Rethinking Capitalism

Shareholder Value

2012-02-28T04:52:00.003-08:00

The idea of maximizing shareholder value has caught the imagination of the corporate world. On the face of it, it makes sense. The true owners of a company are its shareholders. Shareholders invest in a company in the expectation of increasing returns over time. As such, they have a stake in the long run success of the organization. By maximizing shareholder returns, a company is simply giving its real owners a return that they expect and should receive. By this reasoning, any other objective would hurt the shareholders and is therefore inefficient.

There is one major problem with this argument. Value is built over time i.e. in the long run. Shareholders typically hold shares for a limited period. So most shareholders have a short term view of the company. This results in a fundamental mismatch in timing horizons. The effect is that shareholders (specially the larger ones) can pressure company management to produce immediate returns in the short run. Unfortunately, such actions often come at the expense of the long run. The result is that over time, lost value and become increasingly vulnerable to external shocks.

This vulnerability is reflected in the decreasing lifespans of companies. The repercussions of a failing company go well beyond its shareholders and employees. A very large number of people are negatively affected. One company's failure can easily set of a chain reaction. For example, suppliers to the company can also start to fail setting off chain reactions of their own. Even competitors can be negatively affected since companies within an industry have very similar supply chains. Any weakening of one supply chain can reflect onto others.

We also have to keep in mind that companies are always embedded in communities. They do not exist in a vacuum. Much of the salaries that are given to employees are spent in the local community. If these jobs vanish, the external community falls onto hard times with its attendant social problems. So focussing on shareholder value alone is doing a great disservice not just to the organization but also to its supply chain and to the larger communities in which the organization operates in.

Are Markets Perfect?

2012-02-25T02:13:00.001-08:00

The Free Market: A False Idol After All? (Photo credit: elycefeliz)

Current economic thinking essentially states that any demand will be met by a supply because people are rational who are constantly striving to maximize their "happiness". Ofcourse, happiness needs to be defined more closely. So acquisition of material goods is deemed to be a proxy for "happiness". The more goods and services someone acquires, consumes or accumulates, that person is considered to be "happier" relative to someone else who is unable to do the same. By this reckoning, rationality indicates that any demand will be met since by doing so, all parties concerned will be "better off" or "happier".

That is the theory. What about practice? Currently business organizations provide many of the goods and services that we depend on. These are profit making entities whose primary, if not sole mandate, is to make a profit for their shareholders. So any demand should be met. But it isn't. Why not? One of the biggest flaws in the current capitalist paradigm is that it overserves some goods and services and underserves others. The free market system is very powerful. If all costs are properly factored in, then it serves as an excellent allocator of resources most of the time. Most of the time, not all of the time. Why is this so?

If markets are perfect, then no segment of a population should be left unserved. If this happens, then markets are flawed and some corrective mechanism needs to be applied.

Infinite Growth?

2012-02-22T03:40:00.000-08:00

Can any economy grow indefinitely? If it can, should it do so? What is the point of economic growth? For over 200 years, we have lived in a system that takes infinite growth for granted. This has been coupled with a growth in basic science and associated technologies. As a result, there is a firm conviction amongst many (perhaps most) that all problems can be resolved by better and new kinds of technologies. Thus the conclusion is drawn that there are no limits to growth.

In my mind, this is a false conclusion. In a universe of ultimately finite resources, there are going to be limits to infinite growth. The picture is further complicated by the effect that increasing wealth has on demographic growth. In country after country, as the economy has taken off, there has been a baby boom followed by a baby bust. Sometimes governments have intervened in order to limit population growth but even without such intervention, fertility rates have fallen with increasing development. The reason is simple: wealthier parents generally choose to limit the number of their offspring since there is a reasonable chance that their children will outlive them. So they choose to concentrate greater amount of resources on a smaller number of children.

I believe that there are ultimately hard limits to growth. No economy can grow infinitely. The time taken to reach such limits however is dependent on the type of economic growth. Western Europe and later North America developed a peculiarly wasteful form of economic growth. Products are built not to last but to fail. This is exacerbated by carefully and cleverly creating demand for the latest, greatest even if current models function perfectly well. This results in overflowing landfills and enormous garbage dumps in the seas. It also leads to stresses on eco-systems which all too often lead to their collapse. After 200 years of largely unbridled capitalism, we seem to be reaching a point of looming economic collapse simply primarily because of wasteful resource usage.

The Unending Quest For Productivity

2012-02-19T06:34:00.000-08:00

What is productivity? Why is it important? What is the benefit of ever increasing productivity? Is there a natural limit to productivity gains? Modern economies are built around a platform of unending productivity. Much has been written and continues to be written about productivity. The basic assumption of our society (and by society I mean the world) is that ever increasing productivity is unquestionably good.

A basic definition of productivity as given in Wikipedia is total output per one unit of total input. This definition also helps to give an answer to the question of why productivity is important. The more we can produce per given amount of input, the more productive we are and so our production processes are more efficient. This also helps to address a benefit of ever increasing productivity. Greater efficiency in production processes helps to reduce waste and should provide superior quality and service.

Viewed from this lens, productivity per-se is good and greater productivity is even better. Hence it makes sense to try and constantly increase productivity. This is an economic argument that is accepted almost without question. This same argument also easily flows into the private sphere. Thus apart from taking about work productivity, there is constant discussion about improving personal productivity. An entire industry has grown up on how to improve personal productivity. Books, blogs, talks, seminars, there is a huge amount of information and advice available . Anyone wanting to explore this area is quickly overwhelmed. The key assumption behind all this is that only economic activities are worthwhile.

Broken Promises - III

2011-05-26T04:41:00.000-07:00

The process of industrialization makes an implied promise of providing relatively secure, well paying jobs. Indeed in the modern world, governments have to go for industrialization. There is no other alternative. At the same time, there is the process of globalization underway. The problem is that the imperatives of globalization and that of industrialization are often at odds with each other. The interactions of these two trends enables corporations to play one country against another and at the same time successfully impose harsh working conditions on their workforce. The level of the individual concerned is immaterial. The high ranking manager is just as terrified of losing his or her job and all the benefits that accrue with it as the factory worker. This is why both types are willing to sacrifice family and personal life and work insane hours for what are relatively meager rewards for the amount of effort and hours put in.

