jim.shamlin.com

4: Where Markets Work Well - and Where They Don't

Doomsayers proclaim any economic downturn to be the end of capitalism. When downturn turns to crisis, they gain a bit more credibility: a serious recession or financial collapse means that the markets are in a dreadful state, and the assumption is that the prevailing system caused them to be so.

None of these predictions of the end of the free market has had a serious threat to the free market system, which continued with only temporarily impediment caused by attempts to "fix" it. However, "temporary" can be quite a long time: consider that communism persisted for nearly a century before its collapse.

Even so, there remains the possibility the doomsayers are correct: every institution ends. Tribalism was replaced by feudalism, feudalism by capitalism, and it is inevitable that capitalism will be replaced by something else.

(EN: The author seems to overlook a very significant connection between economic systems and society in general. That is, a change in the system follows a change in practice, and does not lead it. Tribalism arose in a hunter-gatherer economy, and did not cease to exist until the nature of the economy changed to agriculture and herding, at which point feudalism took hold - and again, feudalism perpetuated until the economy changed to manufacturing and services, at which point capitalism took hold. My argument is that capitalism will perpetuate until the fundamental nature of economic activity changes. The flaws and inefficiencies of capitalism will not topple it, any more than the flaws and inefficiencies of feudalism created change: it is only when the nature of economic activity changes that the economic system will end and a new era will begin. And I don't see signs of that happening.)

Those who live in capitalist economies have a huge stake in market economies, and cannot perceive any other form of existence - in much the same way that feudal serfs would have defended their own system, being unable to perceive any other form of existence.

The serious and widespread problem of markets is an indicator that the system itself is no longer successful - not that it ever was. The ideal vision of capitalism, completely free and uncontrolled, has never been more than a fairytale.

Discrepancies between belief and reality include:

As such, the author intends to consider the market system's strengths and weaknesses - as well as the ways in which clinging to a flawed theory has brought reality close to disaster. Later, he will get into the ways in which there can be a positive resolution - but it's important to diagnose extensively before prescribing a cure.

Pre-capitalistic economics

Although people have been trading goods since the beginning of society, the present concept of a "market economy" arose in Europe in the fifteenth century, and capitalism did not arise until the nineteenth. Money existed before this time, as did material wealth, as were the practices of pursuing wealth for its own sale.

Merchants have also existed for thousands of years, but it was a small profession and not highly regarded. The protestant doctrine abhorred the pursuit of material goals beyond sufficiency for mere survival, and the desire to have material things was regarded as "the doctrine of the devil." (EN: A similar notion exists in the East, in which merchants were considered to be among the lowest and most contemptible of the social classes.)

Historically, the wealth within a society was gained by force of violence and maintained in much the same way: the ruling classes amassed large tracts of land by warfare and enslaved the lower classes, literally or functionally. Except for a small number of freemen or artisans, all the goods produced in society belonged to the rulers, who decided who may consume them, and who engaged in trade with other rulers.

Even into the nineteenth century, the large proportion of humanity could not engage in trade to any significant degree because they had no possessions of their own to trade, even their own labor belonged to their "betters." Hence there was no opportunity to trade and no motivation to produce beyond what was needed for subsistence.

Ownership changes

Until the 1600s, there were few members of society who owned significant quantities of goods that could be traded, or who owned the resources (mills, ships, forges, farms, and the like) that could be used to produce goods beyond the needs of the household and trade them with others.

The joint stock company, one of capitalism's vital components, began with East India Company in 1600: an organization dedicated to earning profit that, while authorized by the ruling class and operated by a small number of wealthy individuals, offered shares of ownership to the general public.

It was not until the late nineteenth century that corporations became the dominant form of commercial organization, and many companies that were owned by wealthy families converted to the joint stock form. That is, families who held productive resources saw them as a source of income and wealth came to see money as preferable and effectively sold off their resources to the general public. For example, the decedents of Arthur Guinness wished to divest themselves of the brewery but, unable to find a single buyer, instead offered shares for sale, effectively converting the family-owned brewery to a public company in 1886.

