Fortune Work

Nov 08, 2011

We need a flat tax Democrats and Republicans can love

Done right, a flat tax can make the U.S. more competitive and help working people. So let's stop making it so partisan.

FORTUNE—Here’s the bottom line on the hottest issue in the presidential campaign: A flat tax, done right, is a good idea. Herman Cain’s 9-9-9 plan is definitely not a good idea. Rick Perry’s plan is better but a bit murky. We’ll be hearing much more about such plans, and since some kind of tax reform is vital to America’s future, it’s worth taking two steps back from the campaign sound bites to see what’s really on the table.

Today’s thinking on a flat tax originated 30 years ago when Stanford professors Robert Hall and Alvin Rabushka proposed a detailed plan. The basics were simple: Individuals would pay a 19% rate on wages, salaries, and pension income above a generous tax-free allowance; no deductions. Businesses would pay a 19% rate with deductions only for what they paid in wages, salaries, pension contributions, goods, services, and investments, which could be fully expensed in the year made. The system is progressive and efficient, and it offers incentives for the right behavior. They designed their plan to be revenue-neutral, even without assuming it would increase economic growth, though they believed it would do so.

Cain’s plan at first included no tax-free allowance for individuals, making it hugely regressive; he has since promised to fix that, but the plan on his campaign website is unchanged. In any case, the plan’s 9% sales tax still makes it regressive. It’s thus a nonstarter, one indication among many that Cain is just not ready for primetime. Perry’s plan with a flat 20% rate, a big tax-free allowance, and no sales tax is closer to the real deal. But it skews incentives by retaining deductions for mortgage interest, charitable donations, and state and local taxes.

So both plans are flawed—but considering the importance of fixing America’s indefensible tax system, isn’t it a good thing that these reform proposals have become a campaign issue? Maybe not.

The injection of the flat tax into the campaign makes the issue bitterly partisan, which it should not and need not be. Perry is portraying his plan as a badge of true conservatism, distinguishing him from Mitt Romney; such positioning pushes the flat tax far to the right as an issue. President Obama, who has never concealed his fondness for redistributing wealth, wants to make the tax system less flat by imposing a surtax on those with incomes over $1 million, making flat-tax opposition a core value of the left. In the take-no-prisoners culture of today’s Washington, the odds of the two sides coming together on the issue are trending rapidly toward zero.

It was not ever thus. In the ‘80s, Hall and Rabushka’s plan was endorsed on successive days on the editorial pages of the Wall Street Journal and the New York Times, making it the most bipartisan policy proposal since Congress created Mother’s Day. Before conservative Republicans Steve Forbes and Dick Armey pushed the flat tax in 1995, liberal Democrat Jerry Brown made it the center of his campaign for governor of California in 1992. Under cool analysis, a flat tax—done right—offers a lot for almost all to like.

Just don’t call it a flat tax. Call it a top-to-bottom overhaul that will put people to work, close loopholes that serve only certain corporations and the rich, make America more competitive globally, and improve life for people who work hard and save money. A flat tax, done right, can achieve all those benefits and more. Nor is it just theory. Several Eastern European countries have successfully used flat-tax systems for years.

Emphasize that it’s a big change, bigger than most people first realize. Asking whether your taxes would go up or down under a flat tax is too small a question. Such a system would change your income, your taxes, interest rates, the value of assets, and prices of things you buy. All those changes combined would determine whether you’d be better or worse off. If it’s done right, most people would be better off.

A flat tax can be a good idea. Let’s hope it can escape the campaign war zone and get the serious attention it deserves.

This article is from the November 21, 2011 issue of Fortune.

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Oct 27, 2011

Nils Andersen: Møller-Maersk’s trade tracker

Interview with Nils Andersen, CEO of A.P. Møller-Mærsk

FORTUNE—Consumers rarely see one of the most important and dramatic elements of the increasingly global economy: the mammoth ships that keep the whole system moving. Virtually everything we buy traveled by ship at some point or contains materials that did, so shipping trends show how world trade is shifting. By far the largest force in global shipping is A.P. Møller-Maersk, the Copenhagen-based company that operates more than 500 container ships and 225 tankers, in addition to developing ports, operating drilling rigs, and offering related services. Even dominant size doesn’t fully shield Maersk from the whipsawing global economy: 2009 was its worst year ever, and 2010 was its best.

At the helm is Nils Andersen, 53, who became CEO in 2007 after a career in consumer products, mostly with Carlsberg, the brewer. He spends much of his time visiting newly emerging markets, which have no chance of entering the global economy without modern ports and infrastructure; Maersk can build and manage them. Andersen talked recently with Fortune’s Geoff Colvin about why he’s building the world’s largest ships, the trade routes that are growing fastest, the overlooked tragedy of piracy, and much else. Edited excerpts:

Q: Your business is a barometer of global trade. What are you seeing?

A: The developed world has a lot of problems, and that has an impact on global growth. The African and Latin American countries live from raw materials to a large extent, and China and Asia live from exporting things at least partly into the developed world. But overall we see great growth and good development still, especially in Latin America, Africa, and Asia. Europe is actually still doing quite well—we have 5% growth in our transported volumes to Europe. The U.S. is very quiet at the moment—not declining, just stable.

The traditional trade routes are changing—the greatest volumes are not going to be where they used to be. What are the trends?

The changes are very clear. You see a lot of growth in the corridors from Asia to Africa and Latin America, and back with minerals from Africa and refrigerated fruits and foodstuffs from Latin America. You see these parts of the world starting to trade much more with each other. There’s also a lot of growth in inter-Asia trade.

The traditional corridors from Asia to Europe and from Asia to the U.S. are growing slowly. For us it just means we have to look for growth elsewhere. We’ve ordered specialized vessels for the trades to Africa and South America that we are putting into operation now. So our business is growing very nicely.

Why create special ships for the trade between West Africa and Asia?

We’re the biggest transporter in and out of Africa, and so we have very intense knowledge of the trading patterns in that part of the world, including what the drafts are in ports and how we could best design ships. So we worked with shipyards to create a new kind of vessel that could go into ports with difficult, low drafts and still have a reasonable size. A very important part of Africa’s development is getting more access to the global economy. We have to bring down transportation costs into and out of Africa.

That gets to a larger point, which is that Maersk is often the first multinational corporation in a developing country. How come?

I went to the World Economic Forum this year, where there was a lot of talk about getting more growth to the developing world. When you listen in on the sessions, it’s very clear that a lot of things that determine how a country can be successful are logistics. It has to be relatively inexpensive to ship in and out. [Countries] need an effective port infrastructure. They need inland depots, roads, and so on, and our company provides solutions to many of these challenges. So for us to go into a country early is of course very good for us, but it’s also very good for the country because it enables it to become part of the global economy.

Maersk earlier this year announced it has commissioned the largest ship ever built and has since ordered 20 of them, costing $190 million apiece. Each one can carry 18,000 shipping containers. What’s the strategy behind this dramatic move?

When you go from Asia to Europe, it’s a maturing trade. Growth is slowing down. It’s our most important trade, and we have very large markets there. So it’s key to take cost out, and these vessels are very cost-effective. They are also very much in line with our ambition to bring down our greenhouse-gas emissions. These vessels will emit 50% less CO₂ than the average ship trading between Asia and Europe.

Can U.S. ports handle these ships?

You could probably squeeze them into a couple of U.S. ports, but the U.S. port infrastructure is not laid out for vessels of this size. They would basically trade between the largest ports in Asia and the largest ports in Europe.

Which are?

Rotterdam, Bremerhaven [Germany], and Felixstowe [England] in Europe. In Asia it’s Shanghai, Ningbo, and others in South China, and our own Tanjung Pelepas port in Malaysia. These are the biggest ports, and the new ships can easily trade there. But it’s not just a matter of water depth and quayside. When someone offloads 18,000 containers in a port, you have to make sure you can get them out. So it’s inland infrastructure as well. It’s quite a job.

Emissions are becoming a large issue in your industry, which faces an interesting situation. Shipping typically uses very dirty fuel, yet it’s so efficient that it still is the least polluting mode of transport per unit volume.

It is. There are two kinds of pollution. You have CO2 emissions, where it’s a matter of getting fuel consumption as low as possible. But you also have pollution from sulfur and other dangerous substances, and on that we’ve pioneered a fuel switch with the Port of Los Angeles and the members of Congress from Los Angeles. We’ve worked with the engine manufacturers to ensure that the engines can also work with something very close to normal diesel that doesn’t contain as much sulfur. So if you use that fuel when you come close to coastal areas, your pollution reduces to almost nothing. This is now becoming standard globally. Whenever a vessel gets within 25 nautical miles of a coastline in Europe, it has to switch to the low-sulfur fuel. That will be effective from 2015.

These giant new ships are the first ships ever designed to go less fast than the previous generation. Why?

When the whole discussions of CO₂ came, we commissioned a working group of technicians and scientists in our headquarters in Denmark to come up with solutions that could dramatically reduce consumption of fuel on ships. You go through a lot of things—size, hull shape, speed, which paints you use on the hull, your navigation system, how you go with the current and with the waves, how you load the ship. We’re extremely proud of what came out of it. Today we’re a clear leader in the environmental area, which is also good for profits, because with high fuel prices, reduced consumption is money in the bank.

For customers, speed has traditionally been very valuable. Are they telling you that it’s now less important?

We realized that reducing speed is not ideal for the customer. So we went to see thousands of customers to hear what is important for them, and the thing that came out on top was reliability, because if we can make our vessels more reliable, customers can cut their stocks. Just imagine—50% of the container ships in the world do not arrive on time. It’s very, very unacceptable. So we attacked that. The most significant achievement we’re making is trying to get from 50% to 95% reliability so that customers actually know that when they ship with Maersk, the container arrives on time. For most people from outside the industry, that’s what you’d expect.

People may not realize that Maersk has a significant business producing oil in various places around the world, so you obviously have a deep interest in the price of oil. What’s the outlook?

The price at the moment is high—very high in a historical perspective. New finds are being made at very deep water depths, and very complicated production systems are required. So it’s hard to see that you can produce more oil unless the price stays high. We are quite bullish on the oil price, taking into account that even with slow growth at the moment, world consumption of oil and gas is still increasing. We think prices will stay high. They may go down $20 for a while, but we think they’ll stay pretty high.

Your business uses a lot of capital—$12 billion in the first half of this year. The end of cheap capital has been forecast for a few years now, yet at this moment capital is about as cheap as it has ever been. Is the end of cheap capital coming soon?

Capital is basically too cheap for healthy global development. It reflects the fact that governments have a lot of debt and need to stimulate the economy. If we want to make sure investments are flowing in healthy directions and you don’t have bubbles, the cost of borrowing should be a bit higher. We actually have a pretty high cost of capital in our company because after the financial crisis, we reduced our borrowing. So we are working much more with equity, which puts more pressure on us to make money.

Shipping faces a danger that a lot of businesses face, which is becoming a commodity service sold purely on price. How do you avoid commoditization?

We’ve been giving that a lot of thought. I think one of the reasons the industry has become commoditized is that service has not been good historically. I’m not talking about Maersk—we’ve been doing a pretty good job. But if you talk about the industry, when customers expect that only half of their containers will arrive on time, you just try to get the best deal.

What we’re working on now is customer-focused innovation. This week we launched a new initiative, which is daily sailings from Asia to Europe with a penalty if we arrive too late. So instead of building up a big stock that a customer would ship every Friday with the sailing from Shanghai to Rotterdam, he can now ship every day and deliver smaller amounts. And we guarantee that they arrive on the date that we agreed. If they don’t, the customer gets a payment, so we have some money in the game as well. This is at least an attempt to solve a customer problem, and we become a more effective part of his supply chain. We’ll see whether it works. I’m sure that in three months’ time, customers will have learned to appreciate that a lot.

In any other industry, that would not be an innovation. Are you the first in the business to do it?

We’re the first ones, and it is actually a complicated thing because you need to make sure that all the ports on the way operate 100% as planned. You have to have buffers in place if there’s a typhoon hitting or there’s an accident in the Suez Canal or whatever. You have to make sure you’re prepared for almost everything. We’ve analyzed this for a long, long time, and I don’t think it’s easy to copy. You need 70 ships to run such a string, and you need to make sure it works like clockwork. We think we can do it, and if not, we’ll have to pay a lot of compensation to angry customers. But even in that case, they will be better off than they were before.

We haven’t heard much about piracy off Somalia in the past couple of years, at least not with regard to commercial shipping. What has changed there?

Unfortunately, one thing that has changed is that the world has gotten used to it. It’s not new anymore, which is quite tragic because you have maybe 700 seafarers sitting as hostages ...

Right now?

Right now. It’s still a very, very dramatic situation, but the world has just forgotten it. We’re doing what we can to avoid trouble for our ships, which we can do because they are large. They can sail fast. You can have passive protection like water flooding on the deck and barbed wire and stuff like that. But it’s not possible for everybody to do that.

It is a forgotten tragedy, and it is especially tragic because this is in a part of the world where you have a lot of poverty. You need to get goods in, basic foodstuffs, to alleviate hunger and other problems. So it’s doubly bad in the sense that it prevents the development of a region.

What’s the outlook?

I don’t think the immediate outlook is very good. The pirates are becoming more aggressive. It’s a very, very unpleasant situation, and it’s not easy to handle because you can obviously capture the pirates at sea, but on land the people hardly have any alternative to piracy. So there’s a development effort needed to resolve the issue.

Ocean shipping is enormously important to the global economy, yet it’s almost invisible to the general public. What should people know about it that they don’t know?

The great thing about global shipping is that it has enabled global trade to flourish. Containerization bringing down costs dramatically is what has enabled a lot of production in places where it’s inexpensive. That leads to lower prices in the developed countries and the great spreading of wealth across the world.

People don’t see it because you rarely meet a 400-meter-long ship on the highway. It’s not so visible on land, but it is really essential for the creation of global wealth.

The Leadership Series: Formerly called “C-Suite Strategies,” this is the latest interview with a top executive by Fortune senior editor-at-large Geoff Colvin. See video excerpts of this interview at fortune.com/leadership—plus find Colvin interviews with Charles Schwab, the team of Jeff Immelt (GE) and A.G. Lafley (P&G), former New York City schools chancellor Joel Klein, Pimco’s Mohamed El-Erian, Humana CEO Michael McCallister, and many more.

First Published: October 26, 2011: 7:26 PM ET

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Oct 25, 2011

Harry Brekelmans on the future of Shell

Interview with Harry Brekelmans, EVP Royal Dutch Shell

FORTUNE—Figuring out the direction of the world’s largest oil company has never been simple, but rarely has it been more complicated than now. Oil and gas are getting harder to find, governments worldwide are restricting carbon emissions, and the global economy has begun a long-term move toward energy that doesn’t get pumped out of the ground. Imagining Shell’s future in such a world has been Harry Brekelmans’ job for the past two years, made even more challenging because so many constituencies—consumers, communities, environmentalists, politicians—pay close attention to Shell’s every move.

Brekelmans, 46, is a Dutch engineer who has spent most of his career as a Shell geoscientist or operating executive based in Egypt, Britain, The Hague, and Moscow, where he ran the company’s joint venture in the giant oilfield of western Siberia. He says his strategy assignment has given him context that will be valuable in his new assignment, overseeing all of Shell’s interests in Russia and managing its production in Russia and Kazakhstan. He talked recently with Fortune’s Geoff Colvin about the future of biofuels (big), when global oil use will start to fall (before 2040), why Shell is building the world’s largest floating structure (to reach more gas), and much else. Edited excerpts:

Q: Let’s start with the news. The price of oil has come down dramatically since spring. How come?

A: The most important factor is economic growth and the projections for it. The past few weeks have certainly created doubts about the robustness of the economy and growth rates. The fragility of what’s ahead has an immediate impact on projections for energy growth.

Shell has a wide window into energy demand globally. What is that view telling you now—where is strength and where is weakness?

While the near term is very important, it’s crucial to think about the long term. Our industry has a heartbeat that gets measured in decades rather than years. Between now and 2050, driven by demographic growth and increasing economic wealth, particularly in developing nations, particularly in Asia but also in Africa, there will be demand growth that will be significant and perhaps unprecedented. Put that together with the supply picture, where it’s increasingly difficult to see us unlock significant resources, and you’ll see the tension that we’ve seen in recent years continue in coming decades.

If you look across all possible sources of new energy, conventional and unconventional, where’s the greatest increase in supply likely to come from over the next 20 years?

A number of areas come to mind. An important one is Iraq. One could see anything from five to 10 million barrels a day of additional capacity being released there over the coming decade or so. That’s a significant addition. Offshore Brazil is another very significant resource base. Among unconventional sources, heavy oil in Canada is another significant addition. West Africa still holds some promise. Saudi Arabia is working to release further capacity.

What about energy more broadly defined?

Great question—I’ve been focusing on oil with the examples I gave, but adding all that together will not be sufficient to meet demand that will be growing at unprecedented rates. If that were to continue for decades, you would need other sources of energy—very much so—to meet global demand.

First and foremost among other sources is gas. The emergence of unconventional gases in North America over the past decade has added very significantly to gas as a resource. Then you put into the mix renewable sources—wind and solar—which over time we think will be significant but we also think will require time, again measured in decades, to reach scale.

That’s a critical issue for Shell, which has investments in biofuels, wind, and other alternative sources. For a company of Shell’s size, an important question is, Which of them will be workable on a major scale? Because otherwise they can’t have a noticeable effect on the business. Which ones look most promising from that perspective?

You’re right; what is key to us is to differentiate ourselves and make an impact using our specific and differentiated skills and competences. The first area I’d point to is gas. Of all our peers, we’re most focused on developing our gas business. We’re very close to equal balance—fifty-fifty—in our oil and gas production, and we see our gas business growing over coming decades. We feel it’s one of the sources that needs to be focused on more, given that it’s a lower-carbon alternative to many other fuels, particularly coal, used for electricity generation. We are very big on insuring that we retain a lead in that space. If you look 10, 20, 30 years forward, I would say that we’d still be leading in gas, and that probably would be our most significant business.

Biofuels are very important for us. We recently made a very significant investment in a joint venture in Brazil in sugar-cane-based ethanol. That makes us one of the biggest distributors and producers of biofuels. It’s our view that biofuels are a lower-carbon alternative to fossil fuels for transportation and one where we can reach scale quite quickly. We feel we can differentiate, get to scale quickly, and help the world deal with the carbon issue.

In the U.S., ethanol has never been economical without government subsidies. Is that going to change?

Sugar-cane ethanol can certainly be produced economically in the investments we’ve made, and over time we can see ethanol being economical in Europe and North America even without the incentives. Of course there’s an interaction with overall energy prices, but we think biofuels will be an economically viable alternative.

Later this year Shell begins construction of the first floating liquefied-natural-gas platform, which will be the largest floating structure ever created—much bigger than the largest aircraft carrier—costing $10 billion to $12 billion. What makes this worth doing?

It’s an engineering marvel, first of all, and I’m an engineer by background, so I can’t help being very enthusiastic about it. It’s a huge, amazing structure, the length of four football fields. When fully loaded it weighs six times as much as the world’s biggest aircraft carriers.

One of the features of the gas business is that a lot of significant gas resources are stranded. Given the costs associated with transport to markets, a number of significant resources have always been uneconomical. With the floating LNG, you can design and develop one, and then use it many times. You’re suddenly changing the economic equation and opening up a significant number of stranded resources that can now be developed economically.

The first place we’ll use it is our Prelude field off the northwest coast of Australia. That was a resource that until this point could not be developed. Over the coming years we’ll be able to develop a number of other alternatives using that kind of technology.

The energy industry needs tremendous innovation. Shell is known for an approach to innovation called the game-changer process. What is it?

It’s a methodology and a mindset where we allow people to work on off-the-wall ideas that are far away from being viable. They can be put in an incubator and get stimulated with extra funds, so they can grow and bloom within their own space without getting absorbed by the corporate machine. Parts of the floating LNG development were conceived within the game-changer process.

Other examples?

One of the applications we use significantly in our conventional oil and gas business is what are called swellable packers—they isolate the formation from the well itself. We’re using materials that one of our researchers came across when he was in a toy shop. We all know them—they’re these little animals that you throw in a bucket of water and they swell up. We use that same methodology to constrict sleeves that you can insert in wells. They get soaked with fluids, and then they set and expand and provide a seal around the reservoir. It’s very cheap and simple.

Shell’s long-term forecasts show fossil fuels as a source of the world’s energy starting to decline after about 2040. What causes that turning point?

Gas could continue to grow until 2040 or even 2050. Oil we see peaking before that, mostly driven by costs and environmental sustainability challenging the use of fossil fuels. As a result, alternatives such as wind and solar will be gaining prominence, albeit at a relatively slow rate.

How do you evaluate the peak oil hypothesis—basically right or basically wrong?

People talk about peak oil in the sense of supply. But I think of Sheikh Yamani’s classic quote, “The Stone Age didn’t end because we ran out of stone.” People simply moved on to different and better things. The same will happen with fossil fuels. It’s very important to realize that we’ll be moving on to alternatives before we run out of oil and gas.

The year 2040 is not necessarily the demand peak either. The interaction between supply and demand will govern at what point—2030, 2040, 2050—we really see the peak. But rest assured, I think there will be gas and oil left by the time we’ve moved on to those alternatives.

How does Shell grow and prosper after fossil fuels start to decline in use?

Beyond 2040 we will still be using some fossil fuels. Gas will still be important, and given the scale of the global markets, I think that still leaves enough of a commercial space for us to play in.

Biofuels will at that point, and perhaps beyond that, be a very significant business, and meanwhile we’re exploring other alternatives that could provide low-carbon sources of energy. Hydrogen is one that we’ve explored for some time and are still actively involved in. It’s difficult to see that gaining material scale in the nearer term, but it’s not impossible for hydrogen to gain prominence in coming decades, and it’s an area where we have specific skills and will want to play.

We’re also exploring a role we could play in vehicle electrification. We don’t yet see a viable business there, but again it’s not beyond us to see us developing business propositions there in coming decades.

And then urbanization is a huge driver of how efficiently or inefficiently we’ll be able to deal with energy. We’re looking at the provision of energy services to urban areas in a variety of ways that in the long term can provide us viable and significant business opportunities.

One forecast is that by 2050, three-quarters of the world’s people will live in cities, the equivalent of a new city of 1 million every week for the next 30 years. Is that fundamentally good news or bad news?

It could be either. The numbers are stunning, and the work we’ve been doing with a number of experts shows that urbanization is driving energy demand growth. People living in urban areas tend to use more energy than people not living in urban areas, but there is a vast difference in the way that cities could develop and the implications for energy use. There is a striking difference between compact, well-designed, well-governed, usually relatively wealthy cities and sprawling, chaotic, not so well-governed cities. The differences in energy intensity are so vast that it will have a huge effect on whether this will be a positive development or a painful and difficult one.

Vehicle electrification is highly significant in that equation. What will determine whether electric vehicles become a major trend or a minor trend?

A combination of factors—convenience, cost, and technology, and of course they all interact. But there’s no doubt in our minds that electric vehicles will play a role in the way mobility is conceived in the future. The point we would raise is that there will likely be a mosaic of solutions. In some of the cities I visited recently, you see a combination of hybrid vehicles, compressed natural gas, LNG, and electrical vehicles. And the internal combustion engine still has a long way to go in attaining additional efficiencies.

The futurist Ray Kurzweil predicts that solar energy will be able to provide all of the planet’s energy in 20 years. Presuming you don’t agree, where does he go wrong?

Solar is one of those energy sources we should be pursuing. What we would say, however—and we can substantiate it in the work we’ve done recently—is that it takes decades for any energy source to reach scale. It takes about 30 years for any new energy source to attain 1% market share. That’s been the case for gas. Within the basket of gas carriers, it’s been the case for LNG. It’s been the case for nuclear, for biofuels, and for wind.

It just takes time for technologies to be economic and be accepted by users globally. We think the same will be the case for solar. So if you think in terms of three or four decades before we reach 1%, then his theory is challenged. Will solar play a role? Yes, it will.

What’s the outlook for significant international cooperation on carbon emissions?

It remains something that we advocate for. It won’t be sweeping global measures. We think that would be effective, but we recognize the challenges of it, given the diversity of issues that governments face. What you have seen in past months is more regional and local action. If you look at legislation over the past 12 months, there’s been a lot surrounding emissions and environmental impacts that are positive. So we shouldn’t underestimate the fact that on the ground, things are happening. Is it at a sufficient pace to deal with the challenges ahead of us? Probably not.

This article is from the October 17, 2011 issue of Fortune.

