Adam Smith’s Pin Factory, updated

Adam Smith would be horrified with what passes for an economy today. I have this image in my mind of his fellow Scotsman Billy Connolly indignantly bellowing “What the fuh?” as he regales an audience with some tale of outrageous observational humour. Adam Smith used real-life observations as well to illustrate his economic theories, a notch or two down from The Big Yin admittedly. But try it for yourself, look up at that statue of him peering down from his high plinth on the Royal Mile in Edinburgh and ask yourself if you can’t hear him shouting “Are you kidding me?”¬†Because, really, it is unbelievable.

Here’s an example. To illustrate the benefits of cooperation and specialisation Adam Smith explained in “The Wealth of Nations” how pin manufacturing could be made more efficient. He noted that a factory employing ten men might produce upwards of 48,000 pins a day when one man working on his own would struggle to make twenty pins a day. He showed how self-interest was served by combining talents with those who might otherwise be thought of as competitors.

So let’s imagine a group of pin-makers were inspired by his insight. Let’s imagine they formed themselves into a company, bought machinery and set up a production line with each worker doing what he was best at, and as a result they multiplied their individual output many times over, just as Adam Smith had predicted. Then over the years as the company prospered they were able to buy a plot of land and build their own purpose-built factory on it.

Fast-forward to today. The Edinburgh Pin Company has provided a steady living for generations of pin-makers. The business couldn’t be in better shape: they have a strong market presence for a wide range of high quality products at reasonable prices, straight pins, map pins, drawing pins, safety pins; the company owns the factory and thus pays no rent; the partners all work in the company and draw wages that are fair but not exorbitant; there is cash in the bank and the company has no overdraft or mortgage and no investors to pay.

But as with so many businesses, the global financial meltdown has had its effects. Turnover is down as customers cut back on buying and so the company seeks out new markets and new products. They find a big new customer who wants to place a massive order which with their present equipment they can’t deliver on for price and quantity. Time for a major investment. For the first time ever they go to the bank for a loan. The bank says no. The fact the company can show a contract for sufficient sales to completely cover the sum to be borrowed matters not a jot. Despite the government having bailed-out the bank which is now majority-owned by the taxpayer, and the Bank of England issuing fresh reserves to facilitate additional lending by the banks for exactly this sort of need, this bank won’t play ball. There’s not enough money in it for them.

There is a way out though, the bank tells them: get listed on the stock market. And as luck would have it, the bank could help them with that. For a fee. Well, for a lot of “fee” actually. There is a lot more money in it for the bank than merely lending the company the money they need. In fact, by the time they’ve paid for endless lawyers, accountants and other special advisors, drawn up a prospectus and made relevant filings, signed-up with a team of brokers and been well and truly taken to the cleaners by the bank, they’ve used up all their cash reserves and the partners have all had to inject cash from their own private funds. “Don’t worry,” says the bank, “you’ll all be millionaires soon.” Ha.

Unfortunately, by all the measures the stock market uses to assess the value of a stock, the Edinburgh Pin Company comes out rather poorly. It’s capital is seriously under-utilised because while it owns extremely valuable land it earns no money from it because the company doesn’t bother paying rent to itself. Why would it? That’s silly. Nor is the return on investment good enough because the partners run the company to generate only a modest profit, enough to pay the bills and stay in business. And the biggest sin in the eyes of the market? They’re not deep enough in debt. Most normal people would think that not being up to your eyes in debt is a good thing, but investment bankers are not normal people. Looking at the assets and the level of turnover, the company ought to be able to borrow a substantial sum of money but it doesn’t owe a penny. All things considered, the stock market valuation is less than the partners might have hoped. It would still raise the cash needed to fund the expansion which is what they wanted to do in the first place and which is supposedly the point for a stock market anyway, so they go ahead.

The company is launched on the stock market, the partners get their money back and a bit more besides, and there is still plenty of cash left over to pay for the modernisation. For a while it all goes well and the new contract is being serviced and the new client couldn’t be happier. Everyone is upbeat. As a publicly listed company they now have some obligations to investors in a way they never had before when they were privately owned. They have to appoint a CEO and in the way of things, they have to pay top price to attract the best candidate. In order to ensure everything is done properly, they appoint a remunerations board and the bank helps them find suitable candidates for that too. As a larger company with more employees now, they are also subject to a whole raft of legislation they weren’t subject to before, employment, health & safety, that sort of thing. They also have to join a Pin Manufacturers trade association which replaced the Pin Marketing Board which Thatcher abolished years ago.

After their first year of trading as a publicly listed company, they issue their first annual report and hold their first annual general meeting. This is all a bit of a novelty for them, the report took a lot of time and effort to put together – and cost a lot of money – but holding the AGM in a posh hotel in London was a fun weekend away for them since they always used to have their annual meetings in Edinburgh. What they don’t know is that their company has come to the attention of a particularly savvy venture capitalist. He pores over the accounts with a shrewd investor’s eye. All those factors that keep the share price down are the same factors that could be leveraged to borrow a lot of money. Enough money in fact to buy the company. He approaches his favourite investment bank, they are a different creature to the retail bank that wouldn’t lend the company the money in the first place. They lend the venture capitalist as much as he needs on the basis that when he has taken charge of the company, he can sell off enough assets to repay the loan. And he only needs a 51% stake to control 100% of the company. The CEO can see his big pay-day coming too. He has packed the remuneration board with cronies and put in place a very nice incentive scheme should there ever be a takeover bid.

The stage is set. It’s fill-your-boots-time. After a brief and very one-sided take-over campaign the CEO recommends acceptance of the venture capitalist’s offer, not difficult to understand since the CEO stands to gain enormously if it goes through and nothing if it doesn’t. The take over goes through. The first CEO cashes-out a happy man, and the venture capitalist installs himself as the new CEO. He starts to make major changes to the way the company operates, not all of them work, some are disastrous in fact, but that’s no problem for him, he still gets his bonuses. He sells the land the factory is on to a subsidiary company for enough money to repay the loan he took out to buy the company with and Edinburgh Pin PLC now has to pay “fair market rate” for the premises. The situation is not helped when the health & safety consultant orders them to paint the walls pale green to reduce eye-strain on the workers but the union sues them for exposing the workers to paint fumes. Costs are escalating out of control, the final straw comes when an entire batch of thumb tacks is lost because the curvature of the dome was not in accordance with EU specifications.

The CEO seizes his opportunity. He closes the factory and sources everything he needs from the Far East. The company’s bottom line is now looking spectacular; operating costs are a fraction of what they had been and turnover is still the same. The share price sky-rocketed, his bonus that year was astronomical. On top of that, he sells the land for a fraction of its true worth to a company he secretly owned through an off-shore trust, demolishes the factory and builds an up-market gated housing estate. The company he outsourced production to has snapped up production capacity at other manufacturers as well and has now become a monopoly supplier. Prices go up and quality goes down. The customer loses out. It’s worse for the former partners. They are out of work and just have their very modest share of the proceeds to live on, with nothing to pass on to the next generation. The next generation is everything, they are all our futures, but they have been robbed of their inheritance. The banks, the CEO and all those involved in stripping this company of everything, whether entirely legally or at times breaking the law, all get away with it and live happily and richly ever after.

What would Adam Smith have made of all this? There used to be a pin manufacturing company that produced good quality products at affordable prices and which was able to compete in the marketplace. Now it no longer exists. Where did it all go wrong? How can we put it right again?

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