Is the European way superior?

This article was featured in Think: Act, December 2005

The executive magazine of Roland Berger Consultants

Contrary to popular belief, Europe and European companies are operating from a position of relative strength in general and in comparison with American companies. The difference in economic growth rates between the US and the EU is heavily distorted in favor of the former  by differences in population growth rates and statistical anomalies. Few will believe that both regions expanded at the same rate during the 1990s. The higher US growth rates since the recession of 2001 can largely be accounted for by an unprecedented – and irresponsible – financial injection into the US economy. The combination of increased government spending, substantial tax reductions, dwindling consumer savings, growing consumer debt, the lowest interest rates in history and a feverish housing market have all conspired to secure ongoing growth in American consumer spending, which is by far the greatest contribution to the country’s economics growth in American consumer spending, which is by far the greatest contribution to the country’s economic growth. All these impulses are now fading while dependence on foreign creditors has grown to unprecedented heights.

Meanwhile the competitiveness of the European markets is beyond question. Europe maintains a trade surplus with the rest of the world, including a large and structural trade surplus with the rest of the world, including a large and structural trade surplus with US. And European companies are expanding successfully in growth markets such as Eastern Europe, India and China, where they are either ahead of or on par with US companies. Europe is also the recipient of a disproportionably large part of the world’s total direct foreign investment. All this despite the advantages enjoyed by the Us Private sector: a single language, one legal system; fully integrated markets; structurally higher R&D spending; the world’s most advanced ICT and financial sectors; and a widely supported political choice for economic growth over social cohesion. Europe’s performance is all the more impressive when one considers the inadequate state of Europe’s common market and the other structural impediments to growth that the Lisbon Agenda is seeking to address. In this light, the relatively strong EU economy and the advancement of European companies require an explanation. Europe must be enjoying considerable competitive advantages that have remained unnoticed. The identification, defense and strengthening of those advantages should be highly advantageous. Progress in this largely unexplored area will require only modest resources, and is unlikely to revoke resistance from defenders of established rights, which is the inevitable byproduct of structural reform.

Shareholder value vs. economic value

The dominant corporate objective pursued by listed companies in the US (and increasingly throughout the world) is shareholder return on investment. This is nothing more or less than the largest possible increase in stock price measured over the shortest possible time. Moreover, most of these companies operate on the premise that persistent (preferably double-digit) growth in profit-per-share will be rewarded by the stock markets. Logic dictates that shareholders appoint executives who have already proved their mettle in improving share performance. These managers are offered three- to four-year contracts with a remuneration package that assures full alignment between the interests of shareholders and management over the contract period. The result is strong bias to share buy-backs, takeovers to capture cost-cutting opportunities, restructuring, outsourcing and other corporate policies that are believed to have a positive impact on profit-per-share (and therefore on shareholder return on investment) over the contract period of the executive. But share buy-backs do nothing for the company except lowering it’s solvency ratios. Takeovers have a horrendous record, not only for the acquiring but also for the acquired company.

The negative long-term effects of cost cutting and outsourcing, the destruction of embedded knowledge, social and commercial networks, are only now becoming visible. Each of these popular policies has a negative impact on future cash flows and consequently damages the economic value of the company. Even more insidious and harmful is the value that is not being created because policies explicitly designed to add economic value – investments, partnerships, an increase in research and development – are not taken up because of their negative impact on profit-per-share.

Fortunately, European companies rely on stock markets for only 25 per cent of their capital requirements, compared with 75 per cent for US companies. As a result, most European companies are not subjected to the web of expectations spun around the stock price by investment banks, financial analysts, stockbrokers and the media. They are thus much better positioned to focus on creating economic value by building organizations that generate surpluses in the long term.

Enterprise models

So far European companies have enjoyed access to a wide range of enterprise models, from cooperatives to small privately owned businesses and from state enterprises to family-controlled conglomerates. Each model has attractive national and even regional variations. Because markets are constantly changing, it must be an advantage to be able to select the most appropriate form of governance and management, to design the most appropriate organizational structure, to appoint managers with the skills necessary for different stages of company development and to introduce planning and remuneration systems that are conducive to cooperation and value creation. This competitive edge is worth defending against those who believe in the heavily standardized American enterprise model: clear leadership by a chairman and CEO; decentralized decision-making accompanied by tight financial controls coupled with performance-related pay; and managers that have the personality to make great strides and challenge any form of resistance. Surprisingly, this model survived the scandals that touched so many sectors of the US economy, from energy to financial services and from pharmaceutics to telecommunications. This kind of inflexibility carries a price in a changing world.

Moreover the model is fundamentally flawed. Competitive drive is not abandoned at the corporate gate at the detriment of cooperation of experts and middle managers that forms the foundation of most businesses. Internal labor markets are quite prone to cronyism and other forms of manipulation. High management profiles, ambitious targets and large financial rewards intensify the fight for resources and jockeying for positions. Concentration on a limited number of unequivocal and invariably quantitative targets distorts reality. In fact, the world of management and the real world become severed, and this erodes the basis for decision-making with unknown but  serious economic consequences.

Capitalism deserves much better

Increasingly, all kinds of corporate partnerships are required to improve productivity, enter new markets and develop new products. With transaction cost becoming ,more important, legal systems in European countries provide contacting partners with flexibility and protection based on civic codes in which “good faith” and “reasonableness and fairness” are alive ad well. Contracting parties can base their cooperation on principles and do not have to spell out the rules.

This in sharp contrast to the US, where partners are permitted everything not explicitly excluded by law or by contract. Protection has to be found in specifying the rights of al parties in all circumstances – a far cry from the flexible arrangements needed to help a partnership realize its full economic potential. And in an a antagonistic American business culture, litigation is never far away. The economic damage cause by anticipating, preventing starting and facing litigation is considerable. Litigation stays on the top of the management agenda and companies suffer accordingly. Inevitably, managers become more defensive and less entrepreneurial. Their caution remains unchecked: corporate accounts do not register economic value that was not created.

Capitalism deserves better. The strengthening of the Europe’s competitive advantages will help to advance the private sector and create the economic growth Europe needs to protect and improve its own competitive brand of capitalism, including the pursuit of its political, social and environmental objectives.