Why Stakeholder Capitalism Will Fail (Demo)

On January 5, 2020, Steve Denning writes on Forbes:

Klaus Schwab, Executive Chairman of the World Economic Forum, (Photo by Mikhail Klimentyev\TASS via … [+]MIKHAIL KLIMENTYEV/TASS

“We should seize this moment to ensure that stakeholder capitalism remains the new dominant model.”

—Klaus Schwab, Founder and Executive Chairman, World Economic Forum

Stakeholder capitalism—the notion that a firm focuses on meeting the needs of all its stakeholders: customers, employees, partners, the community, and society as a whole—is now on almost every top executive’s lips.

After five decades of commitment to maximizing shareholder value (MSV), which in 2009 even Jack Welch called “the dumbest idea in the world”— big business now admits that MSV has failed and claims to be embracing a new goal: stakeholder capitalism.

This shift comes as we enter a new decade and big business finds itself under attack from all sides: it has been caught single-mindedly shoveling money to its shareholders and its executives at the expense of customers, employees, the environment, and society as a whole. How will this new gambit fare?  

Stakeholder Capitalism

Talk of stakeholder capitalism is now everywhere. It’s the theme of the Davos Manifesto 2020 announced last month by Klaus Schwab, Founder and Executive Chairman in preparation for the World Economic Forum, where the world’s top business executives will meet later this month in Davos, Switzerland.

It’s also the new mantra of the Business Round Table as announced in August 2019 and endorsed by almost 200 CEOs of the largest corporations. “The statement rejects the whole idea of ‘maximizing’ one value to the exclusion of all the others,” as Steve Pearlstein in the Washington Post notes. “Instead, it acknowledges the need for balance and compromise in serving all of a company’s stakeholders.”

The Origins Of Stakeholder Capitalism

Yet stakeholder capitalism is not a new idea. It was launched by the 1932 management classic, The Modern Corporation, and Private Property by Adolf A. Berle and Gardiner C. Means. The idea was that public firms should have professional managers who would balance the claims of different stakeholders, taking into account public policy. For the next 40 years, it was the general approach of big business in the U.S.

When many big firms attempted to implement it over decades, the perpetual need throughout the organization to keep balancing conflicting claims among stakeholders led to mass confusion and what came to be known as garbage can organizations. This in turn eventually provoked a resort to MSV, the very thing for which big business is now being assailed.

The fatal flaw in 20^th Century stakeholder capitalism was that it offered unviable guidance on what is “true north” for a corporation. If big business attempts afresh to implement stakeholder capitalism, it seems likely to fail for this very reason.

Stakeholder Capitalism As A PR Front

What’s going on here? Cynics have concluded that stakeholder capitalism is nothing more an elaborate public relations stunt espoused by big business to get through the current PR crisis. Business, they say, will go on doing what it has done since time immemorial: making money for itself.

The attraction of stakeholder capitalism as a public stance is that it doesn’t commit big business to do anything in particular. Firms can go on privately shoveling money to their shareholders and executives, while maintaining a public front of exquisite social sensitivity and exemplary altruism.

Yet there is at least one grain of truth in stakeholder capitalism. Big business must ultimately pay some attention to all the stakeholders, including shareholders. If big business systematically shortchanges stakeholders other than shareholders, the stock market may soar in the short term but the decades-long diversion of business income to shareholders results stagnating incomes for most of the population. Inequality consequently increases, with risks that populist leaders will emerge and the political consensus holding capitalism in place will unravel.

Why Big Business Is Under Attack

How did the world end up in this mess? Big business is in political hot water because, for the last half century, it has been pursuing MSV, the idea that the sole purpose of a firm is to make money for itself and its shareholders.

The origin of MSV is often seen as the New York Times article in September 1970 by the future winner of the Nobel Prize in Economics, Milton Friedman, which was in turn a response to the confusions of stakeholder capitalism. Any business executives who pursued a goal other than making money were, Friedman said, “unwitting pup­pets of the intellectual forces that have been undermining the basis of a free society these past decades.”

The grain of truth in MSV is that it made sense to focus on a single goal since mathematically you can only maximize one variable. The trouble was: Friedman chose the wrong single variable—shareholders.

When the firm prioritizes shareholder value above all, the other stakeholders—customers, employees, suppliers, society—tend to get shortchanged. What should have been obvious from the start became apparent after several decades: shareholder capitalism is an unacceptable form of institutionalized selfishness that breeds on itself. Each individual act of selfishness leads to another.

One might think that such a bad idea would have been quickly recognized as such. In fact, it was denounced at the time by Professor Joseph L. Bower of Harvard Business School as “pernicious nonsense.” But MSV steadily gained momentum and by the end of the 20^th Century it had become the gospel of business.