Quite apart from globalization, companies are putting efforts in the development of advanced robotic machinery and computerized systems. There is a clear logic behind these efforts. Robots can work 24/7, do not require time off and do not do things like going on strikes. Similarly, knowledge systems seek to incorporate knowledge and insights that a manager will typically acquire over his career. Here the primary effort is to "lock" in the knowledge and insights so that they can be used after the manager is no more on the scene. Both trends tend to have a similar effect. The number of people required to run the system gets smaller. In the past, new forms of technology came along to absorb the people thus rendered surplus. The same will happen again. The question is one of timing. Unfortunately, the process of people being rendered surplus is happening far faster than the development of promising new technology and processes. So a large number of people, specially older workers both managerial and non-managerial, are finding their skills obsolete and their services no longer required.

Clearly something is amiss. Workers of all stripes, educational background and skill level face an uncertain future in which they can never be sure when they become redundant. It does not matter if they are in a developed country or a developing one. The normal argument given in such cases is that people must upgrade their skill and knowledge levels. This ignores their academic inclinations as well as their willingness and ability to learn the new skills required. Besides the problem is that many of the upcoming technologies are in their infancy. They are still being heavily developed. Most have not yet emerged from scientific laboratories. As a result, the knowledge of these industries is changing rapidly as new discoveries are made and new theories are propounded and proved or disproved.

There is the additional question of exactly what new technologies will provide the basis of future growth? The situation is currently murky. Betting on the wrong horse means wasted time and effort for little or no reward. Blithely saying upgrade skills and knowledge does not give people an idea of how to direct their efforts. We are thus faced with a deadly combination of redundancy, globalization and rapidly changing technology with concomitant rapid advances in knowledge. The pace of change is blistering and ever increasing.

Broken Promises - II

2011-05-20T04:23:00.000-07:00

The process of globalization and outsourcing means that jobs are coming to developing countries. While developed countries may be losing jobs, developing countries are gaining them. These jobs are no longer just manual labor or factory work although these are still coming. Higher end "knowledge" jobs are also being outsourced. Basically any job that does not require face time with clients is at the risk of being outsourced.

Most economists generally view this as a net positive when looking at the system as a whole. Consumers in the developed countries get goods at a cheaper cost while people in the developing countries get gainful employment. What's not to like? The problem lies in the very factors that under-gird the process of globalization.

At the lower end of the job spectrum, workers face the constant threat of jobs moving to still cheaper locales. As a result, they become willing work under appalling, often unsafe conditions for exceedingly low "market" wages. The argument that they are nevertheless still better off than previously simply highlights their desperate poverty. The availability of cheap goods comes at a high human cost that is largely invisible to more well off consumers. The wages that these workers get generally allows them no better than subsistence living. This in turn hampers the economic development of the host country. Since domestic consumers are too poor to buy the goods that they help to make, companies do not have an incentive to produce goods for them which means that the foreign investment that comes in is geared towards the export sector while neglecting domestic needs. The only way to break this circle is if the host government takes active steps to mitigate these effects and promote domestic development. However, this is not an easy task since the foreign companies then threaten to shift jobs to other, more pliant governments. There is then the distinct possibility of thousands of workers being unemployed with the concomitant social problems; something that no government will contemplate with equanimity.

At the higher end of the job spectrum, middle class, "knowledge" workers face the same threat both in developed countries and in developing countries. The advances in logistics and communications technology that made it possible to outsource low end jobs are now doing the same at the upper levels. Basically, all back office work can be outsourced. This includes jobs that range from accountancy to engineering design to paralegal work to software creation and so on. All of this work was supposed to be the domain of developed countries but that ignores the fact that anyone can get the same level of knowledge while sitting anywhere in the world. Also, these jobs are much easier to move around than factory work. In the latter case, companies have to shut down physical plants and rebuild them elsewhere. For much knowledge work, all one needs is a computer and fast internet access. Now companies are in the happy position of being able to pit knowledge workers around the world against each other. This reduces the value of this work and lowers wages in these areas. So graduates in developing countries are not immune to the forces that brought them the higher end jobs; these same forces can easily shift such jobs into still lower wage areas.

Broken Promises

2011-05-12T04:38:00.000-07:00

We have been betrayed. All of us. No exceptions except for a tiny minority. It does not matter whether we live in a developed country or a developing one. We were made a promise that has been broken. False reassurances were given. We were lulled into a stupor and now are slowly awakening to conditions that we don't recognize and never agreed to.

The promise was made as a result of the development, export and expansion of the industrial revolution. As a result of this, technological innovation has exploded. New inventions and new ways of doing things are constantly being developed. At the same time there is an increased emphasis on obtaining technical education to fulfill the demands of the new technologically oriented society. This has affected both developed and developing countries. The only difference between the two is that the latter experience these trends later than the former although the time delay has been shrinking rapidly.

So people in the developed countries have been strongly encouraged to obtain a university education. This encouragement has been backed up by reams of statistics from "experts" which showed that people with a university degree earn significantly more than their less educated peers. People were told that the future was in the "knowledge" economy. Thus when the first wave of outsourcing to the developing world hit the labor classes in the developed countries, "experts" were on hand to reassure everyone that the future did not lie in the "dirty" manual labor. Brain power was more important. The blue collar jobs lost will be replaced by higher paying, white collar jobs in which knowledge is more important. No need to get hands dirty when the more important, higher value added, better paying cerebral jobs will be available.

A little thought on this claim would have quickly exposed it as being largely a piece of fiction. There is no monopoly on knowledge. A person in the developing world can acquire the same amount and level of knowledge that anyone in the developed world can. Furthermore, developing countries have lower living costs than developed ones so such a person can be acquired at a cheaper price than a similarly knowledgeable person in the developed world. The same technological, economic and communication factors that have made outsourcing of manual jobs feasible do the same for "knowledge" jobs. So for example a qualified accountant in the developing world can be acquired for a fraction of the cost of an equally qualified one in the developed world. Similarly a developing country hardware designer can design a new computer chip at a much lower cost than a developed country hardware designer. Thus outsourcing of middle class, higher end "knowledge" jobs was only a matter of time and already this process is well underway. What is left are jobs that require face to face, physical interaction with clients and customers. That is why McDonalds can add jobs in developed countries whereas General Motor is shedding them. It is to be noted that at the high end, face to face, physical interaction is becoming less important as technology advances to a point where it becomes possible to transmit holographic images around the world. So at the high end, these jobs will also be under the threat of being outsourced.