The Leadership Series: Formerly called “C-Suite Strategies,” this is the latest interview with a top executive by Fortune senior editor-at-large Geoff Colvin. See video excerpts of this interview at fortune.com/leadership plus find Colvin interviews with Charles Schwab, the team of Jeff Immelt (GE) and A.G. Lafley (P&G), former New York City schools chancellor Joel Klein, Pimco’s Mohamed El-Erian, Humana CEO Michael McCallister, and many more.

First Published: October 5, 2011: 8:28 PM ET

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Oct 20, 2011

What really has the 99% up in arms

It's not that the rich are getting richer. It's that the rest of America isn't.

FORTUNE—The most important fact to realize about the rash of popular protests around the world—Occupy Wall Street in the U.S., demonstrations in Greece, Spain, London, and elsewhere in Europe, violent uprisings in rural China, even the revolutions of the Arab Spring—is that they aren’t about money or inequality. If they were, they’d be easier to deal with. They’re about perceived injustice, which reflects a deeper, fiercer problem.

The spark of the U.S. movement may soon be obscured as it’s taken over by career protesters, labor unions, and others who enjoy any chance to torment corporate managers. But the spark is where we find what’s new and meaningful, and it seems to have emanated from a feeling by the protesters that they aren’t getting a fair shot at prosperity. They believe that big companies, specifically major banks, have rigged the system to their own benefit and to the suffering of ordinary people.

That perceived injustice is the real root of today’s rage. Yes, many Wall Street executives make tons of money, but plenty of hedge fund managers, for example, make far, far more, yet no one is camping outside their suburban Connecticut offices. For that matter, America loves Warren Buffett, just as it loved Sam Walton when he was the country’s richest man. Fellow citizens making billions do not by themselves get many people riled.

Even economic inequality isn’t enough to send mobs into the street. Inequality in the U.S. has been increasing for over 30 years. During most of that period the rich were getting richer, and the poor were getting richer, but the rich were getting richer faster. Though the gap was widening, the lid stayed on discontent as long as everyone was moving ahead. Inequality actually diminished in the recent recession, as it usually does in tough times. If inequality were the problem, people would be less upset today than they were in 2007.

Billionaire parties are still raging

What’s new is that those with medium and lower incomes have not been getting richer for several years, while those with high incomes have been, and the unprecedented slowness of post-recession job growth has left many feeling deprived of their rightful opportunity to improve their lot. More broadly, they feel they’re being punished even though they did nothing wrong, while those whom they blame for the whole mess—the bankers—got bailed out and are raking it in. Infuriating injustice.

The elements are the same in protests worldwide, whether the specific grievance is blatant corruption, as in China and the Middle East, or violation of the social compact, as in Europe. The innocent are punished while the guilty are rewarded. That combination is intolerable.

In the U.S. this narrative is flawed and in some ways plain wrong. Most of the Occupy Wall Street protesters probably don’t know that they, as taxpayers, actually made money from the bank bailout. They may be forgetting that millions of Americans are being foreclosed on because they willingly, even eagerly, took out mortgages they couldn’t afford. Some protesters are simply clueless, like one who responded to a question from the New York Times by saying he’d never heard of Warren Buffett, or one who complained to NPR that “we’re paying for the bailout,” or one who told the Times that the airline Virgin America is a good company because it’s “working on creating solar planes.”

It doesn’t matter. What people know or don’t know isn’t important. All that counts is what they feel.

At a private meeting of movers and shakers a few years ago, a CEO presented the facts on the long-term diverging fortunes of the wealthy and the middle class in the U.S. Henry Kissinger, who was chairing the meeting, observed that the situation held the makings of “a social and political cataclysm.” It seemed an overly dramatic pronouncement, but he was right. Only a feeling of powerful injustice was missing, and now it’s here.

Even if Occupy Wall Street should evaporate, the fuel that’s feeding it will not. Think of it as a warning. Cataclysm is a long way off, and it certainly isn’t inevitable. But we’re a little bit closer.

This article is from the November 7, 2011 issue of Fortune.

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Oct 17, 2011

Even all-star executives need awesome coaches

What makes an Executive Dream Team even better? A superconnected, no-nonsense board of directors.

FORTUNE—A major lesson in the business dramas of recent years is that great executives are almost—but not quite—enough. If the board of directors isn’t right, then nothing’s right. Consider famous failures like Bear Stearns and Lehman Brothers, or costly scandals like News Corp.‘s (NSWA) phone-hacking debacle, in which the boards missed major risks they should have caught. So as we wind up our Dream Team series, we focus on the foundation of any top company: a dream board.

A great board combines several competencies, and well-chosen directors often bring more than one of them. Top of the list now:

Global perspective

It’s amazing how slowly many companies have added genuinely global directors. A foreign passport or a history of exotic vacations doesn’t cut it.

Financial expertise

Sarbanes-Oxley requires that every public company’s board include a designated “financial expert,” and the audit committee has become a director’s most demanding assignment.

Deep understanding of infotech

It’s arguably the largest force shaping global business. Boards need directors who grasp how infotech will change every company’s strategies and business models.

Wisdom, experience, and courage

Two enduring problems on boards are directors who don’t speak up and directors who speak up but don’t know what they’re talking about. The right mix of gray hair, perspective, and assertiveness is worth its weight in gold (even at today’s price).

The contact list of all time

Most companies could use help in broadening their relationships with top leaders in global business and government. Directors can provide it.

Where to find all those traits? Start with global stars like India’s HCL Technologies chief Vineet Nayar, a management visionary, or a Chinese self-made billionaire like Alibaba founder Jack Ma, or a managerial maverick like Haier Group CEO Zhang Ruimin.

Call Hank Paulson. The former Goldman Sachs (GS) boss and Treasury secretary brings finance expertise, government knowledge, long experience, and the cellphone numbers of everyone important. If he can’t reach someone, Condoleezza Rice probably can; she also understands business, having served on corporate boards before becoming national security adviser and secretary of state.

Amazon (AMZN) chief Jeff Bezos may see better than anyone how technology reshapes nontech businesses. For wisdom, experience, and courage, turn to FedEx (FDX) founder Fred Smith, Kraft’s (KFT) Irene Rosenfeld, or recently retired CEOs Doug Conant, who saved Campbell Soup (CPB), James Owens of Caterpillar (CAT), and Neville Isdell, who righted Coca-Cola (KO) and has deep roots in Africa, a booming market of tomorrow.

Assembling a board with all those members—well, that’s probably dreaming. But hey, it’s a dream team. And it would be a dream in another sense: Shareholders could sleep very soundly.

This article is from the October 17, 2011 issue of Fortune.

 

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Sep 30, 2011

Jim Collins: In his own words

What's behind a giant multiyear research project like the one that became Great by Choice? Fortune's Geoff Colvin asked Collins what inspired him, what surprised him, and what may be next.

FORTUNE— Q: Managing through turbulence is topic A for business leaders now, but you and your co-author Morten Hansen chose it as a research focus in 2002. What led you to it back then?

A: We came to believe that growing up in a country like the U.S. in the second half of the 20th century (or in Norway, as Morten did) created a false sense of stability that would likely not return. Think about it: How many times in history does a people come of age in the seemingly safe cocoon of a dominant global superpower during an era of rarely stalled rising prosperity? Ancient Egypt, Greece in 500 B.C.E., the Roman Empire, England in the 1800s, and a few others—these, along with the U.S. in the second half of the 20th century, are rarefied slices of human history. And rarefied slices tend not to repeat. Morten and I came to believe that we were entering an extended period of uncertainty and turbulent disruption that might well characterize the rest of our lives. We wanted to understand what’s required to perform exceptionally well in such a world.

This research is full of unexpected findings about the companies you studied. What surprised you both most?

There were so many surprises! That’s the joy of good research. I was delightfully surprised by the finding we came to call “Fire Bullets, Then Cannonballs.” A successful venture or breakthrough product can look in retrospect like a single-step act of pioneering creativity, but that retrospective bias is deceiving. The path to something like, say, the iPod turns out to be a multistep iterative process—first “firing bullets” to gain empirical validation before making a big bet (firing a cannonball). Who would have expected that empirical creativity, not visionary genius, better explains 10X success in a chaotic world? And here’s the beautiful thing: It’s a learnable behavior.”

The winning companies you identify often defied conventional management thinking. Which of today’s popular management ideas strike you as particularly dangerous?

The idea that results are primarily determined by chance events or forces outside of our control. There is an emerging school of thought that makes an argument something like this: If people in a stadium flip coins and sit down when they get tails, some small percentage will be left standing after 10 flips by sheer chance; in this view, those who build 10X companies or achieve outsize success might merely be those few who just happened to flip 10 or 20 heads in a row. In finance, there might be some truth to this idea. But when it comes to building great companies that outperform their industries for 15 or more years, this view is not only wrong, but debilitating. Those we studied were paranoid about chance events and complex forces out of their control, but they focused on what they could do, seeing themselves as ultimately responsible for their choices and accountable for their performance—no matter what the sequence of coin flips.

Overstating the power of luck seems to be a deep human tendency. How did the winning managers get past it?

They have a paradoxical relationship to luck. They credit good luck for having helped them in their accomplishments, despite the undeniable fact that others were just as lucky. But if they get bad luck, they still hold themselves responsible for their performance. They prepare always for the possibility that they might have to endure multiple hits of bad luck in a row. That’s one reason why they hold freakishly high levels of cash and a conservative balance sheet.

One of your key points is that winning companies maintain a steady pace through good times and bad—what you call the 20-Mile March. But what do they do in a multiyear stretch of a stagnant or shrinking economy, like now, when it may seem impossible to maintain that pace?

The 10Xers simply did not accept any external factors as an excuse or reason for failing to achieve their 20-Mile March. Look at Intel (INTC) and its 30-year-plus march to accomplish Moore’s Law (double the complexity of components per integrated circuit at an affordable cost every 18 months to two years). Gordon Moore and Andy Grove would have never allowed external factors, even the catastrophic industry meltdown of the mid-1980s, to be a “reason” to be knocked off their march.

When you look at the traits of your winning managers, do they suggest an advantage for either men or women?

The best leaders we’ve studied, men or women, distinguish themselves first and foremost by their Level 5 ambition: being fiercely ambitious for a cause or company larger than themselves, channeling ego into that larger goal, infused with the will to do whatever it takes to make good on that ambition. Four of the women leaders I’ve written about previously all share this fundamental distinction: Wendy Kopp of Teach for America (my own choice for entrepreneur of the decade); Anne Mulcahy, who saved Xerox (XRX); Katharine Graham of the Washington Post, one of the 10 greatest CEOs of the 20th century; and Frances Hesselbein, who revitalized the Girl Scouts and is now CEO of the Leader to Leader Institute.

Each of your books seems to arise from questions raised by the previous one. Can you give us any hint of where we go from here?

I’ve accepted a two-year appointment as the Class of 1951 Chair for the Study of Leadership at the U.S. Military Academy at West Point, and I’ll be traveling from my lab in Boulder to visit with cadets multiple times per year beginning in 2012. These young cadets will somehow affect and inspire me. I’m also inspired by young people at social enterprises like Teach for America and the young crop of church leaders. I suspect that the next question to grab me around the throat might well be ignited by these up-and-coming generations.

This article is from the October 17, 2011 issue of Fortune.

Back to Jim Collins: How to manage through chaos

Video courtesy of Detroit Regional Chamber and Detroit Public Television

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Sep 19, 2011

Obama: Looking for jobs in all the wrong places

The president has a very clear vision of how to solve the jobs crisis. The problem is he's completely misguided.

FORTUNE—Even Democrats and Republicans at each other’s throats agree on one thing: Jobs are America’s No. 1 issue. President Obama and his Republican challengers strive to outdo one another with ideas for job growth, and maybe some good will come of that debate. But right now the President is the only one in a position to take action on the problem. The bad news for the country is that he seems fixated on an approach that is delusional and doomed.

President Obama is bedazzled by the idea of manufacturing jobs as the way forward. Just look at his most prominent jobs initiative, his Jobs and Competitiveness Council, which will meet with him at the White House this month. He announced the council’s formation at a giant turbine factory in Schenectady, N.Y., praising the jobs it creates and saying, “I want plants like this all across America.” He next met with the council in June at a lighting factory in Durham, N.C., telling the workers they’re “leading the comeback of American manufacturing. This is where the future will be won.” Total references to manufacturing and building things in those speeches: 17. Total references to services: one, and that was in the phrase “goods and services.”

The President is trying to create a narrative in which U.S. manufacturing fell into sad decline over the past decade but can be restored to its former glory and employ legions of Americans in high-paying jobs. “What was driving our economy was, we were spending a lot on credit cards,” he said in Schenectady, talking about the previous economic expansion. “Folks were selling a lot to us from all over the world. We’ve got to reverse that. We want an economy that’s fueled by what we invent and what we build.”

But that narrative, implying that U.S. manufacturing withered while we bought Chinese products at the mall, is simply wrong. American manufacturing boomed during the expansion. The value of “what we build” increased every year. The problem for the President—and it’s a giant, central problem for him—is that we did it with fewer workers every year.

Four ways to get businesses to invest again

This is the overwhelming reality that the President ignores. The great story of manufacturing in America and every place with a market economy is that we continually produce more stuff with fewer workers. The trend is not new. Manufacturing employees were 39% of total U.S. workers at the end of World War II, and that was the peak. The proportion has declined steadily ever since and is now 9%. Looking past percentages, the raw number of U.S. manufacturing workers topped out in 1979. Today it’s 11.8 million, about half what it was then, though the country is far larger and richer and manufactures enormously more. For perspective, in 1941, before our entry into World War II, we had more manufacturing workers than we have today.

None of this should be surprising, because we’ve seen this movie before. Well over 60% of U.S. jobs were in agriculture in the 19th century, and the proportion has been declining ever since. Today it’s less than 2%. Back when it was 60%, hunger was a significant worry for much of the population. Today that tiny 2% of workers produce so much food so efficiently that obesity is our gravest national health problem.

Fewer people relentlessly produce more and better stuff, whether it’s corn, cars, or any other physical product. The trend isn’t going to reverse.

The President’s obsession with manufacturing jobs goes deep. “I’d like to once again see our best and brightest commit themselves to making things,” he told Georgetown University students soon after taking office. And that’s fine. Smarter, more sophisticated, higher-technology manufacturing is good for America. But one thing we know for sure is that the more advanced that manufacturing becomes, the fewer people it employs. At a time when the country desperately needs more jobs, manufacturing is obviously not the place to look for them. As the President meets with his Jobs and Competitiveness Council, listen carefully to what he says. A delusional policy for America’s No. 1 problem is the last thing we need.

This article is from the September 26, 2011 issue of Fortune.

 

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Aug 25, 2011

The critical facts that no one mentioned in the debt debate

Hiking taxes on the rich has a long history of backfiring. Let's learn from history.

FORTUNE—Is it socially and politically okay to do what we’ve just done—commit to cutting federal spending by trillions without asking anyone to pitch in by paying higher taxes? The answer is yes. In this case it’s definitely okay, current market fluctuations notwithstanding. But the reasons have nothing to do with anything said by either side in the debt ceiling debate. And if we do get higher taxes down the road, as we may, they’re unlikely to be a social boon for the nation or a political win for anyone.

Both sides tried to claim the moral high ground in this debate. President Obama said it was unfair to cut programs that benefit the middle class without making “millionaires and billionaires” pay higher taxes. Republican leaders said raising taxes slowed the economy and cost jobs, which we couldn’t afford with unemployment over 9%.

Far more important is what neither side told us. Taxes are going up anyway, on millionaires, billionaires, and everybody else, because the Bush tax cuts expire at the end of next year. As a result, estimates the Congressional Budget Office, federal tax revenue over the next decade will be greater by $3.5 trillion (or about 10%) than it would under a continuation of current policy. The spending cuts in the debt deal would reduce federal spending by about 5% over the next decade. So it looks as if we’ll all be pitching in plenty.

But what about appearances? For the sake of social harmony, shouldn’t the rich be seen to bear a greater share of this burden? Consider a couple of other things nobody is telling us. Raising taxes on millionaires and billionaires in the U.S. accomplishes little and sometimes nothing. Maryland raised taxes on millionaires in 2008, and so many millionaires left the state that tax revenue from the group didn’t rise as intended, but fell dramatically. New York tried the same thing, after which then-governor David Paterson, a liberal Democrat, said, “I won’t make that mistake again.” He was succeeded by another liberal Democrat, Andrew Cuomo, who faces a huge deficit but strongly opposes renewing the millionaire’s tax.

The reason for these surprising facts is that the U.S. already leans harder on the rich than any other developed nation. Research from the OECD shows that the richest decile pays a higher proportion of the nation’s taxes in the U.S. (45%) than in any of the organization’s 23 other member countries. That top decile also earns a higher proportion of total income in the U.S. (33.5%) than in most other countries, but when you compute the ratios, as the nonpartisan Tax Foundation has done, the U.S. puts the heaviest tax burden on its rich. Trying to extract more from them doesn’t work.

And yet—isn’t the U.S. taxed less overall than other developed nations? Yes, it is, but not because our combination of property, payroll, corporate, and personal income taxes is much different from theirs. On the contrary, says the OECD, they’re almost identical. The developed economies seem to agree on the most that can be extracted through those taxes (it’s about 23% of GDP). The difference between us and them is that they all additionally impose a VAT—a value-added tax—and we’re the only developed nation that doesn’t. So if we’re going to raise significantly more tax revenue to help reduce the debt, that’s where it is likely to come from.

Whether that happens depends on the most frightening word in Washington: Medicare. Until we address its ballooning costs, we haven’t even touched our debt problem. Unfortunately, the new debt deal explicitly prohibits cutting Medicare by more than 2%. If our leaders remain too weak to confront the main element of our fiscal crisis, then it’s not hard to imagine a future in which we let Medicare balloon, impose a VAT to cover the costs, and sink into our own version of Eurosclerosis.

Is debt reduction without a tax increase okay? There’s no need to worry about it, since we’re going to have a tax increase. Instead let’s keep the focus where it belongs. Is debt reduction without major Medicare reform okay? That one’s easy: No.

This article is from the September 5, 2011 issue of Fortune.

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Jul 15, 2011

Zhang Ruimin: Management’s next icon

You'd be hard pressed to find a manager who is more innovative or fearless than the head of Chinese appliance giant Haier Group.

Zhang Ruimin is famous, but not nearly as famous as he should be—or, I suspect, will be. In China he’s a national hero, the man who turned the failing Qingdao Refrigerator Factory into Haier Group, a galloping enterprise with revenue of $20 billion and one of China’s first global brands. But in the West, few other than management specialists know his name. That ought to change. Zhang is innovating radically, maybe more radically than any other manager operating on such a large scale. Even those who think they know him may not realize how far this former Red Guard and municipal bureaucrat is taking capitalism.

Zhang brought me up to date when I sat down with him recently in Beijing. I knew the story of his early breakout from the collectivist mold: how the Qingdao authorities had made him boss of the refrigerator plant in 1984, and he’d quickly found that it produced terrible refrigerators. So he had 76 defective ones pulled out from the rest, gave the staff sledgehammers, and ordered them to destroy every one. The message: Poor quality is no longer tolerated. He expanded into air conditioners, washing machines, and stoves, started exporting, and unlike any other Chinese company, began building a brand. By the late ‘90s he was showing up on lists of Asia’s top entrepreneurs, then Asia’s most influential businesspeople, and by 2005 the world’s most respected business leaders.

That’s about where I had left Zhang, not realizing that he was only getting started. He had successfully organized the company for efficient mass production, which made sense in the capital-intensive appliance business. But he believed that success in the big leagues of the 21st century would require a different competency: meeting the demands of retailer customers faster than any competitor. He reorganized the entire company into self-managed units, now 4,100 of them, each devoted to a customer or group of similar customers.

The units include employees at all levels from the usual functions—design, manufacturing, marketing, and so on. Members who work directly with customers make all the decisions; managers are there only to make sure the unit gets what it needs. That is, the managers manage—somebody has to—but Zhang doesn’t want them in charge because they aren’t in direct contact with customers. “If the members of a unit don’t like the way their manager is performing, they can vote him out,” Zhang tells me.

Each unit regards itself, and is evaluated, as an independent business earning a profit or loss. “The usual accounting statements didn’t tell us what we needed,” Zhang says, “so we had to create something new.” Thus, revenue means cash in the till, not orders booked, as in traditional accounting. Costs have to be allocated from manufacturing, sales, and the other functions; units also get hit with a capital charge for inventory, another break from typical accounting. If a unit’s profit exceeds its target, the members can split the extra.

That’s only the beginning. We could hold a seminar on how Haier evaluates employees (daily, with results posted publicly). Many of the innovations are based on principles described in Western management literature, and some are similar to practices at smaller companies like W.L. Gore. But I don’t know of any manager innovating on a larger scale or more broadly or fearlessly than Zhang.

Why, at age 62, after 27 years of running Haier, does he keep pushing? A hint of what drives him sits on his desk: the framed cover of the October 2002 Fortune China, with an illustration of a sinking ship and the headline WHY COMPANIES FAIL. The article, by consultant Ram Charan and former Fortune writer Jerry Useem, concludes that the explanation is almost never uncontrollable outside forces but rather managerial mistakes.

The reason Zhang keeps at it is pretty simple. His energy mirrors the larger forces driving China’s amazing rise and explains why he’ll probably be a global management icon: He’s still hungry.

This article is from the July 25, 2011 issue of Fortune.

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Jul 13, 2011

Uncle Sam’s first CIO

It's a title to conjure with: chief information officer of the United States. Vivek Kundra, 36, is the first person ever to hold it, having been given the new job by President Obama in March 2009. And what a job...

FORTUNE—It’s a title to conjure with: chief information officer of the United States. Vivek Kundra, 36, is the first person ever to hold it, having been given the new job by President Obama in March 2009. And what a job—the U.S. government is the world’s largest consumer of information technology, spending about $80 billion on it each year. Much of that money is wasted. The federal government has accumulated 24,000 websites and more than 10,000 separate IT systems; servers in some agencies are idle 93% of the time. Kundra’s assignment has been to improve efficiency while also making the government’s staggering quantities of valuable data more available and useful to the public.

Kundra recently announced he’s leaving Washington to accept a fellowship at Harvard. He departs to acclaim; the World Economic Forum this year named him one of its Young Global Leaders. Born in New Delhi, Kundra moved to the Washington, D.C., area with his family at age 11. After earning bachelor’s and master’s degrees from the University of Maryland, he worked at tech startups and was the District of Columbia’s chief technology officer before Obama called. Kundra talked recently with Fortune’s Geoff Colvin.

Q: As the first person to hold this job, what did you find when you showed up for work?

A: If the Obama campaign represented a sleek iPhone, the White House was much more like the rotary phone. We found that billions of dollars in information technology projects were years behind schedule and after the money was spent weren’t even working. For example, at the Department of Defense there was an IT project where they had spent 12 years and $1 billion, and nothing worked. We ended up terminating that project. The President had to fight tooth and nail just to get a BlackBerry. For my staff, mobile devices were assigned based on the square footage of your office and how many years you were in government. I felt like I’d gone back decades.

What were the biggest opportunities?

They were in four areas. First, we wanted to look at this $80 billion that we’re spending every year on IT—how do we make sure that taxpayer dollars are not wasted on investments that don’t produce dividends for the American people? Second was cracking down on inefficient infrastructure—billions of dollars on data centers. Third, cybersecurity. We wanted to shift away from a paperwork reporting model to address a risk that was real, whether it’s nation states that are actively coming after our systems, or organized crime. You can’t confront that by writing reports. And fourth, the most important opportunity was to tap into the ingenuity of the American people. For too long, Washington was designed with a view that Washington has a monopoly on the best thinking, and the reality is, it doesn’t. So we wanted to use technology to tap into the millions of Americans who want to create a more perfect union.

Was there anything the federal government was really good at?

The government had excelled historically and continues to excel at the basic research that has helped create massive opportunities across the country and the world. At DARPA, the Defense Advanced Research Projects Agency, which is where the Internet was born, there’s some cutting-edge information technology work happening. Some of the best minds in cybersecurity are within the National Security Agency.

You created a plan for transforming federal IT management and near the top was a “cloud first” policy. What does that mean? And why did you consider it important?

I asked a very simple question: How would a startup company launch in the private sector? If you went to venture capitalists or your board of directors and said, “I need millions of dollars to hire an army of consultants to stand up my e-mail system and build a custom financial system and build out a data center so I can host a website,” you would get laughed out of the room. And that’s exactly what the federal government was doing.

Startups are going to Google (GOOG, Fortune 500) for e-mail, or to Microsoft (MSFT, Fortune 500), or to Hotmail. They’re going to Intuit (INTU) and using QuickBooks for the financial systems. They’re going to a number of providers online to stand up a website, and they get value day one, literally. They don’t spend months or years procuring those services. Imagine if the federal government, with purchasing power of $80 billion, demanded from the vendor community, “We want value day one. We don’t want to wait years, and we don’t want to spend millions of dollars, because we’ve seen this movie, and it always ends poorly.” That is one of the reasons I focused on cloud first.

