Value Extraction or Value Creation

Two opposing economic practices


Manfred Hoefle 

 

Contrasting a value extracting economy with a value creating one illustrates the difference between a distorted market economy and a more desirable, responsible market economy.
A microeconomic perspective is generally adopted in the following essay. 

Value extraction - a distorted market

Value extraction exists when certain groups obtain an unfair advantage in a market. Such groups are not only marginally active (or rather inactive) in creating genuine economic value, they also grab an excessively large piece of the economic cake for themselves.

The anonymous ownership type of organization (the public company) leaves shareholders at risk of disempowerment by directors and executives. The latter often employ short-term strategies and behavior which ensure them the biggest short-term private benefit: this is also consistent with their short-term employment contracts and with the general aim of short-term capital markets (fund managers), namely, short-term profit maximization. Consequently, managers will continuously exploit short-term market circumstances and opportunities as well as their own company. This neatly combines high short-term profits for fund managers and excessive short-term pay for top-management. 

This value extracting approach is inherent to finance capitalism(1) – also called investor capitalism. Capitalism itself first evolved around two hundred years ago, initially in the form of entrepreneurial capitalism; described as such by Joseph Schumpeter the famous Austrian economist. Between the Great Depression of the 1930s and the 1970s, capitalism evolved into managerial capitalism(2) (with separation of ownership and control). Since then and now investor capitalism(3) has evolved and ruled the roost. 

Characteristics of value extraction

  1. One-sided capital orientation: economic rent-seeking by monopolization of markets and locking-in of customers(4), short-termism (keyword: quarterly reports), manipulation of cashflow, balance-sheet makeovers, asset-light strategy, offshore vehicles and high leveraging.
  2. Dominance of arbitrage: opportunity seeking above all via 'finance innovations' based on separation of risk and return, extensive securitization, fragmentation of production costs, horizontal (outsourced) manufacturing, orchestrated supply chains, minimized R&D, purchasing innovation by acquiring start-ups.
  3. Accelerated external growth: takeovers/mergers with leveraged third-party credit, continuous portfolio churning, preference for size and growth, e-business as transactions model.
  4. Oversized parasitic sector: disproportionate growth of external service providers (investment bankers, strategy and management consultants, lawyers, auditors, tax advisors, certifiers, PR consultants: all of these beneficiaries of self-inflicted complexity and complex regulations), installation of costly compliance and risk management systems.
  5. Denial of co-accountability for social wellbeing : exploitation of 'free' common goods, excessive use of public infrastructure also through storage-on-highway (just-in-time batch delivery), environmental burdens and damage, aggressive poaching of trained staff (instead of in-house training), forced early retirement as cheap way of cutting workforce.
  6. Employees as 'human resources' instead of fellow human beings: ignoring social consequences of enforcing extreme labor flexibility and mobility; excessive privileges and status symbols for top-management; mega-bonuses for CEOs.
  7. Widespread Taylorism (5): undermining personal accountability and commitment, underrating of practical experience, creativity and judgement of workforce.
  8. Instrumentalizing the state/government: aggressive lobbying and influencing of law makers: fraud, corruption, blackmail over location, aggressive tax avoidance. 

Extraction is parasitic and happens at many different levels with various hosts. It was facilitated by a noticeable shift from the real economy to the nominal economy:
in the 1960s in the USA the trend was conglomerization (finance-driven acquisition of firms to form conglomerates), in the 1980s, under portfolio management, it was asset stripping and hostile take-overs, justified above all by the shareholder value approach, around 2000 it was the New Economy, and recently a wave of speculative takeovers and subsequent government rescue of both systemic (too-big-to-fail) banks and the US automotive industry. All these are forms of value extraction.

Political-Economic Order at the crossroads

Considering the economic order should be a fundamental task of Ordnungslehre (Political economic theory) and indeed of politics itself. Ordnungspolitik (Political-economic order) should play a key role in shaping a reformed, socially responsible economy. In line with the emergence of a hybrid system of welfare state and a global capital-market orientated economy the post WWII political-economic order was exposed to and marginalized by unregulated market forces, powerful interest groups, and the micro-empiricism of contemporary macroeconomics.

Due to the absence of effective political economic policy, the exponential growth of micro-regulation, a neo-liberal hands-off approach, and the consequent delayed response to paradigm shifts (such as demographic change and the internet), we now need a reinvigorated political-economic order to help us divide the socially beneficial from the socially damaging types of economic activity. 

Characteristics of a value creating economy

Simply put: the opposite of value extraction is value creation. The latter generally takes place in the real economy where goods are manufactured and useful services are rendered. In contrast, the finance sector should be a relative small branch that serves the real economy.