While MSV delivered a gargantuan transfer of assets to the existing owners of shares, it didn’t deliver for the rest of society. The best analysts could see that MSV was a toxic mix of soaring short-term corporate profits, astronomic executive pay, that led to stagnant median incomes, growing inequality, periodic massive financial crashes, declining corporate life expectancy, slowing productivity, declining rates of return on assets and overall, a widening distrust in business.

In the last few years, awareness of these issues steadily spread from technical specialists to the political sphere. Since 2015, Democratic senators, including Minority Leader Chuck Schumer and Senator Tammy Baldwin, have been pushing the Securities & Exchange Commission to do something about MSV.

In 2019, Republicans joined in. In May 2019, the Republican-led Senate Committee on Small Business and Entrepreneurship, faulted CEOs for focusing too much on the next quarter and not enough on the next generation: “Many business leaders,” said the committee chair, Senator Marco Rubio, “seem to care more about returns for shareholders than the people who work for them.”

The Origins—and Return—Of Stakeholder Capitalism

As the critique of MSV came to dominate the political conversation in 2019, corporate leaders felt under threat and began grasping for alternatives to MSV. The notion that firms could be seen as “serving the needs of all the stakeholders” was seen as a safe haven.

What the original founders of stakeholder capitalism overlooked was that big firms are comprise coalitions of participants and groupings whose personal goals, attitudes and values often conflict. Goals and policies are constrained by past behavior, decisions, policies, values, attitudes, rivalries, and differing objectives of individuals and different divisions and subsets of the organization, as well as differing interpretations as to how long and how strongly any new goals and strategies may be retained. External forces like the stock market, the shareholders, regulators, politicians, and the press also bear down on the firm. Actual decisions are compromises among these different and often conflicting elements.

“Stakeholder capitalism” with its call to balance the claims of different stakeholders on a case-by-case base was an invitation to allow innumerable decisions in this morass of differing viewpoints, values, attitudes and ambitions, to be made by different people at different levels o the organization.

In the absence of clear prioritization among different stakeholders, the result was what management theorists called “garbage can organizations.” These were organizations that couldn’t make up their minds. Goals wandered in and out meetings and decisions happened randomly, depending on who was present. The organization often had no explicit preferences or guidelines. It frequently operated on the basis of inconsistent and ill-defined preferences, goals, and identities.

When the top management itself was unclear as to its priorities among the different stakeholders, then the risk of confusion increased exponentially.

The Emergence of Dilbert-Style Managers

Inside the corporation, in the absence of clear priorities among stakeholders, managers themselves could become unclear in their own minds which priorities they were or should be pursuing. One result was the Dilbert-style manager.

The skill set and the attitudes of the Dilbertian manager were identified in a famous Harvard Business Review article in 1977: Abraham Zaleznik’s “Managers and Leaders Are They Different?” The article has been republished a number of times by HBR.

·       First, the manager focuses attention on procedure and not on substance. The manager focuses attention on how the decisions are made, not what decisions to make. That’s because the manager is typically working in a setting where the goals of the organization are neither clear nor perceived as worthwhile. In the place of goals that provide meaning at work and in work, there is a hierarchical structure, precise role definitions, and elaborate rules and procedures, which often conflict: managers have no way of knowing what is the right answer. The only safe place is to focus on process.

·       Second, the manager communicates to subordinates indirectly by “signals”, rather than clearly stating a position. The traditional rule-driven bureaucracy requires both managers and workers to leave their personal views and attitudes behind in the entry lobby, before they enter the workplace. In this world, the managers’ personal views are irrelevant. The only safe way to communicate is to deploy indirect “signals”, which obscure who wins and who loses. The manager can hide behind process: “It is not what I believe that matters: It is what the system requires.”

·       Third, the manager plays for time. With conflicting rules and procedures, and conflicts about priorities between different senior managers, managers have no way of knowing what the right answer is. The idea of using their own judgment is at odds with the idea that they left their own views in the entrance lobby. Hence playing for time and waiting for the dust to settle are ways of always being on the winning side. These CYA routines are played out, up and down the hierarchy.

While these Dilbertian practices helped a middle manager to survive, and enabled Scott Adams to make a fortune by depicting in his syndicated cartoon how these practices play out on a daily basis in large organizations around the world, they also frustrated employees and customers.

The further result has been the misunderstanding and disparagement of management itself, with frequent calls for “leaders, not managers.” The problem, however, was not so much the managers, but rather the Dilbertian settings in which managers found themselves. When top management had failed  to prioritize among competing stakeholders, how could managers and staff at lower levels accomplish that?

The True North Of A Corporation: Creating Customers

In announcing the Davos Manifesto 2020, the chair of the World Economic Form, Klaus Schwab argued that there were only three alternatives: shareholder capitalism, state capitalism and stakeholder capitalism. Both shareholder capitalism and state capitalism are now both political poison. So, Schwab argues, the only alternative is stakeholder capitalism.