All of the above means that people in developed countries are sitting pretty right? After all, jobs are coming to them. Their counterparts in the developed countries may be getting fired but they are getting hired. And it is not simply low end manual jobs that are coming their way. As the above indicated, high end, "knowledge" jobs are also coming their way. Therefore for the developing countries, good times indeed. Not quite. The picture here is not as rosy as it seems.

Labor as a Commodity - III

2011-05-10T04:05:00.000-07:00

The type of work that you want to extract from a commodity does not matter. It does not matter if oil is used to power a car or an airplane. If labor is to be treated as a commodity, then the type of work that it is to be asked to do should also not matter. It should not matter what industry someone is working in. At any stage, that person should be willing to undergo any type of retraining necessary for the demands of the economy.

The problem with this reasoning is that commodities do not have an independent existence outside what they are asked to do whereas people do. The type of supreme flexibility that this particular assumption implies is simply not present in the case of labor. People develop relationships based on where they live and work. These relationships are not always easy to discard. Retraining is an integral part of the new thinking about labor. Now training has always been a part of work. New technologies demand new ways of working and people have had to adjust to the new reality thus created. What is different now is that people are expected to retrain in completely different areas not once or twice but three to five times in their working careers. It is also assumed that the learning capacity of people does not change over time and that a person of say 50 are able to learn at the same capacity and the same rate as somebody 30 years younger.

Incidentally, the idea of a working career has also changed. Whereas previously people were expected to work for a time and then retire, now they are expected to keep working for as long as they are fit. This is also in alignment with the concept of treating labor as a commodity.

Labor as a Commodity - II

2011-05-07T08:38:00.000-07:00

There are certain assumptions central to viewing labor as a commodity. Incidentally labor here refers to managerial and non-managerial work. Some of these assumptions are:

Labor will behave like other commodities.
The type of work does not matter.

Lets examine the first of these assumptions. A crucial underlying premise underlying the idea that labor is a commodity is that it will behave like other commodities. Generally speaking, the price and availability of commodities depends on the interaction of demand and supply leavened by the availability of substitutes which in turn are influenced by the same interaction of demand and supply. If the price of a commodity goes up, then its supply can be ramped up relatively quickly. Similarly if the price goes down, then its supply can be decreased relatively quickly. The same argument holds true on the demand side.

This is the case for all commodities except labor. In the short term, the supply of labor is essentially fixed. No matter how high the price may go, the demand for labor will increase only gradually and over a long horizon. This is specially true of technical and professional work. It takes time, effort and money to train a professional. Furthermore, in order to maintain a level of knowledge of a certain profession in a society, a sufficient number of people have to undergo training in that profession. Otherwise the requisite skills will be lost at a societal level as older members of the profession retire and are not replaced. It is certainly not the case that a society can ignore a profession and not train people in it and then quickly ramp up production as demand increases. Once the older members retire or die, there will be an increasing shortage of the required skills which will not be easily replaced.

There is another problem that occurs if labor is treated as a commodity. This is a serious problem that has largely been ignored. Advanced economies require steady input of people into professional services. Research and development are essential for the long term growth of economies. Research is never done in isolation. It builds up on previous work and is increasingly collaborative. However, collaboration requires a critical mass of people knowledgeable in a particular area. Without this critical mass, research is severely hampered. One of the reasons why developing countries lag so seriously with respect to developed countries in research is that the former do not have this critical mass of professionals. However people will only enter a profession if they see future prospects in it. but of they don't enter, then the profession is more likely to be shifted to areas where there is this critical mass mentioned above. Thus a vicious cycle sets in through which an economy can lose needed skills in a very short time - generally speaking no longer than a couple of generations.

So labor does not behave like other commodities. Treating it as if it does has serious repercussions to an economy. These are repercussions that affect the long term growth rate. It should be noted that doing this often increases profitability in the short term, sometimes dramatically so. But this growth comes at a serious long term cost.

Labor as a Commodity

2011-05-04T22:30:00.000-07:00

Is labor a commodity or not? Is it just a factor of production or is it something more? This question goes into the heart of the type of society that we have built and are building. Treating labor as a commodity means treating people as commodities. A key point to be remembered about commodities is that they are meant to be used and then discarded. In other words, commodities are either transformed from one state to another or they are consumed either physically or otherwise. When people are treated as commodities, then this implies that they are to be used and then discarded.

For about 50 or so years, there was an unspoken compact between companies and their workforce. This compact meant that workers (and I include both managerial and non-managerial staff in this category) could expect to rise fairly steadily up the hierarchy partially depending on performance and ability criteria and also see a concomitant increase in wages received. This compact is one of the reasons behind the rise of the middle class first in the developed world and then in other parts of the world as well. This middle class is extremely important for the modern capitalist system as it is one of the main drivers of growth in an economy. The middle class is the largest buyer of goods and services in virtually all categories. It is also a bulwark against social unrest. It gives hope to lower income people that they will be able to join its ranks one day.

However, now the compact which helped to create this most important class of people is broken. Companies increasingly treat labor as just one more input to consider. Under such circumstances,what matters is the price at which the commodity is available. Capitalists have an inherent interest in lowering the cost of all input including labor to the maximum extent possible. This is a primary logic behind outsourcing. This is also a reason behind pressure to reduce wages - pressure that is largely supported by economists. There are also some underlying assumptions behind this treatment. The basic assumption is that labor as a commodity will act like other commodities in terms of demand and supply. Another assumption is that the type of work does not really matter. Labor is interchangeable as far as the type of work is concerned in the sense that anyone can be plugged into any type of work at any time anywhere at any price (or in normal parlance pay scale). How far these and other such types of assumptions are true will be examined in later posts.

