Everything We Know Really IS Wrong (at least in Economics)

It’s been almost three years since I first gave a presentation entitled, “Everything We Know Is Wrong,” and it’s been a bit more than two years since I posted a piece about it in this blog.  I now stand vindicated; an article authored by Eric Beinhocker and Nick Hanauer and posted by McKinsey & Co. entitled, “Redefining Capitalism” asserts that nearly all of the assumptions underlying classic economic analysis are wrong (http://www.mckinsey.com/Insights/Corporate_Social_Responsibility/Redefining_capitalism?cid=mckq50-eml-alt-mip-mck-oth-1410).  This article is adapted from “Capitalism Redefined,” which appeared in Democracy: A Journal of Ideas, Issue 31, Winter 2014, www.democracyjournal.org.

Okay, maybe “vindicated” is too strong a word.  But it’s reassuring to read that others are coming to similar conclusions as I have.

The McKinsey article has some overlaps with mine, like pointing out that the economy is a complex, nonlinear system and therefore behaves differently from what classic economic theory would predict.  They call this “wild horse economics” (in which a perturbation can cause the economy to suddenly stampede in an unpredictable direction) versus “rocking horse economics” (in which a perturbation is followed by gradual restoration to the historical equilibrium).

But their article goes well beyond what mine did.  I pointed out that most of our standard economic measures of value (like Gross Domestic Product and Net Present Value) are flawed; the McKinsey article notes this, too, but goes a step further.  They state, “…prosperity in human societies can’t be properly understood by looking just at monetary measures, such as income or wealth. Prosperity in a society is the accumulation of solutions to human problems [emphasis by the authors]. These solutions run from the prosaic (crunchier potato chips) to the profound (cures for deadly diseases). Ultimately, the measure of the wealth of a society is the range of human problems it has solved and how available it has made those solutions to its people [emphasis added].”

This is brilliant – a concise statement of the true value of economic progress.  It’s not driven by money or the accumulation of what has usually been thought of as “wealth.”  True wealth has nothing to do with the number of economic transactions in an economy (which is what GDP measures).  If a course of action provides solutions to some of today’s problems but also creates future problems (e.g., by pushing costs into the future or causing long-term environmental degradation), its value is questionable – despite the fact that an NPV calculation would probably look rosy.  Solving a specific problem today is almost always going to be better than solving it next year, but you don’t apply a simple-minded discount factor to all solutions and all problems the way we currently do with NPV.

Note the second half of Beinhocker’s and Hanauer’s definition of societal prosperity:  “…and how available it has made those solutions to its people.”  A society in which the elite have access to a wide array of solutions to problems but the teeming masses have access to very few is not, by this definition, a prosperous society.  This is where arguments about the broad effects of wealth disparity come to the fore and why a society comprised of the very rich and the just-barely-scraping-by doesn’t feel like a successful society.

The article notes Bhutan’s touting of a “Gross Happiness Index” some years back as an alternative measure to GDP, and the United Nations’ “Human Development Index.”  The authors suggest something between GDP and these somewhat ethereal concepts as a better measure of prosperity – something more measurable than the latter ones, but more meaningful than GDP.  Similarly to how inflation is measured by the rate of increase in price of a “basket” of goods and services, one can track what kind access people have to a “basket” of food, housing, clothing, transport, healthcare, education, leisure, and entertainment, and how that access improves or deteriorates over time.  It would be an imperfect measure, but all measures are imperfect and this one would be much better than what we have now.

For all intents and purposes, this article refutes Milton Friedman’s famous declaration that a business’s only purpose is to generate a return for its shareholders.  Seen through this lens, businesses and industry are the creators of solutions to society’s problems, large and small.  That’s a much broader remit than maximizing return.  The authors propose that providing a decent return to shareholders is a boundary condition; it’s something a company must do in order to be allowed to remain in business.  But it is not the company’s purpose.  All successful companies have, as their core purposes, the generation of solutions to society’s problems.  This dovetails nicely with Paul Hawken’s observation in The Ecology of Commerce that only industry has the resources to solve many of the biggest problems facing the world today, and that it’s up to industry to do so.

