Indirection and the character of capitalism (Part II)

When last we met, we saw that extending the basic capitalist circuit from M-C-M' to something much more indirect, like M-(M-(M-(M-C-M')-M')-M')-M', changes the character of capitalist activity. The controlling party in the more indirect case has little information about or ability to improve the core business process — the combination of commodity C and labor into a product salable for M'.

Our indirect capitalist has basically one meaningful lever that she can exert down the chain of control, which we've called the squeeze. She can try to encourage greater efficiency by insisting that the layers beneath her remain "lean", with a minimum of surplus cash and a maximum of financial pressure.

Her indiscriminate austerity can in some cases lead to real efficiency improvements. But she has no way to titrate the squeeze. She cannot even be aware of the subtleties of the core business process, and the relationships that support it. So it becomes likely that the austerity she imposes will lead to foolish economies, forcing the underlying business to prioritize short-term, "hard" cash flow over "soft" intangibles like relationships, reputation, maintenance and development of skills, standards of product quality. The net effect is to degrade the capabilities of the business, and over time, its economic value as well.

This pathological outcome is often rewarded rather than punished by market forces, even over long periods of time, despite the clear impairment of the core business that it provokes.

Let's understand how this works. We began with an economic unit, M-C-M, and we posited a buyer, so it became M-(M-C-M')-M'. But often a purchaser of enterprises doesn't purchase just one! A "holding company" may have multiple units. Suppose our buyer purchases three units. Then we have a structure that looks like this:


Of course, we can have more than one level of indirection:

          / \(M-C-M')/ \
         /  /(M-C-M')\  \
         \  \(M-C-M')/  /
          \ /(M-C-M')\ /

Maybe the first diagram is a regional supplier that holds three business units (each one its own geographically distinct shop with separate management). The second diagram is what happens when a national firm combines three such regional suppliers.

We might further imagine a PE firm "rolling up" three such national firms, hoping to create an industry powerhouse. The level of indirection would increase by one, and the breadth would grow from 9 once-distinct commodity-transforming business units to 27.

           / \(M-C-M')/ \
          /  /(M-C-M')\  \
        / \  \(M-C-M')/  / \
       /   \ /(M-C-M')\ /   \
      /     M-(M-C-M')-M'    \
     /       \(M-C-M')/       \
    /        /(M-C-M')\        \
   /        M-(M-C-M')-M'       \
  /        / \(M-C-M')/ \        \
 /        /  /(M-C-M')\  \        \
 \        \  \(M-C-M')/  /        /
  \        \ /(M-C-M')\ /        /
   \        M-(M-C-M')-M'       /
    \        \(M-C-M')/        /
     \       /(M-C-M')\       /  
      \     M-(M-C-M')-M'    /
       \   / \(M-C-M')/ \   /
        \ /  /(M-C-M')\  \ /
          \  \(M-C-M')/  /
           \ /(M-C-M')\ /

Obviously, in real life, actual bundlers or acquirers of businesses don't always purchase precisely three firms. We've chosen that number for convenience. Purchasers in real life aren't neatly stacked into levels. Very big firms can acquire tiny assets directly.

But the broad point holds — each degree of indirection magnifies potential scale. One CEO who can handle three business-unit managers as direct reports can indirectly manage many, many units, if her direct reports can also handle three subsidiaries.

It remains the case, as it was in our earlier discussion, that each with each level of enclosure, information is lost about the units that are subsume. It also remains true that the controlling interest has basically one lever by which to try to improve the technical efficiency of inner units, the squeeze.

If the internal capabailities of businesses — how well they produce their product or provide their service — were what mattered most, these behemoths of agglomeration would be stumbling dinosaurs. They would fail in the marketplace. Indeed, during a more enlightened time (the 1970s), it became conventional wisdom that conglomeration was inherently stupid, for exactly the reason sketched here.

But firms have external capabilities as well. Rather than improve business processes internally, they can alter the environment within which their business units compete, and find ways to help those units gain advantage even despite diminished capabilities and product quality. Instead of "focusing on their core technology", in the old business lingo, controlling interests of highly indirected units can exploit market power and political influence to enhance profitability.