I also looked at the wasteful spending on infrastructure—from 432 data centers in 1998 to over 2,000 today. Average utilization of processing power is under 27%. Average utilization of storage is under 40%.

So you’ve announced a plan for closing or consolidating hundreds of those data centers. Makes sense, but why wasn’t it done long before you got there?

In Washington there’s a huge focus on policy, not a lot of focus on execution. So one of the things we did from day one is set specific timelines. We put in people who were responsible for executing and were ruthless about making sure we’re delivering.

For example, one of the first things I did was take the picture of every CIO in the federal government. We set up an IT dashboard online, and I put their pictures right next to the IT projects they were responsible for. You could see on this IT dashboard whether that project was on schedule or not. The President actually looked at the IT dashboard, so we took a picture of that and put it online. Moments later, I started getting many phone calls from CIOs who said, “For the first time, my cabinet secretary is asking me why this project is red or green or yellow.” One agency ended up halting 45 IT projects immediately. It was just the act of shining light and making sure you focus on execution, not only policy.

The IT dashboard was one of your high-profile initiatives. Does it now show the progress of all major federal IT projects?

Absolutely. You can see every major IT project and how we’re doing. Besides the picture of the person who’s responsible, I also decided to put up every company that had won those contracts. So all of a sudden, CEOs were coming to see me. A number of CEOs issued press releases around how all their projects are green. It created this incentive to perform.

Shining light alone is not sufficient, so I decided to go after projects that are not performing well. We were able to save $3 billion after terminating projects that were not working, or de-scoping them. We also halted $20 billion worth of financial systems last summer because these were projects we had spent billions on with very little to show to taxpayers.

All those agency CIOs report to you, but you’re not really their boss. As a practical matter, how can you make things happen?

The key is, you’ve got to keep following up. It’s a very simple management principle. You can’t just shine light and hope that results will follow. You’ve got to be relentless about going after some of these IT projects.

I realized when I was going after these projects, terminating them or de-scoping them, that I wasn’t the most popular person in the room. But I didn’t take the job to be the most popular person in the room. Vendors were very upset because we terminated multimillion-dollar IT contracts. CIOs may have spent years on a specific project, so they continued to throw good money after bad and were emotionally tied to those projects. But at some point, you need to just step back and ask the tough questions.

A fact of life in government is that administrators have little incentive to reduce their budgets. Frequently it’s just the opposite. How do you fight that tendency?

One of the reform areas we’re pushing very, very hard—but it’s going to require an act of Congress—is to change the way we budget for information technology. The budget cycle takes up to two years. So these CIOs are thinking about where they’re going to spend their money two years from today. Steve Jobs develops an iPhone in less time than it takes average agencies to get their budget done—and that’s just the budget, not the spending.

We’re trying to reform the way we budget federal IT so that the incentives are much more aligned with delivering these projects on time. Everybody thinks they have one shot at getting the funding, so they try to boil the ocean instead of moving toward these lighter-weight, agile methodologies for how you deploy projects, and making sure that the money they save they can keep to reinvest.

That helps explain something you were recently quoted as saying: “The average schoolkid probably has better technology in his or her backpack than most of us do in government offices.” How do you fix that while also trying to control IT spending?

There’s a huge divide between the consumer space and the public sector. Why? The reason is that in government there isn’t a Darwinian pressure to innovate that’s in the consumer space. Consumer companies are one click away from extinction, so they have to innovate constantly. Yet in enterprise IT, which is far inferior to consumer IT, victory is considered winning that contract. Once companies win that contract, the incentives are to optimize their margins, not to innovate or make sure they’re providing better services.

You address that problem by adopting consumer technologies. Why are we even in the business of giving mobile devices at an enterprise level? Let all government employees go out there, pick whatever mobile device they want, and let competition decide which is a better technology, instead of having some random bureaucrat setting a standard for millions of people.

One of your major efforts was Data.gov, which makes hundreds of thousands of government data sets available to the public in the hope that the private sector will create valuable ways to use all that data. Have the results been what you aimed for?

Absolutely. We launched it in May of 2009. It started with 47 data sets. Today there are over 390,000 data sets on Data.gov on every aspect of government operations from health care to education to what’s happening across state and local governments. There are 19 countries that have replicated Data.gov. Over 29 states have replicated the Data.gov platform, and a dozen cities across the country, from New York City to San Francisco, have launched these platforms.

In my view this is going to be a transformational platform. We’re now putting up money for competitions for developers and the average American to come in and create applications that the government couldn’t even imagine. When we initially launched this, somebody developed an app called Flyontime.us that allows you to see average delays of flights and people tweeting wait times at airports, so you can make an intelligent decision. Since then, search engines like Bing have used data that’s come out of Medicare and Medicaid that allows you to see how hospitals are rated by patients and outcomes from those hospitals. If you type the name of a hospital, right in your search results you can see that. An iPhone app allows an expectant mother, before she buys a crib, to scan that product and see whether it’s been recalled. It’s shifting power to third parties and recognizing that the government doesn’t have to build everything. It can create a platform very much like what the U.S. military did with GPS satellites that gave birth to an entire GPS industry, or what the National Institutes of Health did with the Human Genome Project that gave birth to personalized medicine.

A lot of companies are saving significant money by using videoconferencing, document sharing, and other collaboration tools. Is the federal government making much progress on that?

Yes. An interesting case study is what the Social Security Administration is doing with videoconferencing. People don’t have to drive down to a Social Security office—they’re doing it through videoconferencing. The General Services Administration recently moved to Google Apps, and part of what they’re going to be doing is using the consumer tools to do video online instead of building these massive brick-and-mortar platforms.

All of which would be uncontroversial in any private enterprise, but it’s a big change at the federal level.

It’s a huge change, and part of the reason is that we’re introducing new competition. Companies like Amazon (AMZN, Fortune 500), Salesforce.com (CRM), and Google, which had never competed for government business, are coming in and aggressively going after that $80 billion opportunity. That is great from a taxpayer perspective. We want more competition, not less. Historically with public sector IT, every solution was based on hourly rates of consultants. So you would throw bodies at problems rather than trying to find meaningful disruptive technical solutions.

Another IT tool, business analytics, helps companies spot improper payments, among other things. The Office of Management and Budget estimates the government lost $98 billion to improper payments in 2009, which sounds like a huge opportunity. Is it?

It is. On the Recovery Act [the stimulus bill], we worked with a company called Palantir, which is in business analytics. To prevent fraud, we were able to slice and dice and cube all this data to make sure that entities that were winning these contracts were appropriate. The ability to investigate and go through massive volumes of data allowed us to prevent it.

Now we’re taking that practice and applying it to Medicare, Medicaid, and other grant programs. Over half a trillion dollars in grants go to state and local governments and then to private sector companies, and the fraud, coupled with the error rate, is huge. That is a huge opportunity.

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Jun 22, 2011

Motorola’s uphill battle

Can Sanjay Jha revive the cellphone legend in a world dominated by Apple and just about everyone else?

FORTUNE—At least there was no place to go but up: When Sanjay Jha joined Motorola as chief of its cellphone business in 2008, the division was losing billions and on the verge of failure. The RAZR phone’s success had evaporated, Apple’s (AAPL, Fortune 500) iPhone had revolutionized the industry, and the recession was pounding down demand. The division’s employees were depressed and cynical, having seen 10 presidents in 12 years. Jha’s assignment was to fix the business.

Born in India and educated in Britain, Jha had risen to COO of Qualcomm (QCOM, Fortune 500), which designs chips for cellphones, when Motorola called. He quickly abandoned Motorola’s own cellphone operating system in favor of Google’s (GOOG, Fortune 500) Android (see “One Hundred Million Android Fans Can’t Be Wrong”) and created a little more marketplace buzz by introducing innovative products, most recently the Xoom tablet. But progress remains a struggle; Motorola is still an also-ran in global market share by units and by revenue. Jha, 48, is now captain of his own ship—Motorola Mobility Holdings (MMI) separated from the rest of the company in January and is publicly traded. He talked recently with Fortune’s Geoff Colvin about differentiating in a crowded market, his toughest challenge, why people cry when their cellphones are taken away, and much else. Edited excerpts:

FORTUNE: It’s the year of the tablet, and you introduced the Xoom to good reviews in January. We’ve since seen the iPad 2, RIM’s PlayBook, the HTC Flyer, T-Mobile’s G-Slate, and many others. How do you differentiate yourself?

SANJAY JHA: The biggest thing we could do is think about what audience we’re addressing. We see large corporations switching entire IT systems to tablets. One reason CIOs like the tablet is that it delivers cloud-based computing and renders it very easily. Consumers love it, and enterprise users love it, because of the immediacy of interaction. Second, we need to deliver the best browsing experience. We support Flash 10 [a media player], and that makes a huge difference. A large portion of the web is now viewable, where in some other devices [notably iPads, which do not support the Flash player] it’s not viewable. Third, we believe you must be able to view all your content, anywhere you keep it, in a mobile environment. We’ve made some acquisitions that will allow you to access all your content on your tablets. Of course, size and form factor are always important, and our brand name has always played an important role in the U.S., Latin America, China, and increasingly in Europe.

Why focus so much on making your tablets highly useful in a big enterprise setting?

About 65% of the devices—tablets and smartphones—that show up on an enterprise network are actually purchased by consumers, because CIOs’ budgets have been cut. These devices must be attractive for consumers and must also have the security to meet the CIOs’ standards.

CIOs get terribly nervous when people bring their personal devices into the business.

That’s right. We call this trend consumerization of the enterprise. There was a time when CIOs said, “There’s just no way you can bring that device.” But increasingly they’re accepting the devices, and we work with CIOs to deliver the security that makes them comfortable.

A lot of managers don’t fully understand the business usefulness of tablets and smartphones. How do you use mobility in Motorola Mobility?

We’re a global company, and we’re really interested in collaborating through videoconferencing. In the olden days audioconferencing quite frankly was better than videoconferencing. Now, with high definition, you can see body language, and that’s a huge amount of the communication in any meeting. And increasingly our people are not in their offices, so being able to participate in videoconferencing using their tablets or smartphones is very important. In addition, the vast majority of our services are being delivered through cloud services. That’s also very important. Of course the normal capabilities of secure e-mail, the ability to wipe the tablet clean if it falls into the wrong hands—we’re using all those things.

Something like 20 manufacturers, including Motorola, are making or will be making Android-based smartphones. Distinguishing yourself in that environment has to be a challenge.

It certainly is. [But it is] probably the largest opportunity in technology in my lifetime. People are saying that in the Asia Pacific by 2015 there will be 3 billion phones [of all types]. Some predictors are saying there will be a billion smartphones in 2014. The compound annual growth rate is over 35%—a great opportunity. But we’re not the only ones playing in this marketplace. We’ve chosen to focus on delivering consumer experiences and simplifying people’s lives. Technology that doesn’t simplify people’s lives is not a technology that resonates over a long period. We’re very focused on our design process. It involves a huge amount of consumer testing. Our designers are nearly always interacting with consumers to find out what will resonate. And again, enterprise and multimedia are two very important areas where we want to differentiate ourselves.

That gets to a really important issue, because you’re doing all this on the Android platform, which is available to anyone. An analyst said recently, “Android is a commodity platform, and to compete, you need scale. They [Motorola] clearly don’t have it now.” Is that a valid concern, and if so, what do you do about it?

Scale is a factor in every business. But over the past 30 years the correlation of a company’s profitability with market share is weak. The stronger correlation is actually with consumer loyalty. You want your consumers to come back and buy your devices over and over. J.D. Power recently showed us to have the second-highest loyalty in the smartphone market. So scale is a factor, but I do not believe that scale is a determining factor. Lots of companies used to have very large scale, and they lost their way. We need to innovate and meet consumer expectations, and that’s going to be our focus.

Before you came to Motorola it had a record of strong innovations, but they were intermittent. The RAZR phone was a big success in 2005, but there was nothing to follow it up. Can you keep a business continually innovative?

Innovation itself is not enough—I sometimes call it corporate entertainment. Lots of things in American corporations are done in the name of innovation. It’s wasted money unless it solves consumer problems. The central thing I have tried to bring to Motorola is how we solve the right problems. It has to be unique and relevant, and I’m very focused on that. Very often, innovation is associated with being unique. Unique is not enough. There’s no one way of doing innovation. You have to create a culture where people are prepared to fail once in a while if you’re not prepared to fail, there’s no chance of success in a sustained way. So we’re taking more chances. We’re creating a culture where people are prepared to say 20% of the time, “This is a high-risk business proposition or a high-risk technology proposition.” We will engage with it. We have what we call a retrospective review process. We reward people on how—given the circumstances—they made decisions and acted, as opposed to setting objectives. We set objectives too, but we look at how people acted toward accomplishing those objectives.

You came to Motorola when it was losing billions of dollars. This was an emergency situation. What were your top priorities?

My No. 1 priority was to make some clear business decisions and focus the organization on objectives. Before my arriving here, we were chasing market share, scale, and a number of different objectives that weren’t clear. As soon as I arrived, I said that within 90 days we’ll make some decisions about the direction of the organization. One of the core decisions we made was to select Android as our platform. It certainly wasn’t clear that Android was a winner, and it didn’t have the scale it does today. Lots of folks felt I had burned my boats and had chosen one path. I believe in making your bets. I believe you fail if you don’t decide which path to choose. If you take too many paths, sometimes there’s no path to success. That decision to focus made a big difference. We still have to focus more, so that what Motorola stands for and how it differentiates itself show more clearly in our products.

What about dealing with employees who were uncertain about their future and uncertain about you, because they didn’t know you. How could you help them understand they could be winners again, and change the psychology of the place?

That was the largest challenge. We had a town hall meeting, and one of the first questions I got was, “Why should we trust you?” My response was, “You shouldn’t. I will promise you a certain number of things, and if I deliver them, then you should begin to trust me.” But it was one thing to trust me. Trusting themselves to be winners was another issue, and we did it with small successes. We set small objectives, and as we began to see ourselves doing well financially and delivering products we could all be proud of, that made a big difference. The challenge was that I was taking $5 billion of costs out—it was done not in one fell swoop. So everyone had some uncertainty about their position, and it’s a testament to the commitment of the employees that they stuck with it. I think it’s broadly recognized as having been the right course of action. But it was very difficult to have two or three cycles of layoffs while you’re asking people to work harder.

Does personal infotech over time end up focused almost entirely on the phone?

I believe the device you carry with you at all times is much, much more important than a tablet, which most of us will carry about 30% of the time. And I absolutely believe that the phone is going to be the best computer, because it’s with you at all times. It’s going to be the best camera, because it’s there when you need it. It will be the best music player because it’s with you at all times. We do surveys and sometimes take phones away from people, and they start crying. They have that amount of personal investment in the relationship. It becomes the digital hub of your life. So I think this is the biggest opportunity. Mobility, Internet, content, computing—all of that is converging into this device.

There’s an argument that this business is fundamentally a hit business—each product is a hit or it’s not. Such businesses are fundamentally volatile, and investors discount their value for that reason. Is there a way to escape that?

I think there is. In the history of this business Nokia (NOK) accomplished that, and today Apple has accomplished it. You’re right though in saying this is a hit business. It’s very much like a Hollywood movie business or a drug selection business. What we need is a business machine that works at a modest profitability level at all times, and then on top of that you can have hits. The question isn’t whether there’s volatility. There is definitely volatility in this business. You’re only as good as your last product. But we have a distribution machine, a supply-chain machine, a development machine, a branding machine, a go-to-market machine, which delivers a level of profitability. I think it’s possible to get that machine to be efficient enough, and then on top of that you take this 20% or 30% innovative bet that some of them could be hits.

History says an industry like this eventually consolidates to a handful of players. Do you expect that to happen, and does Motorola survive as an independent company?

I expect consolidation to occur. Our customers are consolidating, and our supply base is also consolidating. But my view is that consolidation occurs in some interesting ways. I’m not convinced that handset manufacturers acquiring other manufacturers is the best way for value to be created for shareholders. Consolidation across content manufacturers and hardware and software manufacturers—I see a bunch of different ways for this consolidation to occur, to create shareholder value and create different structures to the industry. You’ve already seen the acquisition of Palm by HP (HPQ, Fortune 500), a very interesting acquisition that brought software and hardware assets together. The relationship between Microsoft (MSFT, Fortune 500) and Nokia (NOK) also speaks to that. Do we expect Motorola to be an independent company? I don’t know yet. I hope very much that we are. I believe our strategy is the right strategy and will deliver the shareholder value we’ve promised.

It sounds as if Motorola consolidating possibly with a software outfit of some kind is not unimaginable.

There are lots of opportunities for us to combine different resources and create more shareholder value.

The stock market seems to think Apple is going to rule the world—it’s the second most valuable company in America, after Exxon Mobil (XOM, Fortune 500). What are Apple’s vulnerabilities?

I’m loath to comment on vulnerabilities of a company that has been incredibly successful in delivering world-class products. On the other hand, I would say that scale and innovation very often don’t mix. Defense of market share and other defensive actions very often set in, and middle management begins to drive the culture and strategy of a company. I’m certain the folks at Apple are very cognizant and are prepared to make sure that doesn’t occur. But not speaking about Apple in particular, the scale that comes with that level of success is very often the beginning of a decline.

You’re a global CEO running a global business. What’s the key to America’s competitiveness in the world economy?

Innovation and the education system. We have—or we’ve had—the best secondary- and [college]-education system in the world, and we by and large changed the world—not just ourselves, but also England and some other places. We definitely want to encourage the brightest people in the world to come and innovate here in America. Some of our immigration policies are slightly counter to that direction. We ought to look at that and also invest much more heavily in, first, our education system, and second, what I call pre-competitive research in our universities. When we put a man on the moon, we were spending far more of our GDP on research than we are doing today. It’s important that we go back to the roots of doing fundamental research and then winning on the basis of that.

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Jun 20, 2011

Why can’t we fix Medicare once and for all?

The largest element in America's worsening debt outlook is the growth of Medicare. If we don't fix it the right way, the country will become dramatically poorer and weaker.

FORTUNE -- We can try to fix Medicare in two ways. One is a proven winner, the other a proven loser. The stakes could scarcely be higher -- and right now we're betting on the loser.

Medicare has become the largest issue in America because it threatens the country's economic future. Ten former chiefs of the Council of Economic Advisers, from both parties, warned in March that if we don't get the national debt under control, the result will be "a crisis that could dwarf 2008." The first worrying signs have since appeared; the cost of insuring against a once-unthinkable U.S. debt default rose by more than 50% in late May, and Moody's and S&P have warned that the country's debt rating is in peril. By far the largest element in America's worsening debt outlook is the growth of Medicare. If we don't fix it the right way, the country will become dramatically poorer and weaker.

One way to fix it is the Brute Force approach. That's the concept on which Medicare was built. The federal government dictates which services are covered and how much will be paid to doctors, hospitals, and others for everything they do. To keep costs under control, Washington restricts what it covers or dials down what it pays.

How well has the Brute Force approach worked? "It never works," says Mark McClellan, former head of the Centers for Medicare and Medicaid Services. The House Ways and Means Committee predicted in 1967 that the new Medicare program would cost $12 billion in 1990. Actual 1990 cost: $110 billion. (2010 cost: $523 billion.) The problem is that eternal irritant to grand Washington plans, the market. Turns out that if you unilaterally cut prices, some providers will quit providing services and some patients won't get care, so you can't cut too much. And if you pay providers barely profitable rates when they perform a given service, they will overperform those services, grossly inflating the government's costs. That's what has happened.

The other way to fix Medicare is the People Aren't Dummies approach. It's the concept on which most markets operate. Let people spend their own money -- even if it's given to them -- and let providers compete for it. Providers aren't dummies, so they'll innovate in ways that bureaucrats would never think of. Consumers aren't dummies, so they'll choose what works for them. Quality rises, and costs stay reasonable.

The People Aren't Dummies approach has a proven record, and it's the opposite of Brute Force's record. Medicare Part D, which took effect in 2006, lets users choose from competing private plans for prescription-drug coverage. "Most of those plans aren't at all what the law envisioned," says McClellan. Instead, they're what consumers actually want. And Part D costs are about 45% below what was predicted when it was created.

So which approach are we banking on? You guessed it. Brute Force is the guiding principle for controlling Medicare in the health care reform law. An Independent Payment Advisory Board would control costs in any ways it sees fit; in practice its choices would be limited to cutting prices or limiting care. We've seen this film before.

The approach that would work, People Aren't Dummies, is at the heart of Rep. Paul Ryan's Medicare rescue proposal and has been demonized by Democrats and even some Republicans. But in fact it has a long history of bipartisan backing. Premium support, as it's called in Ryan's plan, was first proposed by two Democratic economists, Henry Aaron and Robert Reischauer. The Bipartisan Policy Center's Debt Reduction Task Force last year proposed gradually converting Medicare to premium support. The proposals' details differ, and hammering out agreement wouldn't be easy. But the basic approach is solidly in the center.

That's the good news. The bad news is that reasoned debate on Medicare seems to have become impossible. Just remember: Our future depends on choosing what works. So far we aren't choosing it.

First Published: June 20, 2011: 6:05 AM ET

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May 13, 2011

Mitch Daniels tips his presidential hand

With decision time approaching, the Indiana Governor shows (noncommittally, of course) why he'd make a perfect candidate for the GOP.

FORTUNE -- Indiana Governor Mitch Daniels still hasn't decided whether he's running for president, but he knows time is running out. "I have to make a decision within a few weeks," he said in an exclusive interview with Fortune.

Of the many possible Republican contenders, Daniels has attracted the most speculation because his success fixing Indiana's fiscal mess positions him best to address the nation's looming debt crisis. Pundits, including Time magazine's Joe Klein and the New York Times' David Brooks, have publicly urged him to run, and many Republicans have beseeched him privately. He has said he'd make no decision until after the Indiana legislature concluded its session -- which it did at the end of April -- and the demands of fundraising probably require that any candidate declare his or her intentions by June. So Daniels knows the clock is ticking.

It's far from clear whether Daniels burns to be president, but he is genuinely passionate about the fiscal threat to America's future. He's a fan of Paul Ryan's multi-year budget proposal: "I think it's terrific. It's clear and visionary and courageous -- the boldest and bravest effort that we've seen. It's already improved the debate, so it's a real contribution." Ryan proposes fundamental changes to Medicare, and though they wouldn't take effect for a decade, some seniors are already beating up Republican representatives who've backed Ryan's plan. Is Medicare still an issue that elected officials can't touch? "Better not be," Daniels says, "because it'll wreck America if that's the case."

To Daniels, changing Medicare as Ryan advocates is good news, not a painful sacrifice: "What people will eventually understand is that the real enemies of Medicare, the real enemies of Social Security, are these people who are saying leave them as they are. They will explode, or implode. Ryan and people who want to go a similar direction are out to save the safety net."

As a candidate, Daniels would make a near-perfect anti-Obama. He scorns President Obama's signature policy triumph -- health care reform -- which Daniels calls "a travesty." Asked why, he says, "How much time do I have? All the claims made for it were false. It's going to balloon the federal deficit, not tame it. It's going to raise health care spending, not lower it. It's going to cost a lot of people the coverage they have -- that was supposedly not true. It doesn't reform anything."

While Obama has expanded the federal government, Daniels has shrunk Indiana's to the point where the state now employs fewer government workers per capita than any other state. Washington is running record deficits, but Indiana now runs a surplus; the U.S. Treasury's credit rating is under threat, but Indiana's has improved under Daniels, to triple-A.

More contrasts: While Obama has made federal regulators far more activist, Daniels says, "I'm in favor of at least temporarily setting aside some of the regulations that make it almost impossible to start a business and hire people in this country -- making sure that we still protect vital interests like the environment and worker safety." While Obama has been extraordinarily friendly to labor unions, Daniels reduced the bargaining rights of the Indiana government's unionized workers six years ago, long before the recent controversies in Wisconsin and Ohio. (Granted, it was easier for him because he could do it by executive order.)

Daniels (Princeton '71) seems every bit as smart as Obama. He has also shown promise against him politically: In 2008, when Obama won Indiana, Daniels won reelection in a landslide.

But Daniels still has work to do making voters feel the urgency that he feels about America's fiscal peril. Asked how he can do it, he says, "Look, debt and its consequences became very concrete and very personal for tens of millions of Americans recently. I don't know what could be more real than the experience many Americans have had, having gotten over-extended themselves, or someone in their family, or the business they once worked for. There's a lot more concern that the nation could go broke, with terrible consequences, especially for low-income people." But exactly what those consequences might be, he doesn't say. If he wants voters to feel good about changing Medicare and means-testing Social Security, he'll have to create a vividly burning platform, and he doesn't seem to have found the words yet.

