The Sunday Review

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MEGABUCKS or MEGABUGS?

A CENTURY ago, the United States was in the throes of a great wave of mergers. It was easy for contemporaries to misjudge what was going on.

But the Progressive movement was right in detecting a profound change in the American economy: the creation of the giant business enterprise.

Today, as another century draws to a close, a similar wave of mergers is in progress. The year 1998 has seen some extraordinary business combinations -- in banking, pharmaceuticals, telecommunications and many other industries. Is a similarly profound change in the world economy under way? And are we in danger of misreading it?

The conventional wisdom is that today's mergers reflect the irresistible force of globalisation. Just as the turn of the last century saw the creation of enterprises on a national scale, so today's mergers are giving birth to the companies that will achieve global domination.

The railways, the car and the telephone erased geographical boundaries in the US a century ago. Today, less glamorous changes -- cheap communications, a rule-based international trading system, a universal set of computing standards -- are achieving the same effect across national boundaries.

The most ambitious big company bosses are seizing the opportunity to become still bigger, it is said, in order to obtain the scale that will forever set them apart from lesser rivals. Merge now, or be consigned to ultimate oblivion.

Most of the building blocks of that argument are correct. But taken as a whole, it is badly wrong. The suggestion that today's merged giants will dominate next century's global economy is flawed.

There are three themes within today's merger wave that cut across the standard view. First is the reality that many of today's mergers reflect weakness rather than strength, a huddling together for defensive purposes rather than an aggressive bid for global domination.

This is most obvious where a stronger company takes over a weaker one -- when Norwest acquires Wells Fargo for example.

But it is also noticeable where the protagonists are more evenly matched. In the oil industry, the mergers between British Petroleum and Amoco, and Exxon and Mobil, illustrate the irresistible downward pressure on costs from low oil prices.

Two apparent exceptions to this rule -- the Citicorp/Travelers merger in financial services and the Daimler-Benz/Chrysler merger in cars -- conceal hidden weaknesses.

Superficially, the Citigroup merger was a meshing of complementary assets. Citicorp brought customer relationships and global reach, Travelers brought capital and products. In reality, both had reached the end of the line in their existing shape.

The merger is a leap of faith, towards an entirely new enterprise, a global retail financial services business, built around millions of individual customer relationships. This is an imaginative and audacious undertaking, but one that reflects underlying weakness rather than strength.

Similarly, the merger that produced Daimler-Chrysler reflects the deep-seated problems of the industry.

Each risked being marginalised -- Chrysler as a producer of skilful variants of boring old cars and Daimler as a luxury carmaker permanently threatened from below -- unless they established a greater presence in the mainstream market.

The merger gives them the opportunity to achieve that, but only if they are able to use their combined strengths to offset these implicit weaknesses. The hard work of achieving the merger's potential still lies ahead.

Even the most aggressive mergers, therefore, contain strong defensive elements. Others reflect a response to outside pressures.

The momentum in the world economy is shifting decisively away from manufacturing towards the provision of services. More importantly, it is moving away from transactional businesses towards ones that require the creation of lasting customer relationships. The two changes go hand in hand. Most manufacturing businesses are transactional ones; many services are based on relationships.

Because companies have got so good at modern mass manufacturing, they are ill-prepared for a world in which they do most things badly. Yet that is the fate they face in services and relationships. Even the very best service companies make many more mistakes -- in product design, in delivery, in after-sales care -- than would be tolerated in a well-run manufacturing business.

There is a reason for this. Getting services and relationships right is much harder. From the customer's point of view, that is no excuse. This shift in the global economy -- from manufacturing delivered well to services delivered badly -- has big implications.

It accelerates the push to consolidate among manufacturing companies, as they realise their ability to generate acceptable profits is disappearing. The worldwide deflation in manufactured goods is far worse than the overall consumer price indices reveal because they are buoyed up by the prices charged by service industry and government.

If central banks achieve their aim of low consumer prices, manufacturing industry is condemned to permanent, progressive price cuts.

Mergers are a logical response. Similarly, mergers follow from the realisation among the new relationship-based service companies of how poorly they are serving their customers. They rush either to acquire skills to serve customers better, or to escape the profitability consequences of failure to do so.

But the most important weakness the merger wave conceals lies in its perceived raison d'etre: globalisation.

Few companies are genuinely global -- measured not by breadth of coverage or nationality of top managers but in the area that matters most: their source of profits.

Most supposedly global companies still derive a disproportionate share of their profits from dominance of their home markets. Their global ambitions are still not much more than an expensive hobby.

The handsome new buildings of the City of London, for example, and the lavish bonuses of its investment bankers stem from the self-indulgence of Japanese, American and European institutions. Buoyed up by a steady flow of profits at home, these new arrivals have poured hundreds of millions of dollars into activities that have yet to show acceptable profits.

This is an ultimately self-cancelling process, because the flood of new entrants erodes profit margins around the world, undermining the domestic strongholds that financed the original expansion. It is this latent weakness that undermines the global pretensions of the new giants.

The turn-of-the-century behemoths were broken up by court order. But they would have collapsed under their own weight, once they were prevented from engaging in the brutal anti-competitive behaviour that provided their original rationale.

The Progressives were right to seek to ban that behaviour, and correct in judging that a new era had begun.

But they were unable to predict the shape that era would take. In particular, they exaggerated the strength of the new giant undertakings they saw around them. A century later, let us not make the same mistake.

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