The Meritocracy Trap

by Daniel Markovits

  Against this backdrop, and beginning in the late 1970s and accelerating through the 1980s, a series of interlocking innovations—in finance, in law, and in management itself—remade the American corporation and launched a new style of management: meritocratic rather than democratic, and with income intensely concentrated at the very top.

  First, companies changed how they fund their businesses. Midcentury firms reinvested the lion’s share of their profits in their own activities, rather than returning them to shareholders or creditors. This practice allowed the firms to fund nearly all their business investments from internal resources rather than requiring new money raised on the capital markets. But as the broader economy financialized, firms began to raise operating capital by borrowing. All in all, publicly traded firms today retain only a small share of their earnings and fund less than a quarter of major new expenditures from past profits.

  This change requires firms now to devote profits to repaying creditors, on a fixed schedule. Indeed, part of the point of debt financing (especially combined with stock buybacks) is to bind managers to produce the revenues needed to pay creditors and to prefer owners over other stakeholders. Top managers lost the discretion that a large stock and steady flow of retained earnings supports and faced new pressures to promote their firms’ bottom lines, including in particular by squeezing payrolls for everyone below them. Where the midcentury firm’s insulation from the capital markets had been so effective that “separation of ownership and control” became the organizing ideal of midcentury management, the contemporary firm’s capital structure makes management intensely accountable to activist investors.

  Second, new legal technologies created the market for corporate control that takeover artists might deploy—routinely rather than just in exceptional cases—to discipline management that failed to maximize shareholder value. The discipline came through many mechanisms, including perhaps most importantly the leveraged buyout—an arrangement whereby an acquirer seeking to take over a firm uses the target firm’s own assets to secure a loan to buy the target’s shares. Beginning in the 1980s, leveraged buyouts acutely increased the pressure that potential takeovers placed on incumbent managers.

  Law firms such as Wachtell, Lipton, Rosen & Katz and Skadden, Arps, Slate, Meagher & Flom developed the legal frameworks to implement activist investing on a massive scale. And investment banks such as Drexel Burnham Lambert and private equity firms such as Kohlberg Kravis Roberts & Company embraced and expanded the tactics of earlier corporate raiders, bringing corporate takeovers from the eccentric fringes of finance to Wall Street’s charismatic center. The dollar volume of mergers and acquisitions in the United States—a good if rough overall measure of the shareholder activism—grew by over 200 percent between 1982 and 1987 (similar years in the business cycle) and then by nearly 500 percent again between 1988 and 1999. By 1990, one-third of the firms in the Fortune 500 had been targeted by a hostile takeover bid, and two-thirds had feared such a bid sufficiently to implement anti-takeover defenses.

  Third, these financial and legal innovations spurred managerial innovations, through which firms displaced the democratic management technologies deployed at midcentury with the meritocratic technologies that dominate management today. The change in who draws the corporation’s bottom line induced an immense, concrete, and practical change in the corporate workplace.

  The market for corporate control cannot directly incentivize workers outside of a firm’s top management. Investors are too far removed from the firm’s internal operations to monitor or control these workers directly; indeed, this distance is what makes them investors rather than being managers themselves. At the same time, the market for corporate control creates exceptionally high-powered incentives for top managers: investors can monitor top managers’ performance and apply both carrots (stock- and option-based pay packages) and sticks (the threat of being ousted) to induce a firm’s leadership to maximize shareholder value. This logic casts managerial discretion among non-elite workers as a cost to shareholders, and at the same time casts managerial capacity among a firm’s elite, if properly incentivized, as a benefit. The market for corporate control therefore induced precisely the innovations in managerial technology that displaced the midcentury regime’s widely dispersed management function in favor of the present-day practice of concentrating management at the very top of flattened corporate hierarchies.

  These interlocking innovations together transformed the American corporation, displacing democratic practices in favor of meritocratic hierarchy. Finance has remade management in its image, bringing the fetish for skill into nonfinancial firms. One might even say, speaking loosely, that management has itself become financialized.

  Like the innovations that transformed finance, the cascading innovations behind the managerial revolution did not arise spontaneously. Instead, they were all—every one—generated from within meritocracy, by and for the newly available supply of super-skilled, Stakhanovite workers coming out of America’s newly meritocratic schools and universities.

  The financial instruments through which corporate raiders accomplish their takeovers, like the other financial innovations just described, required super-skilled finance workers in order to construct, price, and trade them. (It is no coincidence that the takeover boom coincided with the rise of traders at places such as Drexel Burnham Lambert.)

