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February 12th 2010 No Comments

Part I: Roger Martin on the Canadian dimension of the crisis

Roger Martin is dean of the Rotman School of Management in Toronto. Previously he was a director with the global strategy consulting firm Monitor Company, and founded its Canadian office. He has written on integrative thinking, business design and corporate citizenship.

“By burning vast amounts of hydrocarbons or pouring poisonous stuff into rivers, we may get a higher GDP per capita number, but no detriment gets charged to the equation – even if you have wrecked the planet’s stock that much more.”

Roger Martin - Photo & Copyright: Rotman School of Management

Roger Martin - Photo & Copyright: Rotman School of Management

NFB: Many economists argue that 25 years of unfettered free market policies, deregulation and privatization inevitably led to the current crisis. Do you share this view?

Roger Martin: Yes and no. For me, the causes of the crash are narrower. I haven’t seen any credible analysis that deregulation or privatization were the main causes. I pin a lot of the blame on the theory of executive compensation that came into being with an influential article written in 1976 that posited agency theory.

The idea was that corporations have principals, who are the shareholders and agents, the managers who work for the shareholders. According to this 1976 article, written by Michael Jensen and William Meckling, agents are less perfect than you’d want them to be. Instead of working assiduously to better the lot of the principals, whose money they are managing, they’re actually attempting to feather their own nest. So we have this “principal-agent problem.”

This argument had incredible influence, bringing about a massive shift in the management of companies towards the goal of shareholder value maximization. As the theory went, in order to line up principals and agents, you had to give agents large dollops of stock-based compensation. If the stock did well, the shareholders would do well and their agents would do well. It was all aligned.

I would argue that this particular managerial theory is at the heart of the recent crash. Instead of trying to make their businesses do well – managers started trying to jerk around the stock price. This is what was responsible for the market excesses, for pushing up the stock market to a level that meant it had to crash at some point. So rather than attributing the meltdown to deregulation or privatization, I think it was this compensation strategy – a very unhelpful theory – that was the biggest cause of the precipitous crash.

NFB: When you criticize agency theory, you talk about the real market versus the expectations market. How do you distinguish the two?

I use a sports metaphor that some people find helpful. Let’s imagine a game of NFL football. Every Sunday two teams head out onto the field and play a real game, where quarterbacks throw real passes, and running-backs score runs – and they score real touchdowns. At the end of 60 minutes, there’s a real score, with a real winner and real loser. It’s a $10-billion-a-year game, the biggest game in America.

Associated with this real game is another game – not about reality but about expectations of the future. It’s called betting – and by various accounts, it is actually bigger in terms of revenues than the real game.

From Monday through Saturday, people imagine what they think is going to happen on Sunday, and they bet on that. Let’s say the Buffalo Bills are playing the New England Patriots this weekend, and fans are saying that New England will beat Buffalo by 7 points. So that’s a point spread of 7 points – an expectation of the future event. Bookies establish the point-spread, adjusting it during the week, to make sure there’s an equal amount of money on both sides. So while the real game actually happens, the expectations game is all about imagination.

A similar thing happens in the world of business. You have a company – say General Motors – that has real factories with real workers who get paid real money to make real cars that get sold. And at the end of the year you have real profits or real losses.

Meanwhile there’s an associated expectations market, which asks the question: How do we think GM will do in the future? On the basis of that, we’ll decide whether or not to buy their stock. But it’s all about expectations of the future – it’s not about anything real. It’s about the collective belief in the future – and that’s the expectations market.

Now – with NFL football there are very clear rules governing how the principals – the players themselves – can participate in the expectations market, i.e. betting on NFL games. If they ever bet on games, even once, they get kicked out of the sport for life.

So let’s look at the business world, where we also have both a real and an expectation market. What’s our practice? Not only do we not forbid CEOs from playing in the expectations market, we insist that they play in the expectations market in a dramatic fashion by giving them the vast majority of their compensation in stock options, restrictive stock and so on.

The belief is that it’s an incentive to increase performance in the real market. But in fact it’s an incentive to increase performance in the expectations market – which means going down to Wall Street or Bay Street and hyping the stock. Or making acquisitions that are a really dumb idea but make it look like you’re growing quickly. Or doing shady accounting to make it appear that your earnings are rising faster than they really are. It was this compensation theory that was at the heart of the meltdown.

NFB: How do you situate Canada within the current global economic crisis?

Canada was in better shape going into this crisis than almost any other developed country, and that has been enormously helpful. It’s a reversal from the downturn of early 90s – when Canada was in crummy fiscal shape. Going into that downturn, we had a $30-billion deficit, which was huge at the time, while the United States was in better shape. We made some pretty savage cuts then to deal with the situation – cuts that have turned out to be bad for us in the long term.

This time round, Canada’s fiscal situation was the best among the Group of 7 countries as we entered the downturn. We’ve been busily paying down debt for the past 10 years, so that our accumulated debt was way down and our budgets were balanced. So when we’ve had to undertake extreme budgetary measures to stimulate the economy, as all countries have had to do, it was less damaging for our economy than for many others.

Compare that to the US, which is looking at paying interest on a trillion dollars of debt – bigger than almost any economy in the world. That’s their public debt – and they’ll be paying interest on it for a long time. While we Canadians don’t have a great budget situation right now – it’s better than most. This downturn has been bad for every country in the world but thus far I don’t think we’ve been put in position of doing long term damage to our economy.

NFB: Joseph Stiglitz and other economists criticise GDP per capita as an ineffective yardstick of economic wellbeing. What’s your position on this?

Martin: It’s hard to argue with people who say that GDP per capita is a limited system of measurement. That being said, it’s a bit like democracy – it may be a flawed system, but it’s less flawed than other systems.

There are two main drawbacks with GDP per capita. One – it is only a monetary measure. It’s all about things monetary and it’s absolutely clear from any research done on the subject that people with more money are not happier than people with less money. The implicit argument is that greater GDP per capita makes people happier, with greater wellbeing, but it doesn’t work that way. Wellbeing is also about how money is distributed – and cultural understandings of community and civic participation.

The other drawback is that it doesn’t account for the use of the environment – and I mean the environment writ large, not just pollution. GDP is a flow number, measuring how much money turns within the economy in a given year, but it is silent on the stock number – the stock of land, environment and air quality. It does not measure what we had at the start of the year versus the end of the year. It is neutral on that. So by burning vast amount of hydrocarbons or pouring poisonous stuff into rivers, we may get a higher GDP per capita number, but no detriment gets charged to the equation – even if you have wrecked the planet’s stock that much more.

NFB: What about the alternative models to GDP being proposed?

I think it will be a long time before GDP per capita is replaced. It’s like the QWERTY keyboard. It may be really inefficient, but everyone has been trained on it, and everyone’s still using it. In the same way we’re still using the Stanford-Binet IQ test even though we now know its limitations. These models have staying power once they get ensconced.

So many systems are set up around GDP per capita that it will take a while to evolve into something else. There is no other measure out there right now that is as clean and simple, and as well understood, as GDP per capita. So if I were a betting man, and I was wondering what would be the dominant way of comparing economies in five years time, I would still be betting on GDP per capita.

Philip Lewis – researcher-writer with the NFB’s GDP project – asked the questions.

Read the second part of the interview here: Part II: Roger Martin on the Canadian dimension of the crisis

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