James Surowiecki is surprised that CEO’s keep laying off workers even though such moves no longer seem to boost profits:
In the nineteen-nineties, with U.S. corporations in the midst of what the Times
called “the downsizing of America,” a new term appeared: the
“seven-per-cent rule.” It was a simple formula: when a company
announces major layoffs, its stock price jumps seven per cent. No one
worried too much about whether the rule was accurate—it was a catchy
way of expressing a basic assumption about corporate layoffs:
downsizing is an easy way to make Wall Street happy.
Now, Surowiecki points out, citing recent research, layoffs lead to lower stock prices. Why do CEO’s keep laying off workers? His answers are a bit bizarre:
1. CEOs notice when layoffs are successful but forget to notice when they fail.
2. CEOs have a short-term perspective. They won’t be around when the full costs are paid.
3. CEOs have a herd mentality—everyone else is doing it so it’s safe.
The problem with 1 and 3 is that they imply that James Surowiecki has more insight into running a company than the CEO. Unlikely. Possible, but unlikely. The second explanation seems irrelevant. When the company’s stock price goes down, it’s hard to argue that the CEO is sacrificing long-term benefit for short-term gain.
Surowiecki treats the layoff problem as a business strategy for increasing profits. But he forgets they can also be a strategy for avoiding bigger losses. He also forgets the role of stock prices in capturing information.
The reason Circuit City’s stock price fell after the layoffs wasn’t because investors disagreed with the CEO’s strategy. The price fell because the layoffs provided information that wasn’t readily apparent before. The layoffs told investors that Circuit City’s fight with Best Buy was going even worse than they thought.
Pundits everywhere decried the Circuit City layoffs as a greedy corporation trying to inflate the company’s profits to ever higher levels while ignoring the human costs. In fact, they were a desperation attempt to keep a company afloat. That revelation of desperation is what caused the stock price to fall. We’ll see if Circuit City can survive. The stock market suggests that the odds of survival have fallen.
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Should be: CEOs, not CEO's. See the Apostrophe Protection Society's website for more information and the rules of punctuation with apostrophes.
http://www.apostrophe.fsnet.co.uk/
Or, the stock could go down because the market was expecting even bigger job cuts.
By your objection to points 1 and 3, no one can EVER second-guess a CEO because no one EVER knows more about being the CEO of a given company than the guy who actually is CEO of that company. (Good news: Your board of directors never has the right to fire you!)Saying that someone isn't qualified to level a critique is a cheap way to avoid discussing the critique.
Scoop,
Do you really believe that CEOs (plural, not one but many) keep laying off workers even though it costs them profits because they just don't pay enough attention and don't realize it's counterproductive? That's the gist of arguments 1 and 3. My point wasn't that no CEO ever makes a mistake. But arguing that many CEO's make mistakes because you've noticed something they haven't seems unlikely. The incentives just aren't there.
Sorry to be so simplistic, but there's only one GOOD reason to lay off workers: the perception that you no longer need as many… How could Mr. Surowiecki fail to mention that?
Whether that perception ultimately plays out as correct… well, that's why CEOs make the big bucks.
Russ, how do you explain the telecom buildout of the late 1990s? Telecom executives spent close to a trillion dollars building out capacity, money that was (from the perspective of those companies) almost entirely wasted, and that depended on completely mistaken views of how fast Internet traffic was growing. A host of those companies went out of business, others were acquired at rock-bottom prices, the stock prices of the rest cratered, and in the case of companies like Worldcom the pressure to make up for the never-materializing profits led them into accounting fraud. These were many well-incentivized smart CEOs who made what just about everyone now recognizes were many enormously costly mistakes. By your account, any outside observer would have been unjustified in critiquing these strategies.
Or similarly, how do you explain the success of someone like Billy Beane? He was able to exploit, for half a decade, massive inefficiencies in the market for baseball talent, even though the general managers of other teams had every incentive to do an excellent job of evaluating talent and even though there were plenty of outside observers who were telling GMs that they were misvaluing players.