Similarly, capitalism is no longer just an efficient way to allocate resources; capitalism is the engine that drives industry to create, the foundation that incentivizes businesses to search for newer, better solutions.

And finally, there’s government.  Despite some people’s desire to believe otherwise, unfettered capitalism is incapable of a number of important functions.  It cannot make judgments regarding appropriate tradeoffs between solutions created and problems generated by a course of action or an industrial effort.  Capitalism encourages companies to externalize as many of their costs as possible through pollution and consumption of common resources (the “Tragedy of the Commons”).  If we believe that certain solutions (or products or services) should be widely available to most of society, capitalism will not necessarily make those solutions widely available.  And although capitalism is an effective system for promoting creativity, it is completely inadequate for making strategic decisions regarding long-term investments and/or what type of society we want to create and be a part of.

Decisions like these must be made by society as a whole, and no one has come up with a better, more inclusive vehicle for making these types of decisions than a democratically elected government.  Government is the societal equivalent of a company’s Board of Directors.  It represents the people (shareholders); it sets strategic direction and lays out the regulatory framework (corporate policies); it enforces the law and adjudicates disputes; and then it lets industry (management) get on with running the business.

One final note:  I have to confess an ulterior motive for touting this article.  A bit more than a year ago, we generated an Objectives Hierarchy at my company, Decision Strategies, and presented it to the employees for feedback and modification.  At the top of the hierarchy, the Primary Objective was “Find Creative Solutions to Important Problems” – almost verbatim what Beinhocker and Hanauer say a company’s purpose should be (the difference being that most companies will specify the problem they are solving; as a consulting firm, we focus on our clients’ various problems and solutions).  A few employees felt that one of the Fundamental Objectives in the next row down – “Establish Sustainable Profitability” – should have been at the top.  I pushed back.  Profitability is necessary but not sufficient.  Without profits we lose our best people and eventually go out of business.  But our purpose – what motivates us to come in to work every day – is helping our clients to solve their biggest problems.  And providing solutions to problems makes for a prosperous society.

PAST COMMENTS

Patrick has a good blog this month. The only place that I don’t completely agree with Patrick’s thinking is on the role of government – the primary role of Government is restraint of evil. The role he proposes, “the societal equivalent of a company’s Board of Directors” only works if (1) the primary role is being met, and (2) government is competent and has correct values, e.g. Singapore under Lee Kuan Yew’s leadership.

His main point, though, that the measure of wealth is the range and availability of human problems solved makes a lot of sense. Best example: iPhone/iPad and copycat equivalents.

I remember a time in the mid 1990’s when I was connecting through Hartsfield (ATL) airport to come home. When I was exiting the men’s room, the janitor was outside and his cell phone went off. I did not yet have a cellphone, even though I was head of engineering at a chemical company. I remember thinking at the time that our country was going to be OK if a janitor afford to have a cell phone.

Another point Patrick made that I like is refuting “adding shareholder value” as a primary objective. Rob and Aviva Kleinbaum make this point very strongly in their “Culture of Profitability” book. People simply can’t feel inspired to give their best to adding shareholder value – it is a byproduct of something much bigger. Again, Apple under Steve Jobs is an excellent example.

Thanks, Patrick, for another good essay!
– by Dave Charlesworth, Tue, 2015-Jan-20 at 5:48 PM, www.decisions-books.com

Patrick, thank you for your perspective and analysis. From a business development standpoint I have always approached my role from two perspectives – how does our company provide the best possible solution to the client’s problem and how can we help our employees thrive in that solution-focused environment? Profitability is the result of doing both well.
– by Robert Mees, Tue, 2015-Jan-20 at 10:53 PM