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Reshaping Capitalism

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We're all drunks looking under the lamppost.”
—Aviv Nevo, professor of economics, University of Pennsylvania (2018)

On July 1–2, 2019 in Panmure House, which was once Adam Smith’s home in Edinburgh, an international group of multidisciplinary thinkers and doers will meet in response to “a call to arms” to discuss “reshaping capitalism and the global order.” The conference is the first major event to be held in Adam Smith’s home since the passing of the founder of capitalism in 1790. It aims to draw together leading scholars and practitioners who care deeply about the balanced, long-term performance of the economic system and the survival and advancement of liberal democracies.

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Capitalism In Crisis

The context? Capitalism is in crisis. Put bluntly, the social, economic and political fabric of liberal democracies all around the world is unraveling. Populist leaders pursuing dubious solutions are winning political victories everywhere.

The reasons are easy to see: economic stagnation of median incomes for decades, increasing inequality, social unrest, structural unemployment, deskilling, opioid epidemics, economic migrations, financial bubbles and crashes, climate change, nuclear proliferation, cyber warfare, terrorism—and more.

Paradoxically, from a longer-term perspective, on virtually all of the key dimensions of human material well-being—poverty, literacy, health, freedom, and education—the world is an extraordinarily better place than it was a couple of centuries ago when Adam Smith was inventing the principles of capitalism.

Yet hardly anyone knows it, or believes it, or expects things to get better. As a result, international institutions and alliances that have created seventy years of global peace and prosperity are being systematically undermined. National self-interest and self-defeating trade wars are pursued as individualistic solutions to common problems. Autocracy and authoritarianism are on the rise. The institutional arrangements that enabled the greatest advance in material prosperity in the history of the human race are being systematically undone.

Stunted Innovation

It is also a time of unprecedented technological possibility. The human race has hardly even begun to take advantage of the fact that every person and thing on the planet can now in principle communicate with every other person or thing on the planet instantly at almost zero cost. Artificial intelligence enables machines to perform even complex work previously done by humans. New materials are constantly being created. As a result, many human activities are being reinvented before our very eyes.

Yet instead of a golden age of innovation, most organizations in both the public and private sector are mired in bureaucracy and unable to keep up with growing complexity, accelerating change, digitization, burgeoning knowledge work, shifts in power in the marketplace, globalization—all leading to disruption that can come at anytime from anywhere.

The generally slow pace of innovation reflects rampant bureaucratic management. As Gary Hamel explains:

Strategy gets set at the top. Power trickles down. Big leaders appoint little leaders. Individuals compete for promotion. Compensation correlates with rank. Tasks are assigned. Managers assess performance. Rules tightly circumscribe discretion…”

Bureaucracy “constitutes the operating system for virtually every large-scale organization on the planet. It is the unchallenged tenets of bureaucracy that disable our organizations.” Bureaucracy is gripped by “the ideology of controlism,” “worships at the altar of conformance.” and “‘cripples’ organizational vitality.”

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A New Enlightenment?

Next month’s conference represents a step towards remedying these issues. The conference, entitled “The New Enlightenment: Reshaping Capitalism & the Global Order in a Neo-Mercantilist World”, will be hosted by Edinburgh Business School, Heriot-Watt University, and Haas School of Business at UC Berkeley. “The gathering of scholars, policymakers, business leaders, and thought leaders will give a chance to reflect on what Smith saw as the moral and political foundation of capitalism, where economic theory and policy have gone in the intervening 250 years, and what we need to do for democracy, society, and the economy to thrive over the next 250 years.”

Yet aspiring to generate “The New Enlightenment” in a two-day conference with such a disparate audience may be a stretch. Participants will need to keep in mind that the original Enlightenment of the 18th Century had the noble goal of solving all human problems through the use of reason, but promptly led to the odd king and queen having their heads chopped off.

The very idea that an elite body will be able to generate ideas commanding broad popular support isn’t obvious when one of the fundamental roots of today’s troubles is a distrust of elites. The thinking that emerges from the conference, even if substantively wonderful, risks being tainted by the nature of the arrangements from which it emerges. It will be important for the participants to come to listen and understand other disciplines before proclaiming “enlightenment.”

Seeing Adam Smith By Daylight

It will also be important to see Adam Smith by daylight. The ideas that great men put forward, as Isaiah Berlin noted, often have consequences quite different from those they intended. Adam Smith has suffered from this phenomenon more than most major thinkers. Not everyone remembers that his insights in The Theory of Moral Sentiments were as critical to the long-term success of the economic system as those laid out in The Wealth of Nations.

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At the conference, it will be important to avoid the caricatures of hero-worship and demonization. As Conservative MP Jesse Norman writes in the Financial Times:

Smith was not an advocate of laissez-faire; the phrase “invisible hand” occurs just once in The Wealth of Nations; and he did not oppose all state interventions in markets. Indeed, he positively advocates a range of them, from specific forms of taxation to regulation of the banks. He did not think selfishness was a virtue, and he was not a misogynist; far from originating the idea of ‘market fundamentalism’, he would have opposed it; and homo economicus and the efficient market hypothesis are later ideas that badly distort Smith’s own views. Industrial capitalism itself, as the combination of freely trading markets and autonomous corporations, is a 19th-century phenomenon, and only emerged two generations after his death.”