At first, the joint stock companies were owned by large numbers of individuals, and this perpetuated through the mid-twentieth century, at which point there was a significant shift to institutional investment, where the majority of shares in the market (and controlling interest in virtually every corporation) is held by pension funds, insurance companies, mutual funds, other corporations, and a few wealthy individuals.

For example, over 90% of stock in the US was owned directly by individuals in 1957 - by contrast, individuals own about 28% today, and the number continues to fall.

If effect, corporations are now owned by other corporations and the inmates are running the asylum. That is, corporations are run for profit, absent any other motive.

Government control and private control

Even in the parts of the world where capitalism took hold the strongest - the US and UK - the period in which it was unfettered by government interference was extremely short, perhaps as little as fifty years from the late industrial revolution through the first World War.

(EN: Shorter, even, than that. Consider that joint-stock companies were started by government in the first place, and even corporations that were not started by government needed to be authorized by the government. Also, consider the body of legislation on commercial activity that goes back to the medieval era, not to mention broad government invasions such as the Sherman act of 1890, and it becomes clear that capitalism never existed in a pure form.)

Consider also the government intrusion on the individual. In the nineteenth century, inheritance and gift taxes were unknown in the developed world, such that a person's wealth was his own. There was likewise minimal income tax (rarely about 3% in the UK and unheard of in the US), which is in effect government appropriation of each person's labor.

Neither was there any monetary policy as we presently know it. Most countries were on the gold standard, meaning that anyone who had gold could coin money or trade gold at its commodity value. Public mints provided a standard of measurement and reliable coinage, but did not control the value of money. America did not even have a central bank at the time of the industrial boom.

Virtually nowhere did the state own or direct industries, interfere with domestic trade, or show much concern for the workings of markets.

Where government did not interfere in the economy, growth rates were fantastic. Even Marx conceded that free markets and private ownership and control of productive assets was a source of great prosperity, though he saw this as a step in evolution toward his own economic system.

The ideological battle

Bearing in mind that private ownership of production never really existed, how did anyone ever come to accept the notion that free enterprise is the key to prosperity?

The first reason is largely propaganda: the conflict between western Europe and the United States and the USSR was publicly portrayed as a conflict between capitalism and communism. To muster public support, it was theorized that markets on the whole worked well and that centralized control of production and trade had a negative impact. That, in effect, communism was a return to feudalism and capitalism was the only system to preserve liberty for the people.

The second reason is that the transition to private ownership was wrought with serious crises - left to their own devices, private citizens in control of production produced too much of this or too little of that, and when government stepped in to balance the equation, it often did more harm than good. As such, the positive intentions of government were ignored, the harm it did was exaggerated, and people came to the notion that companies would be better off without government control.

That is to say, the excesses and failures during the era of managed capitalism led to the consensus that managing capitalism was wrong, and there was the idealized conception of a perfectly free market in the nineteenth century - which was entirely mythical.

The strengths of the market system

The author concedes that "when it works well, the market system is a remarkable mechanism for utilizing scarce resources for productive ends and for distributing the benefits far and wide across society."

A foundational belief of capitalism is that a free individual will seek to maximize his own well-being. As a supplier, he will seek to get the most reward from his efforts by applying his labor and capital to where it will earn the most. As a consumer, he will spend his money with an eye toward the benefit he will derive from the goods he purchases. Further, that the demand for consumption determines the reward given to supply.

Moreover, there is gain on both sides of a transaction: a buyer values the good more than his money, whereas the seller values the money more than the good - so while the transaction suggests equality of value, each of them feels they are getting something more valuable than what thy give.

In aggregate, supply is driven to meet demand: when a supply of a good is scarce, there is profit to be made in providing it. When suppliers glut the market, such that their supply outpaces demand, its plentitude will cause the price, hence the profit, to fall and some suppliers will seek to put their productive capacity to use elsewhere. This creates a balance of supply and demand that will fluctuate over time, but will largely be self-regulating toward equilibrium.

The underling drivers of supply are self-interest and competition. The desire to get as much as possible, counterbalanced by the fact that others are doing the same, such the the most a supplier can get is influenced, if not perfectly determined, but the price demanded by other suppliers.