In opting for stakeholder capitalism, Schwab missed a better option: customer capitalism. The most successful firms today are those that pursue what Peter Drucker long ago saw to be “true North” for a corporation: “there is only one valid purpose of a corporation: to create a customer”. Generating fresh value for customers is the foundation the basis for generating benefits for all the stakeholders. To be sure, Drucker also saw that there were many other things firms needed to take care of, including safety, integrity, legality, sustainability, and inspiring workplaces, but the overriding goal, the raison d’etre of the firm, which all its forces of a firm must single-mindedly support, if the firm to survive, is to create customers.

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Stakeholder capitalism—the notion that a firm must focus on meeting the needs of all its stakeholders: customers, employees, partners, the community, and society as a whole—is now on almost every top executive’s lips. Whether it’s the Davos Manifesto 2020, or the Business Round Table as announced in August 2019,  or the distinguished professors at Harvard Business School, stakeholder capitalism is all the rage. Yet it’s bound to fail, as I explained in my last article, “Why Stakeholder Capitalism Will Fail”.

The good news is that there is a better idea: customer capitalism. As Peter Drucker declared in his book, The Practice Of Management, in 1954, and reiterated in the years that followed, “There is only one valid purpose of a corporation, to create a customer.”

Like most foundational ideas—like honesty, integrity or accountability—that are the basis of a prosperous society, customer capitalism isn’t a new idea. It‘s not some shiny new object, just discovered by money-seeking consultants hawking the next new management gadget.Today In: Leadership

Nor is customer capitalism a secret. For those with eyes to see, it’s as plain as day. The most successful firms today are those that pursue what Peter Drucker long ago saw to be “true North” for a corporation: creating value for customers. Making money for the firm itself and its shareholders is the result of delivering value to customers, not the goal. Generating fresh value for customers is the basis for generating benefits for all the stakeholders, not vice versa.

To be sure, Drucker noted that successful corporations need to take care of many other things besides customers, including safety, integrity, legality, profitability, sustainability, great workplaces, respect for the community, the environment, and so on. But the purpose, the overriding goal, and the very raison d’etre of the firm, to which the firm must single-mindedly direct its efforts if it is to survive, is to create customers.

We Live In Age of Customer Capitalism

The realization of Drucker’s vision of 1954, and its emergence as “customer capitalism”, was announced in January 2010—exactly ten years ago—by the “Vatican of management”, Harvard Business Review, in the article, “The Age Of Customer Capitalism,” by leading management thinker, Roger Martin, the former Dean of the Rotman School of Management at the University of Toronto.

“Modern capitalism, wrote Martin, “can be broken down into two major eras. The first, managerial capitalism, began in 1932 and was defined by the then radical notion that firms ought to have professional management. The second, shareholder value capitalism, began in 1976. Its governing premise is that the purpose of every corporation should be to maximize shareholders’ wealth. If firms pursue this goal, the thinking goes, both shareholders and society will benefit. This is a tragically flawed premise, and it is time we abandoned it and made the shift to a third era: customer-driven capitalism.”

Peter Drucker’s customer capitalism is a moral posture. It is the opposite of the institutionalized selfishness of shareholder capitalism, in which the purpose of a firm is to make money for itself and its shareholders. In customer capitalism, work, firms, management are in their essence about human beings creating more value for other human beings.

The shift from shareholder capitalism to customer capitalism is not simply an adjustment of the calculus by which firms measure their success. It entails a different mental model of how the world works. The shift is as fundamental in scope and implications as the Copernican Revolution in astronomy.

The Copernican Revolution In Astronomy

On the surface, the Copernican Revolution in astronomy was no more than a simpler way for astronomers and astrologers to calculate the paths of the planets: instead of thinking of the Sun as revolving around a stationary “center of the universe”—the Earth—Copernicus said we needed to think of the Earth as one of several planets revolving around the Sun.

Yet hidden within this apparently innocuous mathematical adjustment was a different view as to how the universe and the human world worked. This view would in due course undermine the plausibility of established religion in general, the Roman Catholic Church in particular, and the Divine Right of Kings, on which most existing governments in Europe rested their claim to legitimacy. Copernicus’s theory, first published in 1543, thus began an inexorable process of inquiry into the entire organization of society. Understandably, the inquiry was resisted by the powers-that-be. Several centuries went by before it was fully accepted.

The Copernican Revolution In Management

Similarly, on the surface, customer capitalism is the simple idea that a firm needs to pay attention to the customer because it is the customer who generates the firm’s revenue and hence ensures its survival.

Yet customer capitalism isn’t merely a suggestion as to how firms measure their success. As with the Copernican Revolution in astronomy, embedded within customer capitalism is a different vision of how the world works.

