Failing Corporations

Failing Corporations: the economic events of the past few weeks were dramatic, but did not surprise me or others who appreciate human cognitive limitations or deplored the depredations of the US administration in the past 8 years. This is not to argue the US is entirely responsible for the global crisis. It is to argue that humans are very small, furry creature who build large systems that sooner or later become uncontrollable. This a law of nature.

I am updating my coverage of failing corporations in my book Group Dynamics and wanted to share this discussion:

In the US, economic booms of the 20th century subsided abruptly on several occasions. In the year 2000, enlarging, merging corporations began to lay off employees by the thousands as economic growth slowed. Large organizations went bankrupt, mergers failed to work, the incompetence and corruption of management was revealed to all. A second bust began in 2007 leading to a deep US recession and chaos in world equity, commodity and currency markets in 2008. Some pundits suggested that recession was no longer a temporary condition and the recovery of economic growth in the 21st century may not be possible. The 2008 collapse of financial institutions in the US and elsewhere could be attributed to many layers of “leverage” that concealed the basic fact that individuals and corporations were surviving on loans they could not repay.

In a remarkable reversal of ideology, Alan Greenspan, the US Federal Reserve chairman for 18 years admitted to a congressional committee that he “made a mistake” in trusting that free markets could regulate themselves without government oversight. Greenspan conceded a more serious flaw in his own philosophy that unfettered free markets sit at the root of a superior economy. He stated: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms. This crisis, however, has turned out to be much broader than anything I could have imagined.”

The desirability of unlimited corporate growth and mergers is doubtful unless enlarging corporations re-organize around small, semi-autonomous groups. The inefficiencies and failures of enlarging human systems is a product of the distinct cognitive limitations of the participants. While smart and apparently well qualified people become CEOs of large corporations their limitations eventually become obvious.

One paradox is that experts are people who focus their attention on details of small parts of large and complex systems, but do not understand how the whole system works. Another paradox is that managers develop competence in smaller systems and advance to the level of their incompetence as the company grows. Even the smartest, best-informed human cannot comprehend how large complex systems work overall.

Politicians usually do not have any training in managing large systems. They tend to be inexperienced managers with simple ideas and slogans instead of advanced knowledge and practical experience. The inventible result is poor judgment, incompetence and in the worst case, reckless mismanagement of human and financial resources.

There is little benefit when governments employ experienced CEOs from big corporations since they are often more expert at concealing their limitations and hiding their incompetence than they are at managing a large system. In reference to state governments in the USA, circa 2003, Princeton professor, Krugman suggested:

”State governments turned into banana republics in part because voters didn't realize that a charming, personable chief executive can also be an irresponsible opportunist, seeking political advantage through policies that ensure a fiscal crisis on someone else's watch. Now the same governing style has moved to Washington and this time there's no safety net.”

While a systems expert may have an outline or overview of how the whole system is organized, the outline is often too abstract and general to really explain how the whole system actually works. Corporate organization charts show a static model. Lines connect the different departments and simple notations show who reports to whom. The all important dynamics are missing. A basic component of systems theory is corrective feedback, a dynamic that is essential to correcting bad decisions and adapting to changing circumstances.

System analysts have emerged with approaches to understanding how the parts work together, but troubleshooting a complex system that is failing is difficult. Humans are always the irrational components in large systems. As corporations become larger and increasingly dysfunctional, conflicts increase within and hostility increases toward other corporations. Customers often face inflexible rules and are treated rudely or face punitive measures if they do not conform to company policies.

Sorkin described the Directors' Consortium, a program developed by the Wharton School, the Stanford Law School and the University of Chicago Graduate School of Business for CEOs of large US corporations. He stated:” The class was not faring well. On its accounting exam the average score was 32 percent… “As I look around the room I'm not sure if this is an executive education program or a support group," said Joseph A. Grundfest, a professor of law at Stanford University. He empathized with the CEOs saying: "I feel your pain."

Collins, writing in Fortune magazine’s annual addition that lists the top 500 US corporations, reflected on the ephemeral nature of big corporations. Only 71 companies of the 500 best listed in 1955 were still in business in 2007. Most of the 2000 companies that made the list in subsequent years have dropped out. Collins blames managers for the failures. He points to examples of corporations that faltered, adapted and continued on a successful path because of new and inspired leadership. While managers are often at fault for corporate failures, I would argue that even the best qualified, most honest managers are just people with distinct limitations who cannot cope with the relentless recurrence and complexity of the problems they face.

Brooks commented on the current crisis in the US economy, October 2008:

“Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest. But during this financial crisis, that way of thinking has failed spectacularly. Taleb not only has an explanation for what’s happening, he saw it coming. In The Black Swan, Taleb wrote: “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. Globalization creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — when one fails, they all fail. Taleb believes that our brains evolved to suit a world much simpler than the one we now face… our perceptual biases distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck. And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters.”

After reading about Taleb in Brook’s article, I found him online and enjoyed his notes. He had given a name, the triplet of opacity, to three of the cognitive features that I have described as limiting conditions in human nature:

1.An illusion of understanding of current events
2.A retrospective distortion of historical events
3.An overestimation of factual information, combined with an overvalue of the intellectual elite