  Moreover, the new legal technologies that created the market for corporate control required super-skilled lawyers to develop and deploy them. The law firms that most consequentially created and developed these innovations—Wachtell and Skadden—were both intensely meritocratic. At midcentury, they set themselves self-consciously apart from the aristocratic lawyering elite, by rejecting the forms of discrimination based on breeding and religion that incumbent firms then still deployed. Today, Wachtell has become the embodiment of now-meritocratic elite lawyering, famously employing only the very top graduates from the very best schools. The firms’ closest competitors, moreover, all cultivate similarly meritocratic reputations and actively contend for the same legal talent.

  Most important, a corporate raider cannot improve a target firm’s economic performance or increase its stock price unless he can replace incumbent managers with expert and industrious substitutes. The entire conceit of shareholder activism depends on deploying the increased elite managerial capacity that gives corporate takeovers their economic foundation. It requires a ready supply of Stakhanovite, super-skilled top managers who are willing and able effectively to exercise the vast powers of command that running a firm directly (without relying on middle managers) requires.

  It is therefore again no happenstance that the 1980s takeover boom coincided with rapid expansions and repositionings in the institutions that produce managerial capacity. Chief financial officers rose to prominence at just this time and brought the perspective of the financial markets inside their firms. And both the business schools that grant MBAs and the management consulting firms—most notably McKinsey, Bain & Company, and the Boston Consulting Group (BCG)—through which MBAs provide essential technical support to top managers in flattened corporate hierarchies experienced transformative growth.

  Management consulting, in particular, changed almost unrecognizably. The consulting industry remained “fledgling at best” through the Second World War and fully embraced the leisured norms of the aristocratic elite. Even McKinsey remained an aristocratic outfit, not hiring its first Harvard MBA until 1953 and continuing to require its consultants to wear fedoras until President Kennedy stopped wearing his.

  But then, as the midcentury economy faded, consulting commenced a campaign to secure its eliteness by performing it. In 1965 and 1966, McKinsey took out “help wanted” ads in the New York Times and Time magazine with the express purpose of generating thousands of applicants who might be turned down; and throughout the 1970s it applied ruthlessly productivity-driven analytic methods to its own business. In the same
decade, the Boston Consulting Group’s Bruce Henderson, a “famed elitist,” advertised in the Harvard Business School student newspaper that BCG sought to hire “not just the run-of-that-mill but, instead, scholars—Rhodes Scholars, Marshall Scholars, Baker Scholars (the top 5 percent of the class).” Today, 25 percent of top business school graduates join elite consulting firms, and the leading topic of career-building panels at the schools is “Investment Banking vs. Consulting.”

  The talent that flooded management consulting took relentless aim at middle managers, openly seeking to “foment a stratification within companies and society,” induced not through respectful application of “silver-haired industry experience but rather from the brilliance of its ideas and the obvious candlepower of the people explaining them, even if those people were twenty-eight years old.” The consultants attacked middle management with a dizzying array of often branded and even proprietary analytic methods.

  MIT’s Sloan School of Management, working with the consulting arm of the Computer Sciences Corporation, developed a process called corporate “reengineering,” which aspired to “break an organization down into its components parts and then put some of them together again to create a new machine.” The remaining parts, left out of the new machine, typically consisted of middle managers. And many firms, including GTE, Apple, and Pacific Bell, expressly cited reengineering as responsible for their downsizings. McKinsey, for its part, championed “Overhead Value Analysis,” which the firm expressly cast as a response to the midcentury corporation’s excessive embrace of middle management. McKinsey admitted that its “process, though swift, is not painless. Since overhead expenses are typically 70% to 85% people-related and most savings come from work-force reductions [to nonproduction employees], cutting overhead does demand some wrenching decisions.”

  The management consultant’s mantra remained staunchly meritocratic throughout, and this legitimated the job cuts. The consultants insisted, in the words of one historian, that “we are all in this together, but some pigs are smarter than other pigs and deserve more money.” In this way, meritocratic management “contributed to the fiercer feel of today’s capitalism.” Super-skilled bankers, lawyers, and consultants stimulated the managerial innovations that themselves favored skill.

  Finally, all these managerial innovations again have their roots in the skill profile of American executives. Meritocratic education has created a cadre of super-skilled workers who are able to run even large and complex firms without relying on elaborate hierarchies of middle managers and are willing to work with an intensity that prior elites would have found degrading. These workers have spawned the innovations in finance, law, and management that strip the managerial powers and incomes from ordinary workers and concentrate them in top executives.

  Safeway, as it happens, exemplifies these recent developments in management also. The firm’s character changed dramatically in 1986 when, despite a sharply rising stock price, rising dividends, and record earnings, it succumbed to a leveraged buyout. Safeway’s new corporate statement of purpose, advertised in the lobby of its headquarters, displaced the old mottos in favor of a promise that Safeway would pursue “Targeted Returns on Current Investment.”

  Divisions of the firm were shuttered, closing stores (often in struggling communities) and costing jobs. When the entire Dallas division was closed, nearly nine thousand employees (with an average tenure of seventeen years) were fired. The firm’s middle management was sharply depleted—Safeway fired many admittedly “very good” employees from its corporate headquarters and eventually paid out millions of dollars to settle wrongful termination suits.

