We are setting ourselves up to relive A Tale of Two Cities by Charles Dickens, except that today it’s the story of two Americas. Just read the headlines: The stock market is booming. Corporate profits are soaring. Business is celebrating historic cuts to corporate taxes. No wonder business leaders are positive about the future. For the wealthiest among us, high fives are indeed in order.
Predictions from government leaders trumpet big benefits to all segments of America — another trickle-down from the rich and big business to all Americans. The rising tide of tax cuts will lift all boats, we are told. But, as in the past 40 years or so, only about 20 percent of Americans have seen their quality of lives go up exponentially. This upper fifth have been reaping all the rewards. They enjoy the best education, access to formal early cognitive development in school, as well as after-school programs, excellent high schools, and the top universities. This has become a plutocratic, privileged group, which enjoys huge tax benefits, exclusive business networking, and the use of their position and capital to influence government policies and more.
But just around the corner, or literally in the neighboring ZIP code, there is another America. Here, nearly 60 percent of America’s homes have to borrow money to put food on the table. This reality is staggering. An economically viable middle class with the ability to grow and contribute to a prosperous GDP simply does not exist. Tragically, almost all of our national income growth flows to the highest 20 percent of earners. In the upper middle class, sandwiched between the eviscerated middle and the thriving top 20 percent, households enjoy an anemic average of only $8,500 in annual discretionary income.
This reality drove Nobel prize-winning economist Joe Stiglitz to assert that four out of five Americans will experience some form of poverty in their lifetimes and former chair of the Fed, Janet Yellen, was widely quoted as saying that a $400 unplanned expense could not be managed by most Americans. In this other America, school dropout rates are high, the quality of education is poor, early education is virtually nonexistent, too few attend college and even fewer graduate. Some 54 percent of all single-parent households are headed by a single mother with a high school education or less. In this other America, wages are grossly inadequate for a decent standard of living and the nuclear family frays under the pressure.
Business must take action, before catastrophic social political turmoil takes over. The status quo is not sustainable.
This insidious income inequality drives down opportunity. Simply put, we’ve created a modern America with an Indian-style caste system where it is almost impossible to move up the socioeconomic ladder. The facts prove it. The so-called Gatsby Curve shows that the United States is the most immobile society among all developed nations. And this gruesome inequality keeps growing every day, begging for some constructive action by business and government. Despite promises during the last election season, the government has done nothing to help this existential crisis. Business must take action, before catastrophic social political turmoil takes over. The status quo is not sustainable.
The causes of inequality
There are many reasons for this inequality, which began to undermine American life some four decades ago. It was driven, in part, by the forces of uncontrolled and misused technology, as well as the growth of developing industrialized nations. China, India, Brazil, Mexico and others formed a rival pool of low-wage manufacturing. Corporations housed in developed nations, and American businesses in particular, were all too eager to ship out manufacturing and routinized jobs. Government policies too often supported the owner/manager group against the interests and well-being of employees. Private industry unions lost power and influence. Sadly, business was to become a major force in generating this inequality. And in an unfortunate but consistent fashion, business was at the heart of using technology, globalization, and government incentives to turbocharge the growth of inequality.
Just as business helped create the two Americas, business is the only institution that can equalize our country by creating widespread prosperity and growth. Government can play a role, but it is a supporting role in fostering, encouraging, and incentivizing the growth of prosperity. In the end, only business, with its $18 trillion contribution to our economy, has the resources to make it happen. By contrast, the public sector’s $4.5 trillion in annual resources is mostly committed to the military, healthcare, and Social Security. There are relatively small amounts of discretionary resources for government to impact this existential crisis of inequality. Business must step up to the plate.
The role of business in building the middle class
Our modern era ushered in a remarkable version of free-market capitalism. It proved to be the most powerful generator of prosperity and growth humankind ever created.
Nowhere in the world was this rapid rise in prosperity more astonishing than in the United States between 1945 and the late 1970s. The burgeoning U.S. economy enabled millions from lowly backgrounds to prosper and build a better future for their families. The greatest achievement of this Golden Age was the creation of the world’s largest consumer market: America’s middle class.
After World War II, the net effect of this free-enterprise capitalism was to build America as the top economic and military force in the world. Corporations worked to optimize the interests of critical stakeholders — customers, employees, corporations, shareholders, and the larger community. Employees were treated with deference and shared in the productivity and innovation they created.
The corporation was well served and shareholders were huge beneficiaries of the fruits of the employees’ labors. The implicit contract between society and business was being fulfilled. Business was given two significant advantages: considerable tax preferences for business over individuals and limited liability for investors and shareholders so they could invest their money with minimal legal risks. In return, business was to behave as a good citizen — responsible for paying people fairly, treating workers decently, and creating new jobs. This system worked beautifully and, as late as 1980, the U.S. Chamber of Commerce championed those roles for business.
The hijacking of free-market capitalism: shareholder primacy
Four decades ago, this remarkably creative configuration of free-market capitalism underwent a tragic transformation into a single focus on the shareholder. Economist Milton Friedman proclaimed that the only role of business was to create shareholder value. In relatively short order, this notion morphed into one where short-term shareholder value was maximized to produce quarter after quarter of unfailing gains.
American workers are now a disenfranchised group no longer capable of participating in our economic growth… The average American has been forgotten.
The business and societal impact of these four decades of shareholder primacy, coupled with globalization, technology, and other factors, has been catastrophic. It has resulted in forty years of flat employee compensation. Profits, innovation, and productivity went up, but the vast majority of employees shared little of these truly extraordinary gains. The additional tragedy is that employee compensation is now considered simply a cost to be compressed as far as possible — even when that cost-cutting will diminish the future potential of the company. All but the most senior employees have become commodities. They feel the lack of appreciation and see the dismal rewards for the work they do. As a result, their motivation and creativity wane.
