Friday, February 20, 2009

The Debts of the World: My 2008 Mid-Term Exam

In March 2008, I was finishing my final year in law school and taking a class in "International Corporate Legal Environments." It was a class co-taught by one business school professor and one law school professor. This was one of the questions on the mid-term exam:

Q) How do multinational firms exploit the value chain on a global basis?

A) My answer:

This is a broad question with a necessarily broad answer. My answer is leverage. Recent events in the financial markets have given leverage a bad name and it remains to be seen whether firms in these businesses will be able to wield the enormous amounts of power they once controlled. However, outside of financial services the concept of leverage remains a potent force in international business.

Multinational firms leverage aspects of their value chain to achieve incredible economies of scale. The concept of a value chain was first advanced by Michael Porter in his book, "Competitive Advantage: Creating and Sustaining Superior Performance". Under Porter's theory, a value chain is a broad spectrum of business functions that managers can use to achieve higher efficiencies in production, sales, operations, etc. However, I expand upon Porter's theory by adding to the value chain and make an abstract concept real through the discussion of three prongs: money, time, and distance.

Money is of course the compensation that firms give to its employees and suppliers as well as the value it receives for the sale of its goods and services. A simple way of explaining the power of money is that it is an instrument of cash flow that fuels a business empire. However, it is more complex than that.

Wages and supplier payments are debt instruments. Debt instruments are by definition obligations to repay today's production with a promise of tomorrow's revenue. This necessarily leads to my next point, time. In North America, the typical time between paychecks is two weeks. The margin for supplier contracts is even greater, often consuming 30 days at the shortest with 60, 90, and even several year periods not unheard of. Moreover, when dealing with consumer markets, firms are generally paid immediately. Shrewd captains of industry realized long ago that by tinkering with the balance between production and payment that they could exploit a wonderful arbitrage opportunity by maneuvering in the gray space of obligatory payments and necessary receipts of income. However, it was not until the Industrial Age that managers discovered the third and final element of their toolbox, distance.

Distance refers not just to physical distance but also a mental separation. When societies transition from one age to another, there is a cognitive dissonance, or gap in thinking, as the humand mind struggles to adopt to new circumstances by continuing to use old gestures to substitute for the new. This transition is especially jarring when the change comes suddenly. For large companies, the dawn of industrialization meant not just increased economies of scale at home but also possibilities abroad to market their wares and possibly find new production sources. Cunning capitalists engaged in a game of logistical and economic warfare against each other as they sought to exploit new markets by creating the first multi-nationals. Those who could not, or would not, grasp the concept of accelerated technological and capital access were consumed. In 19th century America, the iconic image of the industrialist was that of the "robber baron" standing triumphant over his foes in the steel, railroad, and banking industries. However, this transition found its expression earlier in the Civil War as Northern industrialists waged an economically driven war against an agrarian South.

The newly formed multi-nationals also used the power of distance against their workers, many of whom were still reeling from the rapid shift in societal and economic changes. Besides the time distance between paychecks, managers borrowed a new tool, but this time from the government: retirement plans. Following FDR's reforms, shrewd captains of industry realized that they could manage growing worker unrest by once again leveraging the power of distance. Retirement plans gave management the opportunity to co-opt employee dissent by offering the surface appearance of caring for their workers' welfare. However, the financial obligations for these plans would not come due until many years in the future. Now, instead of just relying on a two week distance, management could focus on delivering today's revenue at greater levels of efficiency. As for the retiree obligations, they were destined to become someone else's problem.

There is one last element to distance and one which has become increasingly critical in today's business environment, risk transfers. By transfering risk away from their operations, multi-nationals could insure against business downturns by creating a financial and operational separation. Indeed, the extremely liquid market in futures and options of today has its origins in the same time frame as the Industrial Revolution. Moreover, industrialists discovered the power of lobbying (which also has its roots in the Industrial Revolution) to enable these risk transfers.

Highly skilled actors armed with guile, charm, and numbered trust fund accounts have always been an unofficial part of government. These mercenaries act as representatives for America's corporate constituency by pressuring politicians to implement favorable laws and regulations. However, the modern age turned the industry into a profession. In the United States, lobbyists even have their own code, the Administrative Procedure Act or APA.

It is important not to think of money, time, and distance as discrete elements but parts of a synergistic whole. I presented them separately for narrative ease in showing a historical progression. Elements from one section have always overlapped into the territory of another.

The best international managers are aware of these elements - even if only implicitly - and knows when to apply the appropriate amount of leverage. However, there is always the potential for multi-national managers to lose control of the process. In that case, they should not worry. If the company is large enough, the government will be there to offer support. Then it will become someone else's problem - the taxpayers.

Hey, I got an A in the exam and the class. Thank you Profs. Kowzlowski and Dean Thomas. If either of you are reading this thank you for the words of encouragement!


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