Daniels is an attractive candidate on paper. The big question is whether he wants the presidency bad enough to go through the experience of running for it. He has been perfectly clear that his real passion is preventing a national financial disaster, and he'll run for president if he decides that's the best way he can help do it. But that's not the same as a deep desire for the office. In today's political environment it's hard to see how anyone gets there without that.

That's the calculus undoubtedly going through Daniels' head. We'll know how it comes out soon enough.

First Published: May 13, 2011: 2:46 PM ET

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Apr 20, 2011

Corruption: The biggest threat to developing economies

It's gone beyond petty palm-greasing. Graft across the globe has reached staggering dimensions.

FORTUNE -- "We're thinking of pulling out of Brazil," the CEO of a large American corporation told me a week ago. The company has been operating there for a few years, doing several million dollars of business. The problem? A series of court judgments so inexplicable, and so crushingly expensive, that the CEO doubts his ability to manage the business. He doesn't see how the rulings can be honest -- even former President Luiz Lula da Silva called Brazil's judiciary a "black box" that's "untouchable" -- and if the system doesn't work, this CEO is bailing out.

This is corruption, a problem we'd rather not think about that now threatens the ascension of developing countries into the top tier of world economies. Given its history, optimism on the subject would be foolish. But while the media and Wall Street focus on more tractable issues like inflation and exchange rates, world leaders seem perfectly clear on the greatest threat to the future of the BRICs and other emerging economies. Corruption is the "biggest threat to China," Premier Wen Jiabao told the National People's Congress in March. When U.S. Vice President Joe Biden visited Russia recently, he cited corruption as the No. 1 impediment to better economic relations and pointedly mentioned Sergei Magnitsky, a lawyer who died in custody in 2009 after accusing the police of corruption.

The problem is not just the petty palm greasing that's common worldwide, though that has its own corrosive effects. Developing-market corruption has reached staggering dimensions. India's telecom ministry apparently siphoned $30 billion from various projects over the past few years. A Russian activist posted online documents apparently showing a $4 billion fraud in a state-run company's trans-Siberian pipeline project. In China a minister overseeing the new high-speed-rail network is accused of skimming $152 million (and maintaining 18 mistresses). The threat is broader than it may seem: Corruption discourages the investments needed for economic progress. In India "high-level corruption and scams are now threatening to derail the country's credibility and [its] economic boom," says a report from KPMG.

The societal effects are subtler and arguably worse. Initiative and ambition shrivel: Why try hard when effort isn't the source of success? Respect for authority evaporates. Anger and resentment build, especially as a society becomes richer and the gulf between ordinary citizens and the officially tolerated crooks grows wider. When Premier Wen declared corruption the biggest threat to China, he wasn't talking about its effect on foreign investors; he's worried about "social stability." He knows that while massive corruption isn't the only grievance of the revolutionaries in North Africa and the Middle East, it's a big one.

Many people shrug at corruption because they figure it's eternal and incurable. Not so. England was deeply corrupt in the 17th century, Sweden in the 19th, notes professor Michael Johnston of Colgate University, a corruption expert. Singapore and Hong Kong virtually eradicated corruption in a generation. Still, reform is extraordinarily hard, he says, especially in big economies where "huge stakes are on the table." Reform "can degenerate into political payback" by the reformers. Where to begin? "One of the best predictors of whether a society will do well on corruption is the strength of property rights," Johnston says. "That's not a bad place to start."

An insidious feature of corruption is that it's hard to talk about. I can't identify the CEO who's thinking of leaving Brazil because doing so could imperil his company's ability to operate there. More generally, accusing people in power is inherently dangerous. Graft operates in the dark. So, like the man looking for his keys under a lamppost not because he lost them there but because the light is better, we focus on economic issues that are rich with statistics and susceptible to math. But we're missing a giant danger. It's naive to think the recent official attention to corruption will amount to much. If it doesn't, the progress of the emerging economies could turn ugly.

First Published: April 20, 2011: 10:49 AM ET

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Apr 11, 2011

Income inequality: How to fix it

A close look at new data sheds light on the real reasons income inequality is a problem, plus how we can solve it.

FORTUNE -- The hot topic of income equality gets especially emotional now, at tax time, and will get even more so this year, with the latest IRS data showing what happened in the recession.

A close look at the new data from the past few years -- and from the past few decades -- illuminates some of the real reasons inequality is a problem, plus the reality of how -- and how not -- to fix it. Key points:

Incomes are getting more unequal...
Yet they grew more equal in the recession. The long-term trend is indisputable: High-income Americans have been receiving a growing share of total income for the past 30 to 40 years. The latest IRS data show that in 2008, the top 1% of taxpayers accounted for 20% of total pretax income; in 1986, by contrast, they accounted for only 11%. Over that same period, the share of income going to the bottom 50% of taxpayers fell from about 17% to 13%. You can poke holes in the statistics, as the Cato Institute's Alan Reynolds has done, but there's no mistaking the big picture of growing income inequality.

Yet during the recession, the trend reversed. The bottom half's share of total income actually increased slightly, while the top half's share declined. The people whose income shares shrank most dramatically were the top 10%, top 5%, and top 1%. The rich got poorer, and the middle class got relatively richer. The same thing happened in the recessions of 1990-91 and 2001 and in the Great Depression. So here's one proven way to achieve greater equality: Make the country poorer. No one wants to do that, of course. A popular alternative is to extract more in taxes from the highest earners. Candidate Obama pledged repeatedly to do that, a campaign promise that he prudently broke when he signed the bill extending the Bush tax cuts. It's just as well, because when it comes to income inequality ...

Soaking the rich won't fix it.
Another eye-opener from the latest IRS data is that in the recession the top 5% and top 1% of earners actually paid tax at a higher effective rate than they did in the boom year of 2007, while everyone else paid at a lower rate. That is, the tax system did what it's supposed to do in tough times, taking from the rich and giving to the rest even more than it normally does. The larger point is that redistributing wealth through the tax code can be taken only so much further. Consider: In 2008 the top 0.1% of earners paid more total income tax than the bottom 75% did. The most surprising fact in the latest IRS data is that in 2008 the proportion of total income tax paid by the bottom half of earners sank to its lowest in decades: 2.7%. If we raise taxes on the rich so that we can cut taxes on the rest -- thus making incomes relatively more equal -- we'll create an even larger class of Americans with little or no stake in financing the government. It's a recipe for social and political instability or even chaos.

Worker education is the key.
It will make them more productive -- and richer. Harvard economists Claudia Goldin and Lawrence Katz have shown persuasively that the largest factor in inequality's rise is the slowing pace of educational attainment since the early 1970s. Workers' skills aren't keeping up with the advance of technology, so the shrinking proportion of workers with the needed skills command a larger share of the pie. Get high school and college graduation rates rising again, and the economic forces reverse, spreading the benefits of economic growth more evenly.

There's no clearly ideal level of income inequality, but it is a problem, and your Form 1040 symbolizes one of the most serious reasons why: Too few people now pay most of the country's bills. It could also symbolize the solution. The best news for the bottom half of earners will be when they're making a larger share of the nation's total income -- and paying more taxes.

--This story appeared in the April 11, 2011 issue of Fortune Magazine

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Apr 06, 2011

Wanted in Japan: A rebirth of innovation

Japan's great innovators rose from the depths of World War II. After 20 years of stagnation, will this crisis bring back the Japanese entrepreneur?

FORTUNE -- There is reason to believe that some kind of material good might eventually result from Japan's disaster, and it's confirmed by the way this thirty-something Japanese manager is responding to it: "I have been a 'risk-averse shosha-man [salary-man]' for 14 years, but I decided to quit my big company job to start my new business this June," he emailed six days after the earthquake. He had made the decision before the catastrophe (and doesn't want to be identified because he hasn't yet told his employer). "After the quake, however, what do you think happened to my mentality? Stronger desire to take the risk to SAVE the nation. Japanese people do a bigger job when they face crisis. My venture will surely start in June, despite the much worse economic situation for a new business to be started."

For anyone who thinks it's callous to talk about the economic effects of a staggering human tragedy, this man -- motivated by a deep desire to help his fellow citizens -- shows why it isn't. If he turns out to be typical, if thousands more decide now is the moment to take bigger risks, then Japan just might get back on an upward path.

It could happen. History shows that an upsurge in entrepreneurialism would be normal in these circumstances. Yet Japan's culture offers plenty of reasons for doubt. And if the risk-taking flame dies back down, then even the supposed general salutary economic effects of disaster won't likely come through in this case. This could be just one big, unredeemed horror.

Hope lives because swelling entrepreneurialism is precisely what's needed to fix Japan's overwhelming economic reality: 20 years of stagnation. It's a remarkable problem for a country that once revolutionized major industries -- autos, steel, electronics, among many others -- and in the 1960s grew around 10% a year. What changed? The great innovators of the post-war years -- Toyota (TM), Nippon Steel, Sony (SNE), for example -- became huge and successful, losing their propensity to create disruptive new technologies.

Stagnation nation

That's typical, as Harvard Business School professor Clayton Christensen has shown. What's unusual about Japan is that it "played the disruptive game once," as he says, but couldn't do it again. New generations of disruptive companies haven't appeared. A culture that frowns on employees leaving their jobs, a financing system dominated by banks rather than debt markets, and a government with a penchant for directing technology investment -- all have combined to discourage new innovators from creating fast-growing new industries. Result: stagnation.

Which raises the important question of why the disruptive cycle happened that one time. The answer is that it rose from the desperation of World War II. "Many of the societies that have been hyper-entrepreneurial for extended periods, such as Israel, Taiwan, and Ireland, have had two characteristics: severe adversity and broad-based human capital -- educated, intelligent masses," says Babson professor Daniel Isenberg, an entrepreneurship authority with long experience in Japan. "Look at Japan after World War II, and you see the same conditions."

That pattern reflects human nature. As behavioral economists have pointed out, we all see greater value in reducing pain than in gaining pleasure. For that reason, "the biggest opportunities come with addressing acute needs: war, hunger, disease, and disaster," says Isenberg. "People in general become more risk-taking when they have big, threatening problems, and smart and educated people like the Japanese become more innovative as well."

Thus the possibility that this disaster might spark a remedy for Japan's most basic economic problem. But if that doesn't happen, it's unlikely the country will realize the often mentioned but poorly understood benefits that often seem to follow disasters. The whole notion of a post-disaster economic gain is suspect, based on squishy accounting. A company must record a charge when major assets are destroyed, but a country does not. The loss of capital isn't included in GDP, but the money spent to replace it is, producing an apparent but often phony uptick.

Economics of earthquakes

Accounting aside, Japan's disaster may be especially costly because earthquakes are different. Over time, countries with frequent climatic disasters such as hurricanes tend to achieve higher economic growth than other countries, says research by Mark Skidmore of Michigan State University and Hideki Toya of Nagoya City University, but not because the disasters lead directly to growth. Weather disasters being somewhat predictable, people can protect themselves, so such disasters tend to wipe out property more than people. As a result, residents in those countries invest relatively less in physical capital and relatively more in human capital, a recipe for economic success over the past century. But earthquakes aren't predictable; they wipe out terrible quantities of human capital, as this one did. The researchers found no evidence of economic benefit.

This disaster probably won't push Japan's government over the fiscal edge. The towering national debt, at 225% of GDP, is by far the highest of any developed nation and second only to Zimbabwe's worldwide. If the government now spends, say, 1.2% of GDP on reconstruction, twice the proportion spent on the 1995 Kobe earthquake, the response would still total less than half its stimulus package in the financial crisis. Even Japan's straitened treasury can probably handle that.

The likeliest outcome is that Japan will come through this catastrophe with impressive speed, but nothing larger will change. Perhaps no country on earth is better equipped to absorb this blow. "The Japanese can emerge from this strong," says Michigan State's Skidmore. "They have this undergirding, this institutional and social framework that's really important." The danger is that this impressive framework, built to support stability and order, may form a solid wall around Japan's economic status quo.

But still -- there's that shosha-man and the many undoubtedly like him who yearn to try their idea for something new, unusual, and possibly disruptive. They've been stifled for decades. The trauma of this moment could release them. These are the circumstances when such turning points arrive.

It's definitely a long shot. For now, it's only a hope. But it is, blessedly, a realistic hope.

First Published: April 6, 2011: 12:24 PM ET

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Feb 17, 2011

A New American Exceptionalism

China will overtake us economically, so if we're not top dog anymore, how will we deliver greatness?

FORTUNE -- What makes America great?

That debate has been more heated than usual because of the volatile election results of 2010 (and 2008), Tea Partiers, the recession, and the financial crisis. But it's heating up for another reason as well -- a spreading realization that the widely held current answer to the question no longer makes sense.

The conventional case for U.S. greatness has long rested on our economic success, and understandably so. We're the world's richest nation by far, where the ordinary citizen achieves a living standard unrivaled in any other country of significant size. The problem, the source of our growing identity crisis, is the daily evidence that we're approaching the end of our time at the top. China's economy keeps growing 10% a year, while ours is limping; China, not the U.S., seizes the lead in tomorrow's industries, such as alternative energy; China rolls out a new stealth fighter jet, while we cancel military programs.

A Gallup poll last year found that just 17% of Americans agree that the U.S. "is No. 1 in the world economically." The other 83% are wrong -- our GDP is still No. 1 by a mile -- but only their timing is off. GDP is essentially population times productivity, so it's simple math that China will overtake us, perhaps within a decade. So when we're not the world's top economy, what will make us great?

We can learn from our experience going through the opposite identity crisis 70 years ago. In February 1941, Henry Luce published in Life his essay "The American Century," which Luce biographer Alan Brinkley calls "the most influential article he would ever publish." The crisis then was America's reluctance to accept that it had become, as Luce said, "the most powerful and vital nation in the world." It had to reject isolationism and lead the allies through World War II. That began our current view of what makes the U.S. exceptional.

We must move beyond self-esteem focused intensely on output. Andrew L. Yarrow, senior policy analyst at the nonpartisan Independent Sector, explains this persuasively in a fascinating new book, Measuring America: How Economic Growth Came to Define American Greatness in the Late Twentieth Century. "The United States after World War II," he told me, "increasingly saw itself as the world's greatest because of its measurably booming economy rather than its political ideals, its natural beauty, or its people."

A major reason for this was the Cold War. When Soviet leader Nikita Khrushchev said, "We will bury you," he meant it economically. We needed to show that our system was better for the average citizen than communism, and making that case was not always a slam-dunk. So besides discussing democracy and freedom, we taught our kids that America's great achievement was producing widely dispersed wealth on an unmatched scale. When that audacious claim proved true, we didn't move on to a new concept of greatness; our ideas seemed confirmed.

"The American Century" was about becoming the world's largest economy. Now we must come to terms with not being that, yet still being great. In a December poll, 80% of Americans agreed that "the U.S. has a unique character that makes it the greatest country in the world," but a large majority of them also believed "we're at risk of losing it."

We need a powerful new concept of American greatness that doesn't rely on GDP. For most of our history we saw our unique character arising from the ideals of freedom, democracy, and openness, notions that were feeling shopworn but now gain new vitality as a pointed contrast to China. Shifting to a more economically driven concept was seductively easy. Shifting back will be harder. Whether we can do it -- rather than resenting and denying our changed role in the world -- will be a new test of greatness.

First Published: February 17, 2011: 5:25 AM ET

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Jan 05, 2011

Note to Congress: Don’t blow this historic chance

Congress members: There's no time for pleasantries at the start of this legislative session. If you want to serve your country, here's a three-item to-do list.

FORTUNE -- Dear 112th Congress: Congratulations and so forth, but we don't have time for pleasantries. I'm afraid I have bad news. Do you recall all those charts you've seen showing Medicare costs, Social Security costs, federal interest payments, and the national debt rising steadily for years and then suddenly taking off like a fighter jet? (If not, you can see them in the Treasury's latest Financial Report of the U.S. Government.) Well, the jet's barreling down the runway. Things have been getting fiscally bad for a long time. They're about to get much worse. A new Moody's report says that America could lose its triple-A credit rating on your watch. You've got to decide what to do about it.

Fortunately, what needs doing is perfectly clear. If you want to serve your country -- and your kids, grandkids, and great-grandkids -- here's a three-item to-do list:

Start fixing Medicare
Nothing else you could do approaches the importance of this action. Medicare is overwhelmingly the largest component of future deficits until about 2050, when interest on our swelling national debt becomes an even larger component. You'll need to postpone eligibility for future beneficiaries, means-test them, and stop pretending you can reduce costs through Canute-like decrees to control prices; just look at the bogus mandated cuts in physician fees, which your predecessors triumphantly enacted in 1997 but have overridden every year since 2003 because otherwise too many doctors would stop treating Medicare patients.

It's true that right now is not an easy time to go after Medicare, with the future of Obama's health care reform uncertain. But every year from here on will be an even worse time, because the changes will have to start sooner and will be more frantically resisted. So get going.

Tackle the tax code
Your goal is not to extract more money from taxpayers but to spur economic growth. Everyone agrees that our 3.7-million-word tax code is an abomination that encourages unproductive tax avoidance and burdens our economy with massive compliance costs. The beast has needed slaying for ages. Now, in the space of a few days, the bipartisan debt reduction panel has recommended a total overhaul, and President Obama has said he's ready. Current tax policy is temporary, scheduled to change in two years. This is your best chance.

Don't try to write a code that pulls more of GDP from the private sector into the U.S. Treasury. Even the Treasury's projections acknowledge that getting more than 19% or 20% seems to be impossible. Focus instead on wiping out thousands of deductions, exemptions, and credits, then lowering tax rates. Let businesses and individuals base their economic decisions on economics. What a concept.

Welcome the best and brightest
The reality of America's future is that we're not going to be the world's largest economy for much longer. China's ascent to the top spot is only a matter of time. That needn't be a problem for us, but it means we can no longer rely on our economy's massive size to attract the planet's smartest, most ambitious dreamers and doers. We need a ton of growth to get us through our current mess, and plenty of prospective immigrants would still love to help. Let's make it easy for them. For starters, adopt venture capitalist John Doerr's proposal: Every noncitizen who earns an advanced degree at a U.S. university should have a green card stapled to his or her diploma.

If doing all that seems like too much, you do have another option: Do nothing. We might be able to muddle through until the next election. But history will remember the situation this Congress faced when it convened, and how it responded. You can be the Congress that ignored reality and played senseless partisan games, or the Congress that turned the nation in a better direction. It's your choice: You can be the Nero Congress -- or you can be the hero Congress.

First Published: January 5, 2011: 11:31 AM ET

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Nov 19, 2010

Is bipartisan debt-reduction for real?

Recommendations from a panel of lawmakers are sure to change with the power shift in congress. Here are 4 easy ways to find out if it'll work.

FORTUNE -- The Republicans' midterm surge has given the federal debt-reduction commission -- whose recommendations are due Dec. 1 -- a chance to stand up and be counted. The panel is bipartisan, but as long as Democrats were able to have their way ultimately in both houses of Congress, Republican members had little clout. Now that the balance of power has shifted, the ideas of the panel's deficit hawks, such as Rep. Paul Ryan (R-Wis.), may get a bit more respect. Co-chairs Erskine Bowles (chief of staff for Bill Clinton) and Alan Simpson (former GOP senator from Wyoming) have offered a proposal, but it's only a draft. We'll know the commission blew its opportunity ...

...if it loudly trumpets how it's meeting its mandated target for 2015. The commission was given a bogus goal: Show how "to balance the budget, excluding interest payment on the debt, by 2015," since that would "stabilize the debt-to-GDP ratio at an acceptable level once the economy recovers." No, it wouldn't, as retiring Sen. Judd Gregg (R-N.H.) has pointed out and as common sense confirms: The deficit would still be compounding at the rate of interest on the debt (which would probably be greater than the rate of GDP growth), plus other technical reasons Gregg has identified. In addition, the projected 2015 deficit is based on a Congressional Budget Office forecast that shows real annual economic growth at a knockout 4.1% for 2012, 2013, and 2014. If that doesn't happen, then the panel's proposed actions would fail to achieve even their inadequate purpose.

...if it doesn't hit Medicare head-on. Besides its 2015 assignment, the panel has another, more important job: Recommend policies "to achieve fiscal sustainability over the long run." That goal cannot be reached without significantly cutting back Medicare. Everyone on the panel knows it. The danger is that the panel won't have the stomach to charge back at that issue so soon after the Obamacare battle. "There is health care fatigue," commissioner Alice Rivlin told the New York Times. Watch out if the panel tries to mask its failure by playing up proposed fixes to Social Security or cuts in defense. Those changes are important and must also be made. But without a proposed Medicare solution, the panel hasn't done its job.

...if it even mentions reliance on the Medicare and Social Security trust funds. The panel might try to soothe worried citizens with a reassurance that we still have time -- the Medicare Part A trust fund won't be exhausted until 2029, and the Social Security trust fund not until 2037. Yet every commissioner knows that's nonsense. Those trust funds are invested in Treasury securities; they're just more government debt. Medicare and Social Security start to bite not when their trust funds run out but when the programs go cash-flow negative. For Social Security that happens this year; for Medicare it was last year. We do not still have time.

... if only bland, vague proposals can win the backing of at least 14 of the 18 commissioners. A presidential commission's only hope of true influence is to make substantive recommendations that are strongly bipartisan. On this panel that means getting at least 14 votes -- all of one party's members plus more than half of the other's. Both parties' leaders in Congress have said they would take up any proposals receiving at least that much support. So the commission holds at least a tiny chance of serving its purpose, giving political cover for meaningful action in Congress. But if its widely backed proposals are weak -- or even worse, if the only strong proposals are in some kind of minority report -- there's no chance.

Despite all those warnings, there's reason for hope. The panel's members are serious budget wonks who understand the urgency. They're also veterans who know what will happen if they blow this chance. The two parties in Congress will squabble endlessly and won't be brought together on this issue except by that one tried-and-true motivator of real bipartisanship, a terrible crisis. In this case, it's already on the way.

First Published: November 19, 2010: 5:43 AM ET

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Nov 02, 2010

As Europe cuts, America spends

It's the ultimate economic experiment. Europe is tightening its belt while the U.S. is betting on stimulus. Someone's got to be right - and someone's got to be wrong.

FORTUNE -- Everybody loves a fight. So I'm delighted that we're about to witness a heavyweight title bout between two of the most important ideas that can shape our material lives. The vital question: What's the best way to grow after a bad recession? We in the U.S. are betting heavily on one popular strategy, while Britain and the Euro zone are backing exactly the opposite approach. Rarely do we see such stark conflict in fundamental economic policies on a mammoth scale. The results of this natural experiment will be highly valuable because they'll teach us so much. But they will also be very bad news for one side or the other.

The New World approach, billed as Keynesian, is for the government to pour hundreds of billions of borrowed dollars into the economy to stimulate demand. Companies will hire more, consumers will spend more, and the wheels will resume turning. Then, in future years, the government can reduce the big deficits it has created. As icing on the cake, that stimulus spending can be focused on infrastructure improvements that will make the nation more competitive for decades to come. That's why the U.S. has run trillion-dollar deficits for two years in a row, and why the administration wants still more stimulus spending.

The Old World approach, called "consolidation" by its proponents, holds that people are far likelier to spend and invest in a country that's working to reduce its deficit right now, even though near-term growth may be slow or non-existent. They figure such a country is less apt to raise future taxes or to inflate its currency to ease the pain of repaying debt. That's why 35 of Britain's top business leaders recently endorsed British Prime Minister David Cameron's plan to abolish 192 government agencies and cut the budgets of major departments by 20% to 25%. "Addressing the debt problem in a decisive way will improve business," they say in an open letter. European Central Bank president Jean-Claude Trichet, consolidation's staunchest advocate, says it's good "not because it is an elementary recommendation to care for your sons and daughters, but because it is good for confidence, consumption, and investment today."

In theory, the New World policy makes some sense when the economy is still fragile, as America's is. But it cannot work in practice for at least three reasons.

• People don't trust Washington to reduce the deficit two years from now. Putting off the pain until tomorrow never works, because in Washington, tomorrow never comes.
• People don't believe that the administration's purported future deficit reductions are real, such as the claim that the new health care reform law will reduce the deficit.
• People don't trust Congress to spend stimulus dollars on worthwhile infrastructure projects rather than on useless pork. Why? Google "John Murtha airport" for one example.

I fear that one result of the U.S. strategy will be little faith in America's fiscal future. Just as confidence begets more confidence, lack of it becomes a vicious cycle. As people lose confidence in a country's financial strength, they take their investments and innovations elsewhere, worsening the country's plight, driving more business away, and so on. New figures show that as U.S. companies earn impressive profits, they're stockpiling cash rather than building new U.S. operations or hiring more U.S. workers.