On Work

2011-05-02T04:10:00.000-07:00

For most people, the work that they do is a strongly defining identity. In their minds, their work is a validation of their existence. This thinking is reinforced when people are viewed through the prism of consumerism. This view reduces people into objects and separates them according to their ability to buy. Not only that, it induces people to start viewing themselves as objects. This has several consequences.

One is that people are treated like any other input in the economic calculations of managers. In this environment, profit considerations become paramount and social aspects of work are downplayed and steadily ignored. Thus companies have no hesitation in relocating factories regardless of the impact on the local workforce. Second is that automation becomes easier to justify and implement. People and machines can be treated as being interchangeable. Thus over time the nature of the work changes. A third consequence is that since the job that a person does helps to a large extent to define his identity, when that job disappears, the affected person is left groping in the dark without any guiding light. Society too defines a person's worth on his ability to buy things and this ability is severely hampered by the loss of a job. A fourth and consequent effect is that people are rendered passive in the face of what seem to be overwhelming changes. Most people expect to work in a company and to a very large extent, we are conditioned to this expectation by the strong focus on job growth figures.

These consequences affect all types of work regardless of whether it is blue collar or white collar, labor or managerial, manual or knowledge based. How these consequences are playing out and what can be the form of work in the future will be explored in subsequent posts.

Who Speaks For The Unborn?

2011-04-30T03:44:00.000-07:00

We all love our children. We pamper them, protect them, care for them, worry about them and we tend to keep on doing this right into old age. We want the best for our children and lavish stuff on them that we did not get ourselves. But what about our children's children and their children and their children and so on? Who speaks for the unborn?

This is an important question to ponder. Our descendants yet unborn will inherit a world and a society that will be a reflection of the decisions that we make today. What kind of a living standard will they enjoy depends entirely on us. Will they be able to enjoy nature as we have enjoyed it? Will they have the type of resources that we are using? Answering these and similar questions will determine how we behave in the world in the time allotted to us. Are we caretakers or masters?

So far, we have answered in the latter. We are behaving as if we are masters of the world. The rate and the manner in which consume resources, it is as though we think there will be no future generations. Actually those waiting for the rapture to occur do think in this manner! Masters use available resources as they see fit. The double tragedy is that even the renewable resources are being consumed with such wild abandon that large number of these are under the threat of extinction.

Commoditizing Life - II

2011-04-27T02:00:00.000-07:00

The trend of treating people primarily as consumers is now reaching all spheres of our existence. From cradle to grave, we are wrapped in a cocoon of commercialism that affects not only how we view our world, but also how we view ourselves and our relationships. In a sense, this can be considered as a natural outcome of the relentless pursuit of ever increasing profits that is the current economic and societal paradigm. Once the low hanging fruit has been taken, companies are forced to penetrate ever deeper into people's lives and thoughts in order to produce the profit that is expected nay demanded from them.

It can be argued that the current paradigm has vastly increased our living standards. Not only that our knowledge of the world and its interactions is much greater than it ever was. Does it really matter if there is a side effect of commoditizing our lives? I believe it does. When we treat all aspects of our lives as economic transactions, we end up with a distorted view of the world and our place in it. All our actions and our decision become tainted with an economic and ultimately selfish perspective. This thinking has permeated our societies to such an extent that all income groups and all ages are now affected by it.

Consider that parents often bargain with their children to persuade them to study. Why should that be the case? Why should a child be offered a present as a reward for doing something that he/she should be doing regardless? This same child when grown up would expect all actions to have comparable rewards regardless of context. Take another example: our friendships. There is a whole concept of "networking" which is done with a view to obtaining commercial benefits. In a limited context, this is fine. But advocates of networking strongly recommend doing this at all times with everyone. In this view, our friends should be chosen keeping in mind how we can benefit from the relationship. The recommendation is that if we don't see any commercial benefit with a particular friendship, then dump the friend. Even close relationships like marriage is not immune to this warped point of view. To a considerable extent, marriage is now thought of as largely an economic contract. What am I gaining out of this marriage? What reward am I getting? What is the cost? This is an economic and market based thinking. We are so used to being treated as commodities that we do not regard such views in other spheres strange. I think that part of the upsurge in divorces and single parent households can be attributed to this type of thinking.

When life is a commodity, then our self worth becomes strongly tied to this point of view. The mania for branding everything in sight illustrates this. For example, there is a whole move to brand cities and nations. Does this make any sense? Is a city or a country a product to be used and then discarded? What about our personal selves? Is any one of us inferior to say Richard Branson? Is he inherently superior just because he has more money? What kind of thinking is this? Should we dump a friend just because we think he/she is no longer of any use to us? What kind of a person are we if we do that?

A world that is governed on purely commercial considerations will not be a nice place to live in. It does not matter what your status in life or income may be. If you are rich, you will be afraid for your wealth. If you are poor, you will be desperate to acquire it. If you are in the middle, you will be afraid of falling below and scrabbling to get above. We will be living in an unstable environment with rampant competition for resources. Already we are seeing the effects of this even though the process is partially done. Global warming, pollution, crime, anxiety; these are all symptoms of a world where life is becoming a commodity. Such a world is definitely not one to bequeath to future generations.

Commoditizing Life

2011-04-25T04:46:00.000-07:00

Over the last 30 years or so, the market system has been encroaching on spheres of life that earlier were thought to lie outside it. This encroachment comes at a large cost to the various cultures around the world for markets have a massive homogenizing effect. When McDonald opens a shop in a city and proceeds to drive out local eating outlets, the end result is less choice, less variety and a more homogenous and in many respects more dead cityscape. When English becomes necessary for survival, then local languages start to disappear. A whole way of thinking then vanishes and is replaced by a more homogenous type of thinking.

This is an effect of commoditizing life. Companies have a strong interest in encouraging this process because this way they can start charging for things they could not touch before. This process also plays a role in encouraging materialism. A few examples to illustrate. Kidneys for sale. The very fact that there is a market for kidneys means we have commoditized an essential part of our body. How about wombs for rent? Women are available who are willing to rent out their wombs. We have given a nice name to this: surrogate motherhood. A lovely sounding name for selling your body.

