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Layoffs and Profits

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James Surowiecki is surprised [2] 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.