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In theory, there's no difference between theory and practice

Date: 22 Dec 2008

How much blame should business schools take for the management thinking that has led to the current world crisis? Has it really all come down to the actions of a few greedy bankers who just happened to find themselves all in control of all the banks at the same time? Or were the seeds for the downfall being sown long ago?

Many managers will swear that they draw very little from the world of academia. Academics are seen by such managers as being theory-obsessed, too far removed from the practical, pragmatic world through which management moves.

And yet, the ideas that have come from business schools completely shape the goals that business leaders accept and embrace, and many of the actions that follow.

For years, business schools have taught that managers have to be carefully controlled because, left to their own devices, they may not do what is said to be their main job - to maximise shareholder value. The interests of managers have to be brought into line with those of shareolders by making stock options a major part of their pay.

These beliefs have become so standard, you need never have set foot inside a business school to have your day to day choices affected by them.

And some of these theories have become fact after the event. If you preach that managers cannot be trusted to run business, and they are purely the agents of the shareholders, then in time the fact that people behave as though this were so, makes it so. Even if this is a bad outcome.

If you think management is a science - like the laws of physics are science - then you come up with some strange notions. Such as the notion that things like ethical values should not be a part of it.

This is where Milton Friedman came in - with his oft-quoted line: "Few trends could so thoroughly undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible".

This is important. When companies do bad things, managers often claim that they were powerless to make alternative choices. The demands made upon them in the market, and through the pressure from the analysts and shareholders, meant that their free choice was wholly absent.

Ford, of course, was unable to move away from SUVs and fundamentally improve environmental performance because its marketplace insisted on big cars. How long ago that now seems.

In truth, there is always a choice. Lloyds TSB used to be attacked by some shareholders for not being more adventurous in the cause of ramping up the profit. Its caution turned into a big positive in the end. And the fact the managers had not simply folded in the face of shareholder expectation was shown to be - good management.

But where does the enormous certainty in Friedman's position actually come from? Why do so few dare to question today the idea that the role of the manager is to 'maximise shareholder value'? When did it stop being good enough to get a 'fair return' on investment?

The other big critics of corporate social responsibility will often cite similar factors. According to some, if a manager spends money on something unrelated to maximising profit, he or she is 'stealing shareholders money'. This is not true.

Shareholders don't own the company - not in the way that you and I would understand ownership. They just own a right to some of the surplus cash flows of the company. They don't own the assets. They don't own the business (which is in law a legal person in its own right). And if they did, then they would have to be directly responsible for the actions of the company. When human rights are abused, it would be the shareholders that got sued - which of course does not happen.

But don't shareholders enable the wealth creation in the first place by providing capital? Sure - but only because the resources of management and other employees are applied to it. The staff arguably have the biggest stake in the company. Although people move from job to job, it is still a harder thing to do than it is to buy or sell shares.

What happens in practice with all these theories?

Take the line that you need to police management to ensure they keep in line with shareholder interests. That means that you have to expand the number of independent non-executive directors on boards, split the role of chairman and CEO and the rest of it.

An academic review of 54 studies on how the make up of the board affects the company's performance showed that the number of non-executive directors has no effect. Another review of 31 studies on the difference made by separating leadership roles showed a similar message. And yet these principles have formed governance law over the last few decades.

The payment of CEOs in stock options has led to all sorts of scandals. It has not lead to shareholders being better served. Even Michael Jensen, the original proponent of the practice, noted in the Economist magazine in 2002 that it hadn't worked out the way he had thought it would.

People were quick to point out that Enron had a number of CSR programmes when they thought this might be a stick to beat the CSR movement with. But Enron also had a board stuffed with independent directors (80 percent), had split the role of CEO and chairman, and granted large stock options to its senior managers.

Why do people cling to a theory that clearly isn't working? Because if you do, you can pretend that management is a science. And you can build models around it that will predict what will happen.

If companies have to take due regard to their impact on other stakeholders in society, it is impossible to model that. It depends on judgement, and instinct, and cultural influence.

Friedman said that one of his major aims was that ethical problems would be left to individuals to wrestle with - such concerns would be removed from management theory, which would deal only with the science of transactions.

But of course there is no such science. Modeling the economy rested upon the belief that people would make rational decisions based upon their own self-interest. But tests with real people showed that they allow their decisions to be tinged by notions of fairness, compassion, and community spirit.

So where does this take us?

First of all, we need to use the current crisis to challenge some of the outdated assumptions that have had their hand in creating it. And that includes the business schools - who should be starting to re-evaluate what we have learned.

We need to start asking some fundamental questions and thinking through what they mean for theory - and practice.

What if, for instance, the goal of maximising shareholder value CAUSES credit bubbles, because the only way to achieve the goal is to ramp up consumption until the point it can no longer be sustained, and collapses?

What if climate change means that we need a business model capable of providing sufficient, but not ever increasing consumption? What would that model look like?

Is it easier to achieve if you assume people can make decisions based on something other than pure self-interest, or is it harder?

Would it be helpful at this point in history if business leaders and business schools had more of a dialogue, or less, on such questions?

ACKNOWLEDGEMENT: This article draws together a number of themes I have covered in different articles over the last few years, but is very much indebted to the late Sumantra Ghoshal, whose 2005 article 'Bad Management Theories are Destroying Good Management Practices' provided the business school / academic angles. I am grateful to Shakti Kapoerchan for drawing my attention to it.

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