When contracts aren't written in stone

George Haley, a professor of marketing at the University of New Haven, was a very helpful source for a cover story I wrote about selling in China for Selling Power magazine a couple of years ago. A specialist in Asia Pacific, George wrote a book in 1998, with professors Usha Haley and Chin Tiong Tan, on the Overseas Chinese -- an insular and powerful business community in Southeast Asia that I had never heard of before that. It is available now in a new, revised edition titled New Asian Emperors: The Business Strategies of the Overseas Chinese (Wiley).

Among many other things, the book explains one of the most disconcerting elements of Chinese business culture for Westerners -- the cavalier attitude to contracts -- as follows:

Many Western businesspeople in Asia have problems with the seeming flexibility of contractual agreements in Asia. The Bundesbank's difficulty in collecting on some of its loans to Chinese companies, including government-owned firms, presents a classic example. When Chinese debtor companies ceased paying in loans, Bundesbank representatives demanded resumption of payment. Their Chinese counterparts responded by arguing that circumstances had changed, and hence the terms of the contract must change. Contractual flexibility follows Chinese custom.

Contractual flexibility took hold among Chinese businesspeople because of the nature of their business. Business-to-business transactions occurred largely between long-time associates at the very least, if not actual family members. Hence, if circumstances changed abruptly in favor of one party to the transaction and to the substantial detriment of the other, they would renegotiate the contract so that neither party would suffer unbearably from changed circumstances. This consideration offered to one's trading partner stemmed from self-interest. An unhappy trading partner might not only refuse to do any further business with the offending individual, but also campaign against him within his network, or even offer evidence against him with imperial authorities.

Welcome to the next depression

Richard Posner isn't afraid to use the "D" word. He says we're in a depression -- as defined by a steep decline in output, a widespread sense of crisis, costly remediation efforts, and long-term impacts.

In A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (Harvard University Press), Posner persuasively argues that this meltdown wasn't caused by rotten financiers or grasping investors. Instead, the depression was caused by a systemic flaw -- everybody acted rationally and that caused an economic bubble that, like bubbles do, popped.

I won't go into the details; you really should read the book - even if it gets a little long as the same basic argument gets recycled through each element of Posner's thesis. But there is one section worth calling out for corporate consideration: it deals with why companies tend to get caught out when bubbles pop and this portion of it adds some fuel to the debate over executive compensation.

Riding a bubble can be rational even though you know it’s a bubble. For you can’t know when it will burst, and until it does it is expanding and that means that values are rising rapidly, so that if you climb off the bubble you will have foregone a large profit opportunity. As Citigroup’s then CEO put it in July 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (He didn’t know it, but the music had stopped.)

The tendency of corporate management to cling to a bubble and hope for the best – or, equivalently, the tendency to maximize short-run profits – is strengthened if, as on Wall Street during the boom, executive compensation is both very generous and truncated on the downside. For then every day that you stay in you make a lot of money, and you know that when the bubble bursts you’ll be okay because you negotiated a generous severance package with your board of directors. Limited liability is a factor, too; neither an executive heavily invested in his company’s stock nor any other shareholder will be personally liable for the company’s losses should it go broke.

And how do executives get such a sweet deal? Well, the board will have hired a compensation consultant who will have advised generosity in fixing the compensation of senior management and as part of that largess will have recommended that senior executives receive a fat severance package (a “golden parachute”) if they are terminated. The consultant will have told the board this because if the board is generous to senior management, senior management may out of gratitude hire the consultant to do other consulting for the firm. And the board will have listened to the consultant’s recommendation because the board will have been predisposed to be generous with senior executives’ salaries. Most members of a corporation’s board of directors will be senior executives themselves. And because a firm’s chief executive officer has a say in whether board members are reelected to the board, the higher a board member thinks CEO compensation should be, the more boards he will be invited to join.

The more generous an executive’s compensation and the more insulated his compensation package is from any adversity that may befall his company, the greater will be his incentive to maximize profits in the short run – especially in a bubble, where the short run is highly profitable but the long run a looming disaster.

The inscrutable ways of publishers

I stumbled on Ved Mehta's Remembering Mr. Shawn's New Yorker: The Invisible Art of Editing (Overlook, 1998) at a library book sale -- 50 cents, such a deal! This book in Mehta's multi-volume memoir titled Continents of Exile deals with his years as writer for the New Yorker and his experiences being edited by William Shawn, one of the all-time greats. All writers and editors should read it for insights into their work.

