Better governance would have more impact than any new industrial strategy

Today saw the launch of the Final Report of the Industrial Strategy Commission which describes itself as, “an independent, authoritative inquiry into the development of a new, long-term industrial strategy for the UK”. I attended the launch event which included a keynote speech by Greg Clark MP, Secretary of State for Business, Energy and Industrial Strategy.

The event and the report are linked to the UK Government Green Paper, “Building Our Industrial Strategy” published in January this year at the start of a consultation process that is now closed. The publication of the white paper will follow soon.

As a backdrop to these initiatives, the UK is experiencing a sustained productivity crisis. Martin Wolf has written about this repeatedly for the Financial Times, and it has been the subject of numerous articles and speeches by Andy Haldane, Chief Economist of the Bank of England.

In one article Wolf said, “True, the productivity slowdown has been a widespread phenomenon among high-income countries”. But, he warned, “The UK’s recent productivity performance has been calamitous”. And “calamitous” is not too strong a word. Haldane provides the evidence; “You would have to go right back to the 18th century to see a similarly lengthy period of stagnant productivity.” And Wolf is right when he says, “Rectifying this disaster is the UK’s most important policy challenge, far more so than Brexit.”

Introducing the Green Paper Theresa May said, underpinning the strategy would be, “a new approach to government”. Rather than “leaving Business to get on with the job” the strategy would see the government, “stepping up to a new, active role”. And, “This active government will build on Britain’s strategic strengths and tackle our underlying weaknesses, like low productivity”. “This is vital because if we want to increase our overall prosperity, if we want more people to share in that prosperity, if we want higher real wages, and if we want more opportunities for young people to get on – we have to raise our productivity”.

Having read the Green Paper, and the Executive Summary of the final report from the Industrial Strategy Commission, I can’t help thinking that the most obvious causes of the productivity crisis have been entirely overlooked. In consequence, I fear the Industrial Strategy will fail to include measures to address the problems that should be at the heart of it.

The biggest cause of the productivity crisis is the way businesses are managed. Addressing that, and improving the quality of management, are the fastest ways to improve productivity. Doing so is also essential if any other industrial strategy initiatives are the be implemented effectively.

Haldane was brave in suggesting “A lack of management quality is a plausible candidate explanation for the UK’s long tail of [unproductive] companies.” But he was able to provide evidence that, “There is a statistically significant link between the quality of firms’ management processes and practices and their productivity. And the effect is large.” And, “This suggests potentially high returns to policies which improve the quality of management within companies.”

Numerous indicators of bad management have been put forward: Firms which do not export are poor at raising productivity, perhaps because they are not as heavily exposed to foreign competition; the financial crisis cut off the supply of credit to innovative companies which need funds to invest in new technology and equipment; Ultra-low interest rates could have had some impact and resulted in “zombies” firms being kept alive, with the capital in them not then being reallocated to more innovative and productive enterprises.

There is no shortage of organisations looking for the reasons and proposing solutions. Another example is Sir Charlie Mayfield’s Productivity Commission. It suggests many unproductive companies are just unaware of the fact they are underperforming when, “In fact, we know most companies have below-average levels of productivity and a large fraction of them have seen no productivity improvement for several decades.” A solution they propose is to pair up productive companies with unproductive ones, so good managers can teach others how to boost their workers’ output.

These ideas and solutions probably all have some merit in them, but again I think I cannot help thinking the real causes of the problems are being overlooked, and effective solutions will not be found.

When I say, “The biggest cause of the productivity crisis is the way businesses are managed”, I am referring to a catalogue of management issues. In big business, the average tenure of a CEO is again less than 5 years. That of the CFO, the CMO and other executives is even less. Many employees will also serve short-terms, whether of their choosing or not. A significant number of staff will be on temporary, part-time and, or, zero-hour contracts too. Often this leaves them needing benefits from the government to top -up their income. This results in them being a member of the "Working Poor", a class of society that is now bigger than it has ever been, and continues to grow. This all means that from top to bottom everyone in the firm is “in it for themselves”. This is the real "agency” problem economists should be worried about.

Ironically it is a consequence of the imagined agency ‘problem’ invented by economists Michael Jensen and William Meckling. They claimed the problem existed and offered stock-based compensation, and attempt to align the interests of the CEO and shareholders as a solution. This created the imagined problem it was supposed to fix as Roger Martin, former Dean of Rotman Business School and author of Fair Game, has shown.