The Role of Finance - III

2011-04-22T04:32:00.000-07:00

The financial sector by its ability to create money is in a unique position to dictate which sectors get capital and which do not. This calculation is done on the basis of maximizing returns to the finance sector ignoring the larger needs of the economy. Apart from banks, stock, commodity and private exchanges have played a major role in this process. Once a company undergoes an IPO, the secondary market takes over and people in this market are basically trying to earn rental income. The stock market is supposed to play a role in efficiently allocating capital to needed sectors. What is the secondary market supposed to do? A similar argument goes for commodity exchanges.

Another problem with the financial sector is that it encourages a quantitative style of thinking. Risk is an integral part of finance. The projects that are lent money are not guaranteed to be successful. This risk needs to be measured in some fashion. The financial sector has come up with innovative measurement techniques for doing the same. Unfortunately, these techniques often have many assumptions embedded in them and not many people are aware of these. As a result, these techniques are used in an inappropriate fashion which results in an increase in systemic risk making the entire economy more volatile and fragile. Numbers are seductive. It is only too easy to look at a number and believe that it adequately captures a complex reality.

Debt is an integral feature of the financial system. Fractional reserve banking works by creating debt. History has shown that unless the level of debt (and the level of the associated interest) is controlled, there comes a time when the financial sector starts driving out other sectors. When that happens, the entire economy becomes susceptible to sudden shocks. When the globe becomes interconnected through high speed communication links, a shock in one part of the system gets transmitted to all other parts in the blink of an eye. In this fashion too, the financial system ends up weakening the overall system.

Finance also plays an important if largely unacknowledged role in fomenting environmental troubles. The problem again lies with quantitative assessments of risk and reward specifically the concept of time value of money. If a dollar today is more valuable than a dollar tomorrow, then it makes sense to take advantage of resources today even if in the long run the end result will be massive losses. If you cut down tree cover today because the lumber is more valuable today, then you will end up with soil erosion down the road which will result in far greater systemic losses.

Another factor: transparency is critical for the efficient and proper working of any financial system. However, in the recent past, there has been a major decrease in transparency of the workings of major financial firms. This has resulted in risks becoming hidden from view. In the end, we saw what happened in 2007 - 2008. The entire financial system seized up because there was no transparency.

The financial system today is broken. The existing paradigm has led us into a cul-de-sac out of which we can barely glimpse an exit. Staying in this situation is simply not an option. Some sort of a financial system is required to mobilize capital and deliver it where it is needed in an efficient and cost effective manner. The critical question today is what should replace the current paradigm?

The Role of Finance - II

2011-04-20T05:51:00.000-07:00

People do not consume money. Let's be very clear on that. Money is always a means to an end. It can never be an end in itself. We need money in order to buy things for our survival and/or personal enhancement. Over the last 200 years or so, companies have been the primary mechanism through which we have been able to acquire the goods and service that we need or that we think we need. At the same time, we developed a economic philosophy of continuous growth. The finance sector lies at the intersection of these two trends. Companies need to grow year on year since the capitalist system requires this. In order to do so, they need capital. The financial system can mobilize capital and hand it out to companies that need them. Atleast that is the theory.

In practice, the financial system is subject to the same economic paradigm that affects other sectors of the economy: the need to grow year on year. Left to their own devices, people in the financial sector will seek to maximize their own gains. Economic theory indicates that this individual greed for more results in an efficient allocation of resources. Those sectors of the economy which need capital for growth will attract it while other sectors will lose out. Unfortunately, economic theory breaks down when it comes to the financial sector. The reason for this is that this sector will aggressively seek out areas which will maximize its own growth regardless of the requirements of other sectors. Since they are the providers of capital, they will essentially be able to dictate which sectors are invested in and which ones are ignored. Like most organizations, financial sector companies seek out maximum gain for minimum cost. In other words they will seek out opportunities that provide the quickest returns. The other problem is the financial sector's ability to create money. The fractional lending system literally creates money out of thin air. The result is that over time, there will be increasing amounts of money looking for returns. This is an unstable situation which can be contained only as long as the ability to create money in this fashion is tightly controlled. When such constraints are removed, there is a massive infusion of money seeking quick returns that will distort vast sectors of the economy.

This is precisely what happened in the last decade. A tidal wave of money seeking quick returns swept around the world. This wave sucked in the best resources and the best talent available leaving other sectors starved of the same. It also caused major fluctuations in commodity prices leading to a general rise in specially food commodities thereby affecting millions of people around the world. However, the worst was that companies in other sectors which needed capital to grow were starved of needed financing simply because the returns to the financial sector were too low in such activities. Instead of an efficient allocation of capital to sectors which most need them, we have a distortion which leads to over investment in areas of quick returns to the financial sector and major under investment in other areas.

The Role of Finance

2011-04-18T04:29:00.000-07:00

We are not asking a very important question as a society: what is the role of finance in our economic system? This is an important and urgent question. Finance is usually treated as other types of business when in reality, it plays a special role in our economic system.

Typically, finance is viewed as a necessary intermediary between businesses and investors. Businesses need capital in order to grow and continue to provide new forms of goods and services. Investors have a desire to put their capital to productive use. Finance is the bridge that brings them together. This is rationale behind banks and stock and commodity exchanges. Ultimately, the health of the financial services firms depends on the health of the underlying economy.

Unfortunately, events have shown this view of finance to be hopelessly naive. Financial services firms have gone far beyond their role as intermediaries. They have introduced new financial products with the claim that such products would help reduce risk in the financial system; a claim that was largely true. What they did not say was that the risk would instead be sourced out to other sectors which were poorly placed to assess and take on the risk. At the same time, the financial system was deregulated and privatized in the name of efficiency. The claim was that self regulation would work because of the reputational risk factor. Thus the stage was set up for the perfect storm that engulfed the world. So the question is now urgent. What should be the proper role of finance?

Materialism

2011-04-13T05:35:00.000-07:00

The structure of modern capitalism rests on a foundation of materialism: the basic notion being that happiness comes from possession of material things. Satisfy material comforts and you will be happy. A fulfilled life is one which possesses the latest, greatest object or utilizes the latest, fanciest service. This is a reasoning which inspires people to put down large amounts of money for trivial objects. Why would someone pay $14.3 million for a car license plate? Why would anyone want to spend $1.3 million for a diamond studded mobile phone? What sort of satisfaction or peace of mind is obtained from acquiring such trinkets? Will a car go faster or perform better if it has an expensive license plate? Will phone calls be clearer if made from a diamond studded mobile? How will possessing a Gucci bag or acquiring a private yacht give lasting satisfaction?

