later, when the South Koreans begin producing precision castings, the firm’s new owners realize that to stay competitive they must offer customers still greater value. They prepare a plan to incorporate customized services into the product—milling, drilling, plating, trimming, and finishing the precision casts according to the customer’s special needs. But the employees, suppliers, and other constituents will not be fooled again. They balk at participating in new investment without elaborate formal contracts that complicate and constrain retooling efforts. Covenants on the new debt limit investment options. Each participant insists that every oblig
ation be spelled out in advance, every contingency clearly described. It should come as no surprise that the contract-bound organization proves incapable of the sort of quick, creative responses to customer needs that will keep it competitive.

  This story, too, has been replayed across America. The Chrysler Corporation, for example, received concessions from employees, suppliers, bank creditors, and the government during its near collapse in 1979 and 1980. Everyone contributed out of fear that the company would lapse into bankruptcy if they did not. But Chrysler continued to close plants and lay off workers. By the end, the firm employed one third fewer people than it had at the start, and many of the cars it sold were being made in Japan. Thus the largest beneficiaries of the sacrifices were Chrysler’s managers, who enjoyed magnificent bonuses, and its investors, whose shareholdings increased substantially in value as the firm recovered.9 Those Chrysler workers who survived until the austerity campaign paid off with spectacular gains in profit received only moderate pay increases. It seemed doubtful that Chrysler workers would willingly sacrifice again.

  Other enterprises experiencing competitive strains followed a similar route. In 1982 the management of General Motors persuaded GM workers that to keep the company competitive they had to scale back their wage and benefit expectations. Workers agreed to sacrifice for the long term, but on the very day the new contract was ratified, GM announced a new and more generous executive bonus program. Eastern Airlines faced bankruptcy in 1984. Its workers, challenged to help save the company, agreed to reduced wages and benefits in exchange for a seat on the board of directors and a chunk of common stock. But two years later, when one of Eastern’s unions refused further reductions, Eastern’s board accepted a takeover offer from the Texas Air Corporation. Texas Air’s chairman was notorious with labor for a ploy he pulled off with an earlier acquisition: After buying Continental Airlines he had filed for bankruptcy, which let him repudiate union contracts, lay off two thirds of the labor force, and cut wages by half.10

  Some contracts were simply disavowed when they became burdensome. Pipeline companies that sell natural gas wholesale had expected in the 1970s that the demand for natural gas would continue to rise. So they agreed to pay escalating prices to natural gas producers, who in turn invested in more production capacity. But when energy prices plummeted in the 1980s, several pipeline companies promptly walked away from their agreements without making any effort to negotiate new terms and left the gas producers with excess capacity and substantial losses. In the summer of 1983 the Washington Public Power Supply System merely defaulted on interest payments due on $2.25 billion in bonds held by tens of thousands of investors.11

  Tacit understandings were breached when they became inconvenient. Employees in many companies assumed that they would receive any surpluses that might accumulate in their pension funds’ investment portfolios, over and above minimum sums required to be paid out to them as pensions. But this assumption was based upon informal agreements; the pension plans did not stipulate precisely what would be done with any surpluses. So firms with surpluses in their funds cashed them in, converted the minimum sums to annuities, and kept the surpluses for themselves and their shareholders. By the mid-1980s corporate raiders were on the prowl for firms that had not yet exploited this easy source of cash; when they found one, they offered shareholders a premium over the market price of the shares, reflecting this windfall.

  6

  Nor were shareholders immune from exploitation by the stewards of their wealth, corporate managers. The erosion of good faith was amply illustrated, for example, by the device of the “golden parachute,” which became routine during the merger wave of the early 1980s. This was a generous severance payment, often totaling a large multiple of the executive’s annual salary and bonus, which was awarded—the parachute automatically opened, as it were—when a takeover became successful. The telling point is the justification invoked: The protected executives suggested such insurance was essential to preserve their impartial judgment about unfriendly takeover bids. Without the parachute, so the argument went, the executive would be tempted to fight the takeover even if it was in the best interests of the shareholders. This logic suggested that the only way shareholders could trust corporate executives not to feather their nests at the shareholders’ expense was to provide them a prefeathered nest at the shareholders’ expense.