The negative result has been to encourage the CEO to focus on managing and manipulating the expectations of the market to boost and protect the value of the company’s stock, rather than the creation of real value for customers and other stakeholders. This led to an obsession with costs and productivity, rather than revenue growth, because one is faster, easier and less risky than the other. The practice of delaying short-term spending and investment, even if it has a negative impact on medium and long-term performance, is a common practice.

Profit is the sum of revenues, (the numerator) and costs (the denominator), and the dominant focus has led to what I call Denominator Capitalism. And that has a negative impact on productivity. To increase productivity requires that the focus of management is re-balanced to include a greater focus on the numerator. And a good industrial strategy would move us towards Numerator Capitalism, backed by a supporting policy framework.

Growing the numerator requires management focused on the creation of value. First, Customer Value which generates revenues. But also value to be shared with all the stakeholders the firm depends on to deliver Customer Value. Shared Value is the only way to establish a strong and resilient business model that is capable of continuous improvements in value creation capacity, at the speed that today's business environment demands. And it needs to be coupled with less competitive and transactional relationships with stakeholders, designed to extract value a maximum share of value from the value chain, and a more collaborative relationship focused on the co-creation of customer value.

Good evidence that bad management as a major factor in the productivity crisis is provided by McKinsey and Company provided in the research I often cite. It found a mere 34% of the directors surveyed believed the boards on which they served fully comprehended their companies’ strategies. Whilst “only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries”. This is damning evidence of those responsible for the governance of firms, and of those directors by their fellow directors. It means we should not be surprised we have a productivity crisis. 

It also means we must look first to the board and corporate governance if we want to improve productivity. Particularly if other industrial strategy initiatives are to be effectively implemented. Governance expert Peter Crow will be addressing the topic of “Fulfilling the Board’s Value Creation Mandate” in the first of our Director Dialogues in London on Nov 9th

Another major management issue that links to the productivity crisis in the persistently low levels of employee engagement. And, since people will be responsible for implementing any initiatives, the Industrial Strategy ought to address this issue. Employee costs make up the majority of the operating costs of many businesses. Especially those in the knowledge economy. And Gallup shows little change in the pathetically low levels of employee engagement over the past decade.

What are the causes of disengagement? I suggest it has a lot to do with poor management, job insecurity, the “everyone in it for themselves” culture, and a decade of stagnant incomes for the average worker. To give on example. “Between 1973 and 2013, US labour productivity grew by 74%, while average wages grew by just 9%. That means almost all the benefits went to the very top of the income scale”. If the employee feels his efforts are only going to enrich senior executives and shareholders, and he is unlikely to get a fair share, what interest will he have in being more productive?

This brings me to the point about the purpose of an industrial strategy. The Green Paper suggests it is to increased shared prosperity. That means creating value by meeting needs – the needs of all stakeholders. I have made the case for what I call Valueism – “business focused on value creation”. It includes the concept of a value scheme. And the creation of the scheme requires value creation be considered through the eyes of each stakeholder group. Ideally, they would also be involved in designing the value scheme to ensure they understand it, and their role in relation to it. This is far more likely to result in a better process, better ideas, more engaged employees, stronger productivity, more resilient businesses and greater prosperity for all.

To summarise, there is a danger the Industrial Strategy will have a macro-level focus on investment in infrastructure, economic policies, investment in hi-tech etc. and completely fail to see the real causes of the productivity crisis which starts with staggeringly low levels of employee engagement, and an agency problem that is far bigger than the earlier one the economists invented in the past. It will also fail to address poor governance and bad management demonstrated by an inability to articulate how firms create value. Fixing these issues would have a transformative impact, and the success of any other industrial strategy initiatives will also be dependent on them being fixed. I think there is a danger that in the search for solutions policymakers may be looking down the wrong end of the telescope.

Finally, Much evidence to support these arguments is to be found in an excellent new book, Customer Value, Shareholder Wealth and Community Wellbeing: A Roadmap for companies and investors, by Denis Kilroy and Marvin Schneider. The book is built on extensive evidence-based research. here you can read my review of it.

I am available to speak on this topic and the concept of Valueism. For details email [email protected]