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Monetarism as a Source of Volatility Robert McGarvey

December 2, 2009

In a landmark New York Times article (September 13, 1970), Dr. Milton Friedman laid out the case that managers in fulfilling their corporate duties should focus their attention on profits: “…there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits….” Given Professor Friedman’s standing as one of the world’s leading economists; head of the Chicago School of monetary economics, his article carried great weight and authority. Ultimately it turned out to be more than just an interesting article; it was a pivotal moment in the history of capitalism, changing the course of American business management profoundly.

The Chicago School

The Chicago School was on a roll in the late 60’s, it had risen phoenix like in the post War era, providing a substantial challenge to the ruling Keynesian orthodoxy. In the Chicago School was born a new, hard minded economic fundamentalism. The new set of assumptions that Professor Friedman and the Chicago School brought to economic thought is fairly straightforward; in addition to the normal neoclassical assumptions (Rational Expectations Hypothesis and others) monetarists assume for a variety of reasons that markets are frictionless, essentially perfect. In other words markets are considered to be in equilibrium (the so called Efficient Markets Hypothesis). In these circumstances market signals are assumed to be accurate, essentially objective realities. And given the parallel assumption that all relevant phenomena are ultimately translatable into market signals, it follows that complex human systems are best managed by identifying and controlling a few key financial variables.

In respect to the larger economy, strict monetarists believe that simple manipulation of the money supply is the key to managing the boom and bust cycles in the economy. Translated into a corporate context, monetarism manifests itself in the belief that a business enterprise is best managed through manipulating key variables on the financial statements: cash flow (generally in the form of EBITA), bottom line profits and (indirectly) the company’s stock price.

The Impact 

The publication of Professor Friedman’s article and the subsequent rise of monetarism as a school of economic thought contributed significantly to radical changes that were then taking place in American management practices. The late 1960’s saw the rise of an aggressive and much more numbers-biased managerial class, many with MBAs. Their arrival on the business scene completed the ascendancy of a narrowly focused, Wall Street inspired, ‘financial’ theory of the business; its fundamental premise (relatively new at the time ) was – a business exists to return on shareholder equity; its measure of corporate success or failure, the company’s quoted stock price.

It all went relatively smoothly until recently, then the world changed profoundly and the rosy assumptions simply got overwhelmed by reality. For example, central bankers, idealizing the efficiency of markets, began to overestimate their power; many came to believe they could directly influence macroeconomic outcomes from their central bank desks. Consider Federal Reserve Chairman Ben Bernanke’s statements (September 17, 2008) about commodity prices: “We have lost (monetary) control…we cannot stabilize the dollar. We cannot control commodity prices.” The Federal Reserve could only control, or even remotely influence global currency and commodities markets, if we accept the most extreme forms of market efficiency and purism; it was a gross oversimplification for which we are now paying a very heavy price. Unfortunately for the rest of us, these biases in economic thought are carried forward blindly into the world of business theory and management decision making.

Bounded Thinking in the ‘C’ Suite

From a management point of view, over-focusing on the ‘numbers’ is an equivalent class of error. This critical error has the unintended consequence of elevating a company’s financial statements to previously unimagined heights; today they are the management equivalent of ‘Tablets from the Mount’. The problem with the numbers is they don’t tell the whole story; presently constituted, financial statements don’t come close to quantifying the ‘guts’ of the business. There are a host of ‘soft’ issues that are critical to business success, that because (at present) they’re not quantifiable don’t appear on the balance sheet or the financial statements, and as a result tend to get lost in the shuffle.

Let’s face it many of the most important value drivers in a business today are essentially invisible on management’s present radar screen. As such, when a CEO huddles with their CFO and the hard decisions are made valuable assets are largely ignored (at our, particularly shareholder’s peril).

For example, management’s decision to improve profitability through the adoption of lean manufacturing processes and just-in-time supply chain management (carrying only the minimal product inventory) will almost certainly improve the bottom line. All to the good according to traditional financial management principals, until you discover that those new lean processes have the unintended consequence of lengthening the order and delivery timelines for customers, undermining customer loyalty (i.e. impairing the customer equity asset) and increasing customer defection rates. Or consider the rush to outsourcing, many organizations these days are lowering operating costs by outsourcing software development, customer relationship management and basic accounting functions to lower cost service providers in India and other parts of Asia. Although this makes sound bottom line sense, it carries a variety of associated risks to key nontraditional assets. In outsourcing software development, for example, valuable market insights, technological advances and trade secrets are often inadvertently bundled with the process and sent half way around the world into economies where no legal protection of intangible assets is possible; ironically many of these advances and innovations reappear almost instantly in the form of new ‘lower’ cost competitors.

Assets are the Source of Earnings

The causal agents of corporate earnings are assets. Indeed assets are not only the sources of earnings it is clear from sub-prime mortgage crisis that, they are the root sources of risk as well. If management is to both build and sustain shareholder value more attention will have to be focused at the ‘asset’ level. Furthermore, a larger more balanced asset perspective, including awareness of both traditional and the newer non-traditional assets will open management’s eyes to the many hidden sources of value within their organization and, ideally, alert managers to the historic transformation going on under their noses: the migration of the western economies from their established industrial foundations to newer intangible knowledge-based ‘engines of growth’.

Balanced Decision Making

It is clear that foundational assumptions concerning the primacy of shareholders, key financial metrics and stock market valuation need to be supplemented by a broader perspective. These traditional metrics are not wrong, but are insufficient, to ensure stable long term growth in shareholder value. Like economists senior manager’s today are over focused on effects (cash flow, share prices etc.) not causes (healthy productive assets). A broader perspective and a more balanced set of priorities could certainly help managers see the ‘big picture’ and with a bit of luck, deliver sustainable shareholder value in future.

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