The success of the market mechanism is determined by the interplay of these two forces, driving producers to compete for customer preference (price or quality) by applying themselves to more effective or efficient use of their capital to make a better product at a lower price, under constant pressure of competitors who are attempting to match or exceed their success.

As a result, the capitalistic system has led to great prosperity: consumers get good products at low prices, the quality continues to increase while the price continues to diminish, and suppliers (including people who are individual suppliers of labor) are getting more for what they give.

The ultimate success of capitalism, versus communism, has been the prosperity of people, even on the lowest levels of society, in capitalist economies, compared to the misery, even on the highest levels of society, in communist ones - and ultimately, in the complete collapse of communism.

The freedom connection

Capitalism has as tong correlation to freedom: fee market economies tend to exist only in democratic societies where the liberties of the individual citizen are largely unimpeded by government. Meanwhile, central planned economies exist only in tightly controlled societies where the subjects have few if any rights.

This is not accidental, and should be fairly self-evident, that in order to have a free market, you must have free people. If individuals have no right to own property, and no liberty to choose their own course of action, there cannot be private ownership and free trade.

Where every individual's livelihood is directly (actions) or indirectly (possessions) controlled by the state, this invariably results in a centrally controlled economy. Even if such a system is a democracy in that people may vote for their rulers, it is not democractic in a functional sense.

The author writes "I cannot think of a single example of a centrally planned economy that has also sustained a real democracy." (EN: I think it is quite the other way around.)

Market weaknesses

The author concedes that there is "theoretical support and practical confirmation" that markets encourage the efficient use of scarce resources - but there is also a body of theory and practice that shows a number of significant weaknesses in which free markets bring inefficiency:

It's noted that these defects have been dealt with in free-market societies by restricting the market by various means: using violence against citizens to prevent them from entering into exchanges that are deemed to be harmful. As such, the existence of these defects is not fatal to the market system, but does prevent them from being allowed to be completely unfettered.

(EN: I've poked back at many of these in a superficial manner, and maintain that many of them are predicated on fallacies, but it ultimately cannot be denied that the free market system has flaws that can only be cured by legislation. But neither does that mean the opposite extreme of completely controlled markets is at all desirable.)

The macro problem

A much larger problem, germane to the present financial crisis, is that the practice of conserving money, as it if were a usable asset, leads to non-spending. That is, in difficult economic times, people hold onto their money instead of spending it - and the lack of spending translates into a lack of demand, which causes a lack of production, which causes a lack of value available.

The classical economists did not adequately consider this: money that was withdrawn from the economic system would, in their theory, be eventually returned to it: people save now to spend later, and the money they save is often invested in productive activity.

The problem is, there is no point in productive activity when no-one can buy the product. So while a few people saving a little bit of money has a negligible effect on the economy, this effect becomes considerable when many people are saving money.

Additionally, the more money that is kept in savings and is available to invest, the lower the rate of interest will be offered (there being an abundant supply of dead money), making investment less desirable - and making dead money truly dead to the system. This becomes a self-perpetuating cycle.

(EN: My sense is that in the present crisis, the problem is not so much contribution to savings, but paying off debt - recall that GWB administration provided a spontaneous tax refund, and the result was not a flood of spending, but the average consumer's credit-card debt decreased by virtually the same amount as the refund. The net effect is the same - the money is not put to productive use - but the chief difference is that savings creates a stockpile of wealth that will be returned to the economy and promote production, while debt pays for production for consumption that occurred in the past, such that there is no future benefit.)

The Keynesian challenge

The author asserts that Keynes' brilliance is "still not properly understood today."

The first message is the immediate effect of recession: when the economy slumps, demand sags and the "men and machines" that should be engaged in productive activity will set idle.

The second message, however, deals with a more long-term consequences: that if workers are idle for a long period of time, their skills and their spirit decay, such that they cannot easily go back to work when the economy recovers.

On the grander scale, the wages paid to workers for producing constitute the budget that they have, as consumers, for spending, so the situation exacerbates itself. On the broadest possible scale, when people make less money at work, they spend less in the markets, which causes the need for less work, which results in less spending.

When a single company falters, companies that remain successful can hire the workers they shed - but on the macro level, where an entire economy falters, there is nowhere for them to go. A macro solution (government) is necessary to rectify the problem.

