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Students walk on campus at Harvard Business School. Photo by Brent Lewin/Bloomberg

Column: What’s wrong with the Harvard Business School and American business

Editor’s note: Professor emeritus Bruce Scott was a pioneer at the Harvard Business School, where he insisted that management training had to include the big picture, and helped craft the school’s now-mandatory MBA course, Business and Government in the International Economy (known colloquially as BGIE or “Biggie”) back in the 1970s.

Harvard Business School is the subject of journalist Duff McDonald’s new book, “The Golden Passport,” which examines the school’s basic purpose and role in society. The book caused a stir at Harvard and beyond. It also struck a chord with Scott, who penned this open letter to the school and Harvard. It’s published here for the first time.

— Paul Solman, economics correspondent

To the Harvard Business School Community (Students, Faculty, and Alumni):

“The Golden Passport” tells a well-researched story of how an important U.S. business institution “lost its way,” and contributed to the broader story of how U.S. capitalism lost its way starting in the 1970s (and especially from 1980 onward). Let’s take the two stories in succession.

In the opening pages of his important book, McDonald, using the popular acronym for the Harvard Business School, makes the crucial point that “If there’s a case to be made that HBS is failing to adequately address the spiritual (or societal) component of an education in business, there’s an even more damning one on top of that, which is that the School has failed to sustain engagement with the intellectual challenge which has been staring it in the face from the very start, which is to foster a meaningful ongoing discussion of the nature of capitalist society and the role of the firm within it.”

McDonald focuses on the school’s “approach to the role of ‘social enterprise,’” arguing that ”it misses the point by treating it as a distinct field of study. That’s absurd. Every business is a social enterprise. Every single business ‘makes a difference’– the only question is whether they are making a positive or a negative one.”

While his language may be too self-confident for some, McDonald’s identification of a fundamental problem seems laser sharp to me. He balances his critique fairly by recognizing that HBS used its case method to look within firms, and in so doing developed a “viable theory of the firm, which economics still has not been able to match.”

The “science” of microeconomics has assumed that managers are rational economic actors who maximize their own incomes. It is a false presumption. Nobel prize winner Herbert Simon of Carnegie Mellon had it right when he said, in his 1947 book, “Administrative Behavior,” that we should recognize that much human behavior is oriented toward “satisficing” and not maximizing, and the study of satisficing requires sociology as well as microeconomics. Excessive emphasis on economics, and especially excessive emphasis on quantification, has been a huge source of distortion in understanding the theory of the firm; it has conflated math with science.

I believe that HBS made another important contribution to business education which many other business schools still have not made — and which McDonald also missed in his analysis. In the 1973-74 academic year, HBS switched its first-year required course on the societal context for business from focusing virtually exclusively on the U.S. economy, in a required course on the “Manager in the US Economy”, and alternatively to “Planning in The Business Environment”, both of which focused on the US and were taught from the point of view of firms, not societies or economies; to a new course called “Business, Government, and the International Economy.”

That move involved three changes, not just one. It redefined the relevant business environment as the global economy, not just the U.S. economy; it defined the relevant unit of analysis as the nation-state and not just an industry; and, crucially, it defined government as the relevant protagonist in the cases instead of a firm or a manager.

We looked at countries in a “Chandlerian” way, i.e., in terms of what the business historian Alfred Chandler called “strategy and structure.” We lacked the background to understand something important, however: that we needed the concept of “capitalism as a system of governance” to understand the country analysis. In other words, we needed to learn that governance, rather than strategy, was the critical organizing concept for country analysis. Not many other schools, if any, have made such an attempt even today. But despite our efforts, Harvard Business School has not learned the lesson.

McDonald recognizes much better than the HBS faculty that government has a constitutive role in all capitalist systems. He does not seem to recognize, however, just how far off the mark the mental models of most American businessmen — as well as American faculty — are when it comes to understanding the role of governments in market economies.

McDonald makes a very unfortunate but all-too-common series of mistakes when discussing the declining performance of U.S. capitalism in the 1970s and the rise of mismanagement. He attributes it, rightly, to the teachings of Michael Jensen, who argued that firms should “maximize shareholder value” and firms “undervalued” by the stock price should be taken over by those intent on streamlining them and boosting their share price.

What McDonald misses is the role of government. The 1970s and ‘80s were a period of profound change in U.S. financial markets, as then-Federal Reserve Board Chairman Paul Volcker initiated a credit crunch to stem inflation that hit 13 percent in 1979.

To get inflation under control, Volcker initiated a credit squeeze by raising interest rates to as high as 15 percent. This rate seems to have been a necessary economic evil, but a side effect was a punishing effect on stocks. If you could get 15 percent a year lending money to the U.S. government (by buying its bonds), why buy stocks, which weren’t likely to become anywhere near as valuable in so short a time? Thus the most common measure of stock value, the price-to-earnings ratio, or PE of the Dow Jones industrial average, fell from a previous high of almost 30:1 to less than 8:1 in 1981. That represented a decline of about 75 percent, at which point the shares of many and perhaps most U.S. firms were worth more if sold as “scrap” than valued as going enterprises. Firms could be bought on the cheap, and financial firms made sure they were. The merger boom was on; U.S. capitalism was “financialized.” So-called “investment banking” became the hottest game in town.

This situation could and should have been dealt with by policy: a special tax regime, perhaps, where hostile takeover bids would have been subject to a very high tax for the duration of the credit squeeze and its collateral damage of artificially low stock valuations.. Unfortunately, policy makers had no such understanding of capitalism as a socially constructed system. Market outcomes were considered “right” by definition. There was no explicit recognition that market outcomes were the result of public policies as well as natural circumstances.

There still isn’t. U.S. capitalism was and mostly still is understood as a natural system and not one that was and is socially constructed by government policy. It was also the core of the errors in the financial crisis in 2007, which could have been prevented had Alan Greenspan, as chairman of the Federal Reserve, acted to restrain the credit bubble in mortgages. His reluctance was based upon his flawed notion that markets were self-regulating systems; interest rates, as natural as planetary orbits.

“Free markets” must be one of the most overused expressions in the English language. Stated bluntly, there are no free markets in organized capitalism. All of the so-called freedoms in capitalism are conditional freedoms, and that conditionality is established by, legitimated by, and ultimately regulated by, government. But this conditionality has never been made a clear teaching priority in the 50 years that I have frequented the halls of the Harvard Business School.

When faculty talk about reconceptualizing capitalism, as some do, they still talk almost exclusively about voluntary changes in behavior led by firms, not regulatory changes legislated by government or some combination of the two — topics I’ve written about including in my book “Capitalism: Its Origins and Evolution as a System for Governance.”

When HBS circulates its periodic reviews of the competitiveness of the U.S. economy, its reports routinely read as though the problems come from excessive regulation and taxes. The prescription: less regulation and lower taxes, both of which, in my view, are the opposite of what is currently called for. Completely free markets are not a recipe for prosperity; they are a recipe for plutocracy and corruption, as we are increasingly aware of every day.

One of the biggest flaws in the HBS curriculum results from the switch in mental models from an inclusive stakeholder capitalism to the highly extractive new version called “shareholder capitalism” adopted in the 1970s. This model has played a crucial role in causing the rapidly increasing inequality of income and wealth in America — outsized incomes for those in the financial sector who manage the system, and outsized wealth for those lucky enough to be the shareholders.

While the Dean of the Harvard Business School claims that the curriculum goes beyond shareholder value in its model of the firm, and has faculty discuss the problem, it has yet to reach the point where it influences what HBS was intended to be. An antisocial model of the firm still dominates the faculty mindset, to the neglect of the distribution of income and wealth generated by shareholder capitalism.

I believe that there should be three high priorities for conceptual change at HBS. The first would be to admit that the school has failed to acknowledge or address the excessive deregulation of the financial market (and campaign finance law) that took place in the 1970s.

The second priority should be to understand and acknowledge that the adoption of shareholder capitalism and agency theory were huge and very costly mistakes, as is well pointed out in McDonald’s book.

The third priority: to admit that these mistakes were compounded by excessive use of incentive compensation for high level executives, which went hand-in-hand with the curtailment of compensation for employees starting in the mid-70s — changes that were influenced by free market enthusiasts like Michael Jensen.

U.S. capitalism has lost its way, and the increasing anger of those disadvantaged by the reforms to U.S. capitalism and democracy since the 1970s are right to be angry. It was former President Calvin Coolidge who opined that “the business of the U.S. is business.” I believe it’s obvious that business leaders, and still more obviously U.S. business schools, have been leaders in justifying the path capitalism has taken since the reforms of the 1970s. Their focus on how to extract incomes from their stakeholders and transfer the proceeds to their shareholders — and in reality to the top 1 percent of the population through stock grants — have been, and remain, a fundamental part of what has gone wrong. In my view, U.S. business schools, Harvard included, have helped nourish the anger many Americans feel towards the economy — anger that was on vivid display in the 2016 election.

Shareholder capitalism has been an intellectual swindle, on a par with the trickle-down economics of the Reagan era. If business schools, Harvard among them, want to make the world a better place to live, then as McDonald so nicely put it in his book, “it’s time they stopped pretending to make the world a better place and actually started doing [so].”

Sincerely yours,

Bruce R. Scott
Professor Emeritus, Harvard Business School

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