Clayton M. Christensen: The New Church of Finance: Deeply held belief systems and complex codes must be changed
Corporate balance sheets and profits are in the best shape they have been in over half a century. So why do jobs remain scarce?
The income of the top 1 percent of Americans has grown significantly, and they garner about 28 percent of total income. But total personal income has been flat for about 30 years. Why do the rich get richer while the rest tread water?
In seeking answers to these questions, we need to understand the relationship between innovations and how the decision of companies to invest in jobs is shaped by zealously maintained theories of finance.
Three types of innovation
There are three types of innovations that affect jobs and capital: empowering innovations, sustaining innovations and efficiency innovations.
Empowering innovations transform something that is complicated and expensive into something that is so much more simple and affordable that a much larger population can enjoy it. The Model T did that, making an automobile affordable and accessible. Apple and IBM computers made it so all of us could have a computer. Google made it possible for almost anyone to advertise at low costs.
It turns out that almost all net growth in jobs in America has been created by companies that were empowering — companies that made complicated things affordable and accessible so that more people could own them and use them. When more people are buying them, more people have to be hired to make them and distribute them and to service them. Empowering innovations make up the core engine of economic growth.
Sustaining innovations, on the other hand, account for most of the innovation activity in an economy. They have a net zero impact on employment. A sustaining innovation makes better products that you can sell for better profits to your best customers. When Toyota sells an innovative new car like the Prius, they don't sell a Camry. These innovations are important for the economy because they sustain the economic trajectory, but they do not create significant new growth.
Efficiency innovations arise in industries that already exist. They provide existing goods and services at much lower costs. They are not empowering. Efficiency innovators become the low cost providers within an existing framework. So Wal-Mart can come into town and announce that they have hired a lot of people, but actually they put those working at less efficient retail operations out of work. Efficiency innovations have a negative effect on employment. But the resulting efficiency gains allow financial capital to be invested elsewhere.
In a healthy economy empowering, sustaining and efficiency innovations operate in balance. A healthy economy creates and sustains more jobs before squeezing out inefficiencies.
Over the past 20 years, however, there has been far less money flowing into empowering innovations and much more capital flowing into efficiency innovations and sustaining innovations. As a result, we are not creating new jobs at a rate that will sustain our economy.
Why is financial capital flowing disproportionately to innovations that do not produce jobs? I think the roots lie in a powerful new belief system.
About 40 years ago some people established what I describe as a new church. I call it the New Church of Finance.
The members of this church are finance professors at business schools, a lot of economists and the partners in hedge funds and private equity funds. I call it a church because it has many of the characteristics of a well-catechized belief system. For those committed true believers within this "church" it is inconceivable that the catechism isn't true. People on the outside looking through the window, however, might be justifiably skeptical.
In early Christian history, Christianity merged and consolidated with other belief systems in the Mediterranean. Emperor Constantine urged the leaders of the Christian church to get together and hammer out the orthodox beliefs. Similarly, the leaders of the New Church of Finance have formalized their orthodox beliefs regarding profit. And it turns out that their definitions of profitability are mostly denominated in ratios. You have such concepts as Return on Net Assets (RONA), Economic Value Added (EVA), Internal Rate of Return (IRR), Earnings Per Share (EPS) and Gross Margin Percentage. They are all ratios.
What is measured is managed
By standardizing the definition of profitability, corporations lined up to optimize these profitability ratios. RONA provides a good example. A company could improve its RONA by generating more revenue and put that in the numerator.
But the other way to improve this ratio is to reduce the denominator by a company getting rid of assets. Reducing assets is much easier than increasing revenue. So if a CEO is rewarded for a good RONA ratio, the incentive is to outsource aggressively. When there are no assets on a balance sheet, then this rate of return is infinite, and according to this definition, it might seems like such a company is doing better and better.