Failure of a single government to rectify economic woes on this scale result in emigration, such as what happened as the life blood of Europe flowed into America in the nineteenth and twentieth centuries. But scale up a step further, to the global scale, and a global recession such as the one in which we find ourselves today eliminates even the possibility of emigrating to a strong and growing economy.

The author feels that Keynes's message has been "bastardized and emasculated" by even his followers, reduced to a footnote and a coefficient in a few equations, and as such economists have disregarded the one theorist whose ideas are most germane to the present crisis.

Human nature

Economics is based on a particular view of human nature: each person makes rational decisions based on his self-interest. Self-interest, in turn is driven by the desire to increase pleasure or reduce pain.

However, the atomic unit of society is not the individual, but the family or household: many actions are undertaken that do not seem to be in the direct interest of the individual who undertakes them, but for the family as a whole.

(EN: It occurs to me that much disagreement is based on the definition of the group the individual seeks to serve: himself, his atomic family, his extended family, his neighborhood, his community, his company, etc. The argument of whom an individual should serve is philosophical, but quite significant.)

Those who follow the self-interested model do not balk at this: whatever motivations that might be ascribed to an individual (a family of one) are simply translated to the household, and the same logic applies.

The author takes issue with this view - citing that there are two problems: rationality and motivation. People have the ability to apply reason and to be far-sighted. However, this is not necessary but optional: they regularly demonstrate their ability to be irrational and short-sighted. Also, they are motivated to achieve the end, but are not motivated to undertake the means - that is, they want to have something, but show little interest in undertaking the activity necessary to producing it.

Self and social

The selfish nature of man is often defined by his social circumstances. That is to say that in a social situation, a person is less concerned with having what he needs, but more focused on having an amount equal to or greater than others in his broader society.

The amount of goods a person strictly needs for survival is actually quite modest - people can be satisfied and happy with very little. But the root of much of the unhappiness in society is envy of what others have.

There is also the sense of social superiority that comes from self-sacrifice: people seek to put themselves above others by helping them. A person who donates blood, or "saves" another person from some perceived peril (functional or economic) feels satisfaction at demonstrating that he is better than the people he is helping.

Ultimately, such acts are in a person's self-interest, as it feeds the psychological need to have status, to be better than others, but not in an economic manner.

In some instances, self-sacrifice is driven by a sense of duty: consider that a patent will make great sacrifices to promote the welfare of a child. This is not undertaken to have more status than the child, but to acknowledge that the child has greater status than the parent in the context of the household.

For some people, the psychological need to be better than others manifests itself with an obsession with money. It is their way of keeping score. The idea that everyone is driven by an irrational and insatiable lust for money is unreasonable: it is a fringe behavior, likened to "a mental disorder."

(EN: Flipping back to the previous section, it can also be said that the psychological need to be better than others might also manifest itself with an obsession for self-sacrifice, than is likewise often far out of the range of rationality.)

It's suggested that the obsession with production may also be the same: an entrepreneur or inventor is an individual who is indifferent to money, but obsessed with productivity, driven by "the sheer pleasure" of creation and production, and indifferent to the monetary benefits they receive. Their sense of being better than others derives from their ability to produce greater quality or quantity than others. This is the psychological source of the work ethic.

Split personality

An inherent problem of textbook theory is the assumption that theories exist in pure form: that any individual is motivated, at all times, by one specific thing to the exclusion of all others.

In reality, people have many conflicting motivations, and seek to serve them in multiple ways. Each person strives, in a number of different ways, to put himself above others, by a number of different efforts. To isolate one specific action is to see a small part of the whole; and to form a conclusion based on that is clearly erroneous.

Especially when people work together in cooperative effort, there separate motivations to achieve the same ends. When a company undertakes a project, some of the participants wish to achieve profit, others seek to serve the needs of the customers, still others are focused on the manner in which the work is done.

Ultimately, human behavior, individual or collected, cannot be distilled simply to a single theory of motivation.

The creative and the distributive

Economics can be divided into productive and distributive activities. Productive activities create value "out of nothing" whereas distributive activities merely take value from some and give it to others.