It goes without saying that Mehta also has a way with a story, including this vignette about his adventures with book publishers:

I engaged in battles to get jacket designs in keeping with the spirit of the book. The battles eventually resulted in tasteful, if quiet, jackets, but publishers regard presentation as their preserve, and what they saw as my meddling seemed to have the effect of making them feel redundant. My interference was resented even more when it had to do with jacket copy. Yet the jacket copy that each of the publishers provided not only was completely at variance with the character of the book but was so badly written that when I showed an example to a colleague, Renata Adler, she exclaimed," It seems to have been written by a lower form of humanity!" The publishers and I went back and forth on several versions, and finally both just threw up their hands and told me to provide them with something.

This cracked me up because I have yet to get jacket copy from a publisher that looks like it was written by someone who actually read the book. I'm not sure that publishers even try to write good copy; maybe they send drivel knowing full well that the author will be compelled to fix it. I always have and thanks to Mehta, I now know I'm not the only one.

One question: Les Leopold

Les Leopold's readable new book, The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—and What We Can Do About It is out this month from Chelsea Green. Les directs two nonprofits, The Labor Institute and The Public Health Institute, which are aimed at educating union workers on public policy issues.

The crux of Les' thesis, if I can summarize without subverting, is that the roots of this recession lie in the gap between productivity and real wages, which began growing in the early 1970s. Instead of going to workers in the form of wages, who would have spent the money on real goods and services that grow economies, productivity gains began going to owners and executives, who, having all the stuff they needed, invested the money. All this new money seeking good returns led to risky lending practices and financial instruments, which, in turn, led to the current mess.

This is a provocative and debatable argument, and certainly one that will resonate in pro-labor circles. My question for Les: In pegging the financial meltdown in the U.S. to the decoupling of productivity gains and real wages, the underlying inference is that those gains – or a larger portion of them – were wrongly diverted away from wage earners. What caused this divergence and why are wage earners entitled to a larger portion of productivity gains?

Here's his reply:

There really is no consensus on why productivity and wages diverged so dramatically. I can only give you my read. I think several trends entwined to undercut the price of labor.

First was what we call “globalization” which, in this case, refers to the ability of corporations to move capital quickly to all parts of the globe. The Bretton Woods agreements, which ended in the early 1970s, had previously prevented such rapid movement of investment capital. But after its collapse, corporations could set up shop in low-wage areas and import the final products back into the United States. American labor, in effect, was in direct competition with workers all over the globe.

This led to the second factor: the decline of unions. The globalization process and its impact on U.S. workers could have been mitigated, in my opinion, had the labor movement been stronger. But labor union density had been in a secular decline since the mid-1950s. Why that happened is a much longer story, but the impact was two fold: First, unions could not moderate national policies on deregulation, capital flight and cheap imports; and second, unions could not effectively bargain hard at the workplace.

The third set of factors involved a shift in political power to the upper income brackets. During the Reagan era and beyond, social programs were slashed, taxes on the wealthy were reduced, the minimum wage was not increased to keep up with the cost of living, and labor laws were weakened.

I don't think we can blame new technologies for the transfer of productivity gains. The computer revolution came later as did the Internet. Manufacturing was becoming more and more automated throughout the 1950s and 1960s. In fact, there was much hand-wringing in the late 1950s about the impact of automation on work and the rise of leisure --- what would workers do with all their free time?

That's why my main point is the following: The distribution of the fruits of productivity is more like a tug of war – a genuine struggle between the investor class and the rest of us. It’s not automatic. Policy impacts the division of the pie.

There is, however, an additional and very important factor to consider, no matter whether you favor more money for working people or more for the investment classes. I think we are living through a real life experiment about what happens when you let too much money accumulate at the top: It runs out of tangible investment opportunities in the real economy and much of it ends up in Wall Street’s fantasy finance casino.

There is a relationship between the rising gap between the super rich and the rest of us, and the crashing of the economy. Such were the conditions before the Great Depression and those conditions almost led us there again. I believe that for the sake of the entire economy, it is best to narrow the income/wealth gap.