All of us are essentially indoctrinated into materialism from childhood. Here's a nugget of information: the average child sees 20,000 ads in a year. Each ad touts a product or a service. Each one sends a message that health, wealth, happiness, success can be obtained by consuming things. The more things consumed, the better. Lasting happiness and eternal peace of mind is yours if only you have the latest, greatest product from BMW! Gucci! Coca Cola! [insert any company name here]! But ofcourse it does not work out like this. Acquiring the latest product from any company will make you happy until the next version comes out or your neighbor acquires something better. Then there is tension and unhappiness until the new product is also yours even if the old one is functioning perfectly well. The worth of a person is determined by the ability to buy. The less this ability, the less worthy the person.

Materialism imposes fairly heavy costs on the individual and society. As individuals, we are constantly under the stress of trying to obtain the latest version. The steady barrage of ads convinces us that our worth as a person is closely tied to our purchasing ability. Thus we acquire products that we don't really need. Not only that, now we are under pressure to buy the latest version of the same. This clutters our homes and ends up in landfills. So the cost of materialism goes beyond just paying for something. This added cost is also paid by society. The more we consume, the faster we consume resources and the more energy we end up using. Our land, water and air become increasingly polluted which has strongly negative effects on our health. So society pays through higher pollution costs which result in higher health costs.

Many of the problems that we face today on a global level are a consequence of rampant materialism. Diminishing resources, increasing levels of pollution, troubles in different parts of the world, global warming etc. are a result of an insatiable demand for material things because nearly all of us have bought into the notion that our humanity is dependent on acquiring every shiny new trinket that comes our way.

Innovation - II

2011-04-11T04:45:00.000-07:00

Innovation. A buzzword like no other. Every business seeks to provide innovative products and services. All business gurus harp constantly on the theme. The media, electronic and otherwise, is in love with it. It is touted as the panacea of all (economic) ills. It is often obsessively measured. The number of patents issued in a country is often taken as a proxy for innovation. The questions of how does my country rank in the number of patents it issues and is its rank going up or down is examined in critical detail by business leaders, governments, pundits and others like them. However, we need to take a step back from this love fest and ask ourselves: how much innovation is actually going on? And what does this innovation do for the people?

For all the talk and hype about innovation, most companies have surprisingly little to show for it. Nearly all major companies have a major breakthrough; something that can rightly be said to be innovative at some point. Whether its an innovative product or service, whether its a new way of combing things that are already present, whether its some different method of producing and marketing a product or service, many companies have an aha! moment. Then they go off to sleep. Changes made are at best incremental. Usually they are nonsensical. And that is also when they start screaming loudly at how innovative they are. For example, car manufacturers unveil each year's model with great fanfare. They talk about the innovative new features in this year's model which makes it so much better than last year's model. But examine the car more closely and you will see that the emperor is wearing very few clothes. Why are we not driving around in electric cars? Where have the flying cars gone? Why can't we go from one end of the country to the other on a single tank of gas? Instead, we get a new shape or new headlights or some new power steering technology which feels just like the old one. The media falls over itself touting the "innovative" new features when what we get is essentially old wine in a slightly newer, shinier packaging.

Innovation is generally very hard work with an uncertain payoff. Most managers are conservative by inclination, training and the way they are evaluated. Most consumers are also conservative by nature. People have a very difficult time in imagining, much less articulating something completely new. That is why if they are questioned about what the future will look like five or ten years from now, they will paint a picture that looks very similar to the present. That is also why most companies prefer to rest on their laurels and be rent seekers rather than be continually innovative.

Moral Hazard

2011-04-07T10:33:00.000-07:00

It is a basic axiom of neo-liberal thought that the private sector is inherently superior to the public sector. Not only that, it is more moral than the government. However the private sector, specifically the financial sector, has for the last two decades suffered from the problem of moral hazard. For a long time, it has been accepted amongst economists and business people that government regulation is a form of market distortion. Regulations imposed by fiat lead favor some forms of behavior over others. Instead of the government imposing its will, the private sector should be allowed to self-regulate. This will succeed because any business that acts in a fraudulent or self serving manner will be punished by the market. Consumers will flee from such organizations and competitors will take advantage.

This idea presupposes that not only do consumers have complete access to information they need to make an intelligent, informed decision but they also have the capability to analyze and understand this information. Unfortunately, this is not the case. Producers generally have far greater information than consumers. They also have a very strong incentive to hide relevant information. Many of the products that they sell, specially financial products, are highly complicated and opaque. Indeed financial innovation has introduced products which can literally be understood only by mathematicians and physicists. In such circumstances, firms have a very strong incentive to accentuate the positive and downplay the negative. How then are consumers expected to make informed decisions?

This is the basis of moral hazard. When companies are insulated from the risks of their actions, they have a very strong incentive to behave in a riskier fashion. This has certainly been true of the financial sector. New, innovative products were highly opaque and extremely difficult to understand. These also had a very high element of risk. These were sold to parties that were far less sophisticated and in most cases were in a poor position to take on the associated risk. These products also did not stay confined to the financial sector; they spread rapidly into the industrial sector. By the time the whole house of cards collapsed in 2008, many firms which were (and still are) viewed as industrial ones had become in fact financial firms. Household names like GE and GM derived much of their profits from financial products. In addition, most of these firms were so large that their bankruptcy would have serious repercussions in the wider economy. This was the second leg of the moral hazard problem; companies that were simply too big to be allowed to fail.

This means that managers in these organizations have a strong incentive to take on extraordinary, even foolish risks. The probability of these risk exploding in their face was small and by the time the whole structure collapsed, they were likely to have moved on to greener pastures. Their entire remuneration structure encouraged them on to take these risks. The upside was simply too large to ignore while the downside was limited.