Successful societies maximize the productive and minimize the distributive. A purely distributive society cannot exist (if nothing is produced, there is nothing to distribute), and one that is mostly distributive is generally impoverished, and are also usually "intensely violent."

The author suggests that a man living alone must produce everything he needs for his own consumption. Once other people appear, labor specializes and there is a market for goods, with each producer negotiating how much of his good is worth in terms of other goods.

If people in such a society compete by attempting to produce more than others, the combined output should rise and everyone has more of everything. But if they compete by arguing for a share of combined output, this will tend to reduce it - because if any party feels that they are not getting fair recompense for what they are required to give there will be no incentive to produce it.

(EN: In theory, this reduces the incentive to produce goods that are not valued and redirects production to goods that are of greater value. The problem arises when those whose labor is distributive rather than creative exceed or are for whatever reason awarded a disproportionate share. This makes non-productive work more valuable than productive work, and lures resources away from production.)

Competition in modern society

Another way of looking at competition is in the scarcity of opportunity: if one person wins a job (gains the opportunity to do productive work), another party loses it, and the net result is zero for society. The same applies to firms competing for business.

(EN: This hypothesis seems a bit screwy: the person who gets the job has gained it, but the person who does not get a job has not lost anything - that is, the loser's result is zero, not a negative number that is the equivalent of what someone else has gained. I suspect this fallacy will blossom in what follows.)

The more developed a society becomes, the more it stands to gain from competition that increases total input, but the more at risk it becomes for behavior that merely redistributes rather than creates. When taken to extremes, this can reduce the total amount of output.

As such, it is necessary for government to encourage the kind of production that results in creative activity. There's a particularly oblique reference to the ways in which the Venetian government coaxed the wealthy families into considering it a sign of prestige to provide galleys for the navy, such that the family that provided the best galleys were considered to be more prestigious than those who provided fewer and less powerful vessels - hence one-upmanship among the rich resulted in a well-appointed navy.

The creative/distributive spectrum

The author suggests that there are purely creative occupations and purely distributive ones, but most professions are some mixture of the two.

He considers a doctor to be completely creative, but teachers to be distributive because their pupils will compete with the pupils of other teachers in society. Anyone in marketing is considered to be purely distributive, because they are fighting for market share. Their success in selling their firm's product means that other firms providing the same product to the market sell less.

He also notes that people shun the notion that they are involved in distributive work. There are aberrant individuals who take some twisted glee in making other people lose - but most people don't function that way, preferring to believe they are making a positive contribution to society.

As such, it is suggested that people whose professions are creative are happier than those whose jobs are distributive, even though the latter may earn much more money.

So rather than encouraging a "completive free-for-all" which results in companies fighting to take customers from one another (distributive), the benefit of society is served by finding the right balance between competitive and noncompetitive interaction among firms that results in the production of the greatest amount of good (creative).

The nature of the firm

Firms exist because production is most efficient and effective when the efforts of individuals are coordinated. Consider Adam Smith's example of the pin factory in which the task of making pins is organized into a process, each person doing a small part of the work, and their productive activities are controlled and supported by others.

It is possible to imagine a productive system in which each worker is self-employed and negotiations prices with the other workers in a factory, but the author suggests that this would be a practical nightmare that would introduce countless inefficiencies, constant disorganization, and create a lower output.

This notion could be extended to an economy as a whole, as the output of most firms is merely the input of others (the firm that makes thread supplies its output to the firm that weaves cloth, then through a few other firms as the cloth is made into clothing), but the author suggests that "this is exactly what the communist system was all about, and it didn't work very well."

(EN: What the author seems to be considering, I an oblique manner, is the notion of vertical integration: whether an individual or firm is capable of efficiently producing finished goods from raw materials, or if it is better for different people and firms to do different steps in a process independently. I don't expect there is a single, universal answer for all products, but it depends heavily on idiosyncratic aspects of production of a specific good.)

The author suggests it is a "great paradox whose profound importance is not fully appreciated" that the markets represent both competition and collaboration between individuals and firms - and the heart of the argument is whether the greatest effectiveness and efficiency is to be achieved by voluntary cooperation or authoritative control over the ways in which they interact with one another.