The idea that CEOs are not subject to the same decisionmaking flaws and biases as other humans, or that market incentives necessarily drive them to optimal policies in terms of something like employment, is purely a religious concept. There is no theoretical or empirical evidence to support it. Your entire post basically consists of, as so many of your and Don's posts do, incanting the phrase, "The market knows best."
K. Williams,
You've missed the point. Maybe I wrote it badly. It has nothing to do with the "market knows best." I'm not saying that CEOs don't make mistakes. Here's what I'm saying:
1. Ex-post explanations that explain bad decisions by invoking stupidity are not useful. That doesn't mean stupidity doesn't exist or that CEOs and others don' t make mistakes.
2. Ex-ante criticisms can be right just by randomness. It is unlikely that someone who is a casual observer with no stake in the decision will make decisions as well as someone with a huge stake in the decision. But of course it can happen. Grady Little did get fired and I was glad.
3. As for Billy Beane, I'll write more on that later. Sometimes, there are $20 bills lying around on the sidewalk. But when the people who walk on the sidewalk have only a modest incentive to find them, they will go undiscovered longer than on a sidewalk where lots of people with lots of incentives are walking there.
K.W.
Russ said it is possible the Surowiecki knows better, but it's not likely. Like many others, Surowiecki is not willing to back up the certainty of his claims – that is – if what he is saying is true, there exists a massive arbitrage opportunity for him. EMH doesn't require every market participant to recognize those opportunities for supernormal profits, it only requires a small handful of participants to do so.
David — what's the massive arbitrage opportunity created by CEOs believing that layoffs are more effective than they are? You can short companies that do massive layoffs, but what's the arbitrage gap that's being closed? And how would this force CEOs to adopt a smarter strategy? Is the opportunity for their competitors? Well, the available evidence suggests that they're doing it, at least to the extent that they outperform companies that don't.
The point is, to really know whether or not layoffs have, in general, a benefifical effect on the bottom line, you need to do rigorous research across a huge number of companies, while trying to control for all the factors that affect performance. This research is, by its nature, imperfect, since there are so many factors that shape performance. But it's been done, and it suggests that layoffs do not have — and never have had — the effects that CEOs imagined they did. Now, you can just dismiss all this work and say, the CEOs must have known better, so therefore the work is wrong, or else you can say that many CEOs have made a mistake — perhaps simply because they've never looked at the available research.
The fact that corporate America is periodicially swept by faddish behavior, and that executives engage in strategic herding as a way of protecting themselves, is totally uncontroversial to anyone who doesn't believe that incentives always lead CEOs to pursue optimal policies. That's why I'm still waiting to hear Russ' explanation of the telecom investment boom of the late 1990s. It's also why I'm waiting to see any evidence — theoretical or empirical — that the market's operations guarantee optimal profit-making decisions by corporate leaders. And no, simply invoking the EMH doesn't count.
Based upon my experiences in business, I would not necessarily discount the stupidity argument. Unfortunately, the Peter Principle can also apply to higher levels of management. That being said, it is not an explanation in itself for the layoffs. In the past, there were similarly incompetent managements, but not as many layoffs. Those were also the days when America did not face the same kind of global competition. In addition, I believe that those times also reflected the desire of shareholders for long-term performance instead of today's short-term emphasis.
From a longer-term perspective, I would be interested is finding out how many of those who lose their jobs can find comparable ones with similar benefits. You get concerned when middle-class jobs get replaced by McJobs. However, I don't know if there are any reliable statistics on this question.
I think the Circuit City example is a good one. Could it be that CEOs, if is true that companies layoff people don't perform well, are already in trouble? So they are making every effort to try to cut costs.