At the heart of customer capitalism today is the idea that the world has changed. Power in the marketplace has shifted from the firm to the customer. Abruptly, frighteningly,andto the great surprise of command-and-control managements of big firms,the customer is now the boss.

Globalization, deregulation, and new technology, particularly the Internet, have provided the customer with choices, reliable information about those choices and the ability to interact with other customers. Suddenly the customer is in charge and expects value that is instant, frictionless, intimate, interconnected, and preferably free. Now firms survive and thrive only so long as they are nimble enough to adapt to customers’ shifting needs and desires better than the many other firms vying to do likewise. The result? A Copernican Revolution in management.

The Results Of Customer Capitalism

Ten years after Martin’s article, the initial results of this Revolution are in. The largest and fastest growing firms on the planet are those that concentrate on delivering value to customers. Their names are famous: Amazon, Apple, Facebook, Google and Microsoft. They have a combined market-capitalization of some $4 trillion. All of these firms have flaws, which need to be redressed. But these firms shown beyond question the money-making potential of customer capitalism.

The principal reason they have been so successful is that they have delivered to customers the current gold standard of corporate performance: instant, frictionless, intimate, interconnected value at scale, and preferably free. Firms that can deliver this have become rich beyond the dreams of avarice. Those that can’t are still struggling.

The Necessary Transformation Of Management

Why then don’t all firms commit to customer capitalism and deliver the gold standard of corporate performance if the financial gains are so great? And why are so many big businesses, the World Economic Forum, the Business Round Table, and Harvard Business School, wasting their time with the already-failed notion of stakeholder capitalism?

It turns out that implementing customer capitalism is not as simple as it looks. Delivering the new corporate gold standard of “instant, intimate, frictionless, interconnected value for customers at scale” entails a transformation in management. The slow-moving command-and-control bureaucracies of the 20^th Century are incapable of meeting the needs of customers who want things “now, just for us, with no hassle, compatible with what we have already, wherever and whenever we want it.”

Embedded in customer capitalism is a different worldview, which threatens the hegemony of all the big hierarchical bureaucracies that systematically dispirit those doing the work, frustrate those for whom the work is done, repeatedly disappoint society and yield increasingly meager returns for investors.

Customer capitalism has thus begun an inquiry into the contribution of command-and-control leaders who currently preside over large organizations in both the public and private sectors. It shreds the assumption that executives of big corporations are by definition value-creating entrepreneurs, worthy of extraordinary compensation. It invites a re-examination of the duties, rights and privileges of all those who happen to be occupying managerial positions.

A Journey Into The World Of The Customer

The shift in the center of the corporate universe from firm to customer is a radical idea. As my colleague, Hunter Hastings of Economics For Entrepreneurs points out:

“Value is in the mind of the customer. It’s an experienced benefit, a feeling, an emotion. That’s why it’s called subjective. If value is in the customer’s mind, then firms can’t ‘create value’ (business school lingo) and there is no such thing as ‘shareholder value’. Firms can create customers, and they do so by facilitating the customer’s value experience. Meeting the needs of customers lies entirely in the customer domain.”

This is a domain that command-and-control management is unfamiliar with. It lacks the aptitude to deal with it.

A Shift From Complicated To Complex

A domain that management can control—the internal workings of the firm, its processes, systems and modalities—is a very different domain from a world in which the customer is the boss. The command-and-control domain of the firm is often complicated, but it is manageable. It is controllable. It is predictable. It can be governed by routines and processes. It can often ignore how the human beings involved in its processes might feel about things. The command-and-control corporation is a machine that grinds relentlessly onward.

Bureaucracies, the executives who run them, and the business schools that teach them, are often much more comfortable solving complicated problems of these command-and-control machine-like organizations than they are understanding and mastering the complex, interactive world of customer capitalism, where the world is governed by the all-too-human values, attitudes, feelings, and dreams of customers.

Dealing with complexity means grappling with uncertainty and the need to be adaptive and agile, to learn by doing, and to respond to feedback. The discomfort in dealing with complexity is a key reason why executives have been slow to do what us necessary to embrace customer capitalism. Executives have to stop trying to “command and control” the world and instead discover how to run their organizations in an agile, adaptive fashion.

A few years ago, surveys by Deloitte and McKinsey suggested that less than 10% of big firms were making progress in becoming more adaptive and agile. More recently, a survey by PwC suggests that perhaps as many as a quarter of respondents from big firms believe they are making progress in redefining their core business model and changing the way they operate.

These are difficult lessons, foreshadowed back in 1954 by Peter Drucker, but ones that the entire economy is now having to learn. As Kodak, Blockbuster, Nokia, GE, and many others, have discovered, the message is simple: change or die.

https://www.forbes.com/sites/stevedenning/2020/01/10/the-triumph-of-customer-capitalism/#3efad7b44fb7