(EN: Cooperation, voluntary or otherwise, ensures the handoffs between one step and the next are effective - the output of one firm is easily consumable by the next. Competition, meanwhile, ensures the productive processes are efficient. Where two or more individuals propose to provide the same product, competition between them means being attentive to the price/quality needs of the buyer.)

The author finds it curious that firms often strive to develop "team spirit" in their staff, to "foster a distinctive corporate culture and identity." The Japanese seem to have taken this notion to extremes, creating a cult-like environment where people in their company songs and participate in corporate exercise sessions. But ultimately firms seek to get their employees to work cooperatively than competitively, knowing that people working together toward a common goal is not only more efficient, but makes for happier employees who are more effective in their roles.

One of the most obvious signs of a dysfunctional company is the conflict that occurs between business units who are fighting with one another - that is, the members of one department are seen as hostile to the interests of another, and there is a clear need to focus them on a common goal by redrawing the "effective boundary" between competition and cooperation. Companies are social constructs and the way in which employees behave is a social phenomenon.

The same is true on the greater scale, in which companies interact with one another, as well as other groups and organizations, in the greater context of society. Production of good is maximized for all of society when companies work together toward common goals.

Instability and insecurity

Another problem with the theories pertaining to market is the inherent assumption "ceteris paribus" - that the market is static, and will remain so, and only the single factor we wish to change will have any effect. In reality, the very essence of the market economy is constant change and instability.

In the employment market, there are countless examples in which academia recognizes a demand for skills - but by the time they can gear up to train workers, the environment has changed such that the level of demand for those skills has either abated or been satisfied in the meantime - such that graduates with specialized degrees find no opportunity to sell their skills.

The same can be said for the ways that firms react to increased demand of goods: by the time they recognize the demand and gear up to produce for it, it has gone away.

It's not only the corporate world in which this is apparent, but it seems part of human nature to be hostile to change. We form attachments to people, places, and activities and wish to achieve things against points we presume to be fixed. As such, people form lifelong attachments to their home town, their alma matter, their favorite sports team, etc. that continue, even when situations change. Hence people who form an attachment to a boom town remain there even after the economy has gone bust.

Our connection to these things is a source of self-esteem, pride, and social status. Working for a "good" company is important, and so important that we will continue to work for the firm even when it has gone sour. We do not recognize the need to change, and it is only when something catastrophic occurs, either all at once or by a slow and agonizing process, that we recognize the problem.

This reluctance of change, to the point of fear, is the reason companies and entire markets are not responsive to changes in the environment.

How pay is not determined

Companies are seen as intermediating mechanisms through which labor is supplied to the economy. The author feels this is an area in which the market doesn't worth the way it ought to, because the mechanisms themselves are flawed.

When economists speak of the supply of goods to a market, this is a representation of the way in which productive labor is applied: the things that are supplied exist only because someone undertook action to create them.

In the same way, when a supplier demands a price for a given quantity of goods, he is negotiating for the reward that should be granted to those people whose efforts produced it.

However, there is potential (and much practice) for unfairness in the system because the revenue of the supplier is not passed directly to those whose effort has produced it.

That is, while salaries still constitute the majority of expense for a company, a disproportionate amount awarded to those whose work is distributive rather than creative. Compare the compensation of a marketing executive or an accountant to that of a worker who produces the goods that they must market or account for. Hence the reason that executives are very often vilified.

(EN: I sense what the author is striving toward might be better understood by contrast. Consider the worker, such as a plumber or carpenter, who is independent: what buyers pay compensates him 100% for the value he has created by his work. Now consider the plumber's assistant, whose pay is subject to the arbitrary decision of his master - and the master maintains the position that he should claim some of his assistant's revenue, because the master provided the tools, the master provided the customer, the master has risked his capital in creating the business, etc. The master may find various means to justify the reason his assistant receives a small fraction of the revenue that results from his work - but this justification is inherently arbitrary and subjective, and has the potential to be completely so.)

Ultimately, the price paid to those individuals in an organization who do not engage in creative work is paid twice by a society: it is paid once as a consumer, as some portion of the price we must pay for a good pays the salaries of such workers; and it is paid a second time as a supplier of labor, as some portion of the revenue we have earned for the firm is not paid to us, but to the nonproductive employees of our firms.