The story of McDonnell Douglas, however, provides a cautionary tale. The DC3 was its warrior. McDonnell Douglas made everything in the DC3. But its return on assets was low. So with each of the subsequent airplane models they outsourced more, until the company outsourced everything with the DC10.
McDonnell Douglas stopped making things, but instead became an assembler of sub-systems. RONA increased to about 60 percent. The company reduced its assets because it no longer made components. But when customers needed spare parts, they went to the suppliers of McDonnell Douglas rather than McDonnell Douglas itself. Although "profitable" by one definition, once the company had sold the DC10 there was no ongoing cash flow sufficient to do a DC11.
Internal Rate of Return (IRR) is another finance ratio that discourages empowering innovation. Empowering innovations tend to emerge 5 to 10 years after the investment. But IRR encourages investors to get in and out of a company fast. IRR disappears for something that will take five years to pay off. It effectively prevents investors, private equity players, and venture capitalist from investing in the long term. Sustaining innovations and efficiency innovations, on the other hand, have a quick turnaround.
A better measure?
I went to Taiwan and China to seek answers to this puzzle. The semiconductor industry is instructive. Intel is the only company that still makes its own chips domestically. Everyone else outsources it. If you become a semiconductor manufacturer without any factories, the New Church of Finance gives you high marks for profitability because your RONA is wonderful.
But when I talked to Morris Chang, chairman of TSMC in Taiwan, he asked why Americans are so eager to get assets off their balance sheets. He was quite happy to put assets onto his balance sheet, even though it costs about $10 billion to build a new factory.
Although he did so kindly, Chang essentially explained why our focus on ratios is senseless. Chang noted that banks don't accept deposits denominated in ratios. In doing so he reminded me that there is a simpler way to account for finances: in whole dollars. After all, that is what banks accept ?— dollars. Consequently, Chang suggested what is probably a better measure of profitability: tons of money. His dictum is that more tons of money is better than less tons of money.
The focus on carefully calculated ratios might make sense when capital is scarce because every dollar needs to be used optimally. But today capital is not scarce. Corporate balance sheets are flush with cash and sovereign funds in places like Abu Dhabi have money in the trillions of dollars.
American capitalists, enthralled by the doctrines of finance, have put their income statements in service of the balance sheet. But under that model, cash won't be invested in new growth businesses because of the way the "priesthood" of finance defines profitability.
Remember the bottom line
In a more dynamic economy, the balance sheet would be in service to the income statement. It's the bottom line of the income statement that a company can actually deposit in a bank. In a growing and balanced economy, companies would be focused on the bottom line of the income statement and the top line of the ratios. But modern finance encourages CEOs to manipulate the denominator.
The religion of finance has emancipated cash from the balance sheets of companies, placing it in hedge funds and private equity shops. This migratory capital seeks very fast financial returns. The minute it's in, investors want to pull it out, and if they can pull out more capital than they put in, they are successful and profitable. But that's not the kind of long-term investment that creates growth and jobs.
Our current tax code encourages this kind of migratory capital. If you put money in a company for 366 days, investment returns count as tax-favored long-term capital gains. I would prefer to see the tax code restructured so that taxes on capital gains declined on a scale over a much longer period. Migratory capital would disappear if, when you left money in a company for a period of something more like 6-8 years, there might even be no tax on your gain. Such treatment would encourage capital to invest in empowering innovations, not flip in and out of sustaining and efficiency innovations.
The financial doctrines so zealously followed by American companies might help optimize capital when it is scarce. But capital is abundant. If we are to see our economy really grow, we need to encourage migratory capital to become productive capital — capital invested for the long-term in empowering innovations. But until deeply held belief systems and complex codes are changed, I fear we will continue to experience over-investment in efficiency and meager attention to empowering innovation, growth and jobs.
Clayton M. Christensen, a Harvard Business School professor, is consistently ranked as one of the world's leading thinkers on innovation. He is a member of the Deseret News Editorial Advisory Board.