The opposing sides in this battle have a tough time debating each other because they have deeply different views of human nature. The New World approach regards people more as economic beings whose macro-behavior can be described with equations. The Old World approach regards people more as psychological beings whose individual behavior can be understood but not easily charted.

When we have a winner, the losing side will rationalize the results, saying they don't prove much, because the two situations were different going in, and that with a little bit of tweaking, their strategy would have prevailed. We should resolve to cut through the inevitable spin and declare a winner. Whatever the results, I'll embrace them. But I think I know how this will turn out, and it won't be good news for America

First Published: November 2, 2010: 11:05 AM ET

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Oct 20, 2010

Uncertain of future regulation, businesses are paralyzed

Companies have rarely felt so unsure of what the laws and rules governing their industries will be, which has put the brakes on economic growth.

FORTUNE -- Dick Kelly wishes he knew what his industry should do. "If we had a national policy and knew what the rules were, we could take action," says Kelly, CEO of Xcel Energy and chairman of the Edison Electric Institute, the association of shareholder-owned electric utilities. But Kelly's industry knows only that momentous changes in the federal laws governing it are probably on the way; what those changes might be, and when they might happen, managers have no idea. So they "are holding up decisions," Kelly says, on multibillion-dollar investments to convert old coal-fired power plants to natural gas. "Is there going to be a price on carbon?" he asks. "Will there be a timeline? Will we have to use a certain percentage of renewables?" No one knows, so nothing is happening.

Multiply the utilities' experience across the economy, and we begin to see an important reason why growth is getting slower rather than faster as the recovery creeps along. When people aren't sure what's going to happen, they freeze. We all know it, and if you require validation of your instincts, check the scientific literature on "uncertainty paralysis." When we're unsure, we turn especially cautious.

Life is inherently uncertain, of course, but this is different. As I travel around the country, businesspeople tell me they've rarely felt so unsure of what the laws and rules governing their business will be. Like Kelly, they sense major changes ahead -- but what? So instead of investing and hiring as usual in a recovery, U.S. companies are sitting on more cash than ever. We shouldn't be surprised. It has always been true that the more activist the administration in Washington, the more uncertainty it spawns. The reasons are several.

Sweeping new laws -- like the 2,400-page health care law and the 2,300-page Dodd-Frank financial services law -- create winners and losers, but the horsetrading continues almost until the President's pen signs the bill. Did you know that Dodd-Frank exempts car dealers from the oversight of the new Consumer Financial Protection Bureau? Such oddities are legion, but in major legislation still to come, such as an energy bill, no one knows what they'll be.

Once these mammoth laws are enacted, government agencies must write new rules to implement them. For example, the Dodd-Frank law requires 243 new rules, by the count of the Davis Polk & Wardwell law firm, and no one yet knows what they'll require.

It takes a long time to figure out what the new rules really mean, especially at 2,000 pages. When I asked AT&T (T, Fortune 500) chief Randall Stephenson whether the new health care law might cause him to drop medical coverage for his employees, he did not say anything to reassure workers. "We don't know exactly what we've got here yet," he said. "But something will change." McDonald's (MCD, Fortune 500) recently said it might drop medical coverage for 30,000 employees because of a rule buried in the new law. Such surprises are only beginning.

These historic new laws bestow significant new powers on administrators, who are not elected and are highly unpredictable. For example, the new Consumer Financial Protection Bureau has been granted extremely broad powers; its director (not yet nominated) is apparently "beyond the control of the President, the Fed, and the Congress," says Investment News magazine, citing the new law. What new rules will it promulgate in its first five years?

Uncertainty is a Republican talking point in the midterm elections, so Democrats disparage it, maybe leaving ordinary citizens to dismiss the debate as partisan sniping. That would be a shame. The businesspeople I talk to aren't libertarians who want a minimalist government. They're pragmatic managers who want to make an honest buck. As Dick Kelly says, "If they explain the rules, we'll figure it out. We've always figured it out, and we'll figure it out again." More than at any time in many years, businesspeople just don't know what the rules are. They're frozen. Writ small, that's a frustration. Writ large, it's an economy that can't get going.

First Published: October 20, 2010: 5:12 AM ET

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Aug 31, 2010

The staggering pace of technology

10,000 transistors now cost less than a grain of rice. Here's why that matters.

FORTUNE -- I have more transistors than neurons. So do you. That's something worth caring about, because it signals the advance of a weird new world that most of us aren't prepared for. Yet we'd better get ready, for the world of the Syfy channel is looking startlingly plausible.

Remembering how proud I once was to own a transistor radio with five transistors, I wondered how many transistors I own today. (For those needing a refresher, a transistor is an electronic switch that's either on or off, a one or a zero in the digital world.) When I performed this exercise nine years ago, I was astonished to find that the total was 4 billion to 6 billion, counting every device in my office and in my family of four.

Well, things have changed. At this moment I'm using a year-old laptop computer with more than 37 billion transistors. My desktop machine in the office has about the same number. My iPod has more than 256 billion transistors. My BlackBerry has maybe a billion. My Kindle has over 16 billion. Then there's my family's car, washing machine, TV, DVD player, microwave, coffeemaker, dishwasher, refrigerator, modem, wireless router, printers, security system, thermostat; they all contain transistors, at least tens of millions in each device. Even leaving aside shared family devices, my personal transistor count is in the hundreds of billions.

For comparison, your brain and mine each contain about 100 billion neurons. By itself, that comparison doesn't mean much: A transistor has one connection leading in and out, while a neuron may have thousands or tens of thousands. But those devices are increasingly connected to one another via the Internet, which will soon be dominated by disparate devices increasingly working as one. Further, the transistors-to-neurons comparison helps us nongeeks grasp the simply staggering pervasiveness of technology.

Consider: The world produced about 10 quintillion transistors in 2009, which is 250 times more than all the grains of rice consumed last year, according to Applied Materials (AMAT, Fortune 500), which makes the machines that produce all those transistors. At Best Buy, a 16GB flash drive (128 billion transistors) costs $32.95; at the supermarket across the street, a five-pound bag of rice (150,000 grains) costs $4.85. For the price of a single grain of rice, a retail shopper can buy about 125,000 transistors.

The incredibly low and ever-falling price of transistors means they're everywhere, doing new kinds of jobs. They're in golf clubs (to analyze your swing), in golf balls (to help find lost ones), and in running shoes (to adjust cushioning at each stride). Mercedes-Benz engineers tell me that a new S550 uses 8 billion to 10 billion transistors. Floor it in a tight turn and the car may refuse to open the throttle fully. The accelerator isn't connected to the engine, but to a computer that wants to keep you from doing something stupid.

Mainstream experts are now seriously considering the implications of machines far smarter and more capable than ourselves. The Association for the Advancement of Artificial Intelligence convened a group of leading computer scientists last year to study "the implications of systems that emote, that express mood and emotion (e.g., that appear to care and nurture), when such feelings do not exist in reality." The U.S. Navy's study of "autonomous military robotics" considers, for example, the possibility that "we ... may not be able to halt some (potentially fatal) chain of events caused by ... systems that process information and can act at speeds incomprehensible to us." Think the May 6 flash crash, but the computers have machine guns.

We need to imagine this unimaginable future. An accessible way to follow developments is to keep an eye on Watson, the IBM computer system (named after company founder Thomas Watson) with the lofty goal of succeeding at a deeply human task: competing on Jeopardy. Bernard Meyerson, IBM's vice president for innovation, says the challenge isn't the amount of computing power but "writing the software that can understand the subtle cues of language." Watson is performing impressively and may compete against humans on the program this fall.

As for my counting exercise, it may soon become impossible. I asked IBM's (IBM, Fortune 500) experts how many transistors Watson has. The system is so vast, complex, and ever-changing that they just don't know.

First Published: Aug 31, 2010: 5:38 AM ET

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Aug 12, 2010

Desperately seeking math and science majors

The number of China's engineering grads are growing while Americans major in fitness. Why?

FORTUNE -- Applied Materials had to fly in 100 interviewers just to screen all the job applicants for its new Solar Technology Center in Xi'an, China, last year. The company wanted to fill 260 high-tech jobs. It got 26,000 resumes. A fraction of those applicants were invited to interview. The final selectees, board member Andy Karsner tells me, "were top-of-their-class, English-speaking engineers. They're the best of the best."

Now some of the most advanced research in this high-value, fast-growing field is being done in China -- instead of in the U.S. with American engineers. Why should we care? Because it's graduation season, when we see how starkly the direction of the American educational system differs from the way that faster-growing economies are headed.

Those Chinese solar researchers are the cream of an engineering crop that included an estimated 10,000 Ph.D. graduates last year. This spring the U.S. will graduate about 8,000 Ph.D. engineers, an estimated two-thirds of whom are not U.S. citizens. About 150,000 students who majored in engineering, computer science, information technology, and math will collect bachelor's degrees. The Chinese government claims that in recent years the number in China has been well north of 500,000 and rising fast; even if overstated, as some believe, the real number is much larger than America's, and the quality of those graduates is improving.

Americans should be alarmed, not because we have to beat the Chinese on every statistic, but because those facts threaten the heart of our great economic story. Until the past decade most Americans lived a little better every year. From the nation's beginnings, the engine of that improvement has been technology that makes millions of workers more productive. That's why you learned about Whitney's cotton gin and the McCormick reaper in elementary school. A stagnant living standard has terrible consequences, one of which is that the country eventually stops attracting and keeping the world's best and brightest, triggering a downward spiral that grows ever harder to break.

The spiral may be well under way. Instead of staying in the U.S., our non-U.S. Ph.D. graduates increasingly judge home to be a more attractive option. Anand Pillai, a top talent executive at India's giant HCL Technologies, says that his best young recruits used to insist on being sent to the U.S. for a time, but now many of them resist going: "They see such great opportunities at home."

Its next turn could be the worst. As math and science talent accumulates abroad, companies do more of their hiring there, reducing demand in the U.S. That's partly why undergraduate engineering majors are a shrinking proportion of the total, down from 6.8% to about 4.5% over the past 20 years. Employers then claim they can't find engineers in the U.S. -- so they have to hire abroad.

The fastest-growing college majors in America as of 2007, says the U.S. Education Department, were parks, recreation, leisure, and fitness studies, as well as security and protective services. That's not a great omen for technology breakthroughs. If the next great technological advances in energy, the environment, medicine, and information are made elsewhere, American workers will have a much tougher time earning good pay in those key industries.

When the National Academies (experts in the sciences, engineering, medicine, and research) raised this alarm in a landmark 2005 report, a chorus of quibblers sidetracked the discussion by arguing that China's engineering graduates weren't up to the same standard as America's, so the statistical comparisons weren't valid. Five years later it's clear that the National Academies were prophetic. For America's great economic story to continue, we need to reverse the downward spiral now, before it picks up speed. That means changing our culture -- hard but doable. As our graduates collect their diplomas this spring, we should send the next classes a message: that as an economy we want more science and math majors, and as a society we prize them. 

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Jul 28, 2010

Who’s to blame at BP? The board

BP's directors are all at the top of their careers, but despite their A-list credentials, you can hold them responsible for the disaster in the Gulf.

FORTUNE -- BP's Gulf disaster is the board of directors' fault -- and not just in the sense that everything is ultimately the board's fault. This board has earned its blame in a very direct way. Yet you'd never suspect it from the directors' all-star credentials.

If you're looking for doddering peers who prefer liquid lunches in the House of Lords dining room or earnest but clueless academics, you won't find them on this board. It's a knockout: Every member has reached the highest levels at famous, successful corporations. Governance wonks could fault the group for including too many BP execs (five of 14 directors), and it won't win any diversity awards. But if you want achievement and pedigree, look no further: They include the former CEOs of Ericsson (ERIC), Duke Energy (DUK, Fortune 500), and United Technologies (UTX, Fortune 500), the current CEO of Anglo American, and the former chairmen of Unilever (UL) and McKinsey.

But wait, there's more. This board appears to have done everything right to make sure that BP was identifying and managing its risks and to ensure that a catastrophe like the Macondo well blowout, which caused the spill, didn't happen. A safety, ethics, and environment assurance board committee monitors nonfinancial risk. A group operations risk committee of executives reports to the CEO. A dense flow chart shows how all the pieces fit together to support BP's goal of "no accidents, no harm to people, and no damage to the environment." Obviously this elaborate structure failed, just like the well. But is it really fair to blame a terrible accident in the Gulf of Mexico on 14 people in a London boardroom above St. James's Square? It is, and here's why.

The board had known for years that something was wrong with safety at BP (BP). An explosion and fire at BP's refinery in Texas City, Texas, in March 2005 killed 15 people and injured 170; it was America's worst industrial accident in almost 20 years. Just four months later a potentially deadly hydrogen fire broke out at the same refinery, and the following month community residents were ordered to stay indoors after another accident there. That's when BP assembled an independent panel, headed by former Secretary of State James Baker, to investigate safety at its U.S. refineries. While the panel worked, a BP pipeline in Alaska leaked more than 200,000 gallons of crude in March 2006.

The panel's report, published in January 2007, is brutally direct. While its immediate focus is BP's five U.S. refineries, its findings go far beyond them. Calling for "leadership from the top of the company, starting with the Board and going down," the report found that "BP has not provided effective process safety leadership." Time and again the report notes that BP has the right standards and programs but cannot make them work. It cites specific areas in which the company failed to enforce standards, including "critical alarms and emergency shutdown devices."

The report emphasizes that the many failures it cites were "not isolated." Repeatedly it notes that "the lack of effective leadership was systemic, touching all levels of BP's corporate management." While it is management's job to implement effective safety practices, the report says, "BP's Board did not ensure, as a best practice, that management did so."

Remember, BP asked for this report. The directors wanted to know what was wrong with safety at BP and how to fix it, and the panel gave them a 347-page answer. Corporate-governance authority Robert A.G. Monks, who testified as an expert witness for a Texas City worker, says, "The BP board was on notice that the corporate culture of 'saving over safety' pervaded BP. They were on notice that the mechanisms for informing the board were dysfunctional. The board had an affirmative duty to understand the risks involved in the drilling of this well."

BP declined to make any directors available for interviews, but a spokesman says "there are no grounds" for the allegation that the board bears particular responsibility for the gulf disaster. "Since Texas City in 2005, the company has turned around its process safety systems, which have been largely rolled out across the company," he says.

It's worth remembering that after the Texas City explosion, BP announced it would "do everything possible to ensure nothing like it happens again." The board was told what needed doing. We've seen the result.

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Jun 14, 2010

Nielsen’s $78 million CEO

David Calhoun left a big job at GE to run Nielsen in 2006. With an IPO on deck, now we know why.

FORTUNE -- What was he thinking? That's what many wondered when David Calhoun left a vice chairman's job at General Electric to run the Nielsen TV ratings company in 2006.

At GE, he managed businesses with revenue of $40 billion. Just months earlier, a Fortune cover story had declared him headhunters' "No. 1 draft pick in the game of grabbing top executive talent, the most lusted-after managerial star who isn't already a CEO." He was getting offers to lead giant corporations, including Boeing. Yet he turned them down and then left GE to head tiny Nielsen (revenue: $4 billion).

What could possibly have enticed him?

Now we know. Headhunters had presumed his Nielsen pay package must have been staggering and that the jump could have paid off hugely. But for now, the most audacious corporate job switch in years appears not to have done Calhoun a bit of good financially -- though he has done just fine, and the story could still take some sharp turns.

The much-sought information on Calhoun's compensation is in Nielsen's recent prospectus for an initial public offering. The company has been owned since 2006 by a group of private equity firms, including the Blackstone Group (BX), the Carlyle Group, Kohlberg Kravis Roberts, and Thomas H. Lee Partners. They were determined to pry Calhoun loose from GE. Here's what it took:

Start with a signing bonus of $10,613,699.

Then, to make Calhoun whole for GE stock options and restricted stock that he forfeited upon leaving, add $20 million, which was to be reduced by his GE severance pay; the net was $18,840,627.

On top of that, Calhoun is entitled to receive "deferred compensation" of $14.5 million after his employment contract expires at the end of next year, plus interest at 5.05% a year from his employment date in 2006, which totals about $18,881,000. This is to be reduced by any deferred compensation from GE, an amount that has not been publicly reported.

It all comes down to the IPO

He was given six million stock options at a strike price of $10 a share, a price the firm deemed a share's "fair value" at the time, plus another million options at a strike price of $20. (Those share prices likely bear no relation to the eventual price of the IPO shares; Calhoun's shares and strike prices will have to be adjusted after the offering.) We can't use the usual Black-Scholes model to value his options because we have no market data on the stock, but a standard rule of thumb values them at about $20 million; they don't expire until 2016.

That's what he got or was promised just for walking in the door, but as in many private equity employment deals, this one had another side: Calhoun invested $20 million of his own money in Nielsen, buying two million shares at that same $10.

With Calhoun in his new office, it was time to start paying him for actual work. He was guaranteed a base salary of $1.5 million, which has since been increased to $1.6 million. He also gets an annual bonus, which last year was $2.5 million. He receives fairly standard perks, such as financial planning services, car and driver, tax gross-up, and others, which were worth about $135,000 last year.

Let's add it up. That signing bonus is doled out in installments, of which a couple have yet to be paid, but since Calhoun needn't meet any performance targets in order to get the remainder, let's credit him with the whole amount. For the same reason let's also count the whole deferred comp, but we'll ignore the interest that will increase it, since the total will be offset by his GE severance pay, which we're forced to ignore because we don't know it. We have no market data for the value of his stock, but Nielsen figures its shares were worth $11.50 at year-end 2009, so Calhoun had a putative gain of $3 million on his personal investment. Some of his options apparently failed to vest because the company didn't meet performance targets in one year, but Calhoun could eventually earn them back, so let's count all of them.

The total: $78,213,291 so far.

That's a lot of money, but is it any more than he would have made if he'd stayed at GE (GE, Fortune 500)? He likely wouldn't have made much more or less than John Rice, the highest paid vice chairman since Calhoun left. (CEO Jeff Immelt has been receiving less pay than his top lieutenants during GE's difficult recent years.) Using the same methodology we applied to Calhoun's pay, Rice's total over the same period (mid-2006 through 2009) was about $55 million.

A potentially lucrative future

But remember, Calhoun's total includes $20 million to compensate him for stock and option awards he forfeited on leaving GE, while Rice still has his awards accumulated over a GE career of similar length. So it appears that Calhoun is financially almost exactly where he would have been had he stayed put.

The big wild card is the eventual value of his options and stock -- they could be worth far more or far less than we've assumed. The omens are good. If Nielsen's value really has increased 15% during Calhoun's tenure through 2009, as the company's "fair value" estimate says, that's a terrific performance in a period when the S&P 500 dropped 14%. It suggests that Nielsen's private equity owners, who bought the company for $9.5 billion, got more than their money's worth by paying Calhoun as they did. But what really counts is the market's verdict, which the IPO will tell us.

And if Calhoun expected to do much better for himself -- which he presumably did, since in mid-2006 almost no one suspected the worst recession in decades was just over the horizon -- well, he hasn't done badly so far.

Nor is his story even close to finished. When his contractual term at Nielsen ends on December 31, 2011, he'll still be just 54 years old, with the opportunity of plenty more CEO work if he wants it.

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Apr 30, 2010

My own private Goldman testimony

In a historic market dislocation, there were -- guess what -- winners and losers. Last time I checked, that was not a crime or even a scandal. It's the way economies work.

(Fortune) -- I was not asked to testify at the recent hearings of the Senate Permanent Subcommittee on Investigations, probably because I've never worked at Goldman Sachs or anywhere else on Wall Street, or had any involvement whatsoever in the market for synthetic CDOs, all-natural CDOs, or subprime mortgages of any kind. Nonetheless, had I been invited, I would have been pleased to respond to some of the Senators' remarks as follows:

Edward E. Kaufman Jr., D-Tenn.: The idea that Wall Street came out of this thing just fine, thank you, is just something that just grates on people. They think you didn't just come out fine because it was luck. They think you guys just really gamed this thing really well. Forgive me, Senator, but have you been in a cave the past three years? You think Wall Street came out of this thing just fine? You might want to ask the thousands of unemployed workers from Bear Stearns and Lehman Brothers, and you might check in with the former shareholders of Merrill Lynch, or the current shareholders of Citigroup (C, Fortune 500). Those are four of the most storied names on Wall Street, and they did not come out just fine.

The reality is that in a historic market dislocation, there were -- guess what -- winners and losers. Last time I checked, that was not a crime or even a scandal. It's the way economies work.

Claire McCaskill, D-Mo.: Let me just explain in very simple terms what synthetic CDOs are. They are instruments that are created so that people can bet on them. It's the La La Land of ledger entries. It's not investment in a business that has a good idea. It's not assisting local government and building infrastructure. It's gambling, pure and simple, raw gambling. They're called synthetic because there's nothing there but the gamble, but the bet.

Gee, Senator, your vitriolic scorn for gambling might surprise the hundreds of thousands of Missouri voters who love to play the Missouri Lottery, and it might really surprise the many Missouri farmers who are glad they can hedge their risks by buying crop and fuel derivatives, which are also "instruments that are created so that people can bet on them."

But that's beside the point. Your description of synthetic CDOs, if stripped of the loaded language, is basically right. They're bets. That's important to remember when you look at the case the SEC just happened to bring against Goldman (GS, Fortune 500) last week. Since the synthetic CDO at the heart of the case was a bet, the two hedge funds that bought it were well aware that someone else was, by definition, betting the other way. The fact that it was John Paulson, which Goldman didn't tell the buyers, is irrelevant; he was just another hedge fund manager, and at the time no one knew whether he'd be right or wrong. The buyers were fully informed about the contents of the synthetic CDO, and they chose to bet as they did. Turns out they lost a billion and Paulson made a billion. That's what happens every day -- every minute -- in the financial markets.

By the way, if it turned out that Warren Buffett had advised the hedge funds in the SEC case to buy the security that Goldman was selling, and the hedge funds didn't tell Goldman, would you urge the SEC to sue those hedge funds? Or if everything had happened just as it did except that Paulson had been wrong and had lost a billion, do you suppose the SEC would still have sued Goldman? Just asking.

Byron Dorgan D-N.D.: If the disclosures at these hearings are not the final nail that persuades the American people to demand this [financial regulation overhaul] be done now, I don't know what would be. To bet against your clients, to bet against your country, all for the sake of big profits.

Could we add some violin music please? Greedy Wall Street bankers! Picking America's pockets so they can bathe in Champagne! Look, Goldman was not betting against its clients and certainly not against its country, and you guys cannot be so dumb that you don't know that. But just in case, here's how it works, in terms even a Senator can understand.

Goldman's clients want to put their money to work, so those clients buy and sell financial instruments. They do it all day, every day. Goldman serves them in part by putting buyers and sellers together, and sometimes by being the buyer or seller. Goldman and a given client could be betting the same way in the morning and the opposite way on a different transaction in the afternoon. And to repeat -- since you all seem to have a really hard time with this central idea -- no one at the time knows who's right. Do you honestly believe that Goldman was withholding its secret knowledge of where the markets were going? If so, you might want to join one of those Area 51 chat groups.

Or think of it this way: If it were wrong to "bet against clients," as you mistakenly call it, then no investment bank could exist, because any position it took would oppose some position held by one of its hundreds of clients. And by the way, the clients know how this all works, and, believe it or not, it doesn't seem to bother them.

As for betting against the country -- you can't be serious. If trading on the belief that securities are mispriced is seditious, then you'd better sponsor a bill to expand the federal prisons, because every investor in America is going to jail.

Carl Levin D-Mich.: You are betting against the same security you're out selling. You've got a short bet against that security -- you don't think the client would care?

No! Have you been hanging out with Dorgan? Of course the client wouldn't care. The client knows very well that someone else has an opposite view on that security -- after all, the client thinks it's worth buying, and somebody else obviously thinks it's worth selling. Otherwise there wouldn't be a transaction. Duh! And both Goldman and the client know exactly what's in the security. Nobody got hoodwinked.

And despite the way that you and your colleagues are foaming at the mouth today, I suspect that all of you actually realize that.

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Apr 22, 2010

The real outrage is how CEOs are paid, not how much

If you want to get mad at companies for screwing up executive pay, here are three good reasons.

(Fortune) -- It's outrage season, formerly known as proxy season, when recession-shocked Americans get furious at the new list of insanely overpaid CEOs. The leader so far is Occidental Petroleum chief Ray Irani ($59 million), an excessive-pay hall-of-famer, but he may be overtaken by others as more proxies are filed.

The bad-boy headlines will misleadingly suggest that CEO pay levels overall are a problem. They're not. For hundreds of big-company CEOs, pay came down in the 2001 recession, rose in the expansion, and has come down again in this recession, just as you'd hope, according to research by the University of Chicago's Steven Kaplan.