(EN: This further begs the question of who, in an organization, is hiring whom? One could argue that the marketing executive pays the salaries of the workers who merely produce the goods that he sells, or one could argue that the workers pay the salary of the marketing executive who merely sells the goods they produce. Your perspective determines which of the two you will side with.)

(EN: Ultimately, the argument here is that compensation is not based on production in an organization. Not only is compensation based on contribution to the revenue generated by production, rather than directly by production itself, but it is also determined by external factors such as the supply and demand of a specific kind of labor. That is, there are far more people who can do the productive work on an mechanized assembly line than can design and maintain the machinery, hence the mechanic whose work produces no salable product is compensated more than the assembly-line worker whose efforts directly effect the product. But again, that does not mean the effort of the mechanic has no value and is not responsible for the generation of revenue.)

The agency problem

In a capitalist system, each individual seeks to make the most productive us of his time and resources, earning the greatest benefit to himself by providing the greatest benefit to others. While this seems reasonable for an individual, it is lost in the collective.

The corporation is a collective in the capitalist system, through which individuals combine their resources to achieve common goals that are much greater in scope than they can individually achieve. In theory, the corporation is a democratic organization that is controlled by the owners to this end. In practice, it is not so.

Most corporations are not operated by their owners, but by a professional management team that is appointed by the owners to act in their interests. But in practice, the connection between the owners (board of directors) and the managers they have employed (executive council) is tenuous.

The executives are in a position of great power to act as they will, disregarding the bidding of their employers who are aware of problems that are obvious, egregious, and have already happened. In many instances, malfeasance is not discovered for many years, after considerable damage has been done. As such, the managers may act for their own benefit, or according to entirely arbitrary principles, rather than the objectives for which the owners founded the company. This is a problem of agency, in that the agent is not acting in the best interest of his employers.

Supposedly, the way this is prevented is scrutiny by the shareholders, who are the managers of the topmost employees of the corporation, but shareholders have little influence on the behavior of managers, and have little method other than to replace them - which, again, happens only when they notice the consequences of a long period of hidden misconduct.

Boards also determine the compensation of managers, and attempt to use compensation to encourage responsible behavior, by means of various "incentive schemes" such as performance-based bonuses or equity grants, hoping the managers will share in the interests of owners. This has not worked very well because the schematization of incentives have encouraged excessive attention to short-term performance (profit and share price) rather than the long-term health of the business.

A more insidious problem is in the nature of the owners themselves. The author has previously mentioned the degree to which shares of ownership are in the present day predominately held by other firms, who manage pension funds, mutual funds, trusts, and other pools of assets and act on behalf of their clients.

Given this situation, we cannot expect investing institutions to behave like real owners, with an eye toward the long-term health and sustainability of the firm. If there is greater immediate profit to be made in closing down a factory and selling its assets for scrap than by continuing to operate it, they will do so without hesitation.

These inherent problems are further complicated by "liquidity fetishism," the principle that investors desire to have access, on short notice, to the funds they have invested. That is, they expect the ability to cash out at any time, whereas businesses need to have possession of capital for long periods of time in order to fund long-term projects and operations.

(EN: This is a Keynesian argument that is true of banking, but not of investments. Shares of ownership are not redeemed with the treasury on demand and even debentures are written for decades or longer, so an investor who "cashes out" does not withdraw directly from the firm, but sells his investment to another investor. The working capital of the firm is not impacted at all, so this last criticism must be dismissed.)

Success despite failings

The author has provided a considerable list of flaws and failings with the market system, and he expects that many of them are obvious and already well known to many who participate and work to perpetuate the system. And yet, they accept the system for all its flaws because, in a sense, it is working, or seems to be so.

There is great conjecture about the interplay between government and the private sector. Some would argue that the market is working in spite of the negative influence of government. Others would argue that it is only working because of the positive influence of government.

The author sides with the latter camp, and feels that the present problems with the system are because the government has not done quite enough to solve the problems inherent to the system.

JIM.SHAMLIN.COM
DISCLAIMERS · CONTACT