  Elite management came increasingly from outside the firm. Safeway’s present CEO is trained as a certified public accountant and got the job on account of running a competitor that acquired Safeway through a merger, and his predecessor came to the firm after twenty years in the transportation and energy industries. Meanwhile, the firm’s top managers became immensely rich. Safeway’s CEO’s annual compensation was increased by about 40 percent in the year after the buyout, and his bonus nearly tripled, from 40 to 110 percent of base pay. The pay rise proved permanent and in fact only increased over time. In 2014, Safeway’s CEO received $8,982,429 in total compensation, nearly ten times what his predecessor in the 1960s was paid.

  WHY INNOVATION TODAY FAVORS SKILL

  New technologies did not always favor skilled workers. When elite incomes still depended on capital, innovation was biased against skilled labor. The technologies that inaugurated the Industrial Revolution replaced artisanal production with factory methods that separated previously complex tasks into simple components, which might be routinized and performed by less elite workers. Skilled artisans understood this and resisted. At the end of the eighteenth century in Leeds, England, well-paid artisanal weavers saw that the increasing use of automated looms would displace them in favor of fewer, less skilled, low-wage workers. The weavers organized (coming to be known as Luddites) and petitioned against the “scribbling machines” in local newspapers. When their arguments failed to protect their jobs, they conducted a campaign of sabotage and even riots against the machine looms.

  A technological bias against skill endured deep into industrialization, as “many of the major technological advances of the nineteenth century . . . substituted physical capital, raw materials, and unskilled labor, as a group, for highly skilled artisans.” In gunmaking, for example, cheap lumber from American forests, combined with lathes, allowed gun manufacturers to replace the skilled workers who had previously hand-fitted gun stocks with unskilled mass production using prefabricated parts.

  Nor were guns exceptional: “The butcher, baker, glassblower, shoemaker, and smith were also skilled artisans whose occupations were profoundly altered by the factory system, machinery, and mechanization.” Indeed, innovation’s bias against skilled artisans continued into the early twentieth century. In the 1910s, for example, the development of assembly lines allowed the Ford Motor Company to build cars without the artisan-mechanics who had previously dominated production.

  By the middle of the twentieth century, when unionized factory labor began to hold its own against capital and to sustain middle-class affluence, equality’s champions had come to welcome innovation. Midcentury thinkers commonly supposed that technological innovation would favor middle-class workers and divert income from capital to labor. Moreover, as Joseph Spengler wrote in a 1953 note for the American Journal of Sociology, they believed that “a decrease in the fraction of national income going to property, coupled with an increase in the wage-salary fraction, tends to be accompanied by a decrease in income inequality.” When economic battle lines were drawn based on the dispute between capital and mid-skilled labor, equality’s champions embraced innovation as their friend.

  The recent histories of finance and management suggest why innovation has changed course and now opposes economic equality. In each case, a rising supply of superordinate labor, produced by newly meritocratic elite education, bent the arc of innovation toward the skills that those workers possess. When economic battle lines were redrawn around a new conflict between mid- and super-skilled workers, innovation changed course to favor skill and promote inequality.

  The shift follows an intelligible inner logic. Innovators are not dispassionate but rather work in a social milieu and have human and economic interests. Their context drives which thoughts and ideas, from the immense set of imaginative possibility, they actually discover and then take off the drawing board to develop and implement. This applies especially to innovations that are deployed in production, which are by nature pursued not for knowledge’s own sake (if such a thing were even possible), but rather in response to practical considerations and opportunities for profit.

  Interested innovators adjust the technologies that they invent to suit economic background conditions, including in particular the resource base that their society possesses—the broad set of as
sets that new technologies might exploit. This has been so from the very earliest days of innovation, indeed since the invention of agriculture. In the first agrarian economies, for example, a society in an arid country might develop drip irrigation, while a society with numerous rivers might develop paddy field farming. Later the abundance of slave labor in the ancient world is often said to help explain why even very advanced societies never industrialized. (Hero of Alexandria even devised a mechanism by which steam might spin a ball, but no one deployed this technology in productive engines.) And more recently, societies in which labor was scarce relative to land (such as the United States) developed very different agricultural techniques from societies in which land was scarce relative to labor (such as Japan).

  One important resource that every society possesses is the skill and industry—the human capital—of its workers. Indeed, after millennia in which both wealth and economic production were dominated by land, and perhaps a century in which they were dominated by industrial machines, human capital has become the greatest source of economic wealth in the rich nations of the world. And just as the path of innovation once adjusted to suit society’s natural or physical resources, so it now adjusts to suit society’s human resources, and in particular the skill profile of the society’s workforce.