The inflation-adjusted average is lower than in 1998, at just over $11 million. That's nothing to sneeze at, of course, but the real problem is the way in which CEOs are paid -- the incentives they're given. Despite new SEC disclosure rules and the painful recession, by some measures the situation is getting worse.

If you want to get mad at companies for screwing up executive pay, here are three good reasons:

They're incentivizing managers to do stupid things

A large majority of companies base their long-term and short-term incentive payouts -- which often form the bulk of executive comp -- on the company's reported income, earnings per share, total shareholder return, and various other ratios, according to a new analysis by the James F. Reda compensation consulting firm. Sounds sensible, but it isn't.

Research has long shown that reported earnings and EPS correlate poorly with what shareholders actually care about -- the value of their company. In addition, earnings, EPS, and return ratios are easy for managers to manipulate through all kinds of arbitrary decisions about reserves, write-offs, taxes, pension assumptions, and other factors. Even total shareholder return can be gamed by paying out a big dividend, potentially destroying value.

Much better to incentivize managers with an economic profit target (operating profit minus a capital charge), as Best Buy (BBY, Fortune 500), Deere (DE, Fortune 500), and many other top performers do. Research shows it correlates far better with stock value, and as Best Buy chairman Richard Schulze says, it "focuses management to think like shareholders."

They're paying based on irrelevant comparisons.

Among the 200 biggest U.S. companies, 53% based their long-term incentives on comparisons with a peer group or index in last year's proxies, up from 44% the year before, according to Reda's analysis.

But shareholders don't care how well a company performed relative to its industry; they care whether the company was a good place to park their capital. When managers focus on beating their industry peers, they forget that investors can put their money anywhere. Executives shouldn't be rewarded for performing a little less poorly than average in a lousy industry, because it does investors no good at all.

If they're in a lousy industry, they should get out.

They're not always telling us their real goals.

SEC rules that took effect in the 2008 proxy season require companies to disclose the targets that executives must hit in order to earn incentives -- the percentage increase in profits, for example, or the specific return on invested capital -- and then report the company's performance vs. those targets.

Yet many companies just aren't doing it, claiming they'd be giving away competitive information (the SEC sometimes grants exceptions on that basis).

For example, the 2009 CVS Caremark (CVS, Fortune 500) proxy statement doesn't disclose the company's three-year EPS growth target for the period ending in 2010 because that "would result in competitive harm to the Company." Reda raises a more disturbing possibility for some nondisclosures: Companies may be offering their executives incentives for performance below publicly announced profit forecasts.

As outrage season progresses, we'll hear plenty about this year's crop of egregiously overpaid CEOs. Let's just remember that far more hazardous to shareholders is the irrationally paid CEO.

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Jan 29, 2010

Stop blaming Big Business

Punishing Wall Street for the recession won't solve the real problem - that most Americans still won't be better off.

(Fortune Magazine) -- The top-grossing movie in the world, Avatar, is on screens now, and it clearly identifies the most evil force in the universe. It's business.

"There's only one thing the shareholders hate more than bad publicity," says the smarmy manager of an unnamed company's mining operations on the planet Pandora in Avatar, "and that's a bad quarterly report." Slaughtering hundreds of peace-loving Pandorans may generate some nasty press, but he decides to do it anyway -- in the name of profit.

That portrayal -- echoed in the Oscar contender Up in the Air -- may seem cartoonish, but it's in line with the popular mood, which is why President Obama knew he was on safe ground when he recently derided "fat-cat bankers."

Polling shows that America and the developed world still loathe business two years after the U.S. recession began; a 2009 survey by the Edelman PR firm says that only 30% of Americans (and 13% of Brits) think the reputation of large global businesses is good. Now Congress is weighing a "Wall Street tax" meant to penalize the financial services industry for its transgressions, and Britain and France already have enacted high taxes on bonuses.

None of those sanctions will achieve their goals, because the intended victims can evade them or pass along the costs; they'll just throw a bit of sand in the gears and impose a burden of inefficiency on everyone.

Instead, these moves are all about payback: Voters love them because they punish the sector of society that so many blame for the recession and their own poor financial state. Unhappiness with the current state of affairs is entirely rational, but ...

Blaming business is not only nuts, but also dangerous.

It's nuts because if you really want to name those who caused the recent recession, the list is long: stupid and shortsighted companies for sure, but also a government that encouraged and mandated risky lending as well as millions of people who willingly took on mortgages they never should have.

More important, it's dangerous because it's a delusional response to a far larger issue. As miserable as this recession has been, the hard reality is that even when it's over (and it may be over already), most Americans won't be any better off than they were a decade ago, nor will their prospects be bright. Hanging business from the rafters won't do a thing to help.

The real problem for most Americans isn't the recession.

It's the more ominous fact that average household income hasn't budged for the past 10 years. That's true in every income quintile of the population, even the top.

And for the bottom 60%, that stagnation has lasted twice as long. Most of the country has just been treading water over a period that spans expansions and recessions, bull and bear markets, and Republicans and Democrats in charge.

Just try finding the bad guy in our real-life movie. The advent of a large-scale global labor market means that millions of Americans are competing for jobs with Chinese, Indian, and other workers, pushing our high pay down. Social trends have led to more single-parent and typically lower-income households. Perhaps most important, America no longer boasts a world-beating education system that turns out masses of graduates who can support an ever-rising living standard.

Who's the villain?

It isn't a few evil people or any one sector. It isn't the rich; the gains of the top 1% needn't cause declines at the bottom. Our society isn't behaving villainously at all. It just isn't adapting to a changing world. Don't despair; we can return to a rising standard of living. We've done it before. But we'll never do it as long as we refuse to face the real reasons that so many Americans are in economic trouble.

How to raise living standards

1. Increase accountability and pay in public schools. We can turn out better graduates by realizing that principals and teachers respond to the same incentives as the rest of us.

2. Embrace high-performing immigrants. They don't steal American jobs; they create them and make the U.S. more competitive.

3. Lower the U.S. business tax rate and end corporate welfare. That will help make U.S. companies more globally competitive and aid American workers. 

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Jan 11, 2010

A new financial checkup

Forget the other performance ratios. A new metric has emerged that can't easily be gamed.

(Fortune Magazine) -- In business as in life, be careful what you wish for. I know a company that wished for a better return on equity. What could be wrong with that? It paid its executives according to that measure, and man, did they deliver. In some years the firm had the best ROE in its industry. It was winning bigtime.

The firm was Lehman Brothers, now dead because managing for ROE caused executives to overborrow; after all, debt is capital that earns a return (in good times). Yet it isn't equity, so extreme leverage simply juices ROE until bad times arrive. Wishing for the wrong thing -- managing for the wrong ratio -- killed the company.

The larger, chilling reality is that every other ratio out there can lead to the same disaster. Gross margin? Earnings per share? It's easy to make any of them look better while damaging the business.

Which is why a new ratio that you've never heard of, EVA momentum, is so intriguing. It has been developed by consultant Bennett Stewart, one of the creators (with Joel Stern) of the measure called economic value added, or EVA.

Now used by myriad firms, including Siemens (SI), Best Buy (BBY, Fortune 500), and Herman Miller (MLHR), EVA is essentially profit after deducting an appropriate charge for all the capital in the business. Because it accounts for all capital costs, its proponents say, EVA is the best measure of value creation.

Now Stewart is making a bold claim about his latest idea: EVA momentum, he says, is the one ratio that can't be manipulated. "It's the only percent metric where more is always better than less," he says. "It always increases when managers do things that make economic sense." If he's right, it is worth knowing about -- for managers at every level and for investors.

It's the change in a business's EVA divided by the prior period's sales.

So if a company increases its EVA by $10 million and the prior period's sales were $1 billion, then its EVA momentum is 1%. That's not bad, considering that for most companies this figure is zero or negative, and the average for many companies is generally around zero.

Stewart's firm, EVA Dimensions, has crunched the five-year data for firms with revenues of at least $1 billion. The three top performers by EVA momentum: Gilead Sciences (with an average annual EVA momentum of 24.3%), Google (22.7%), and Apple (12.1%).

It's no surprise to see those names identified as excellent performers; what's interesting is the way they did it. The key insight is that achieving high EVA momentum requires a business to do two difficult things at once. It must grow while at the same time maintaining healthy EVA profit margins or improving poor ones.

Apple (AAPL, Fortune 500) and Gilead (GILD, Fortune 500), a biopharmaceutical company, grew spectacularly while also increasing their EVA profit margins impressively; Google (GOOG, Fortune 500) simply maintained an excellent EVA profit margin while growing sales 760% during the five years. That combination of increasing sales and an excellent or improving EVA is the extremely rare basis of great financial performance.

It's hard to see how. A popular gambit of conniving managers is to shrink a ratio's denominator recklessly, which is what Lehman executives did when they cut the E in ROE dangerously low. But the denominator in EVA momentum is the last period's sales, so it's fixed going in. Relentlessly jacking up EVA -- the numerator -- is difficult; a proper calculation of EVA values spending on R&D and employee training, the kinds of long-term investments that help companies over time.

EVA momentum is brand-new -- Fortune is the first to write about it -- and while Stewart has measured it in hundreds of companies, real businesses have yet to apply it. So we don't know what will happen when this ratio confronts actual managers trying to make actual profits. But when a big new idea comes along, adopting it first creates a major advantage. This could be one of those times.

1. Don't obsess about sales. Managers fixate on how to increase their company's revenues, but if it doesn't boost EVA, it does nothing to create value.

2. Bail out of EVA-negative businesses. Ford's sale of capital-intensive, EVA-sapping Jaguar and Land Rover shrank the company, but in the end increased its value.

3. Annihilate wasted capital. Cutting working capital, as Wal-Mart (WMT, Fortune 500) did in 2009, and offloading unproductive assets are great opportunities to build EVA when growth is slow. 

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Nov 10, 2009

Leading during a downturn

Leadership problems come up again and again in a downturn. Solving them doesn't take fancy technology - just character and courage.

(Fortune Magazine) -- Businesspeople love to tell me their problems, and in the waning days of this recession they keep describing three of them more than any others. They have to do with vanishing leadership, changing corporate culture, and talent.

They're problems that grow particularly acute in a downturn -- which means every company needs to worry about them. Here's what they are and how to fix them.

This is a classic recession problem: employees frustrated that just when they're most afraid, their leader seems to be disappearing rather than stepping forward.

Have pity on such leaders before condemning them. In times of crisis leaders have to spend more hours on the phone and closeted in meetings, reducing their visibility, and they're particularly starved for the information they need to make high-stakes decisions. Every force is pushing them to "hunker in the bunker," as American Express CEO Ken Chenault expressed it to me.

Morgan Stanley's (MS, Fortune 500) John Mack is one leader who fought that temptation in this crisis. When the meltdown struck, his firm wasn't strongly dominant like Goldman Sachs (GS, Fortune 500), nor was it a basket case like Lehman Brothers. It was in the middle, and everyone looked anxiously to Mack.

He didn't have all the answers -- even the best leaders never do -- but he spoke often to customers, employees, and the public about what he knew and was thinking. He also answered critics by announcing a redesigned bonus plan before any other major Wall Street firm. That's textbook leadership.

If your leader won't lead, try telling him or her not what you want but what you hear from the employees that they want; that's the tactic one executive at a Midwestern manufacturer uses.

The economic recovery may be faint at the moment, but the best companies adapt to a changing world before the change is obvious.

It isn't always easy. An HR manager at a metals company recently told me she was going nuts trying to change the criteria for promotion at her company to emphasize growth over cutting costs. The culture valued skinflint managers, and seemingly nothing could budge it.

That manager was right to realize that a culture of adaptability is crucial. Look at Thomson, formerly one of the world's greatest newspaper publishers, which decided in 2000 -- the all-time best year for newspaper ad revenues -- to get out of papers entirely.

The move looked insane, but Thomson (now Thomson Reuters (TRI)) was adapting to the world it saw coming. Its culture encouraged such radical thinking; in previous decades the company moved into and out of oil, airlines, and other businesses.

Unfortunately, battling a calcified culture may be futile unless you're the boss. I told that HR manager that as soon as the economy turned up it might be time to move.

You'd think a recession would be an easy time to get rid of underperformers -- you can see clearly who they are, and you may have to cut headcount anyway.

The problem is that some managers seem to think problems are caused by everything but people. When James Kilts took over at Gillette, sales and profits had been flat for years. Yet when he analyzed performance reviews, he found 74% of managers had been given the highest rating and only 3% had received the lowest.

It's tough to eject poor performers when almost everyone's a genius. The solution? Honesty in evaluations: Encourage a culture where anyone at any level can tell the truth. It may not be popular, but explain you're facing reality.

These problems are deep-seated. The good news: Solving them doesn't require new technology or complex analysis, just character and courage, which are available to us all -- and which a historic recession might help bring out.

1. Stand up and be seen. It's a simple yet powerful way for leaders to be effective. Warren Buffett raised his profile in this recession, reassuring investors and even helping to calm markets.

2. Steer the culture with stories. Southwest Airlines (LUV, Fortune 500) has always understood this, celebrating stories of employees who perform heroically for customers. Make sure the stories you repeat embody the culture you're aiming for as the economy recovers.

3. Upgrade your people standards. With high unemployment, you have an opportunity to raise the bar on whom you hire and promote, as McKinsey and other top leader factories are doing.

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Oct 28, 2009

Fewer deaths during a recession

The death rate went down as unemployment rose - a lesson for companies: overworked employees can be bad for business.

(Fortune Magazine) -- Profits are down at Hillenbrand, America's largest maker of caskets. Admittedly, this fact sounds like the setup for a punch line, but the cause of the shortage in stiffs contains lessons for politicians and business leaders alike.

Hillenbrand's CEO, Kenneth Camp, explained his company's main problem this way in a recent conference call with analysts: "Continuing lower death numbers."

As we grind through the longest recession in 75 years, Americans across the land are not dropping like flies. In fact, there's a virtual epidemic of people not dying.

This rise in the living was predictable. The truth, little known but well documented, is that death rates decline and healthy living habits improve in tough economic times.

Extensive research by Christopher J. Ruhm, an economist at the University of North Carolina, shows that a one-percentage-point rise in the unemployment rate reduces the death rate by 0.5%. Those are U.S. results, but other studies show the same effect in Spain, Germany, and the 23 OECD countries in aggregate.

People live longer in recessions mainly because they become healthier, not because they face fewer external causes of death, such as auto accidents, which decline because people drive less, for example.

What's more, the evidence of improved health shows up in ways beyond lower death rates. As unemployment gets worse, general medical problems become less prevalent: When the economy gets sick, people get healthier.

An important reason seems to be that people adopt smarter lifestyles in recessions, especially those people with the worst health habits. Chain smokers cut back. The indolent go to the gym. Even the severely obese start to lose weight. Combine those improvements and you get a healthier nation, even in the short period of a typical recession.

The obvious question is why people improve their habits when times turn bad. Statistical analysis shows that lower incomes aren't the reason; strapped consumers apparently aren't getting fitter because they must bike to work and survive on oatmeal and turnips.

Instead, one reason seems to be extra free time. Having no job means more time to hit the gym or just go for a walk. Exercise leads to weight loss, and research shows that it correlates with less smoking (though which causes which isn't clear). Being unemployed or underemployed also means more time for sleep, which improves health.

Policymakers in Washington and CEOs can draw two important lessons from the recession's effect on health.

A lesson for health-care reformers is that their focus, our system of insurance and care, isn't the root cause of America's high medical costs. The recent downturn in dead people is a reminder that the No. 1 culprit for rising health-care costs is lifestyle. It's significant that recessions reduce smoking, inactivity, and obesity.

"Those three things drive chronic conditions," says Cleveland Clinic CEO Dr. Delos Cosgrove, "and chronic conditions account for 75% of the cost of health care in the United States."

If reformers haven't figured out how to alter U.S. lifestyles -- and they apparently haven't -- they shouldn't expect dramatic results by changing how those costs are paid for.

A lesson for companies is that it's possible to make employees work so hard that it's bad for the business. If employees can't find time for physical activity -- or are exhausted after grueling 60-hour workweeks -- the employer will pay a price in lost productivity and higher medical costs.

As for Hillenbrand (HI), the recession may be thinning profits, but the company is adapting to the long-term trend. A few years ago it introduced its Dimensions line of caskets for the extra-wide loved one. Sales are brisk.

1. Make it easy to be fit.

Not every company can afford a deluxe on-site gym like Google's (GOOG, Fortune 500), but subsidized gym memberships cost an employer almost nothing. More companies should offer them.

2. Penalize vice.

You can offer financial incentives to employees with healthy habits, as Aetna (AET, Fortune 500) does, and even fire those who don't stop smoking, a policy that CFI Westgate Resorts adopted six years ago. Yes, it's legal in most places.

3. Lead by example.

Employees focus on what matters to the boss. Everyone at Alcoa (AA, Fortune 500), for example, knows that CEO Klaus Kleinfeld, a marathoner, believes in healthy living.

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Sep 28, 2009

Stay lean and mean even after the recession

It's critical to stay lean and mean during an economic recovery - and even expansion - so you're ready for the next disaster.

(Fortune Magazine) -- If ever you were entitled to start breathing easier, now would seem to be the moment. So why am I telling you not to?

The end of the recession seems so close that you can almost smell it. The stock market is surging, China and India are firing on all cylinders again, and no one would be surprised if in the next quarter the U.S. economy shows signs of growth too.

Yet this is exactly the wrong moment to let up on the mean and lean strategies you've adopted over the past year and a half. In fact, it's time to go further and develop a new, even tougher mindset: managing for -- yes -- the next recession.

Downturns are only a small part of the economic cycle, but they are the moments when the pecking order shifts -- and when entire sectors change in ways that last for years.

Think of how the landscape shifted among investment banks (Goldman Sachs (GS, Fortune 500) stronger than ever; Lehman Brothers and Bear Stearns gone for good) and automakers (Chrysler bankrupt and bought; Toyota (TM) roaring past GM). The primary factor in determining which companies won and which lost was the way they were managed during the boom.

So now that the next expansion is about to start, it's time to make sure not only that you grow and succeed, but also that you position your business to prevail in the inevitable next recession. Three imperatives:

Make friends now with the people you'll need later.

At a meeting of leading CEOs this past spring, a top Obama administration official (speaking on the condition that he not be named) told the corporate chiefs bluntly that they had done a lousy job of making friends in Washington.

When the government needed businesspeople to serve on task forces, he said, companies sent functionaries. But when a company wanted to lobby officials on a potential tax or regulatory change that would benefit them, the CEO showed up and had plenty of time.

Such behavior isn't forgotten when a company suddenly appears asking for help, the official said.

Listen to unconventional wisdom.

For unsuccessful companies, risk is a hot topic at the depths of a recession. For great companies, it's a hot topic at the height of a boom.

In the previous expansion, contrarians like Yale professor Robert Shiller, New York University professor Nouriel Roubini, and fund manager Jeremy Grantham were saying what no one wanted to hear -- that real estate and other asset prices had become insane bubbles. Well, Grantham is still here, while many fund managers are not.

When the good times return, make it a priority to find the thinkers who stand apart. Like? Check out economists Emmanuel Saez of the University of California at Berkeley and Susan Athey of Harvard, the two most recent winners of the John Bates Clark Medal for America's best young economist. Saez is an expert on tax policy -- an important topic as federal rules are being rewritten. Athey studies investor behavior and market structure, another key subject.

And always be alert for others. You can't know if they'll be right, but considering their views will make you wiser.

Don't go soft on evaluations.

Expansions make it easier for everyone to look like a star, leading undisciplined managers to believe somehow everyone just got better. The best companies, like Procter & Gamble (PG, Fortune 500) and McKinsey, are as rigorous in evaluating people during good times as bad. Otherwise they'd find themselves with a roster of C players when the next downturn arrives.

This whole way of thinking may seem backwards. Good times seen merely as preparation for the bad? But managing intelligently during the next expansion will be much more than a chance to clobber competitors. At least as important will be preparing the organization for the make-or-break environment of the next recession.

1. Manage capital fiercely. It is always hard to try tightening receivables and payables when everyone else is doing the same. So get capital efficient when you don't have to, as Deere (DE, Fortune 500) and Staples (SPLS, Fortune 500) did in the last cycle.

2. Recession-proof your model. Silverjet and Eos, flying all-business-class jets across the Atlantic, failed in this recession. Southwest (LUV, Fortune 500) gained market share. Is your business model ready for the next downturn?

3. Keep growing personally. Adversity builds character; good times can erode it. The best managers find new ways to challenge themselves as the economy picks up. 

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Sep 21, 2009

Renovating Home Depot

That's part of CFO Carol Tomé's job, and after the housing bust it's tougher than most - but the lessons are valuable for anyone.

(Fortune Magazine) -- Think the recession has been tough on you? If you're in the housing sector, like Home Depot, this is the downturn's fourth year.

The company's revenues are down, and the stock has dropped 36% over that period -- but revenues have held up at its rising competitor, Lowe's (LOW, Fortune 500), and its stock hasn't suffered as much.

All of which makes life more than interesting enough for Carol Tomé, 52, Home Depot's CFO since 2001. Her boss, CEO Frank Blake, thinks highly of her; he has expanded her responsibilities to include the company's growth initiatives and real estate portfolio, and he has called her "the central nervous system of the company." Analysts think she could be a future CEO.

Born in a log cabin hospital in Jackson, Wyo., Tomé (pronounced toe-may) is very likely one of the few Fortune 500 CFOs who knows how to brand cattle. Her father owned a bank, and as a university student she intended to work in it -- until he sold it. From a career perspective that was probably a lucky event. She talked recently with Fortune's Geoff Colvin about the outlook for housing, the state of the U.S. consumer, leadership in tough times, and much else. Edited excerpts:

Home Depot has as great an interest in the housing sector as any company in America, so you spend a lot of time developing an outlook on housing. What's the outlook now?

We look at every housing indicator you can imagine, and the statistic that we seem to be most correlated with is private fixed residential investment as a percent of GDP.

The 60-year average is 4.8%. At the height of the homebuilding market, that number stood at 6.3%. At the end of the first quarter of 2009 the number stood at 2.7%, so there has been a huge contraction, which has certainly impacted our business. Between 2006 and 2009 our sales will be down about $15 billion.

So I look at the number 2.7% and 60 years of data and say, Hey, it's logical to assume that the worst is behind us. Could there be continued contraction? Sure, but that serious, significant decline that we've experienced should be over. That gives us some comfort that recovery will happen. The question is when.

And what's the answer?

We don't know. I wish I could give you a definitive date, but we don't have it.

We've also seen that the housing crash is highly regional. What have you learned?

We've seen great variability across the country, and one thing that we are looking at very closely is foreclosures. In states like California, where we saw foreclosures accelerating, our comps -- same-store sales -- in the first quarter were worse than the company average, but in states where foreclosures are decelerating, like Indiana, our comps were better than the average.

If there's a silver lining in any of this, could it be that foreclosures are a good thing for Home Depot? Anybody who buys a house in foreclosure almost certainly needs to fix it up.

There is always a silver lining. When homeowners come into a foreclosed home they need to do some work. They often need to clean the house, and we've got a wide variety of cleaning products. They need to replace the carpet, paint, replace the faucets, perhaps the window coverings -- so yeah, we see a real opportunity there.

Housing is at the center of this recession. Do you have an economic forecast?

For the home improvement sector we were forecasting a contraction in 2009, and that's turning out to be true -- with the first half worse than the back half, and that's turning out to be true. As we build our plans for 2010 and beyond, there's a lot of inconsistency in what we're hearing, a lot of wanting to believe that the recovery is soon upon us. Our approach is to be more conservative. If we're wrong and the upside happens before we plan, that will be great.

Home Depot spends a lot of time and effort studying the U.S. consumer. What's the state of the U.S. consumer today?

For the consumer shopping in our space, their spending patterns have changed dramatically. There's been a real shift away from discretionary big-ticket projects to the core repair and remodel. In this year's first quarter, tickets of $50 or less were basically flat year over year. But tickets of $500 or more were down by double digits. People are coming into our stores, but they're shifting how they're spending.

We also know that credit is an important part of the value proposition, and the U.S. consumer's ability to get credit is lower than it was a year ago. The credit quality of our customers is quite high, but we think perhaps consumer credit will keep tightening.

So that's your environment. How has the company responded?

First we wanted to make sure that we kept our associates, the men and women on the floor of the store, totally engaged. In an environment where a lot of companies were cutting back, we said no. We are going to invest in those associates. We're going to pay merit increases, pay bonuses, make contributions into the 401(k) plan. We're going to be singularly focused on them so they can take care of the customers.

We introduced something we call power hours inside our stores. In the hours when traffic is heaviest we stop all activity that is not customer facing -- pack-down activities, say -- and spend 100% of our time taking care of customers.