Indeed doing so becomes the core technology of the holding company. As the degree of indirection grows, the holding company becomes ill-suited to compete on the basis of technical excellence with smaller firms whose management sits much closer to the technical process. They would be outcompeted in that niche.

Further indirected firms are instead specialists in exploiting market and business power. As an economy tolerates greater degrees of indirection, one should expect technical quality to decrease while strategies based on exploiting market and political power come to dominate.

BOEING 777                          |
by Jon Hyatt                        |          .-'-.
                                 ' ___ '
                       ---------'  .-.  '---------
       _________________________'  '-'  '_________________________
        ''''''-|---|--/    \==][^',_m_,'^][==/    \--|---|-''''''
                      \    /  ||/   H   \||  \    /
                       '--'   OO   O|O   OO   '--'


There are, of course, a lot of caveats.

Business processes may have technical economies of scale and scope. The argument above tacitly assumes that each business unit is already at the scale that exhausts technical economies of scale. If that's not the case, perhaps purchasing equipment and talent exploited too artisanally, and then bundling them into an enterprise that operates at scale, could yield efficiencies that more than compensate for any information problems or the social costs of market power.

Of course nearly all business combinations tout supposed "synergies" by which greater technical economies of scale will be exploited. Both logic and experience suggest we should be wary of those claims.

Logically, there is no need for a firm operating capably but at an inefficient scale to take on the information costs associated with less direct ownership. To improve efficiency, a more direct controlling interest can just raise external capital and grow to scale. This way, control remains at the level of the business unit, where managers understand the technical process, and are drenched in soft information about relationships with workers, vendors, and customers.

If — but only if — firms are expected to thrive or die primarily based on technical prowess, then capable 19th-Century-style capitalists, hands dirty from the processes they manage, should be the ideal parties to raise external capital. Finance would mostly be a competition to find mid-scale business (most technical efficiencies are exhausted by moderate scale) whose principals are hip-deep in managing their firms.

But if financiers see market power as the great determinant of success or failure in an industry, capital will flow to bundlers rather than do-ers, to important people rather than talented builders. Once some firms enjoy outsize market power, it becomes implausible for technical excellence alone to compete. A bad equilibrium takes hold. Capital providers expect winners to win, and become reluctant to finance smaller units, unless their exit strategy is to be acquired by a bigger fish. Investors understandably perceive a "kill zone" in going against "market leaders", and don't want to risk capital there.

"Market leaders" then substitute predatory pricing for technical acumen, making quick work even of superior competitors who can't raise external capital to outlast the assault. And they can't. They would have raise a tremendous amount of capital, on incredible faith by investors, to last long enough that their less capable but better resourced competitors would even come under pressure to relent.

Beyond the borders of Hyde Park, South Chicago, tactics like predatory pricing, payola, and construction of advantage by exerting political influence are effective. Capital providers understand this, so are disinclined to invest in quixotic new entrants. Then high cost of capital becomes yet another reason why smaller, more capable firms cannot compete.

Any hope of a diverse "ecosystem" collapses. Only the consolidated survive.

Ironically, given the hype bundlers deploy to justify acquisitions, even when there really are unexploited technical economies of scale across subunits, bundlers may lack the information and skill needed to recognize and exploit them. It doesn't matter. "Exploiting synergies" was always at best a secondary aspiration. Mere acquisition is enough to increase the bundler's market power. If there is "efficiency improvement" available, it is usually to shut down elements of the acquired business unit, eliminating competition while letting other units exploit the zombie brand.

This may indeed be business-efficient! Revenue goes up! (We sell more brands, against less competition.) Costs go down! (Workers are laid off.) But no production efficiency is introduced. No business unit is transformed to operate at a more efficient scale. The only talent actually deployed is keeping a straight face while you gush to the world about the synergies.

Actually exploitating economies of scale would involve neither retaining acquired business units, nor shutting them down, but combining them. It would require bringing the talents and assets of multiple business units together to hammer out a unified processes with thick information flows. This is hard, and risky. It requires deep knowledge of the various businesses, and still often fails. Indirect controlling interests know enough to know this. They don't usually try.

