Posted by: Dr Pano Kroko Churchill | February 1, 2014

Corporate Profits along with Economic Value for all is Simply Good Business and Democratic Economics

Google Chairman Eric Schmidt just gave a “fireside chat” in Davos, Switzerland, at the World Economic Forum about the State of the US economy and by extension that of the world…

In the context of talking about global inequality, which Schmidt thinks is partly the result of technology and is going to get worse before it gets better, Schmidt revealed a critical truth about the economy that few other successful investors and executives appear to understand or at least admit: ‘The stagnation in middle-class wages is not just a middle-class problem. It’s an economic problem. And it’s one of the main reasons that global economic growth is so lousy.’

Let’s now explain, Why. Why do stagnant middle-class wages hurt the economy?

Because the middle-class folks whose wages are stagnant are the global economy’s biggest spenders.

And when they don’t have money to spend, their lack of spending hurts not just them but all the companies that depend on them for revenue.

Including, Schmidt pointed out, Google.

Put differently, one company’s expenses (wages) are another company’s revenues. So, collectively, when companies are cutting wages, they’re also cutting their own future revenue growth.

Right now, companies are so focused on cutting wages — by paying their employees as little as possible and replacing them with technology whenever possible — that wages as a percent of the economy are now near an all-time low (see chart below). And this weakness in wages is the big reason demand in the economy is so weak.

WagesSt. Louis Fed

Wages as a percent of GDP.

Very few corporate executives and investors seem to understand this.

Instead, they act like it’s a law of economics that they have to pay their employees as little as possible, so they can “maximize profit.”  And, in the process, they hobble the economy.

Eric Schmidt and Google, do understand the wage/growth tradeoff — but most all other company executives don’t get it…

And that’s one reason why, even if you’re skeptical of Google’s initiatives in wind farms, self-driving cars, robotics, and other projects that are seemingly unrelated to its core business — or if you’re annoyed by Google’s penchant for paying its most valuable engineers so well — you should at least appreciate that all of this generous investment and spending helps the economy.

If more companies behaved the way Google, Amazon, Microsoft, Apple, and many other smart companies do — spending more than they absolutely have to and investing for the long-term rather than “maximizing current earnings” — the economy would be much better off.

It is now abundantly clear that we Need To Stop Maximizing Profit And Start Maximizing Value, because this system is heading off the cliff. And it doesn’t work well enough for our Democracy anymore.

Since the late 1970s, when American companies were fat and complacent, the focus of American business has been on the bottom line.

Spurred on by activist shareholders, private-equity firms, and bonuses based on stock prices, corporate managers have become obsessed with maximizing quarterly profits.

This new focus has produced remarkable results.

Corporate Profit MarginsSt. Louis Fed

Corporate profits have hit an all-time high as a percent of the economy.

Over the past three decades, big American companies have gone from having below-average profit margins to the highest profit margins in history (see chart at right).Unfortunately, this obsession with profit maximization has come at a cost.

By focusing their entire effort on the bottom line, many American companies have reduced their value to the other constituencies that truly great companies serve, namely customers, employees, and society.

One result of the profit obsession, for example, is that big American companies are now paying the lowest wages as a percent of the economy in history. (See chart).

Wages To GDPSt. Louis Fed

Wages have hit an all time low as a percent of the economy.

This means that a record-low percentage of the vast wealth these companies have is being shared with the people who help earn it.Another result is that companies are now scrimping on capital investments, which have also dropped sharply as a percent of the economy. (See chart).

Both of these efficiency initiatives help “maximize profit,” at least in the near term.

But they hurt the economy.

And they also hurt our companies’ overall growth rates.

Why?

Because every dime that companies pay out in wages and capital investment becomes revenue for other companies.

Capital InvestmentsSt. Louis Fed

Capital investment as a percent of the economy (non-residential) continues to fall.

Rank-and-file employees at American companies–Walmart employees, for example–are also American consumers. They spend nearly everything they earn buying food, clothes, gas, houses, entertainment, and other products and services. This money then becomes profits and wages for companies that provide those products and services. And so on.The problem in the American economy right now is not that there isn’t enough investment capital. There’s plenty of it. (There’s so much of it, in fact, that some companies don’t even know what to do with it: Witness the massive cash mountains building up at companies like Apple, Cisco, Google, Bank of America, JP Morgan, et al.)

The problem is that rank and file American consumers are over-indebted, under-employed, and broke.

And these consumers account for a staggering 70% of the spending in the U.S. economy.

To restore the economy to health, we need to persuade our companies to balance their priorities–to share more of their wealth with the employees who help earn it.