  1. Accountability is the cornerstone: long-term thinking, robust business models, limits to high-frequency trading, sustainable management practices (R&D, building up financial reserves), comprehensive liability in business, company obligation to be good citizens including fair contribution to cost of using common goods.
  2. Human beings as end not means: employees seen as human beings not economic factors in a cost/benefit analysis: working autonomously wherever possible, compatibility of work and family, lifelong worktime models, lifelong learning, bilateral loyalty, treating people with respect and fairness.
  3. Stronger, leaner state: limited to providing basic legal framework, sanctions (effective, simple, transparent) and infrastructure.
  4. Innovation/improvement as continuous task: own R&D, continuous improvement processes (kaizen), embracing all employees.
  5. Conservation of resources: avoiding waste (muda), high material efficiency, use of regenerative raw materials, reusability (cyclical economy); multiple-use (sharing models), repairability/upgradeability, self-reliant economies (subsidiary economies), regenerative energy systems.
  6. Organic growth: emphasis on internal growth, decentralization, regionalization.
  7. Simplicity and transparency: Big enough limits (avoiding too-big-to-fail status); breaking up of critical company structures, deploying regional clusters, close networks and partner relationships.

Value creation - accountability in a market economy

After the national-socialist legacy of moral bankruptcy and material devastation, Europe (in particular Germany) needed a new liberal political-economic order/governance with a constitution that ensured a lasting balance between the pursuit of self-interest (the individual), and the social wellbeing: this political-economic order was known as the social market economy (Soziale Marktwirtschaft). The original purpose of the social market economy was to create social value: specifically, to rebuild the post-WWII German economy which was generally accepted as a common objective. At present with economic disruptions due to the recent, ongoing global financial crisis, the slowdown of economic growth, high unemployment across Europe, and the excesses of globalization, it is urgently necessary to recall the successes and benefits of this post-war value creation economy.

Value creation requires comprehensive, unconditional accountability in the human, economic and ecological spheres ― in that order. This is consistent with the timeless human desire for meaning and satisfaction in a social context. It implies a balance between conservation and innovation, security and incentive, protection and risk, consumption and conservation, civil society and individualism. Instead of short-term profit maximization, a value creation economy emphasizes voluntary limits. Instead of redundant complexity, principles of simplicity and transparency must be adopted.

A value creating economy offers a hopeful future and a realistic alternative to the cancerous growth of extractive economies as experienced in recent decades.

A national economy is not self-serving: it is an instrument to increase and spread prosperity and social wellbeing. This will happen only if we accept continuous change that embraces people who are embedded in and identifying with their community. Distortions that arise from excessive extraction of wealth must be eliminated. Value creation is and must remain the principle purpose of economic activity in a regulated market economy.

 

Literature

  • Berle, Adolf, A.; Means, Gardener, V.: The Modern Corporation and Private Property; The Legal Classics Library, Gryphon Editions, Betheseda, MD, 1993, New York and London 1932.
  • Drucker, Peter, F.: Management, Tasks, Responsibilities, Practices, Harper & Row, New York, 1973.
  • Ferguson, Niall: The Great Degeneration: How Institutions Decay and Economies Die, The Penguin Press, New York, 2013.
  • Hayek, Friedrich, August von: Freedom and Economic System, Chicago, 1939.
  • Minsky, Hyman, P.: Stabilizing an Unstable Economy. McGraw-Hill Professional, 2008 [1st. Pub. 1986].
  • Olson, Mancur: Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities,Yale University Press, 1982.;
  • Acemoglu, Daran; Robinson, A. James: Why Nations Fail – the Origins of Power, Prosperity, and Poverty; Crown Publishing Group, New York, 2012.
  • Schumpeter, Joseph, A.: The Theory of Economic Development: An inquiry into profits, capital, credit, interest and the business cycle), 1911 (Translation (1943) of Theorie der wirtschaftlichen Entwicklung, Berlin 1911); New version: Transaction Publishers, 2011).

 

(1) Although a value extracting economy is a new term it perfectly describes the phenomenon. Kapitalkapitalismus is the term used by former German Federal President Horst Köhler (speech in Herrnberg on 30 Jan 2013: Capitalism – Creative Destruction?)

(2) This includes the de-facto control of capital corporations by management (agents) not owners (principals).

(3) This sequence of "capitalisms" was described by Hyman Minsky (1919 – 1996) a student of Schumpeter. He also used the term "Money Manager Capitalism". 

(4) The business models of Amazon and Google are in this category. The massive online accumulation of direct and indirect customer/user data is exploited to build self-reinforcing customer loyalty ('gluing').

(5) This means all functional areas are considered processes (fragmentation of work tasks, detailed step by step instructions).