For K. Williams, I am sure that there is a connection between the Fed's easy money policy and the telecom expansion. It would have been cheaper to expand where it would not have "normally" been prudent. By the telecom's realized they had over expanded it was probably too late. You also add onto that investors who were just buying telecoms to buy telecoms and not really looking at the underlying numbers. It allowed companies to do some strange book keeping. The excitement of those individuals could have possibly kept stock prices artificially high, not allowing the pricing of the stock act as an indicator of the true performance. For the most part the general investor is lazy, if they continue to make money they don't start asking questions until the money stops rolling in, to sound somewhat cliche.
"By the telecom's realized they had over expanded it was probably too late."
This is precisely the point. Highly incentivized, generally well-experienced CEOs essentially all embraced similar, and similarly disastrous, strategies at the same time — even though there was plenty of evidence available at the time to suggest that their basic assumptions were wrong. And they didn't realize they had made a terrible mistake until it was too late. That's why simply saying "it's unlikely CEOs are wrong because they have too much of an incentive to be right" is an inadequate response.
Surowiecki’s entire premise is flawed at it’s core. If CEO’s viewed layoffs as mere tools for stock price manipulation, the “excess” employees would have had to been hired for the express purpose of being laid off at a specific time.
On the stupid CEO sideline; everyone seems to have badly missed Russ’s point.
If Surowiecki were speaking of a particular CEO, and was somehow himself pitted against that CEO, then there would be a rational argument for Surowiecki, maybe, knowing more than a particular CEO.
That’s not what was said however. Is it likely that someone like Surowiecki knows more about being a CEO than CEOs in general?
As Russ said, not likely.
Another point that ought to be noted here is the difference between managing and leading. As cliché as it sounds, it is nonetheless true that managers maintain the status quo, while leaders tend to change.
Sometimes what looks like great leadership is merely very competent management, and sometimes managers who shouldn’t be leading attempt to do so and fail.
Point being to that, and it connects to my initial post as well, is that the only reason to lay off workers is that the company can no longer support or no longer needs that many employees. Enough work for 50 guys when you have 100 on the clock is a problem. And I’ve worked for companies who laid off all of the wrong guys, while keeping the wrong ones, and vice versa.
Or, in other, shorter words, because Billy Beane did what he did, all other baseball managers are stupid? From here on out? Then why aren’t the Cubs looking to hire more sports journalists to coach their club?
about the fiber buildouts, I'm not an expert but I believe the problem was one of coordination with providers of last mile services. These firms misjudged the amount of competition based on speed really existed in the country.
We could also include the easy money of the day, not only through the FED but also in IPOs.
Finally, the potential of return could have been enormous, which may have justified investors taking large risks and CEOs hoping that their company would become the big fish (Level 3 seems to have won that race)
K Williams and D. Graf
If CEOs are stupid, please explain two things:
1) Why their boards go to the trouble of a world wide search just to get people you, an outsider, can see are "stupid"
2) Describe a system that could remedy this. Don't forget to point out why this system isn't already in place by our profit-seeking corporations.
The basic point, already mentioned: you are postulating a free lunch.
I think you seriously underestimate the information required to know with any kind of certainty that any given round of layoffs are suboptimal. The simpler explanation is that CEOs in fact do pretty well with the information available to them. They've faced intense competition to get to the top and I'm willing to give them the benefit of the doubt over your (and mine) opinions as outsiders.
The key piece of information from this layoff was that they lopped off the top earners among their floor staff. This tells me that management thought their labor expense was too high, but that they valued numbers of staff over quality (assuming that higher paid staff were generally more successful salespeople). If the variance in salaries was higher than the variance in sales, then the move, followed with the invitation for the laid off employees to apply for lower salaried positions, makes complete sense.
I still see Circuit City as a superstore for the willfully ignorant. The shopping experience is terrible, the sales staff are like Africanized bees, the selection is sadly incomplete at the high end, and they really do make their money on cables and warranties. As Best Buy did with Geek Squad, Circuit City seems to be betting a bunch of the farm on service with its Firedog brand. On the one hand, it seems to be a good thing for housewives in $150K+ households. On the other, you'll see more incidents like the one involving Geek Squad in SoCal where the Geek was caught videotaping a customer's daughter in the shower. The whole thing is just creepy.
