Economies of scale are not guaranteed. Take that lesson from Citigroup’s sale of a controlling interest in its Smith Barney brokerage operation, and its decision to split itself into two pieces.
The myth that bigger is always better is a powerful one that is not likely to die, even as Citigroup and Bank of America struggle to regain their footing on the frigid ice of the 2009 world economy.
The funny thing is that the bigger-is-better myth was as seductive to communists as it was to capitalists. It held sway in Moscow as strongly as it ever has on Wall Street or in Detroit or on the suburban campuses of corporate America.
It also tempts the general public. Even new college econ students have heard of “economies of scale,” though they may not know that it refers to a situation where the per-unit costs of producing some product decline as the size of the factory increases.
Pride in having the biggest house, city, ship or cannon seems a human impulse that goes back to cave people. But conventional theory supposes that rational profit-maximizing dominates business decision-making. So why build hapless behemoths like Citigroup or General Motors?
Engineering relationships produce some economies of scale. A 100,000-gallon oil tank requires substantially less steel per gallon of capacity than a 1,000-gallon tank. A blast furnace that produces 2 million tons of iron per year uses less fuel per ton than one that produces 100,000 tons. A computer large enough to serve one small-town bank has capacity to serve 10. The per-passenger cost of the cockpit crew of a 747 is less than that of an Embraer regional jet.
Stalinist central planners were obsessed with economies of scale. The Soviet Union built enormous steel mills, hydroelectric dams and irrigation canals. It engineered a steam locomotive with 14 driving wheels to haul huge trains out of the Donbass coal mining region.
This obsession outlived Stalin. In the early 1970s, under Leonid Brezhnev, the Soviets set out to build the world’s largest truck factory, with 85 acres of buildings stretching for miles along the Kama River.
The American finance industry’s drive to assemble mega-companies in the 1990s was based on economies of scope as well as scale. The difference is that scope economies stem from selling a broader range of products rather than just having a bigger firm.
Sanford Weill headed the merger of Travelers with Citicorp in 1998. The new company, Citigroup, included fragments of such varied firms as Smith, Barney; Salomon Brothers; Shearson, Lehman; and even the Commercial Credit division of Control Data, once the pride of Minnesota’s high-tech sector.
The idea was that a large firm would offer a comprehensive range of household and business financial services across the nation and around the world. It would be a commercial banker, a retail broker, a mutual fund manager and an insurer. It would advise large corporations on mergers and acquisitions, and families on retirement planning. It would trade stocks, bonds, currencies, commodities and derivatives for its own account.
Weill was not the only such empire builder. Phillip Purcell oversaw the merger of investment bank Morgan Stanley with brokerage Dean Witter. That included Discover charge cards and financial products sold at Sears stores.
Ten years on, these have proven as bad an idea as a 14-wheel locomotive or an 85-acre truck factory for the same basic reason. “Big” often means clumsy and hard to manage.
Running mega-companies cobbled together out of disparate acquisitions proved difficult, to say the least. In many cases, each component of the merged firm — investment banking, commercial banking, insurance, household financial services — saw still-independent specialized competitors out-perform them again and again. Being part of a comprehensive global corporation could be a liability rather than an advantage.
The scope advantages proved similarly illusory. People did not necessarily want to buy mutual funds along with a new kitchen range or wrench set. Buying car insurance from one’s stockbroker attracted few.
Like General Motors and 1970s-era IBM, they suffered the same problems of too many layers of management, unimaginative marketing, poor cost control and poorly defined goals. Billions in shareholder value disappeared.
This is not new. In manufacturing, at some point, managerial diseconomies of scale often outweigh any engineering economies. In financial services, the underlying operational economies are proportionally smaller and get outweighed earlier.
The fact that Citi’s predecessors had played a major role in two preceding financial debacles, that of Third World debt in the 1970s-1980s and commercial property lending in the early 1990s, should have warned potential shareholders. Whatever money it made them in its good years has been thoroughly flushed away now.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.