Demand and Supply

2011-04-05T03:10:00.000-07:00

Everyone who studies introductory economics get introduced to the demand and supply curve graph. We may remember nothing about economics but this is definitely remembered. Demand and supply curves are the bedrock of economics and fundamentally underpin the modern capitalist system. Intuitively, these curves make sense; we have a downward sloping demand curve and an upward sloping supply curve. The point where these intersect is a equilibrium. This is the point at which the quantity demanded is exactly matched by quantity supplied. Therefore this is the point at which optimal allocation of scarce resources. These curves help to explain the dynamics of all sorts of products and services.

Makes sense right? Then how does one explain the demand for luxury products? Or for antiques? Or for paintings of the Old Masters? Or for aged wine? Or for financial products? In all these cases, demand increases as its price increases. Some of these cases can be explained through a modification of the demand/supply curves. In the case of the Old Masters and antiques and aged wine, supply cannot increase with demand. So the supply curve is a flat line instead of an upward sloping curve. Increasing scarcity will increase the value of the product. But what about luxury products? Their supply is not finite. It can and does increase as demand increases. Why then does demand increase as their prices go up? Most interesting is the case of financial products. In nearly all of them, increasing demand will result in vastly expanded supply and rapidly increasing prices. This is basically how stock market bubbles form. In both cases, traditional analyses of demand/supply curves will lead to wrong conclusions. A basic failure to understand this was to a certain degree responsible for the financial collapse that the world has been going through since 2008 - a collapse that has affected not just the financial system but the real economy which underpins all of Finance.

Market Assumptions - Time Lags

2011-04-02T01:36:00.000-07:00

Among the many assumptions of perfectly competitive markets, there is one that is largely unspoken. This assumption is that there are no time lags in buyers and sellers entering or exiting the market. This assumption is quite critical because most analysis of this model and its variants has no time lags as a underlying basis. Taking no time lags as a fundamental basis of analysis also supports the other assumptions of this model.

When we assume no time lags, we can talk about instantaneous changes in demand and supply. Whenever there is a change in the supply of a commodity, the demand for it immediately adjusts appropriately and vice-versa. A new equilibrium price is swiftly reached and no extraordinary profits can be made. Some suppliers will swiftly exit or others will swiftly come in depending on the direction of the change. These changes will also be instantly reflected in changes in employment. Labor made redundant in one area is instantly available for other areas.

As a purely theoretical framework, the perfectly competitive model is excellent at understanding the basic forces that operate on different (but not all) commodities. However, problems arise when this model or any variant thereof is made to fit the real world. Take the problem of time lags. In the real world, things do not happen instantly. There is an often significant time lag between a change in demand occurring and companies responding to it. Similarly, there is also often a significant time between a change in supply occurring and companies and consumers responding to it. These time lags allow extra-ordinary profits to be made. They can also have the effect of entrenching existing companies such that new entrants find it harder to compete. Thus time lags can actually enhance entry barriers. Time lags can also result in a mis-allocation of resources. Projects take time to complete. A project can make perfect economic sense when it is proposed, analyzed and started. However, conditions can change almost overnight and a project that made perfect sense suddenly can become a perfect liability. Dubai discovered this when global economic conditions changed for the worse in 2008. All of a sudden, major real estate projects were forced on hold or cancelled. The result was a large number of sad, empty shells standing forlornly. Thus any model that neglects the effects of time lags will result in faulty conclusions being drawn regarding the economy. The actions that are taken as a result of such conclusions will often be worse than taking no action at all.

Market Assumptions - Entry / Exit Barriers

2011-03-31T00:35:00.000-07:00

What is the impact of entry and exit barriers in the real world? In the perfectly competitive market model, there are no entry or exit barriers. Buyers can enter or exit any market at any time instantly. And that is an important secondary assumption underlying the assumption of no entry/exit barriers: no time lags between entry and exit. Under such assumptions, no single buyer or seller can dominate the market. More importantly, the possibility of extra-ordinary profits simply does not exist. If such profits are being made, new sellers will enter and drive prices down. If profits are too low, some existing buyers will exit. In all cases, the market will swiftly return to a hypothetical equilibrium point.

While economists are pontificating about such issues and teaching millions of innocent souls such theories, in the real world conditions are very different. Both entry and exit barriers exist. Also, things do not happen instantly. There is often a time lag which can be significantly long.

Entry barriers arise from many causes. They can be regulatory, financial or caused by the market size of the incumbents. A good example of regulatory entry barriers are the rating agencies in the US. The regulatory authorities demand that public companies get their bonds and stocks rated by a limited number of firms and by no other. Some markets are natural monopolies. In such cases, the nature of the market itself acts as an entry barrier. Most markets, specially digital ones, tend to have a winner take most nature. Such markets have two or three dominant firms and a bunch of niche players. The dominant firms act as strong entry barriers. Predatory practices also act as entry barriers although these tend to be discouraged by governments. Microsoft, as an example, cemented its near monopoly in the computer operating system market by penalizing hardware manufacturers who wanted to use other non-Microsoft operating systems. Copyrights and patents also serve as very strong entry barriers. These are like toll booths on a highway. Without the appropriate payment, no one else can enter. And the toll booth operator can shut down access to the highway completely. Copyrights and patents can be so lucrative that an increasing number of companies are becoming dependent on them for their revenue; a classic rent seeking action.

What about exit barriers? There are often cases of zombie companies which cannot survive on their own but which also refuse to die. Like zombies, they shuffle along consuming resources that could be put to better use elsewhere. Exit barriers often arise because of market failures. The company is unable to dispose of its assets and thus carries on its miserable existence.

What is the effect of entry and exit barriers on the economy? Does it matter if these exist? I believe that it matters hugely. These barriers distort market signals and result in a mis-allocation of resources. One of the strengths of the market system is supposed to be its ability to efficiently allocate resources through pricing signals. These kind of barriers prevent such allocation. A much more insidious effect of the entry and exit barriers is that these can inhibit innovation. The modern global economy depends on continuous innovation as a major engine of growth. These barriers inhibit this innovation. They tend to encourage the continuation of the status quo even beyond its usefulness. New ways, new product, new services tend to be undervalued and at best delayed and at worst never get to see the light of day. In the end, a few people prosper while the many suffer.

Market Assumptions - Information Symmetry?