You're missing the point. I'm not saying that all layoffs are a mistake, or that any CEO who engages in layoffs is necessarily making a mistake. I'm saying that it's clear that the business world goes through fads and that CEOs often engage in behavior that is suboptimal for their companies (although not always suboptimal for them), and that therefore critiquing CEOs on the basis of substantive academic research is a reasonable thing to do. All the responses here simply amount to saying, again, "They're CEOs. They must know best." But this is completely inadequate.
I'm also not saying that a CEO who believes that layoffs are more effective than they really are is also stupid about everything else in his business, so the "why would a board hire an idiot" riposte is meaningless. It's perfectly possible that you can have very smart, motivated people who nonetheless believe certain things that aren't true.
As for this argument pitting me against all CEOs, that's not true, either. There are plenty of companies that have never done massive layoffs, and there are a number of very successful companies, like Southwest, that refuse to do them as a matter of policy. (This doesn't mean they guarantee employees lifetime employment. It just means that mild downturns in business don't provoke them to immediately cut workers.) So it's obviously not something that all profit-maximizing CEOs believe is necessary.
Finally, Carl's response about telecom makes my point for me. He says the investments were justified by the potential enormous return, and that Level 3 is a good example of a company that gambled and won.
Level 3's stock price in 1999 was $118 a share. Its stock price today is a little more than $6 a share. That really was a great gamble. Now I see why we shouldn't be criticizing CEOs.
K W
"what's the massive arbitrage opportunity…"
It's about Surowiecki's claim that most or all of these CEO's are somehow mistaken. If most or all of these CEO's are mistaken, then it only takes one or a few people to realize the misallocation of productive resources, and capitalize on it.
I had no intention of proving empirically that "layoffs are good for the bottom line," or visa-versa. There is no hard and fast rule we can apply to human actions – sometimes it is beneficial to lay people off, sometimes it's not. In both sets of circumstances, some people make the right decisions, and others make the wrong ones.
Ben,
History is replete with examples of where people in positions of leadership including CEOs were not up to the task. That does not mean that they were stupid. For example, the people like McNamara behind the debacle in Viet Nam were known as our "best and brightest". And so, I agree with you that it doesn't really shed any light on the problem to call someone else stupid when they screw up as a CEO.
Regarding how do you select a good CEO, I can think of several ideas. One would be to open up the screening process. Ordinary employees who have contributed to the company's success as well as prominent customers should have input into the decision. They see the company from the perspective of where the "rubber hits the road" and may have insights not known to an outside board of directors.
I would also increase the stake that corporate boards have in the success of a business. They should pay a price when things go badly wrong and receive more generous rewards when things go right with a company's performance. This would encourage them to do an even better job at selecting the CEO.
If we want to improve the performance of CEOs, then we may want to reconsider their role in a business. It may be that we're asking too much of any one person given the size and complexity of businesses today. Moving towards a more decentarlized business management structure could be a big help in this area.
I suspect that we also need to look at what people do or have to do to advance up through the management levels. The skills required to move up may not necessarily have much in common with the skills needed by a CEO. At one place where I worked, those who went up the chain often did so on the basis of friendships and common social interests. Eventually, it caught up with the business and it had to be sold.
I don't claim to have the answers, but I think it's high time for us to start looking for some new answers because layoffs are no longer the all-purpose solution that some considered them.
I know of no CEO who believes that laying off workers is a good business strategy and would want to make a practice of it. So I think the anecdote about Southwest is a bad example. Also in a business like the airlines industry, they had the advantage of coming in later in the game. Southwest has made their money in the deregulated market. I think you also have to look at the competition within the airline industry. Southwest is currently still running lean, where the “old” airlines were bloated. I believe I read a report when Delta issued for bankruptcy that they had somewhere in the area of 30k employees. Where as, Southwest was operating with a third of that number and growing at the same time. Of course they aren’t, on principle, going to make it a practice of laying off workers. When government “deregulates” industries you will end up loosing much of that labor force. Steel is another good example of how rent seeking unions were able to bloat the companies’ labor force.