More broadly, we need to persuade our companies to focus on creating value for all of their constituencies, not just shareholders.
Take Walmart as an example. Walmart employs 1.4 million Americans, approximately 1% of the entire American workforce. The average full-time Walmart associate makes $12 an hour–$480 a week and $25,000 a year. That’s just above the poverty line. These 1.4 million Americans who are dedicating their lives to making Walmart successful, in other words, are paid so little that they’re nearly poor. Walmart itself made $27 billion of operating profit last year. If Walmart were to give each of its US associates a $5,000 raise, it would cost the company $7 billion a year. This would reduce Walmart’s operating profit to a still-extremely-healthy $20 billion. It would also give 1.4 million hard-working Americans another $100 a week to spend. And, chances are, they’d spend a lot of it at Walmart.

The same can be said for Bank of America, Citigroup, and many other huge American companies that are furiously engaged in finding ways to fire people and cut costs. In addition to their massively profitable Wall Street operations, these banks have huge branch networks in which tellers and local loan officers make modest salaries while serving their communities. Some of them would undoubtedly be grateful for a raise. And they’d probably spend it close to home.

The point is that our three-decade drive to make our companies more efficient has been spectacularly successful–so successful that, in the interests of “maximizing profits,” we’re now starving the key growth driver of the economy, average Americans.

Lower profits Higher wagesSt. Louis Fed

How can we fix the economy? We can reinvest profits in people.

To fix this, our companies need to share more of their wealth with their employees.They need to aim to earn a reasonable profit, not a “maximized” one.

And they need to reinvest their excess profits in creating more value for their other constituencies, namely customers, employees, and society.

“Fairness” and “sharing” have become dirty words in our country, words that immediately get the speaker branded a liberal or socialist or even communist.  This is just silly if not stupid and outright depressing. Basic knowledge of Economics and Democracy as well as schooling in Fairness and sharing is a must and then you start recognizing that these issues aren’t political concepts, and the fact that they’re interpreted that way shows just how uneducated and polarized the country has become.

But given that half the country now associates “voluntary sharing” with “communism,” arguing that companies should share their wealth because it’s the right thing to do won’t get us very far.

So let’s just base the argument on self-interest.

It is very much in companies’ self-interest to pay employees more.

If companies pay their employees more, they’ll increase loyalty, reduce turnover, and get better employees. Over the long term, this should reduce training and hiring costs. By increasing customer satisfaction, it should also increase revenue. By paying their employees more, companies will also put more money in the hands of American consumers, who will then turn around and use it to buy products and services from American companies. So the companies will help accelerate the growth of the economy as a whole. And as the economy grows, so will the companies. This, in turn, will help create more long-term shareholder value.

In short, to restore our economy and society to health, we need a new corporate mission in America and the world: Maximize Value for the Society at large because when you do your bit for the Economy at large — we all do well.

We need to stop always looking at maximizing profit and start seeking ways to maximize value in order to achieve the balance required for an Economically vibrant Democracy. We call this Demonomics, because we know that the key ingredient here is the greatest benefit for the Middle Class since that is the bedrock of Democracy.

If you have any doubts about this, just look at Economic Theory as it follows practice and the value of Demonomics has been proven ever since the Golden Age of Athens some twenty four centuries ago…

Yours,

Pano

PS:

And what about the UK — the old Blightey?

The Office for National Statistics has just published their first Q4 2012 GDP estimate: It fell by a
shocking 0.3%, which means after a one-quarter hiatus post Olympics, according to our official GDP, the UK is back in the doldrums. It is not the first time, but it is very difficult to truly fathom what is going on here on most levels.

The reported GDP decline continues to contrast dramatically with the ongoing strength of the UK labour market. If we are to believe all the reported data as being equally accurate, then the only conclusion can be that post the 2008 crisis not only has the cycle persistently struggled, but our productivity has apparently collapsed. An equally depressing conclusion would be that the apparent productivity beforehand wasn’t really true – just like the credit-infused GDP growth which was false, too.

A much less bleak interpretation could be that the GDP data is badly missing something, and the labour market data is a more accurate portrayal of the cycle, but, of course, this is just a plausible interpretation rather than a fact.

Another interpretation – which doesn’t explain the employment strength, but would explain the weak GDP – is that the UK is just, plain and simple, following the wrong policy mix. Trying to aggressively tighten fiscal policy at the same time as persistently pressurizing UK banks to raise large amounts of capital is just the wrong thing to do. And, of course, if you really believe that the weakness of the euro area is persistently bad news for UK exports, then it is an even easier accusation.

And if all of this wasn’t enough, then we now have the issue of a 2017 EU referendum on the table. I am really quite torn about this topic. Part of me – a growing part – thinks the UK needs a fresh referendum on the topic as it persistently just hangs there as an ongoing constraint. We need to be either “in” or “out”, and if we get a mandate to be “in”, maybe we should be more “in” than anyone currently really thinks. And if we want to be “out”, then so be it. From a business perspective, one might even describe the issue as “Honda” versus “Land Rover”. In the past fortnight, both companies announced equal-sized job cuts and job additions — the cuts due to European weakness, and the additions due to Chinese strength.  Furthermore, there is the crux of the UK external trade issues ahead.


Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: