Clayton Christensen on rescuing free markets.

Question: Why is there such a crisis in business leadership?

Christensen:    Can I just maybe make two provocative comments, which are not that provocative but I really believe that they’re true.  There is a fellow that came to Boston about 10 years ago who is a Marxist economist from China and he’d gotten a Fulbright Scholarship.  And he came to Boston to study capitalism and democracy of all of the arcane topics.  We got to know him very well while he was in Boston, so at the end of his time, we invited him and his wife and child to our home just to have a goodbye dinner.  And I asked him, “So of all the things you learned about capitalism and democracy while you were here, was there something that was very surprising to you that you just did never thought about before?”  And with no hesitation, he said, “Yeah.  I never understood how critical religion is to the functioning of free markets and democracy.”  And I’d never put these things together before but it’s like this guy flies in from Mars and this is what he sees.  And he said, “You guys are living on cultural momentum that’s actually losing its momentum now.  But if you go back 150 or 200 years ago, almost everybody in America on the weekend went to a synagogue or a church and they were taught there by people who they respected that they should voluntarily follow all the rules, because even if the police did not catch them, God will catch them.”  And so you’ve got to be honest, whenever you make a commitment, honesty requires that you follow through.  You’ve got to respect other people’s property and never take it from them.  Their life and freedom are as just as valuable as yours.  And he said, “Because most Americans most of the time have voluntarily followed the rules, democracy works.”  Even if the police don’t show up on your doorstep to beat you up, you pay your taxes, because we’re conditioned and the root cause was it was our religion’s that instilled in us that ethic.  Now, he said, you just look around the world where America has gone into a country and just snap its fingers and said we want democracy right here and we want it right now, if you don’t have a foundation of a religion there and you said it’s not any religion, that it’s got to be a religion that teaches those particular rules and has enough power over people’s lives that they instinctively follow those rules.  If you try to put free markets and democracy into a country that doesn’t have that foundation, all you get is chaos like Haiti, for example, where they don’t have that foundation, we try to impose democracy and free markets and just get a complete breakdown of social order.  It’s what happened in Russia to a large extent.  So my first concern about our system is that if you don’t have an instinct and generally born from a religious tradition amongst the CEOs to voluntarily follow the rules, capitalism just doesn’t work.  There is no way that you can police honesty if it doesn’t come instinctively for you.  And, you know, I thought a lot about this conversation with that Marxist economist, and as so many institutions in our society try to push religion out of the public eye, what they don’t get is these are the very institutions that gives us our civil liberties in the first place.  So it’s a broader issue than just CEOs, but if the CEOs don’t come with that commitment to honesty, it’s very hard to police it.  It’s very hard to instill it later on.  The second thought is that the economists have done a great disservice to capitalism with this notion that managers are responsible for maximizing shareholder value.  It turns out God did not reveal this to any of the prophets of prophet, but rather economists in the 1800s as they were building mathematical models of microeconomic problems, the tools of economists are calculus.  And calculus forces you to find some function that you can maximize or minimize, and so they began to make assumptions in these mathematical models that management’s responsibility is to maximize the return to shareholders.  And the use of that assumption made the mathematics [tractable].  And so more and more economists began to use that assumption, they’d go into classrooms, teach that assumption and their models to their students.  And somehow over the hundred years or so that intervened, it came to be believed that management is responsible for maximizing shareholders value.  That even has gotten ensconced into some laws.  And then another group of economists came in with this theory called the principal agent theory and the idea there is that the principals who are the managers have a different motivation than the…  I’m sorry, the agents who are the managers have a different motivation than the principals who own the stock.  And so in order to align their motivations, we have to have, we have to give to management a financial incentive to maximize shareholder value.  And so, over the last 20 years, these principal agent economists have so influenced boards of directors that they’ve given the managers of these companies’ extraordinarily attractive financial incentives to inflate the stock prices and so on.  And I think this is just, it’s a broken paradigm.  In the 1960s, the average shareholder held the shares of your company in her portfolio for six years.  Today, 40% of the trading on the stock exchange is done by hedge funds whose average holding period is 60 days.  Fifty-five percent of the activity on a typical day on the stock exchange is executed by mutual funds and pension funds whose average holding period is 10 months.  So, 95% of the volume is executed by people who don’t even hold the shares of your company for a year.  Do you want to call these people shareholders?  They’re not.  They’re speculators or investors who temporarily find themselves owning the securities of your company.  And so rather than the management believing that they’re responsible for maximizing shareholder value, it’s really time to say no.  You guys temporarily find yourself in possession of the securities of my company and you’re responsible for maximizing the returns on your investments and God bless you.  My responsibility is to invest to ensure the long-term health of this company, the prosperity of the employees who work within it and the communities in which the employees live in and which we do our work, and that really is what management ought to focus on doing well.  And this business that managers aren’t incentivized, anybody who knows a manager knows that these are driven people to achieve and to build and to do good things.  And what the economists have done to us by giving this people financial incentive is just really perverted the system.  And so I think if we can get rid of those assumptions that you’ve got a principal agent problem and that managers are responsible for maximizing the income of speculators, if we took them out and brought people who just had a great grounding in the value of honesty because of their background, the CEO problems will disappear.