I think it says something about the CEO themselves, because it means that they made a mistake somewhere along the way. It means they hired too many people, maybe over expanded, weren’t running efficiently, etc. So no CEO is going to make it a practice of laying off workers, both in principle and saving face.
I thought it was fairly common knowledge that "layoffs" are now more common because they are a better way to jettison unproductive workers without inviting individual lawsuits. If you are a CEO, would you rather fire 100 bad workers individually and expose your company to 100 lawsuits from people who feel they were wrongly dismissed or would you wait until the dead wood piled up a bit and cashier 100 all at once under the cover of a business restructuring? That is why layoffs are a common feature of the landscape even in good times.
We can't expect perfection when humans are involved, in any endeavor.
Most businesses are run as hierarchical power structures. In such structures, politics is the norm for behavior.
Keep in mind that corporate law requires that corporations have a least a nominal hierarchy.
It all still boils down to: who makes the decisions?
The key point in the discussion of the Circuit City case is that it was just one step in a long series of moves by Circuit City to reduce labor cost. Remember this is the same company that fired all commissioned salesmen several years ago.
Retailers in general and in electronics in particular are in a bind because they are experiencing actual deflation, not disinflation but actual deflation. The typical retail model is a mark-up model. You buy an item for x and sell it for 2x and the difference goes to pay wages, overhead, profits, etc.. As long as these prices experience similar moves this approach works fine. But, as is the case now when they are moving it opposite directions it causes major problems. If last year you bought an item at wholesale for $100 and sold it for $200 you have $100 to pay all your other expenses and make a profits. But in a deflationary environment this year you buy the item for $90, a 10% drop and still use a 100% markup you sell it for $180. But this means youn now only have $90 to pay salaries, overhead, debt service, etc that cost you $100 last year and probably will cost you over a $100 this year.
This has been going on for about a decade and most retailers deal with the problem by
realizing very strong productivity — over the past decade retail productivity growth has been stronger then manufacturing growth.
But rather then try to improve the quality of its labor force and make them more productivity Circuit City has followed a strategy of reducing both the quality and pay of its labor force. Consequently, it has not realized the productivity gains other retailers experienced.
So the reason the Circuit City stock fell on the announcement that they were going to replace well paid, productive employees with lower paid, less productive employees is that investors realized that the announcement signaled that the management –read CEO — of Circuit City was continuing to follow the same strategy that had been failing for the past several years.
"Circuit City was continuing to follow the same strategy that had been failing for the past several years"
Perhaps it's a case of people knowing how to manage a busines, but not adequately understanding the market. They are competently managing a company into the ground.
"So the reason the Circuit City stock fell on the announcement that they were going to replace well paid, productive employees with lower paid, less productive employees is that investors realized that the announcement signaled that the management –read CEO — of Circuit City was continuing to follow the same strategy that had been failing for the past several years."
Spencer – I've read that there was almost no difference in productivity among employees who had been there for a year, or employees who had been there for 7 years. Yet the long-term employees were earning in some instances $9 or $10 an hour more than the new-hires.
How did they measure productivity for individual employees?
Sales that they ran through the cash register?
I think Russ was making a point about whose knowledge counts in this discussion. On the one hand, you have a CEO with powerful incentives to seek out the best information regading a decision, and to use that information for the greatest benefit of the shareholders. On the other hand, you have an outside third-party with far less information and incentive than the CEO, but with greater opportunity to exercise hindsight bias. Who would you bet on? (And, I mean before you knew how the future would actually turn out.)