Meaning everybody in the store?

Everybody. Even if you're in the receiving area, if you're in the vault, you come out on the floor. It's a wonderful experience. We hear from 100,000 customers a week more or less. They rate us on a number of attributes, and our scores are better than they've been in three years. So the voice of the customer is telling us we're doing the right thing.

A lot has happened from an expense and capital allocation perspective as well. We made some really hard decisions last year, including the closing of 15 stores. We removed 50 stores from our new-store-opening pipeline. We exited our [high-end] Expo business, 34 stores that we closed earlier this year. We reduced our support staff by over 2,000 people. We made the right choices to take care of the customer and preserve the company for the long term. Part of the choice that we made was looking at our square-footage growth and saying, Hey, this country is over-stored. We're going to rationalize square-footage growth and reallocate capital into activities inside our stores that should help the customer experience.

Adding stores used to be something that Home Depot did on a mammoth scale. Now that has almost come to a stop within the U.S. That's a strategic choice. Is there a danger that you may be at a competitive disadvantage some years down the road? Because you have a strong though smaller competitor in Lowe's (LOW, Fortune 500), which is expanding more aggressively.

You can't win the game by square-footage growth. You win by the customer experience, making sure that service is there and the products are there at the right price. We realized over the years that you could continue square-footage growth because there's plenty of real estate out there, but you'd dilute returns. That is not in the best interest of the customer or the shareholder.

We have a three-legged strategy, and you will recognize this from Jim Collins's book "Good to Great." What are we passionate about? We are passionate about our customers. What are we the best at? Product authority. And what drives our economic engine? Productivity and efficiency. It is no longer driven by square-footage growth.

We're still going to open stores -- we're opening 13 stores this year. But it's not about that any longer. It's about how do we get more sales per square foot in the existing stores? We do that when the market recovers, and we do that by capturing market share. The market share focus is something we are starting to show great results on.

In a recession practically every company has to decide what it's going to cut and what it absolutely will not cut. How did you decide?

We really let the customer make some of the decisions for us. Investing in the associates was a decision that I mentioned. Reducing our support staff was a hard decision. We lost 10% of our officers. They were personal friends of mine, they'd come to my house for dinner, and they are no longer there. That was hard. But it was the right thing to do for the company. In the first quarter we were $80 million under our expense budget. We're finding opportunities that you wouldn't believe -- we're so big that a small change can mean real money.

For example?

We have a pro desk inside our stores. The professional contractor is a very important customer to us -- 3% of our transactions and about 30% of our business. We serve coffee at the pro desk. By changing the brand of coffee -- not stopping the coffee, because coffee is important -- but by changing the brand we will save our company $500,000. It doesn't take too many $500,000 decisions to make a penny per share.

Another key strategic decision is pricing. In your space you have to decide whether you'll use everyday low pricing, the Wal-Mart strategy, or use promotions. You've been on both sides of that choice. What's your thinking now?

Our thinking is everyday value. Every product in our store has a role and intent, and they drive the pricing strategy. Two examples. Think about insulation -- we should be the destination for insulation. When you say, I need to put some insulation in my ceiling, we should be top of mind. So when you come into Home Depot (HD, Fortune 500) for insulation, we should be the very best price, the lowest price in town. That would be a destination category for us. Now think about batteries. Are we top of mind when you need a double-A battery? No, that's an impulse product for us. We will have a good price, but we don't have to be the best price.

Imagine the power of assigning role and intent to everything we sell. We said we would grow our gross margin, and in each of the past seven quarters in the U.S. our gross margin has increased. We're able to bring great values every day to the customer and still grow our gross margin.

Can you give more detail on that? Lots of people would love to know how you grew gross margin in this environment.

We've moved off the promotion, and when you don't repeat promotions from the prior year you get a margin benefit. We've also looked at our assortments and decided that for some categories we're happy where we are. We are the No. 3 retailers of appliances. We're happy being No. 3. Appliances are a low-margin category. If you don't increase the penetration of the low-margin categories, you can grow your gross margin.

When a company has a prominent competitor, like Lowe's, differentiation becomes really important. How is Home Depot going to differentiate itself?

Today one point of difference is that we have more stores and are more convenient, but that will erode over time if they continue on their path of opening stores while we are rationalizing our square-footage growth.

So then what is the point of difference inside the store? It is really that belly-to-belly experience between the associates and the customer. The customers who are shopping us today are saying they see a difference. Our challenge is to invite back those customers who may not love us because we've disappointed them. We need to invite them back so they can experience that point of difference.

From a merchandising perspective, I will tell you that if you go to our hand-tools or power-tools aisle, we've got a broader assortment than anyone in town. We have great prices, and we should always win on product. But what is the stickiness? The stickiness has got to be about the human experience.

What are the financial measures on which you reward store managers?

An interesting point -- we changed it for our store managers. They have a financial bonus and a nonfinancial bonus, and for the financial bonus you have sales and profit. We changed the weighting so it is more heavily weighted on profit, and in an environment where expense control is so very important, guess what happens -- they are all focused on expense control. The store managers understand it impacts their wallet. So we are seeing a tremendous performance across the board from an expense control perspective. You know, you can drive behavior based on how you compensate.

The Employee Free Choice Act, generally known as card check, is a huge issue for Home Depot, with 300,000 non-union employees. Does it worry you less now than it did six months ago?

We are worried about it because we think it is just wrong. It has morphed a bit [with a key provision weakened in the latest version], and that we think is very good news. But we think it's wrong.

Any expectations about what's going to happen with it?

No, but let me tell you what will happen. We will do the right thing for our stores. When we talked to our store associates and said, Why would you want to join a union, you know what we learned? It is really not because of our pay. It is because of the relationship they have with their boss. So the most important thing for us is to make sure that our store manager can call each of his or her associates by name without their apron on and know something about them -- to create that connectivity, the family within the store, which keeps any organizing activities outside, regardless of what might happen.

Financial organizations are traditionally very male, and there aren't many women CFOs in the Fortune 500. What's the key to becoming one?

The key is to surround yourself with the very best talent. I am currently blessed. I have the best financial team in corporate America, I believe, and with them we have done just great work.

You're the only senior manager at Home Depot who has worked for all four of the company's CEOs -- Bernie Marcus, Arthur Blank, Bob Nardelli, and now Frank Blake. They are radically different human beings. Tell me honestly -- what is the key to your longevity at the top of the company?

It boils down to a few things. I am really passionate about the business. I am not kidding -- you cut me, and I will bleed orange. I love the business. I also know the business. When I started in the company 14 years ago, I knew the company only as a customer. I didn't know it from a retail perspective or a merchant perspective, and I learned very quickly that I needed that knowledge. So I put on an apron and worked in a store. I know the numbers, but I know the drivers behind the numbers even more, and I think that has really helped throughout my career.

Bernie Marcus told me when I became the CFO, "Carol, I think you're charming, and you can use your charm on Wall Street." I was, like, okay. Then he said, "But I won't know that you're really doing your job until somebody calls you a bitch." I said, "Well, I can do that too." Listening to the advice that I get now, I might have taken Bernie's advice a little bit too literally.

What have you learned about leadership from the experience of these past two or three years?

I've learned a lot. I've learned that it is really about the power of the team and the importance of alignment. You've got to break down silos, particularly in an environment like this. The only enemy we have is the company headquartered in North Carolina [Lowe's]. We need to be aligned as a team, and we have made great progress in that regard.

I've learned that you've got to have a sense of humor. We've had some dark days, and the ability to just crack a joke or laugh for a minute really does help. It really is important to laugh at yourself and to say, Okay, I blew that, but that's okay. Pick yourself up and keep going on.

And never lose sight of the customer. At the end of the day it all comes back to the customer. The more time you can get out of the office and spend time talking to the customer, the better it is.

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Aug 11, 2009

3 Big Myths about health-care reform

With historic legislation on the line, the spin is coming from all sides. Here's how to sort through it.

(Fortune Magazine) -- One of Washington's true epic battles will play out over the next several weeks. It's the fight over health-care reform, of course, and it will be big, brutal, and ugly.

The stakes are high -- trillions of dollars, the reelection prospects of hundreds of legislators, and President Obama's legacy. So let's acknowledge right now that nobody will be fighting fair. We will hear half-truths, shameless spin, and outright lies coming from all sides.

How to keep your head when all about you are losing theirs? You can start by understanding three myths about health-care reform we're guaranteed to hear repeatedly. Remember them. Whenever you hear one of them, you'll know that someone is trying to mislead you.

Myth no. 1: Rising health-care costs are a problem in themselves.

We've all seen the graph that shows health-care costs increasing much faster than GDP; it's usually presented as evidence of the crisis we're in.

Take a graph with that same trajectory and label it "Sales of hybrid vehicles" or "Downloads from the iTunes Music Store," and nobody proposes government intervention to stop it. Yet health-care costs, too, are in fact revenues, and fast-rising revenues are generally seen as exciting and laudable in every industry except one. How come?

It's because we all sense that in health care we aren't getting our money's worth -- that tons of dollars are wasted. So the problem isn't that we're spending so much, but why.

That distinction is crucial because partisans on all sides will soon be telling us how their plan would slow the rate of spending growth. But slowing spending is easy -- just give people less care.

Instead, make advocates tell how their plan would address the "why" by cutting waste and boosting efficiency. When they do, make sure they don't invoke ...

Myth no. 2: The fee-for-service system is a major part of the problem.

You hear this from both sides: When you pay providers for each service, they have an incentive to sell you more services. Thus, the argument goes, we squander billions on needless MRIs, doctor visits, hospital nights, and so on. The trouble with this reasoning is that we avoid that problem when buying other complex services, from consulting to car repair, on a fee-for-service basis.

The reason we buy loads of unnecessary health-care services is not the fee-for-service system, which we use to buy almost all services. It's that we aren't paying with our own money. Only 12% of U.S. health-care spending is out-of-pocket, a proportion that has been falling for decades.

If each of us controlled more of the money that's being spent on our behalf for health care, we can be certain it would be spent more carefully, on services directly or on insurance that covers those services.

Don't let reform partisans tell you how they'd eliminate fee-for-service; make them tell you how they'd let consumers direct more of their own health-care spending.

Myth no. 3: A well-designed government plan can avoid rationing.

The Obama administration has stated flatly that "health care will not be rationed" under its plan. So let's be clear on this: Health care will be rationed. It must be. To say otherwise is to say the government can supply it in unlimited quantities to everyone.

This point is so obvious it should not be controversial, but the high-voltage word "rationing" seems to blow people's processors. (By the way, health care is rationed in private systems too, but it's done by price, and we don't call it rationing.)

Reform that broadens coverage, improves outcomes, and reduces waste is such an ambitious goal that we may fail to achieve it. The contending forces are so powerful and have so much at stake that I won't attempt to predict the outcome. But we're likely to get something, so we should at least try for reform that isn't based on these myths. That may be asking a lot.

First Published: Aug 11, 2009: 12:00 PM ET

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Jul 09, 2009

Making big drugs during troubled times

Amgen CEO Kevin Sharer's job is to produce blockbuster drugs. Will health-care reform make that harder?

(Fortune Magazine) -- These are momentous times for Amgen, the world's largest biotech company. The health-care revolution brewing in Washington could be dramatically good news or bad for a business whose drugs tend to be life-changing -- and highly expensive. Also on deck this year is a critical FDA decision on Amgen's denosumab, a possible blockbuster treatment for osteoporosis and bone cancer on which Amgen is betting heavily. If it's approved, analysts expect annual sales of at least $1 billion -- maybe double or triple that. Overseeing it all is CEO Kevin Sharer, 61, who joined the company 17 years ago as a newcomer to biotech after a career with the U.S. Navy, McKinsey, General Electric, among others. Amgen (AMGN, Fortune 500) stock has been up and down during his nine years as chief, but right now Wall Street likes its prospects: 19 analysts rate it a buy or a strong buy, based on denosumab's prospects and further operating efficiencies, while five say it's a hold in light of the recession and strengthening competition. Fortune's Geoff Colvin talked with Sharer recently about health-care reform, cancer treatments, advice for new CEOs and aspiring CEOs, and much else. Edited excerpts:

Health care looks like the big issue of the summer, and President Obama's major theme is cost reduction. Many Amgen drugs are very expensive. Does that make them especially vulnerable?

To give a little context, the biopharmaceutical industry, including pharmaceuticals and biotechnology, is about 8% of the total health-care bill, and it's projected that, due to generic drugs and a few other things, that expenditure line is going to be flat for a few years. So the biopharmaceutical part of the system is sort of self-correcting.

As for individual biotechnology drugs, I think we have to look to value. For example, one of our drugs, Enbrel, is profoundly important to people with rheumatoid arthritis. It lets people who in many cases couldn't even get out of bed have a full life. It's an expensive drug [costing typically $20,000 to $24,000 a year], but the value it delivers is there. Sixty percent of the potential medicines for cancer are in the biotechnology pipeline, and if we can have a cancer drug that has profound benefit, generally that's seen as really good value. But we do have to be able to defend the value of the drug.

What about value in enabling the system to avoid costs that would be greater without the drug?

The way I think about value is avoided cost and quality of life or extension of life. Extension of life is very, very hard to achieve, but quality of life is important. We haven't yet developed a language in society to have that conversation. We need to develop a language of value in health care.

A central part of the debate right now is whether the program, whatever it turns out to be, should include a public plan. What's your view?

The devil's in the details. I would generally favor a private-sector solution, but if a public plan is deemed necessary, I would hope that it's on a level playing field. I fear statements like "What the industry needs is a not-for-profit plan to keep it honest." I'm not sure how that works. We do need to get access for people who don't have insurance. But I'd favor private sector over public.

If you could write the bill and have the President sign it, how would it read?

There are three big principles I'd want to keep in mind. First, access -- are we giving access to people in a reasonable and affordable way? Second is hope. The real thing I think America looks for my industry to do is come up with cures for the toughest diseases society faces, and I wouldn't want to do anything to diminish innovation. And the last thing I'd hope for is equity -- each member on the game board is going to have to contribute money to pay for this new environment, and we're probably going to have to tighten our belts. I hope those decisions are made on an equitable basis and everybody feels like they're paying their fair share.

When biotech was getting started back in the 1970s, part of the excitement was its potential for someday defeating cancer. It's 30 years later -- how are we doing?

It's still an important goal. There's definitely been progress made. There are many cancers that would've been a complete death sentence 30 years ago and that now we manage in a chronic way. We still have a lot of work to do. We understand the biology a lot better, but cancer is hundreds of different things, at least seven to 10 different biological mechanisms. And the body is amazingly redundant -- you block one thing, something else happens. I think we're going to be fighting cancer as a disease for the next 50 to 100 years, which seems very, very long, and it is long, but in a medical products development time frame, that's probably four or five product development cycles. We are making progress, there's no doubt about it.

They say every problem is an opportunity. Have you found any opportunities in this recession?

The opportunities are for a company that has a strong financial position and a good reputation. In our industry there are many biotechnology companies that are having a hard time raising cash. Those are opportunities for us to help them develop products. Our biggest opportunity in this situation is to reach out to some of the earlier-stage companies and see if we can find some products we can help develop. Just the other day we announced a $50 million investment in a small company called Cytokinetics (CYTK), which has a novel mechanism of action for congestive heart failure. It's a difficult disease. This is an early stage, but we think the biology is exciting, and we were delighted to have the chance to invest.

In April you cut Amgen's full-year sales outlook. How come?

For the first time in anybody's memory we're starting to see the biopharmaceutical industry and the medical industry at large affected by a recession. I think there are a couple of reasons. One is very high unemployment, and every time the unemployment rate goes up, people lose health insurance. Second, I think people are more aware of what they have to pay -- some of the cost has been shifted to them. While people don't have a full understanding of their cost of health care, they now bear more cost. That combination, I think, is unique.

And so what we did, out of caution, is we said it looks like a 1% effect on sales. We cut some costs, and our earnings should still be fine.

Everybody has made cost cuts in this recession, but choosing what to cut is a major management decision. How did you make that decision?

We made it as a team. I have eight or nine people I work with, and we try to make decisions based on collective judgment. The most important thing is to develop the products we have in the pipeline, so we protected that. Equally important is to make sure of the quality of the products we deliver to the market -- no compromise. But you'd be surprised when you look at things as mundane as travel, temporary workers, and vendors. You can get more money out than you might think. It's no one big thing. It's tightening the belt across the board but keeping the critical activities well funded.

One area where companies typically cut in a recession is training and development. What have you done?

We have not cut anything in development. When I became CEO about nine years ago, we decided that executive development was profoundly important, and we run weeklong classes with case studies from Amgen's experience, mostly things we didn't do well, because that's what you learn the most from. We haven't cut back on that at all. Developing people is the future of the company.

Earlier in your career you worked in three of the highest-performing organizations I know of: the U.S. Navy, McKinsey, and General Electric. What lessons did you take away about what creates a high-performing organization?

I was in the submarine force in the Navy, Adm. Rickover's child, and the basic thing that came out of the Navy was that the level of excellence you should hold yourself to should be extraordinarily high. At McKinsey what I learned was to make complexity simple in an analytic way and to communicate it so people can quickly understand it, and be right. At General Electric (GE, Fortune 500) I learned how to be a general manager. It was probably the best factory I ever saw for that. I spent time on the chairman's [Jack Welch's] staff, and watching him up close showed the power of embracing reality, being nimble, being adaptive, aggressive, competitive -- but still, as he used to say, we can be hardheaded in business yet softhearted when it comes to taking care of people.

All those organizations are intensely people-focused.

My life experience has taught me that there is no substitute for the best team. If I were going to give advice to a new CEO, I'd just say there is no substitute for the best team, and do what it takes to get one.

What have you learned about evaluating people when you're trying to distinguish the future stars from the rest?

Early in my career I thought I was able within a minute or two to evaluate anyone. I'm not that cocky anymore. So I've learned it's good to have multiple views of someone before you make a decision. The second thing I've learned is that personal characteristics are fundamental. If you don't have the right personal characteristics, I don't care what experience you have. The third thing is that, particularly at the senior levels, looking at where someone has been and what they've done is profoundly important in deciding what they can do. Then there's some intangible that's hard to describe, but you know it when you see it -- and if you're right three out of four times, you're in the hall of fame.

You mentioned Enbrel, the arthritis treatment. It accounted for almost a quarter of revenues in the first quarter, and sales of it were down markedly. How is Amgen going to make up for that?

One of the things that has affected that drug is these high co-pays that I talked about, and we've taken steps to relieve consumers of that burden. We're making sure that consumers don't pay any more than a nominal amount in co-pay, and we basically will handle the co-pays for them.

Why are investors and the industry so interested in denosumab?

Denosumab is a drug for osteoporosis. It has a new mechanism of action. It works on the bone biology to slow down the molecule that chews up the bone. You only have to take a shot twice a year, and you're protected from osteoporosis. We've very, very excited about it. We're also developing it for a kind of bone cancer, and we look forward to the final results of those trials this year. This has been a drug we've worked on for 15 years. We did the fundamental biology and invested over $1 billion. I bet my job on it. So I was happy that it turned out okay.

What happens next?

We're working with the FDA now, and it's not over till it's over, and you never predict exactly what agencies in the government are going to do, but I'm very, very enthusiastic, and more important, the doctors who've looked at it have been very positive in their response. I think it'll really be important for patients.

How dependent will Amgen be in its near-term future on this drug?

As is often the case in our industry, one drug is important, and this is clearly important in the intermediate term to us. Some analysts have predicted that it could have quite large potential. The unmet need for osteoporosis is huge. So it's very, very important to us.

You're an engineer, not trained or educated as a biologist or scientist, but you're managing a company that's built entirely on science and biology. How can you make the big decisions you have to make?

I leave the early discovery decisions to the scientific leadership. It's not something I have expertise in. It doesn't cost that much money. When I get involved is when we start spending a lot of money, which is when we start registration trials. For example, denosumab was over 10,000 patients, 25 countries, hundreds and hundreds of millions of dollars. We put the firm's reputation on the line. It gets publicity. So as the product moves through the pipeline, I get more and more involved. Again, I don't independently make the decision. I just convene the right people, listen to the conversation, and ask the right 10 questions.

Would I be correct in saying research is the core of Amgen?

Yes.

So much depends on the passion and dedication of your scientists and researchers. How can the CEO manage that?

The board asked me that question, and sitting on our board is a Nobel Prize winner in biology [David Baltimore, now president emeritus and a professor at Caltech] and a distinguished physician-scientist who's run big systems [Gilbert S. Omenn, former CEO of the University of Michigan Health System, now a professor at Michigan]. So it was a serious question. When I knew I was going to be CEO, I took a little sabbatical at their direction to learn about R&D, and I thought maybe there was a system, an answer. What I found out is, there's about 16 things you've got to do right, but the single most important thing, I decided, was hire the best person in the world to run research and development, and support that person. That's what I tried to do, and I think I got close to succeeding. [Amgen's R&D chief since 2001 has been Dr. Roger M. Perlmutter, a former Merck executive and professor at the Howard Hughes Medical Institute at the University of Washington.] It's having that person, then giving them the money and telling them to swing for the fences.

Presumably that person has tremendous power to attract other scientists.

Another easy concept I have is that A's don't work for B's very long, so you'd better start with A's at the top.

Earlier you told us your advice to a new CEO. What's your advice to somebody who wants to be a CEO but isn't one yet?

First is broad responsibility -- don't get channeled into just one functional area. Second is to focus on the job at hand, not your career. Third, be willing to embrace risk and know that you only grow outside your comfort zone.

Talkback: What diseases do you think Amgen should focus on when trying to develop the next blockbuster drugs?

First Published: Jul 9, 2009: 12:00 PM ET

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Jul 07, 2009

National healthcare may never happen

Americans love the idea of insurance for all - until they realize how much it will cost them.

NEW YORK (Fortune) -- The latest polling looks great for President Obama: It shows that Americans love national health care. If history and polling trends are any guide, however, that will change. Voters right now are in what the famous pollster Daniel Yankelovich called the Wishful Thinking stage -- a moment in the life of an opinion analogous to the dreamy early days of a relationship. Yankelovich believed opinion evolved through seven stages: Dawning Awareness, Greater Urgency, Reaching for Solutions, Wishful Thinking, Weighing the Choices, Taking a Stand, and Making a Responsible Judgment. In the next few weeks, when voters discover what national health care will cost and how it would affect their own care, romance will give way to reality.

Americans favor by more than 3 to 1 "the government offering everyone a government-administered health insurance plan that would compete with private health insurance plans" and other large-scale federal initiatives. At least that's what they thought as of mid-June in a New York Times-CBS News poll. But the respondents in that poll were opining about an idea, not hard facts.

Only after most of the polling was complete did the Congressional Budget Office release its bombshell evaluation of Sen. Edward Kennedy's reform bill, which would just begin to do what the poll respondents so enthusiastically favor. The report's sobering bottom line: The bill would increase the federal deficit by $1 trillion over the next decade yet make only a dent in the number of uninsured, who would decline from 19% of the non-elderly population to 13%.

That combination -- huge cost, minor benefit -- is probably not what most people thought they'd be getting. Another bill, from the Senate Finance Committee, would cost still more. Legislators are scrambling for fixes, but even if they find them, they'll face a separate problem. Health-care reform is going to cost major dollars no matter what, and those dollars will have to be extracted mainly from those most able to pay, the top-earning 40% of the population. When these top earners figure out that they're being asked in a recession to shell out more -- through increased taxes, higher insurance premiums, or other mechanisms -- for benefits that will go mostly to others, they won't be happy. And that top 40% knows how to make itself heard in Washington.

This isn't just speculation. Similar scenarios played out in 1992 when the Clintons pushed for their ill-fated Clinton Care plan and in 1988 after Congress passed an insurance plan to protect the elderly against the costs of catastrophic illness. In 1988 polls had shown that Americans overwhelmingly favored such a plan in the abstract, and large bipartisan majorities passed it in both houses. Only the top 40% of seniors would have paid a tax surcharge to fund the plan, but those were the people who tended to carry supplemental insurance already. Once they realized what was happening, they howled in a way that legislators couldn't ignore. Seventeen months after President Reagan signed the bill into law, Congress repealed it. None of its provisions ever took effect.

Today, with more ambitious reforms on the table, a scenario not unlike 1988 could be taking shape. Dig deep into the latest polling, and you'll find that while most Americans believe health care is a serious problem, 77% are satisfied with "the quality of health care you receive." When that large majority finds they're being asked to pay more for something they're basically happy with, they will enter Yankelovich's fifth stage, Weighing the Choices.

Yankelovich wrote rather presciently in the pages of Fortune back in 1992 that stage five is the hardest because it is the moment on the journey to a rational judgment when people must come to grips with the painful tradeoffs inherent in all complex issues. So when will that happen? I predict that stage five will begin in August, assuming the House passes a bill before Congress takes its August recess. Only then will we discover what citizens truly believe about health care. The result could be far more modest reform than we've been led to expect.