This shareholder primacy culture keeps wages flat while returning, on average, 90 percent of operating profits to shareholders. This has been achieved through a dividend rate representing 36 percent of operating income, the highest rate since 1933, stock buybacks (now at the highest levels in recorded history), cash hoarding (overseas or on balance sheets), and diversion of investment away from both R&D and basic research.
The financial markets and a group of predatory shareholder activists serve as the enforcers. The net effect of this version of free enterprise capitalism generates the highest profit margins in history for businesses while decimating what was once a thriving middle class. American workers are now a disenfranchised group no longer capable of participating in our economic growth. The stock market soars while the middle class stagnates. The average American has been forgotten. As a most unfortunate corollary, the principle of shareholder primacy holds that the vast majority of employees are fungible assets. Companies aren’t set up to recognize and reward the average employee as the fulcrum of a company’s ability to earn a profit, even though creative, customer-focused employees are crucial to productivity — especially when they generate innovative improvements to business systems or product lines.
This basic philosophical change turned out to have catastrophic consequences. One wave after another of new technologies would sweep through enterprises to increase productivity, not by adding value, but by replacing American workers. Business began outsourcing tasks overseas. Some of the moves made sense; others simply helped bolster foreign competition. But shareholder primacy cared not a whit about people outside the C-Suite or the long-term viability of the company. If there were no short-term fixes, the CEO would be fired and rewarded comfortably as he departed. If that didn’t get results, shareholders would just dump the stock and move to a brighter opportunity. Worse yet, predatory activists could move in, extract cash, slash employee costs, eliminate R&D investments, and eventually flip what remained of the company.
Today in America, employees do not share in the incremental value of the productivity and innovation they produce. As a result, the only people who can produce increases in innovation and productivity — the employees — are dramatically under-motivated to do so. A recent Gallup survey showed that more than two-thirds of American employees are truly disengaged from the companies they work for. The end result is a labor market that divorces compensation from output and a financial sector determined to extract as much value as possible from American business.
Business can reimagine free-market capitalism and rebuild the middle class
Some enlightened employers recognize that they need to do something to change this deplorable system. A good many companies realize that people do matter and that our low productivity and innovation could be increased by the distributed creativity of the workforce. Home Depot looks to the “man on the floor” in its stores as the critical driver of business. And so does Costco, Starbucks, Pepsi, Delta, Publix, and many others in the vanguard of a new paradigm that places the employee as the most crucial source of a company’s success. It is interesting to note that the very successful, world-leading tech companies have violated all the rules and demands of shareholder primacy as they have grown and thrived. They pay people well, respect and reward their employees, and invest heavily to invent and reimagine their companies on a continuing basis — finding new ways, large and small, to delight customers.
Today, with low interest rates, money has become cheap and ubiquitous. The shareholder as equity provider is no longer the differentiator between success and failure. People are. Employees are a company’s core competitive advantage now. They are the primary creators of new value, but that’s true only if they are satisfied and motivated. This is not some new, radical way to think about making a profit. It’s essentially the way we did business half a century ago, restoring free-market capitalism’s sense of responsibility to multiple stakeholders, and to our society as a whole.
The ideal solution for everyone is not a wealth transfer from shareholders to employees. Rather, it is simply for employees to share incrementally in the value they create through on-the-job innovations in processes and systems or by generating ideas for new products and services — as well as the increases in productivity they help generate.
Companies must increase investments in their own businesses, for the long term, to become more competitive and to create new jobs. Each company needs to adapt and adjust to this new normal with its own wisdom and flexibility, given the dynamics within their own enterprise and industry. They need to think about wages in the context of the cost of living in their own region. Abundant market data shows that when companies organize themselves around the welfare and satisfaction of employees, then employees devote themselves to the welfare and satisfaction of customers. Everyone wins. Every stakeholder, including the shareholder, does better than they do with companies that have the opposite attitude toward their people. From a societal perspective, these more justly paid employees will have more money to spend and will add value to the American economy from the middle out. They will become the new middle class with the capacity to drive demand and provide sustained economic growth.
From our business community and national perspective, the role of business must be redefined. The world’s largest equity manager, BlackRock, set the tone. Larry Fink, the company’s CEO, said publicly in January of this year that the role of business is no longer to produce short-term profits, but to focus on long-term growth and society as a whole. Bill McNabb, the chairman of Vanguard, echoes this sentiment. Dov Seidman, CEO of LRN who has been consulting leaders like myself when I was CEO at Young & Rubicam, says, “The business of business is no longer just business. The business of business is now society.”
The shareholder as equity provider is no longer the differentiator between success and failure. People are.
JUST Capital has proven the same point. This nonprofit organization measures the top 1,000 corporations based on surveys of what the American people consider a “just” organization. It has documented that the most “just” companies are the real winners in our economy: They have a 30 percent better return for shareholders than most of their competitors. That’s the irony and the tragedy of our current cancerous policy of short-term shareholder value maximization. Doing the right thing actually means the shareholders will do even better. There is nothing to stop companies from following the lead of these enlightened, profitable companies, except fear of their shareholder activists and the complicit financial community.
Conclusion
Conquering our existential challenge of income and opportunity inequality will require a long-term monumental effort. Education must be reinvented. Quality education must be available to every child, regardless of social or economic status. Fair pay must become standard; family structure must be supported. Ethical and moral values must become part of who we are as citizens and Americans. And inclusion and respect for all people in this country must be a permanent goal.
The only barometer of our success is the sustainable progress of our middle class. As it strengthens, so will our health as a nation, our economic prosperity and our national security. It is imperative that business start this effort now. Soon enough government will follow. It always does. We need enlightened and courageous business leadership, a responsible new culture, and mostly the will to act.
