Wednesday, August 11, 2010


Mike Dorf

Future archeologists who read the Aug. 9, 2010 issue of the New Yorker may think that the uproarious piece therein by David Sedaris (abstract here) was written in reaction to the curious case of Steven Slater, the JetBlue flight attendant who finally cracked after dealing with one too many surly passengers.   In his essay, Sedaris describes the unpleasantness of air travel these days as only he can, including some tidbits about the (apparently justified) contempt in which flight attendants hold most passengers.  Sedaris should get credit for prescience, for his essay was written many months ago.  I know because I heard him perform an earlier version of it live in April.

Sedaris speculates in his essay that the ill tempers one sees (and experiences) in modern air travel are not so much the product of stressful situations but the way we really are, merely exposed by those stresses.  Perhaps, but either way, it's worth asking about causes.  I'm going to take as a given that there is less civility in contemporary  interactions between customers and agents of large corporations these days than in the relatively recent past (as recently as, say, twenty years ago).  Think of the last time you were frustrated by an endless series of prompts on the customer service line of the phone company, cable company, or whatever.  Now think of the last time you yelled at the hapless customer service representative who continually repeated some nonsensical non-answer to your question when you finally got through to him or her.  Ashamed?  Me too. The mystery I want to address is why has customer service gotten so bad.

The culprit, I think, are the large rewards available to investors and managers for short-term performance.  Our capital markets have become very good at squeezing short-term profit out of productive enterprises, and that has been bad for both employees and customers.  A company that invests in excellent customer service or in making its employees feel valued (through pay, benefits and amenities) can reap long-term profits as a result: Loyal customers provide repeat business, while satisfied employees save on training costs, etc.  And some enlightened managers pursue this course.  (It's easier if you're running a closely held company.)  But if you're trying to show an increase in quarterly or even annual profits, slashing expenditures on employees and customer service will likely do the trick in the short run--and the long run is someone else's problem.

Now, this explanation isn't really necessary for the airline industry, which has been in bad shape for a long time.  With many airlines operating in the red, the need to cut costs is over-determined.  And some of the problems arise from tightened security measures.  But I think these factors merely exacerbate in the airline industry a situation that is bad in most sectors.

So far I have a mechanism--shortsightedness--but I still don't have an underlying cause.  How have the incentives changed in recent years to make corporate directors, managers and even shareholders more shortsighted?  The answer here, as in the financial crisis, was the explosion of compensation.  Gigantic annual bonuses paid to managers who showed large profits in boom years and then skedaddled when the bust came were a big part of what enabled institutions that should have known better to make terrible long-term bets on housing derivatives.  That same dynamic has been at work for some time in undermining customer service and employee satisfaction.

But now the bad news.  The solution with respect to managers gutting companies is apparent (which is not to say that it's going to be adopted): Tie compensation to long-term corporate performance differences between the firm for which managers work and the industry overall.  In short, the mismatch in incentives between managers and shareholders is an agency problem that should be addressed as such.  But solving that problem will not do much for customer/employee relations so long as the principals--the shareholders--are also focused on the short term.  And that seems to be the case, especially when one considers that with computer trading, stocks are now held for mere fractions of a second.

So it looks like we're in for a lot more "cropdusting" (a term explained in the Sedaris essay), if not worse.


C.E. Petit said...

I'd like to suggest an alternative, contributing factor: The Securities Act and Securities Exchange Act... and accounting/MBA academia's acceptance of the quarterly and year-over-year reports as the definitive measure of any company's performance, not just a publicly traded company's performance.

That's not to say that I'm against the kind of disclosure mandated by those acts; it is very much a matter of choosing one's poison. The disclosure-oriented quarterly report regime required by the securities acts is probably the lowest-cost, least-intrusive means of limiting or eliminating the most-pervasive securities fraud. Too, a larger proportion of companies are publicly traded, or are directly related to publicly traded companies, now than in 1933 and 1934. (Example? All of those franchise car-car facilities that have pushed the Norman Rockwellish corner garage out of business in most urban areas and are working their way through semirural and rural America.)

In short, I think some of the shortsightedness is mandated by law — with "standards"-based follow-along effects for those not directly regulated — as a prophylactic against fraud. It has gone too far, particularly in the entertainment industry (where dubious accounting practices verging on fraud are the default, albeit gussied up with compliance statements that wouldn't fool my dog); but some of the alternatives might be worse.

Bob Hockett said...

Nice thoughtful post as ever, Mike.

I'm going to propose a related, but nevertheless partly distinct, cause from those countenanced by you and by C.E. Petit.

(Incidentally, like C.E.'s dog, I suspect, your and my dog friends seem to be pretty bright, so I won't assume that some measure that would not fool them is on that account to be deemed not very subtle.)