First Published: Jul 7, 2009: 12:00 PM ET

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Jul 01, 2009

Business gets taxed, workers get hurt

The Obama administration wants to whack companies with stiff new taxes, but the real victims are already suffering enough.

(Fortune Magazine) -- Sometimes what's politically irresistible is economically nonsensical, as we may soon be reminded. The Obama administration, desperate for revenue and spotting an easy target, is proposing three hefty tax increases on business. If the administration gets its way, the result will be bad news for all Americans.

The first instance of dangerously mixing politics with economics was the administration's announcement in May that it wanted to "reform our international tax laws" so that they don't "stack the deck against job creation here on our shores."

In a smooth bit of political rhetoric, the White House linked international corporations to individuals who illegally evade taxes by secretly stashing income overseas. "Today our tax code actually provides a competitive advantage to companies that invest and create jobs overseas compared to those that invest and create those same jobs in the U.S.," or so began the White House's May 4 statement. In the very next sentence, the administration segued to "our tax system is rife with opportunities to evade and avoid taxes through offshore tax havens."

The average citizen had to conclude that most big U.S. companies are tax cheats. Only a dedicated student of accounting would figure out that the term "tax haven" as defined by the Treasury Department means any country with a lower corporate tax rate than America's, which is all countries except Japan.

The reality is that the administration is lashing out against perfectly legal behavior. A U.S. company that makes money in Country X pays Country X's taxes on that money. If the company ever brings the money back to the U.S., it must also pay the additional tax that would be due under America's higher rate. The administration argues that since America has virtually the world's highest corporate tax rate (and even Japan's is only a fraction of a point higher), current rules create incentives for U.S. companies to operate anywhere but here, at the cost of U.S. jobs. The White House therefore proposes charging all American companies full freight -- the whole difference between their overseas taxes and the U.S. corporate rate -- on all their profits as soon as they're earned, no matter where. This measure, in their minds, would bring jobs home.

If the logic eludes you, you're not alone. The bottom-line effect of the change would be a steep tax hike -- more money vacuumed out of corporate coffers. Would that make U.S. companies competing in a global economy more inclined to hire additional workers in the highly expensive U.S.? The answer is clear. It's why Microsoft chief Steve Ballmer said recently that if the change is enacted, "we're better off taking lots of people and moving them out of the U.S. as opposed to keeping them inside the U.S."

That's Obama's first proposed business tax increase. Another would require companies to account for their inventories on a first-in-first-out (FIFO) basis rather than a last-in-first-out (LIFO) one -- an eye-glazing change that's highly significant. In an era of rising costs, to assume that you're selling your oldest inventory rather than your newest increases reported profits and thus taxes, even though nothing real has changed. If inflation turns worse, as many analysts predict, FIFO would force companies to pay real taxes on phantom profits as the value of goods gets inflated while they sit in inventory.

The third business tax hike would be the new levy on carbon emissions. Regardless of the form it takes -- a cap-and-trade system or a carbon tax - and despite the good reasons for it, it's still a tax, money out the door for which a company gets nothing.

The problem with sticking it to business in these three major ways is that ultimately business doesn't get stuck. Taxwise, a company is just a bunch of incorporation papers; all taxes are paid by people -- customers, shareholders, and employees. And guess who would bear most of the burden of these tax increases? It's the U.S. employees of the companies being taxed.

Research has shown that when business taxes are raised by a dollar, 70¢ to 92¢ of it comes out of employees' pay. When workers wake up to that fact, they may decide this is one time they don't want the White House beating up on business.

First Published: Jul 1, 2009: 12:00 PM ET

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Jun 10, 2009

Geoff Colvin on The Upside of the Downturn

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May 28, 2009

The Upside of the Downturn

This recession will change the course of your career. Whether you're damaged or strengthened depends on the way you respond. Can you rise to the challenge?

(Fortune Magazine) -- The recession that followed World War II was hard on everybody, but it was especially tough for Bill Hewlett and Dave Packard. Supplying equipment to the government had been a big part of their young company's business, and that revenue mostly disappeared when the war ended.

Beyond that problem, the overall economic contraction that followed the drop in government spending meant that companies - HP's (HPQ, Fortune 500) other class of customers, since it didn't then sell to consumers - weren't buying either. The firm faced a crisis of survival.

It was one of those moments when the behavior of a company's leaders in a brief period will determine its future for a very long time. As biographer Michael S. Malone has documented, Hewlett and Packard had built their business from the beginning on the principles of loyalty and trust, but in these circumstances they realized that they simply could not avoid mass layoffs. They fired 60% of their employees.

Among the survivors, though, something curious happened. Those who remained were forced to stretch themselves in new ways. The company's manufacturing chief turned himself into a knockout marketer and was so successful that he remained in that role for the rest of his career. Even Packard himself found muscles that no one suspected he had. Though never considered a genius engineer - that was Bill Hewlett's role - Packard returned to the lab at this time when the company was desperate for new products, and he invented one. It was a voltmeter, the beginning of a product line that would serve the company quite profitably for 50 years. Packard never invented any more products; his genius was managing the company. But when a dire situation pushed him beyond his apparent abilities, he excelled.

This recession is much worse than the one following World War II, and for millions of people globally it's a time of deep personal trials. Truly everyone is being stress-tested. Yet of the many opportunities that arise out of troubled times, the most valuable of all for many businesspeople are the opportunities for personal growth, particularly for developing as a leader. But the growth isn't automatic. Achieving it demands that we respond in the right ways.

Turmoil presents the ultimate leadership opportunity, but for every inspiring story of James Burke and the Tylenol crisis, there's at least one less heralded tale of a leader who blows it. Coca-Cola (KO, Fortune 500) CEO Douglas Ivester happened to be in Paris in July 1999 when news reports said that cans of bad Coke had made several Belgian schoolchildren sick. Ivester, a brilliant financial executive with a sharply analytical mind, quickly determined that all production procedures were being followed and that his products did not pose any health risks. He got on his plane and flew back to Atlanta. But more people got sick, images of suffering children dominated TV news, politicians demanded action, and the mess eventually cost Coke millions of dollars plus years of distrust and bad will from all its stakeholders. It also contributed to Ivester's getting fired within months. In a crisis, he turned out to be a manager, not a leader.

So what does true leadership under unimaginable stress look like? It can be boiled down to four actions. They're simple to state and may seem deceptively simple to do, but they aren't. Finding the strength to take these steps will contribute significantly to any leader's growth.

1) Be seen early and often. This most basic requirement is important for a fundamental reason that is often forgotten: People want to be led. The reasons we crave leadership are deep. We want the leader to be a repository for our fears. When people are desperately worried, they want to know that someone with greater power than theirs is working to solve their problems. Thus, successful leaders in a crisis first make emphatically clear that they are present and on the job. This kind of visibility isn't easy, because the leader in a crisis has a million things to do, most of which require being on the phone or meeting with small groups. In a business crisis, lawyers may be advising the leader not to make any public statements. Yet it must be done.

Michael Dell's company was not large or well established in the early 1990s when he was scheduled to appear at a conference where I was moderating. The day before, Dell (DELL, Fortune 500) had announced unexpectedly terrible results. The stock had plunged, and some people wondered whether Dell himself, who wasn't yet 30, could lead his organization past this. The situation was so serious that most of us at the conference assumed he wouldn't show up. But he did, appearing unfazed and explaining his plan. Simply appearing reassured his constituencies and increased their confidence for the future.

2) Act fast. It's amazing how people who would be at one another's throats in good times will accept that in a crisis, decisions have to be made. Leaders in a crisis must not lose their rare opportunity to act. The difficulty is that just when decisions are most easily accepted, they're hardest to make. All business decisions are made with incomplete information, and that's especially true in the heat of a crisis. At the same time, the stakes are much higher than usual. Every instinct tells you to decide more slowly than usual, yet it's vital to decide more quickly.

3) Show fearlessness. When Robert the Bruce led the Scots against the English at the Battle of Bannockburn, he led them literally, riding a horse in front of the rest. As legend has it, a mounted English knight spotted him, lowered his lance, and charged. Bruce stopped and didn't move as the knight thundered toward him. Then, at the last moment, he stood in his stirrups, turned sideways, swung his battle ax, and split the passing knight's helmet (and head) in two. Bruce's troops were so inspired that they roared into battle and won the greatest victory in the history of their nation.

We want our leaders to show us that they're not afraid. In business that means facing bad news head on without cringing. The effective leader announces trouble in unvarnished terms - people can smell evasion a mile away - then explains confidently how it will be defeated. Fearlessness can be shown more tangibly as well, when a leader cuts his own pay or, even more powerfully, uses his own money to buy company stock, as several CEOs have done in this recession.

Note that the advice here is "show fearlessness," not "be fearless." A prominent CEO, who didn't want to be quoted for obvious reasons, told me, "Any CEO who isn't terrified in this recession has no sense at all." To suggest that you be fearless would be ridiculous. But what counts is what you show. Robert the Bruce was probably terrified. It didn't matter.

4) Tell a story that puts the crisis in context. Extensive research has shown that how people are affected by stress depends heavily on the way they see it. Those who see stressful events as bad, abnormal, and inescapable tend to suffer from them much more seriously than do people who see those same events as normal, interesting elements of life from which they can learn and to which they can respond. Some research has found that members of the first group suffer much worse health than those in the second group. The first group burns out more quickly and performs much worse than the second, even though both are subjected to the same stress. A critical question for leaders is whether they can help everyone in the organization respond more like members of the second group. The answer seems to be yes.

When the stock market was dropping in late 2008, I asked Charles Schwab about it. He began his answer by saying, "I've been through nine of these darn breaks. This happens to be the most pervasive in terms of how it has spread through the economy." He went on to explain how it differed from previous market declines and how the market would eventually climb back up. This was precisely a group-two response, starting with the idea that what some investors considered financial Armageddon was really just part of a very long pattern. His overall message was that this is interesting and something to which we're all capable of responding.

***

These four steps may require you to stretch beyond your comfort zone. And that is exactly the point. Research has established that what turns average performers into great performers is a process of being continually pushed just beyond their current abilities, and then responding to the new challenges with focused efforts to overcome them, accompanied by abundant feedback about the results.

But constantly attempting what you can't quite do, which is the essence of the process, is a recipe for trouble in most jobs. It means that you will inevitably make mistakes and have failures. Now if you ask accomplished businesspeople, as I have often done, whether they learned more from their successes or their failures, 100% of them will say the latter. But most employers don't want to hear that your mistakes have been an absolutely necessary part of your growth. They just want you to perform.

So that's what most people do in their jobs, operating entirely within their comfort zones and as a result not getting any better. We know this not just from observing it in our own workplaces but also from considerable research showing that most people improve rapidly in the early days of a given job, then plateau, and may continue for years thereafter without progressing.

Seen against this backdrop, the precise nature of this opportunity is clear. The recession, by pushing everyone past the limits of his or her current abilities, places us all on the first step of the process. Whether we take the next steps is for each of us to decide.

Certain practices that are always valuable for a business actually become easier to adopt in a recession.

1) Evaluate employees better. In good times it's easy for employees to look like stars, so evaluations tend to become less rigorous. Managers are fooled into believing they've assembled all "A" players. In tough times it's much easier to distinguish the true stars from the third-stringers. Just as important: With the unemployment rate rising, employees are much more inclined to take evaluations seriously.

2) End guidance. Telling investors what quarterly earnings are likely to be, then talking that number up or down as the quarter progresses, and then contriving to beat it - that corporate game has never served a useful purpose and can lead to much harm as managers feel pressured to hit announced targets. That's why such respected firms as Aetna, General Electric, Intel, and Unilever have stopped giving quarterly guidance in recent months.

3) Manage for value. In good times your company's performance is probably attractive almost any way you look at it. Now it's more critical than ever to focus on what really matters, which is earning a return on your company's capital that exceeds the total cost of all the capital in the business. If that seems painfully obvious, please stop and reflect on whether you or anyone in your business is being paid explicitly for achieving that goal. Most employees at every level are paid to hit other targets - salespeople have sales quotas, plant managers have quality goals, even the CEO may be focused on reported earnings per share. None of those goals is the same as value creation.

4) Expand your mind about risks. The most dangerous risks your company faces are the ones no one wants to address. That is always true; now the trauma of this recession has made it far easier than it has been for years to talk about unimaginable risks.

5) Mine employees for ideas. Potential improvements can hide in a million places. Staples recently found $21 million of efficiencies in the way it runs its warehouses. When I asked CFO Christine Komola how they knew where to look for the savings, she replied immediately, "Ask the associates. They know." 

First Published: May 28, 2009: 12:00 PM ET

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May 12, 2009

Sympathy for the devils

How to get Main Street off Wall Street's back.

(Fortune Magazine) -- Is something very wrong with our financial system when the nation's biggest banks are talking about seven-figure bonuses while ever more Americans are losing their jobs? Millions of people seem to think so: If we could calculate an outrage index, it would be marching toward an all-time high. But before we institute public floggings for bankers, let's take a closer look at who or what is really to blame.

At the root of the public's anger is a timing issue: In recessions the stock market tends to anticipate the recovery by six to nine months. That means that business at Wall Street firms, including those that accepted TARP money, will pick up while most of the country is still suffering. So Wall Street employees who are paid in part through bonuses will see those bonuses rise from last year's deeply depressed levels.

At the same time, overall unemployment generally does not improve until the end of a recession or even later. So for many months to come, maybe a year or more, Americans will be jobless in growing numbers while Wall Street firms will be hiring and paying more - with taxpayers' dollars - and Washington will be caught in the middle.

That means we'll see many days when headlines carry bad news for workers and good news for bankers. It's happening already. In late April, as Chrysler and GM (GM, Fortune 500) were headed for bankruptcy, Citigroup (C, Fortune 500) chief Vikram Pandit was talking about paying big bonuses to high-performing employees who've never been near a mortgage-backed security or anything else associated with the bank's collapse. Before he could do so, though, Pandit had to go to Treasury Secretary Timothy Geithner to plead for permission. Meanwhile, a front-page New York Times analysis of first-quarter pay at several TARP recipients found, not too surprisingly, that pay was going up, igniting an outcry from vast swaths of pundits who were predictably outraged.

Why shouldn't Wall Street be punished? Because it would be bad for the country. Now that all of us taxpayers own a piece of the banks, thanks to the Bush and Obama administrations' bailouts, we need our investments to pay off. It's in the immediate interests of taxpayers, and in the longer-term interests of the economy, for Bank of America (BAC, Fortune 500), Citigroup, Goldman Sachs (GS, Fortune 500), and the rest to do well financially. The more money they make, the sooner they can pay back the Treasury and focus fully on their necessary roles in the economy.

Restoring profitability to the banks will require paying bonuses. The only way these firms succeed is with superior human capital, and the way they get it is by paying for it. Plenty of global financial firms did not take TARP funds, and they can pay what they like. Analyze the first-quarter results of Credit Suisse (CS), Deutsche Bank (DB), CIBC, and others that compete with TARP recipients, and you'll find that they, too, are paying their people more.

The results are just what you'd expect. "Citi is hemorrhaging people, and the government restrictions are making it worse," says Alan Johnson, a compensation consultant whose clients include many Wall Street firms. "I have clients who are not TARP recipients and who are giddy that they can now steal people like they never could before."

You're unlikely to hear anyone in the Obama administration defend bonuses. No politician will even think of trying to tell millions of the unemployed why it makes sense for a Wall Street firm that was given tax dollars to pay some employees more in a week than most Americans earn in a year. "The government has to step back and say, 'If we want to maximize the value of our investments, we've got to get the best people in place,'" says Spencer Stuart headhunter Peter Gonye.

One quick way the Obama administration could tame the outrage index would be to deal with Wall Street the way it is dealing with Chrysler. If Citi and Bank of America are actually insolvent, as some analysts claim, then let the government break them up and reorganize them. That would go a long way toward dispelling the notion that the Treasury is bailing out fat cats at the expense of working stiffs.

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May 05, 2009

The government’s new definition of rich

President Obama's tax plan won't help balance the budget, and it may hurt the upper middle class.

(Fortune Magazine) -- Are you rich? If you make $250,000 a year, President Obama and Gov. David Paterson of New York think you are. The SEC disagrees. It tells financial firms that a high-net-worth individual is someone with at least $750,000 parked at a particular institution or someone the firm "reasonably believes" to have a net worth exceeding $1.5 million.

The reason this debate matters is that federal and state governments are looking at the worst deficits ever seen. In their desperate search for funds, they are going to tax some subset of the wealthy. Let's hope they train their cross hairs where they do the least damage.

When President Obama said he would raise taxes on the wealthy, he set the increases to start at an income of about $250,000. Gov. Paterson recently worked out a rise in New York's state income tax that takes effect at the same level. If all that those politicians mean by "rich" is the small portion of the population at the top of the economic heap, then households making over $250,000 is a fair definition: Only about 5% of U.S. households have annual incomes over $200,000.

The flaw in that definition of rich is that plenty of families making $250,000 a year don't feel rich. They probably see themselves as upper middle class, especially if they live in blue-state coastal cities and suburbs. An income of $250,000 is a lot richer in Abilene, Texas, than in New York's Nassau County, where it takes $430,000 to enjoy a similar quality of life, according to bankrate.com. So let's call them the "working rich."

What's troubling about raising the tax burden on the working rich is that this group already pays proportionately more tax than the super-rich. In addition, the working rich aren't as adept at sheltering their wealth from the tax man through deferred-compensation schemes or other loopholes.

In 2006, the most recent year for which information is available, the average tax rate for the working rich was 22.8% - that is, after all was said and done, they ended up paying 22.8% of their adjusted gross income in income tax. The floor for being in the top 1% was an income of $388,806. That same year the average tax rate paid by the super-rich - the 400 filers with the highest incomes - was only 17.2%.

What is possibly more galling than the easier ride of the super-rich is that raising taxes probably won't accomplish much when it comes to getting us out of these troubled times. Consider a couple of harsh realities:

Soaking the rich doesn't stimulate the economy. It only changes who is doing the spending - the government or private citizens.

Soaking the rich doesn't even seem to increase tax revenues. The top marginal tax rate has fluctuated wildly over the past 50 years, from 91% to 28%; it's now 35%. But individual tax revenue as a percent of GDP hasn't varied much at all - it hovers at about 8% - and its variations don't correlate with the top tax rate. The reasons are many, but the bottom line is that as government deficits soar to unimagined levels, taxing the rich isn't likely to yield nearly as much as governments are hoping for, and it may not yield anything when the numbers are all totaled.

The best alternative is to rein in spending. If we are going to create record deficits, it would have been better to do it by cutting taxes than by jacking up spending, but that battle is over. Now let's be sure not to increase the stimulus, as Obama has suggested we might, and not let taxes rise in 2011 as they're scheduled to do. Most important, the Federal Reserve needs to keep interest rates low, which research shows is the main factor that ends recessions.

There is one thing that soaking the rich will do effectively, and that's redistribute wealth. Obama's new budget would increase federal payments to low- and some middle-income Americans through increases in the Earned Income Tax Credit, the Child Tax Credit, and other programs. Candidate Obama was quite clear that he intended to do that, so he can rightly claim that the voters gave him a mandate for it. Let's just understand that reslicing the pie to give the rich a smaller piece doesn't make the pie any bigger - and won't get us out of the recession any faster.

REPORTER ASSOCIATE Alyssa Abkowitz contributed to this article.

First Published: May 5, 2009: 8:50 AM ET

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Apr 21, 2009

How to manage your business in a recession (January 8th, 2009)

(Fortune Magazine)—Exciting as it is to be living through historic economic drama, you can’t just stand by and watch. You have to act - yet you have no script.

So much of today’s turmoil is unprecedented that we can’t find much guidance by looking to the past. For managers across the global economy, as well as for Team Obama on its way to Washington, today’s great question is, What do we do now?

Managing in any recession is difficult; managing through this one is especially hard because it’s different from previous ones in multiple ways. Most immediately significant, employment is plunging more steeply than in a long time - by more than two million jobs last year, more than during the previous two recessions, and this one is far from over.

At the same time, U.S. consumer spending is falling sharply. In the third quarter it sank at a 3.1% annual rate, the steepest decline since 1980 - meaning that managers who have made it through the past four recessions have never confronted anything like it. Best Buy (BBY, Fortune 500) president Brian Dunn said recently, "In 42 years of retailing, we’ve never seen such difficult times for the consumer."

The drop is worrisome because consumer spending is more than 70% of America’s economy, and while it may rise quickly or slowly, it almost always rises. During the whole of the last recession (2001), consumer spending never declined at all; its growth only slowed.

Compounding the problem, consumers are more deeply in debt than ever, an immediate concern for companies that lend to consumers; American Express (AXP, Fortune 500) CEO Ken Chenault calls this "one of the most challenging economic environments we’ve seen in many decades."

Longer term, consumers’ balance sheets are so ugly that many executives believe this recession may linger as people slowly rebuild their finances. Dunkin’ Brands chairman Jon Luther says, "This downturn will not have a typical V-shape, where it bounces right back. It could be a couple of years before consumer spending goes up again."

Consumers aren’t the only ones deleveraging. Companies are too, and on a more massive scale than ever seen before. That means business-to-business firms are also suffering. Cisco (CSCO, Fortune 500) CEO John Chambers predicts that his company’s sales will decline for the first time in five years.

Deleveraging is typical in a recession, but because boom-time leverage had reached unprecedented levels, the reverse process may become particularly violent. Deere (DE, Fortune 500) CEO Bob Lane cites current deleveraging as a main difference between this recession and previous ones: "The U.S. economy has never been through anything like this, and we don’t know what the effects will be."

Yet another important difference - the credit crunch - affects even those companies that are reducing debt, but especially those that aren’t. Virtually all firms depend on a constant flow of credit to carry them smoothly through the ups and downs of business fluctuations. While it’s entirely typical for lenders to get more cautious in a downturn, the near freezing of credit is something else again. Even companies able to pay higher interest rates may find that credit isn’t available from the usual sources at any price.

Making this recession unique above all is its sheer interconnected complexity. Consider this sequence: The U.S. housing bubble bursts, pushing U.S. consumer spending down, leading to less demand for imports from China, causing slower growth of the Chinese economy, thus decreasing demand for copper, pushing copper prices down to their lowest levels in almost three years, causing big problems for you and your warehouse full of copper. You can conduct pretty fancy scenario planning and still not be ready for that - and it’s safe to say we’ve barely begun to see the rippling effects of a recession in an information-based, truly international economy.

Yet that’s the environment in which you must manage. How? Insights and practices from global executives, consultants, and others suggest several steps you can take now.

As usual in these situations, much will depend on how quickly you move. It’s human nature to avoid confronting bad news and to imagine that today’s troubles will pass more quickly and easily than they really will. Virtually everyone Fortune spoke to recommends the opposite: Assume conditions will be worse than you actually expect.

"You identify areas where you think you can be more efficient by assuming the worst-case scenario," says Intuit (INTU) CEO Brad Smith. "Then you end up saying, Why don’t we just do that anyhow?" Facing the coming reality before your competitors do can make a big difference in which of you stays healthy or even who survives.

It must be said that some of the most effective moves you can make for prospering through a recession are ones you established a long time ago. In times like these the strong get stronger and the weak get eaten. In the tumultuous third quarter, while Washington Mutual and IndyMac Bank were failing, Bank of America (BAC, Fortune 500) - which got out of subprime mortgages in 2001 - attracted $21 billion of new consumer deposits as consumers ran to safety. When the Wickes furniture retailing chain filed for bankruptcy earlier this year, more than 100 truckloads of furniture were on their way to its stores; a Milwaukee retailer that had remained financially solid, Steinhafels, bought the contents of several at bargain prices.

Remember that for next time. For now, what’s done is done. No matter what shape your business is in, it will benefit from following these ten recommendations.

• Reset priorities to face the new reality.
• Keep investing in the core.
• Communicate like crazy, balancing realism and optimism.
• Your customers face new problems, so give them new solutions.
• Don’t rush to cut prices.
• Focus on capital - how you’re getting it and where you’re using it.
• Reevaluate people - and steal some good ones.
• Reexamine compensation - what is it offering incentives for?
• Think twice about offshoring.
• Be smart about mergers and acquisitions.

It’s hard to be upbeat in a recession, but it truly is an opportunity. Marathoners and Tour de France racers will tell you that a race’s hardest parts, the uphill stages, are where the lead changes hands. That’s where we are. When this recession ends, when the road levels off and the world seems full of promise once more, your position in the competitive pack will depend on how skillfully you manage right now.

Reporter associates Steven Gray, Christopher Tkaczyk and Yi-Wyn Yen contributed to this article.

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