2011-03-29T04:00:00.000-07:00

A basic tenet of perfectly competitive markets and one that is assumed to hold for other types of markets is that of information symmetry. This is the assumption that buyers and sellers in a particular market have the same amount and quality of information regarding the transaction under process. A secondary assumption (which is still nonetheless very important in its own right) is that even if there is information asymmetry, it will exist for a very short while and the cost of acquiring the required information is low or non-existent.

Do these assumptions hold in the real world? The short answer is no. I cannot think of any market where these assumptions hold true. In any market environment, there is some form of information asymmetry. Almost always the seller has greater information regarding the product(s) on offer. What is more, the cost of acquiring information is usually large. This cost is not just monetary. There is the cost of the time required and the opportunity cost of not being able to do something else while the search for information goes on.

This particular fallacy is thought to hold particularly well for financial markets especially the stock exchanges. The efficient market hypothesis holds that any information relevant to the stock in question will immediately be reflected in the price of the stock. The reason for this being that given the large number of people playing the market, someone somewhere will analyze and act upon the new information. This is a fundamental reason why some economists insist that stock markets are efficient. However, others have pointed out a contradiction at the heart of this idea. If any new information will immediately be acted upon by someone somewhere, then there is no point in seeking out this information. This will hold true for all players. Therefore no one will have an incentive to seek out new information that may be relevant and so the price of the stock will not reflect all available information. The financial services industry has also evolved new financial products nearly all of which have one primary feature: they literally require a rocket science degree in order to understand them. The sheer complexity of these products also means that the buyer (and frequently the seller too) does not understand the basic product. Theoretically this poses no problem since such products are supposed to be sold to sophisticated institutional investors. However as we have already seen, such investors are actually not very sophisticated. The result has been that all sorts of buyers have been exposed to a high level of risk. Is this efficient? No.

Information asymmetry can be seen in many other markets. Take as an example, the market for lawyers. Why are legal fees so high? The reason is that legal documents are couched in obscure jargon which is almost impenetrable to a lay person. Ordinary people simply do not have the information required to be able to bring down legal fees. Infact virtually all professional services markets are able to command high prices because of information asymmetry. Almost all secondary markets suffer from the same malady. Why do previously owned cars sell at a steep discount? Because the buyer does not have the same amount and kind of information regarding the condition of the car that the seller has. Fear of buying a lemon brings down prices for all sellers. Assuming markets have information symmetry is not only wrong, it is actually foolish. A model based wrong assumptions will inevitably lead to wrong conclusions and wrong policy decisions. And then everyone wonders what went wrong?

Market Assumptions - Are People Rational?

2011-03-28T09:06:00.000-07:00

The most basic definition of markets would be a place - physical or otherwise - where people can exchange goods of equivalent value in such a fashion that all parties to the exchange are better off than before the transaction. This is an elastic definition that covers a wide range of markets. We are all familiar with traditional markets. These are places we go to shop and hang around in. These are sometimes classified as business to consumer (B2C) markets. We are also aware of business to business (B2B) markets. Then there are financial markets, commodity markets, internet markets and even virtual markets. These are all types of markets that exist in the real world.

Do the assumptions of perfectly competitive markets hold for them? Examining these assumptions one by one, we are forced to conclude that they largely do not hold true in reality. Studying perfectly competitive markets therefore may make sense at an elementary level when students need to be given a model that can be compared to the real world. When these assumptions are applied to the latter, the wrong conclusions will be drawn and these will result in misguided policy prescriptions.

Take one of the most basic assumptions of economics: rationality. Are humans rational? Economists certainly assume so. Assuming rationality is an extremely tempting simplification to make of a complex reality. After all, each of us has the power of our intelligence to make decisions that will best suit our circumstances given the information on hand. Yet, despite our powerful brains we continue to make important decisions based on emotions.

Emotions are integral parts of our personality. Our rationality is tempered by our emotions. When these two are in balance, it is only then that we make optimal decisions. Unfortunately, often our emotions overrule our rationality. This is most obviously seen in financial markets particularly the stock exchange. If any market is considered to be the closest in characteristics to perfectly competitive markets, then stock exchanges are it. Elaborate models have been built that show that we cannot beat the market and that bubbles and busts cannot happen. But they do. With annoying regularity. And often devastating effect. For example, in 1987 Wall Street crashed by 22.6%. This was the largest single drop ever and was considered to be statistically improbable. In fact its probability was calculated as happening once every 20 billion years. An event so extremely unlikely that it could not happen in any human lifetime. Nor was this a one-off. Wall Street crashed again in 2001 and then once again in 2007. Three statistically improbable events happening within a lifetime! What happened? Economic models based on rationality ignore the elements of greed and fear which play important roles on the stock exchange. When greed rules, the market goes up and a bubble can form. When fear rules, the opposite can happen and the market can crash.

Stock exchanges are not the only places where emotions sway people. Research has shown that people value possessions very highly even at the expense of rational economic calculations. People also fear loss more than they fear gain. They will make a less than optimal choice based entirely on this. So one of the most important assumptions of perfectly competitive markets do not hold in the real world. Yes, people are rational but this rationality is tempered by emotions. Marketers know this and in many markets, they take full advantage of emotional impact. Fear is a great motivator to persuade people into courses of action they would otherwise be reluctant to take. Models that do not take emotions into account simplify reality to an extent that they become useless. Relying on such models is not only pointless but can cause needless suffering and misery.

Next time - an examination of another assumption of perfectly competitive markets.

Rethinking Capitalism

Shareholder Value

Related articles

Are Markets Perfect?

Related articles

Infinite Growth?

Related articles

The Unending Quest For Productivity

Related articles

Broken Promises - III

Related articles

Broken Promises - II

Related articles

Broken Promises

Labor as a Commodity - III

Labor as a Commodity - II

Labor as a Commodity

On Work

Related articles

Who Speaks For The Unborn?

Commoditizing Life - II

Commoditizing Life

The Role of Finance - III

Related articles

The Role of Finance - II

Related articles

The Role of Finance

Related articles

Materialism

Innovation - II

Related articles

Moral Hazard

Related articles

Demand and Supply

Related articles

Market Assumptions - Time Lags

Market Assumptions - Entry / Exit Barriers

Related articles

Market Assumptions - Information Symmetry?

Related articles

Market Assumptions - Are People Rational?

Related articles