Berle and Means famously grappled with the separation of ownership and control inherent in modern corporations. In a public company, the controlling interest is really management and the Board of Directors, even though in principle the "owners" of the firm are shareholders. How do we prevent the managers of the firm, who are present and effectively control it, from putting their own interests before those of dispersed, distant, disorganized, passive, shareholders?

Indirection turns that logic on its head. With indirection, owners remain distant, but they are organized, unified and active. Instead of protecting owners from managers, the struggle becomes to protect productive business units and the broad public from the predations of owners whose competitive strategy is to accumulate and exploit market power and political influence.

And not necessarily owners.

In order to explore "indirection', we've started by imagining small firms getting acquired and bundled into bigger agglomerations, yielding a kind of syndrome where

  1. The controlling interest of a large enterprise is informationally distant from the units in which core business processes occur
  2. The controlling interest imposes dictates on the units in which core business processes occur, even though it lacks detailed information about their operations and circumstances. Usually this is a "squeeze" to maximize the short-term cashflows remitted to the controlling interest.
  3. The dictates imposed by the controlling interest successfully achieve short term objectives, but impair the longer-term technical capability of the agglomeration.
  4. The agglomeration enjoys competitive advantage despite impairment of its internal capabilities, by shifting its focus from internal process to external action. It deploys market power and political influence to manage the environment in which it competes, rather than pursue production excellences.

It is the syndrome, not the particular history, we are interested in. We claim this syndrome amounts to a niche or equilibrium that many industries find, and that the broader economy and financial system comes to accommodate or even demand, ensuring its reproduction.

The controlling interest need not be owners. The term chickenization is derived from the experience of chicken farmers who are notionally independent, but who work under contract to integrators. Integrators both supply the chicks and feed, and pay for bulked-up birds. They dictate nearly every aspect of "independent farmers'" production process, yet squeeze them (setting them against one another in tournaments) to somehow fatten their birds ever faster. The integrators are the controlling interest, by virtue of the monopsony power they wield, even though they never formally acquire the farms that raise the chicks. I don't think anyone could argue that Tyson Foods, Pilgrim's Pride, or Perdue produce the healthiest or tastiest or in any sense best chickens. To the degree those leviathans seem to be "efficient" it is largly by virtue of shifting costs and burdens to workers, farmers, and consumers' long-term health in exchange for keeping prices at the register cheap. The chicken farmers they integrate have little scope in which to innovate. Product quality simply is not the basis on which these firms compete.

Boeing is an interesting mix. It has grown informationally distant from the units where core business processes occur. However, this was not because it acquired but failed to integrate new firms, but simply due to a change in management in 2003. The new management had no visibility into Boeing's traditional, very excellent, technical processes. What they could not measure, they could not value, discipline, or control. So they undertook to reorganize the firm to be more legible and more "bottom-line focused".

The reorganization succeeded, in the sense that the old technical processes were diminished, and replaced by contracts with outside vendors, which the new managers were capable of negotiating, understanding, and monitoring. Sometimes the outside vendors were spun out of Boeing itself.

Unfortunately, this new regime is technically far inferior to the one that it replaced. Even competently outsourced work is more informationally distant than the well-integrated in-house process which Boeing had enjoyed when its leadership had been promoted from within its own ranks. And Boeing's outsourcing hasn't always been very competent. "Negotiating great pricing" feels like a competence to a manager. But when you negotiate from a firm you just spun out better pricing than the costs you would have borne if the work were still in-house, probably you haven't achieved some magical market efficiency. Probably you've just bullied a supplier into cutting corners, and hoping you won't notice.

Boeing has a great deal of market power and political influence. The firm is essential to the United States in both commercial aviation and defense markets. Not many firms can get away with killing 346 people through incompetence and gross negligence in spectacular mediagenic accidents, yet face almost no meaningful sanction.

The new, more outsourced Boeing is substantially a controlling interest of its smaller suppliers, over whom it wields tremendous monopsony power. Those great prices it negotiated, all those efficiencies that eventually turned into catastrophies, were just the squeeze.