Looking into Firms to Understand the Crisis

In discussions about the crisis an important piece of the puzzle is missing: the analysis of firm-level microeconomic causes. Since the crisis manifests itself as a macro disturbance, market mechanisms and macroeconomic imbalances are usually indicted. And for sure, macroeconomic causes are apparent. As Padoa Schioppa noticed in his speech at The Economy and the Open Society, the annual international forum co-organized by Bocconi, the market's capability for self-regulation operates under certain conditions. In particular, it must be true that buyers have access to the knowledge and information necessary to judge the quality and value of what is being put on offer. And there's nothing more regulated than a so-called free market. It needs rules and regulations to maintain competition and consumer guarantees.
It's clear that neither condition was met in yesterday's global financial markets. So the crisis was a market crisis, generated by a knowledge deficit, and a regulation crisis, resulting from gaps in oversight and regulatory powers entrusted to national and international institutions. Such problems in macroeconomic governance have been hotly discussed. Analysts have usually framed the problem splitting into two camps: those that criticize the market's faults, and those that criticize faults in regulation, repeating the old cliché of the state vs the market, all of which impedes the search for innovative solutions.

At the source of the current recession, you will find a third type of crisis: distorted decision-making inside firms. What micro motivations have led to such disastrous macro behaviors? Why were bank managers allowed to peddle toxic assets? Why did managers in major corporations decide to multiply debt leverage and speculation to absurd levels? Were they all scoundrels? No, any moralistic explanation would be superficial.

At the root of such behavior,within companies too large to enable the usual tools of hierarchical control, was the widespread use of incentive schemes inspired by the idea of aligning the objectives of managers with the objective of shareholder value maximization. So the micro causes of the crisis lie in at least two linked factors: the size reached by a firm and its mode of governance.

As for incentives as tools of governance, existing economic theory would not have prescribed stock-related incentives and pay-for-performance in massive doses. It would make sense to link manager compensation to the price of stock if this were a reliable indicator of the value of the firm, but this is not so. Managers do not have as much power in affecting equity value as do other imponderable, subjective and speculative factors. And company value is not only determined by the decisions of its managers.
Secondly, the idea that a company must maximize shareholder value undermines one of the main benefits for the joint-stock corporation to exist: to separate the interests of the firm as an institution from the private interests of all actors, including those conferring capital. It also undermines one of the main benefits of business organization: to integrate in a deliberate way qualitatively different objectives, from technological innovation to the design of products meeting specific needs.

As for size and scale, there is a widespread view that only big corporations can withstand global competition. But the literature on the optimal size of companies says that size is a function of several variables: economies of scale are not the determining factor, since they can be reaped also in the absence of vertical and horizontal integration, as the diffusion of industrial districts has proved. The costs of coordination and control in major firms are more important than sheer size, and particularly so in this crisis. Little attention is given to the fact that major corporations are like little planned economies. But they are like national economies in that they cannot be run exclusively with plans and commands, because a planned economy cannot deal with complexity and uncertainty. Thus, it would be appropriate to revise the bigger-is-better myth of company growth. And to remember that beyond rules and authority on one side, and prices and market incentives on the other, there exists a third system for simultaneously achieving decentralization and more-aware coordination in large organizations: it usually goes under the name of democracy.

Structural and institutional reform should not be oriented solely at building new international institutions that bring new rules of transparency to discipline the world's markets and financial industries. Reforms should also design new rules for the integration of the knowledge and interests in corporate governance present within companies. The effort we need from the economic and managerial sciences is to help build robust, representative business structures, able to withstand the shock of unpredictable events.