Some of the comments critical of the incentivized, insider CEO remind me of Hillary Clinton's use of a think-tank report that showed certains costs of outsourcing that "weren't commonly considered" by managers engaged in ooutsourcing. She used this report to chide New York managers for "needlessly shipping jobs out of state." I could see CFOs all over the New York slapping their foreheads and saying, "Doh, I should have consulted Hillary's economic brain trust."
K Williams
I'm not saying that all layoffs are a mistake, or that any CEO who engages in layoffs is necessarily making a mistake.
Nobody is saying you think that.
I'm saying that it's clear that the business world goes through fads and that CEOs often engage in behavior that is suboptimal for their companies (although not always suboptimal for them)
So you're alleging frequent breaches of fiduciary duty that apparently go undetected by their boards, but you, an outsider, are capable of detecting. Is that what you are saying? Or are boards complicit in the suboptimal behaviour? If so, for what reason?
In case you hadn't noticed, there is competition between modes of organisation and if boards were really that incompetent you could not expect them to attract investors.
What is really going on is that you are using the wisdom of hindsight to judge decisions which turn out to be wrong.
All the responses here simply amount to saying, again, "They're CEOs. They must know best." But this is completely inadequate.
You haven't read the responses properly, this is an over-simplification of what is being said. In fact its misleading.
David Graf
History is replete with examples of where people in positions of leadership including CEOs were not up to the task.
Hindsight is 20/20. You cite McNamara's failures – presuming, of course, he was responsible for them. But without hindsight could you think of a more talented individual in that position? Can you be certain he or she would have done better? True, many CEOs and leaders turn out bad, but the question is whether boards are doing the best they can with the information available to them.
The rest of your post is spent saying that boards ignore $20 bills on the footpath. If it were as easy to improve as you say, wouldn't they have done it? Afterall, corporations daily solve much harder problems than that. The simplest explanation is that you are missing something.
M. Hodak
Exactly.
Again, Ben, give me a explanation for how the behavior of telecom companies in the late 1990s was, ex ante, optimal. Come up with a plausible explanation.
Also, explain how major league baseball general managers' evaluation of talent pre-Moneyball was optimal, and how, if it was optimal, Billy Beane was able to exploit such massive mispricing opportunities.
Explain how American car companies' CEOs — and the boards — response to foreign competition was, ex ante, optimal.
CEOs engage in suboptimal behavior all the time, not because they're corrupt but because they're limited in their knowledge. And they're not violating any fiduciary duty because they don't know it. I'll say it again: to know whether layoffs, on average, increase profitability, you need to look at a long time series of data and do relatively sophisticated regression analyses. I will happily wager that the vast majority of CEOs do not do such research and instead rely, like most humans, on fast and frugal heuristics. These are often effective, but there are times when they fail. The faith in downsizing appears, at least from the evidence, to be one of them.
As for the hindsight question, how else are we supposed to judge their decisions? CEOs have been downsizing now as a default policy for more than a decade. We can now look at that data and judge whether they made good decisions or not. The evidence says they didn't. Period.
In regards to the American car industry company, technically they were acting optimally prior to foreign competition. The telecommmunications industry was also highly regulated, so would it be possible for them act optimally, like they would in market competition?
"I think you seriously underestimate the information required to know with any kind of certainty that any given round of layoffs are suboptimal"
I think this is backwards. I think KW is saying that CEOs underestimate the information required to know with any kind of certainty that any given round of layoffs are optimal.
K WIlliams
Ok I think we're on about the same page as the ex ante/ex post thing.
As for the hindsight question, how else are we supposed to judge their decisions?
By asking whether a bad outcome could have been reasonably anticipated ex ante given that company's circumstances at the time. That is not a question you have been asking.
We can now look at that data and judge whether they made good decisions or not. The evidence says they didn't. Period.
Excuse me, but what evidence? What you are saying is that, other things being equal, downsizing was inferior to not downsizing. That's a different question to what Surowiecki addresses, because his "but for" does not account for the possibility of larger losses without layoffs, as Russ noted.
Come to the newly formed LayoffCafe.com and express yourself!