Here goes: Like C.E., I think that acceptance of a particular species of 'paper performance' as definitive of *firm* performance might be playing a role here. I doubt that SEC-mandated such reports are the most apposite ones, however. My guess is it's short- to medium-term share price performance. That affects behavior of the sorts you describe per the mechanisms you describe among publicly traded firms, and the latter firms' norms then radiate outward to influence behavior among some (though presumably not all) closely held firms, as well as other firm forms.

Why, in turn, would share price performance take on this focal point role? I think it's likley owing to the pervasive influence of the (theoretically compelling and empirically well corroborated) efficient capital markets hypothesis (ECMH) -- first in financial theory, thence in financial practice.

(I myself subscribe in large part to the theory, let me admit straightaway. I just think many of its proponents misunderstand what it actually entails, more on which below.)

The theory has it that all value-pertinent information is quickly impounded in share prices. Presumably information concerning the long term profitability consequences of compensation arrangements, employee relations, and customer relations would be included in the information in question. Hence believers in the theory, in taking share price to capture all that matters to longterm firm performance, will take it to include all that matters (all that truly adds value) in respect of customer relations, employee relations, and so forth... (continued)

Bob Hockett said...

(remainder of post) ...

Among these believers have been, conspicuously, federal regulators, federal judges, and shareholders. (State courts have generally been more skeptical of the ECMH.) And with actors that influential believing in the hypothesis, decision-makers within firms are apt to do what they can to give them what they are looking for -- good (relative) share price performance -- even when they themselves might be skeptical of the theory (which it seems often they are).

Often this will mean cutting corners in the short run, particularly when it can be expected that other firms are thinking along the same lines and hence apt to do likewise. (There's of course a colllective action story at work here, more on which in a moment.)

The problem, I think, is that believers in the ECMH often neglect that the theory itself admits that would-be relevant but *unavailable* information will of course *not* be impounded in share prices. My guess is that the longterm profitability effects of declining customer service and employee relational standards are of precisely this type. That would be so both for straightforward epistemic reasons, and for reinforcing collective action-related reasons. It is highly 'speculative' if not indeed largely discountable information, after all, particularly in view of the aforementioned prospect that *many* or *most* firms might be expected *simultaneously* to lower standards with a view to cutting costs and boosting profits in the short- to medium-term. For firm A's profits don't take such a hit in response to eroding service standards if firms B through Z are doing the same thing.

In sum, then, I think we might be viewing a sort of race to the bottom, fueled by the facts that (a) all look to share prices as the measure of value, (b) share price performance can be boosted quite quickly in the short- to medium-term by any individual firm's cutting corners, all while (c) longer term share price performance in consequence of such corner-cutting are difficult for anyone to predict or to measure, especially when everyone expects *all* firms to act as described by (b).

I wonder if we're back, then, to something like your earlier game-theoretic account of overbooking some months back. Here the game-theoretics concern a variety of forms of corner-cutting.


C.E. Petit said...

Mr Hockett, that's an interesting analysis. (For the record, I do not buy the strong form of the ECMH, because it discounts both time and structural barriers to information diffusion; but that's for another time.) I would suggest, though, that the way the information that is being assimilated into the market price is more strongly influenced by securities regulations (both in form and in content) than I made clear.

As a specific example, consider the hypothetical year-over-year comparisons for Scholastic, Inc., for 2000 through 2006. These figures vary wildly, for a very simple reason: Harry Potter release dates. Discrete events like that are not well handled by either rigid year-over-year (or quarterly) reporting requirements, or by the ECMH.

Then, too, an awful lot of the information that is being assimilated by the markets is available only due to reporting requirements in the first place...

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Bob Hockett said...

Thanks, C.E.,

On the ECMH, my understanding is that the so-called 'semi-strong' form is the best corroborated thus far. (Fama's 'Efficient Markets II' article is the canonical report of the testing, I think. Not that I think very highly of Fama as theorist, for reasons alluded to above.)

On the role of the '33 and '34 Acts' disclosure requirements, I of course quite agree that they themselves surely are responsible in part for what I above called the 'availability' of some of the information that finds its way into securities prices. There seems still to be lively empirical-analytic debate, however, as to how much of that information might have found its way into prices even absent the disclosure requirements. (I seem to recall that Romano used to do interesting work along these lines.)

For what it is worth, when debates of this sort remain unresolved, I think the best default position is expressible in some such maxim as 'when in doubt, require disclosure.' For even if undisclosed information might ultimately find its way into share prices via the imitated trading behavior of a few insiders or analysts, the speed and the fit are apt to be much better the more quickly and widely the information is directly disseminated.

All best and thanks for the stimulating thoughts,