The Pathology of Financialization

We all know the story of enclosure as it applies to the commons. The lesser-known story is that businesses are enclosing themselves – aggressively cannibalizing their own internal productive capacities in order to maximize short-term profits.

Harvard business guru Clayton Christensen argues in Forbes magazine that business executives are so habituated to seeing the world through a scrim of financial abstractions that they are blindly undercutting their own long-term productive capacities. The problem is so pervasive, says Christensen, that “whole sectors of the economy are dying.”  (The full column, by Steve Denning, is headlined, "How the Pursuit of Profits is Killing Innovation and the U.S. Economy.")

A good example, he says, is the American personal-computer industry. It slashed costs by aggressively outsourcing to foreign companies the manufacturing of PC components, final assembly and even design. This has reduced costs and improved profitability – Wall Street cheers! – but it has also hollowed out the internal capacities of companies themselves. At this point, Dell Computers is little more than a brand; most everything else is outsourced. The same dynamic is practiced in a range of American industries – steel, auto, oil, pharmaceutical and software.  As if to replicate the Cartesian split of body and mind on a global scale, the "advanced" countries have cast themselves as the "mind" and relegated all the dirty work of production to "the body" in the poorer regions of the world.

How perversely satisfying to learn that this "rational" strategy is not really working!  As if to echo Marx himself, Clayton Christensen blames “the pursuit of profit” for hollowing out the long-term capacities of business and subverting long-term profitability. Here is one of those deep ironies of capitalism.

The problem:  Financialization is a reality-distortion field. It typically does not take into account the dynamic, long-term value of technological and manufacturing knowledge, for example. It doesn't express how the loss of inhouse expertise and hands-on engagement hurts a company's ability to innovate in the future. Fixated on the short term and assuming a static reality, financialization fails to understand that outsourced knowledge will eventually be put to good use by others. And so outsourced vendors in China and Korea morph into innovative, low-cost competitors.

Christensen argues that profitability has become too abstracted from productive realities. He writes: “There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Because if you ever use your money for something that doesn’t pay off for years, the IRR [internal rate of return] is so crummy that people who focus on IRR focus their capital on shorter and shorter term wins.”

Another metric is called “rate on return on net assets,” or RONA. If profits are judged using this percentage, selling off assets it reduces the denominator in the percentage – thus boosting profits. The choice is clear: sell off assets to maximize profitability.

The elemental problem is that financial measurements fail to represent all the actual value that goes into producing something. This, of course, is the identical dynamic that occurs when markets enclose the commons. The remote executive who engineers an outsourcing deal (or a market enclosure) doesn't care about the many subtle, long-term, contextual factors that are needed to produce a product -- and to continue doing so sustainably. He/she just wants to generate money quickly.

It's incredibly short-sighted, of course, but that's what markets reward and that's what financial “wisdom” now endorses. The business executive with long-term commitments is either a sucker or a monopolist – or a Warren Buffett who has sizeable stores of “patient capital” to invest.

It is small consolation to realize that market enclosures and the hollowing-out of U.S. corporations are simply different aspects of the same pathology. Market enclosures are far more devastating to real people in direct, personal ways. But it is revealing that commoners are not the only ones being victimized by the short-term compulsions of financialization. Shareholders are suffering, too!

Ah, but I don't foresee any new alliances developing between commoners and long-term investors to fight their shared enemy. That, too, is another one of those nasty paradoxes of capitalism.


A perverse analog of the tragedy of the commons

I'm not an executive in the personal-computer industry (I run my own itsy-bitsy software company). However, it seems to me such people have a problem bigger than reliance on metrics such as IRR and RONA. One might even say they face a perverse analog of the tragedy of the commons. China and the other countries where electronic devices are now made are full of people willing to work for next to nothing. If your company doesn't exploit them, other companies that do will be able to undersell you, and you will shortly go out of business.

In a business that moves so fast, where consumer tastes are so fickle, thinking ahead even five years is apt to seem rather impractical. I realize sheer greed does play a role; Apple isn't just getting by, it's racking up record profits, even as it subsidizes its own eventual liquidation. Still, American workers would have to be paid so much more than Foxconn's drudges that it seems reasonable to wonder whether Apple could survive without outsourcing. (By the way, Apple has taken to claiming it has no choice but to outsource because "the U.S. has stopped producing people with the skills we need." ( I suspect this is simply a lie, and it really is just that Americans with the skills they need can't be had for $17 a day.)