  By the mid-1980s another technique known as the leveraged buyout had come into vogue. The process was quite simple. Executives borrowed money from banks or the credit market to buy up their company’s stock. The loans or bonds, which carried high interest rates, were backed by the company’s assets. The executive then owned the company. The argument was that once managers’ wealth was tied up in the company, they would adopt a more efficient, more entrepreneurial managerial style and improve the firm’s performance; executives who owned their company would work harder and better. Yet from the standpoint of the company’s shareholders, this was a curious argument indeed. If ownership would so improve management, it had presumably been deficient in the past. Perhaps the managers, unmotivated by their salaries alone, had lounged around the executive suites daydreaming about how energetic they would be if only the company were theirs. Or perhaps they had developed some new product or marketing scheme, but delayed releasing it until they could reap the full reward. Executives proposing to buy their companies had an inherent conflict of interest. How could they advise owners on whether to sell their shares when they themselves were the aspiring purchasers? If a small group of top managers could borrow to the hilt to buy their company and still expect a handsome return, it would seem wise for the original shareholders to hang on to their stakes in order to gain some of the action.

  7

  When is it economically rational to violate a trust? Those who renege on informal promises and understandings surely bear a burden: They must live with a sullied reputation. Notoriety has its costs; parties who once repudiated obligations will find it harder to gain trust in the future. Employees who abandon a firm after gaining valuable experience, managers who abandon suppliers and employees after gaining concessions, suppliers who walk away from burdensome contracts, managers who feather their nests at shareholders’ expense—all must live with the long-term consequences of their onetime gains. But these consequences may be more than balanced by the onetime gains of exploitation. This is especially likely in a highly mobile, anonymous society. Reputations, like unpaid bills, often cannot keep up with those who move quickly.

  For many Americans a lifetime of work entails relatively few repeat dealings. The typical American curriculum vitae records an unattached self who advances from job to job, organization to organization, place to place—as horizontally mobile as upwardly. By 1985 the average corporate manager stayed put for four and a half years; the average chief executive, four years; the average employee, even less.12 Corporations themselves changed hands at a rapid pace, often altering their names, locations, and images in the process. Mergers and acquisitions remained a favorite sport, and nearly half of all senior executives left their jobs within a year after their companies were taken over.13 When Esmark absorbed Norton Simon, Inc. in 1983, for example, many key Norton Simon executives departed. A year later Esmark itself was acquired by Beatrice Companies, which proceeded to slash Esmark’s staff. Two years after that, Beatrice, in turn, was taken over by a group of investors that included several former Esmark executives, who promptly dismissed the latest regime. In these games of corporate musical chairs, the underlying production process typically remains unaltered.

  Trust breakers thus stand a good chance of dodging the full consequences of their behavior in part because they outrun them, and in part because the damage is inherently cumulative and systemic. Rather than attaching solely to the offending person or firm, the effects are likely to be diffused—resulting in a general reduction of trust in all commercial dealings. Managers who feel exploited by departing employees are less forthcoming with subsequent employees. S
uppliers or workers who are mistreated by one set of managers do not make the same mistake again when they deal with a different set. Shareholders are more meticulous in their choice of firm. Like jilted lovers, these parties are far more cautious next time. And their caution is shared by others who, although they have had no direct experience of being exploited, learn by observation to keep their guards up. No one wants to be a sucker.14

  This systemic erosion of trust precipitates all manner of precautions. Commercial dealings are hedged about by ever more elaborate contracts. There is a proliferation of work rules, codes, and standards to be followed. Requirements and expectations are well documented in advance; enforcement procedures are minutely delineated. Laws are spelled out in greater detail, so that next time no party will be surprised by the opportunistic move of another. Rules governing bankruptcies, pension plans, the fiduciary responsibilities of corporate officers, and corporate takeovers, among other transactions, are rendered ever more specific. Reciprocal rights and obligations are codified in ever more voluminous detail.

  As a result, the opportunistic behavior of a relative few reduces the flexibility of the entire system. Collective entrepreneurialism becomes impossible. Because no one can be sure that someone else might not violate a trust, everyone takes precautions. Like a university honor code that, once transgressed, is replaced by a book of detailed stipulations, the exploitation of tacit commercial understandings results in a stifling profusion of contractual particulars.