The Goal Of A Firm: The Self-Interest Of Businessmen

One issue that will inevitably emerge at the conference is: what is the purpose of a firm? This is a debate that has been going on for centuries. It was already visible in Smith’s two books. The Theory of Moral Sentiments emphasized the sympathy that human beings have for each other.  The Wealth of Nations emphasized the general benefit that emerges when businessmen pursue their own self-interest.

Smith offered his famous deus ex machina, the “invisible hand”, that helps make the self-interest of businessmen come out right. He emphasized that the effectiveness of the invisible hand depends on “the moral foundations for a well-functioning market system to be operating.” While he put markets at the center of the economic system, their proper functioning requires “the adoption of moral standards and the rule of law.”

The Goal Of A Firm: Maximizing Shareholder Value

Milton Friedman won the Nobel Prize for Economics in 1976 but his article in the New York Times on September 13, 1970, was not particularly scholarly. It was instead a ferocious tirade in defense of the idea that the purpose of a firm is to make money for itself. Any business executives who pursued a goal other than making money for their firm were, Friedman said, “unwitting pup­pets of the intellectual forces that have been undermining the basis of a free society these past decades.”

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In 1976, in one of the most-cited, but least-read, business articles of all time, finance professors William Meckling and Michael Jensen offered a quantitative economic rationale for maximizing shareholder value, along with generous stock-based compensation to executives who followed the theory.

In 1990, an article in HBR by Michael Jensen and Kevin Murphy gave shareholder value thinking a new push. The article, “CEO Incentives—It’s Not How Much You Pay, But How” suggested that CEOs were being paid like bureaucrats. Instead, they should be paid with significant amounts of stock so that their interests would be aligned with stockholders. Thereafter, the use of the phrase ‘maximize shareholder value’ exploded and CEOs became very entrepreneurial — but in their own cause, not necessarily their firm ’s cause.

Soon shareholder value thinking was everywhere but the results weren’t good. As Bower and Paine wrote in 2017, it is “weakening companies” and “damaging to the broader economy,” with negative effects on “corporate strategy and resource allocation.” … As a result, managers are under increasing pressure to deliver ever faster and more predictable returns and to curtail riskier investments aimed at meeting future needs.” When the goal of maximizing shareholder value as reflected in the current stock price is joined with bureaucracy, it becomes even more toxic.

Once shareholder value becomes dominant, rather than creating fresh value and new customers through innovation, executives become busy extracting value for shareholders. As a result, it has been  “raining share-buybacks on Wall Street.” The Economist has called share buybacks “an addiction to corporate cocaine.” Reuters has called them “self-cannibalization.” The Financial Times has called them “an overwhelming conflict of interest.” In an article by William Lazonick that won the HBR McKinsey Award for the best article of the year, Harvard Business Review called them “in effect, stock price manipulation.”

ASSOCIATED PRESS

Some CEOs have spoken out. The supposed prime exemplar of shareholder value, Jack Welch, denounced it as “the dumbest idea in the world." Vinci Group Chairman and CEO Xavier Huillard called it “totally idiotic.” Alibaba CEO Jack Ma said that “customers are number one; employees are number two and shareholders are number three.” Paul Polman, CEO of Unilever, denounced shareholder value thinking as “a cult.” Marc Benioff, Chairman, and CEO of Salesforce has declared it to be “wrong.”

Moreover, it has become steadily more apparent that companies that are run in a traditional fashion of profit maximization, are missing shifts in the marketplace. “Market-leading companies,” as analyst Alan Murray wrote in the Wall Street Journal, “have missed game-changing transformations in industry after industry…not because of ‘bad’ management, but because they followed the dictates of ‘good’ management.” According to Thomas M. Siebel, "we are witnessing a mass extinction in the corporate world."

It turns out that maximizing shareholder value as reflected in the current stock price is not only bad morally and socially: it is also bad economically and financially. It doesn’t work, even on its own terms.

The Goal Of The Firm: Customer Value

By contrast, Peter Drucker stated flatly in 1954, and again in 1973 and 1985, that “there is only one valid purpose of a firm: to create a customer.” The commonsense view that the purpose of a business is to make money for itself, he said, is wrong. Firms, that are dedicated to providing value for their customers, as a result, make money for the company. Making money doesn’t have to be the primary, overriding goal. It can be a measure, not the goal.

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Initially, Drucker’s view had little support. Then a funny thing happened. Customers struck back. In the 21st century, power in the market-place shifted from seller to buyer. Through the Internet, globalization, and deregulation, customers suddenly had choices, reliable information about those choices and an ability to communicate with other customers. The firm-centric marketplace of the 20th Century turned into a customer-driven marketplace. In this new world, firms that were primarily focused on delivering continuous new value for customers began making huge amounts of money. Those that weren’t, struggled to survive.

By 2018, evidence had accumulated. The shift in power in the marketplace had taken effect and the Fourth Industrial Revolution was well under way. Firms that focused on continuous innovation for customers and were organized to be nimble, adaptable, and able to adjust on the fly to meet the shifting whims of a marketplace driven by end-users were flourishing and had become the largest firms in the world. The examples included: Alibaba, Airbnb, Amazon, Apple, Etsy, Google, Lyft, Menlo Innovations, Microsoft, Saab, Samsung, Spotify, Tencent, Tesla, Uber and Warby Parker. In these firms, profits were, by and large, the result, not the goal, of the enterprise.

By contrast, firms being run in the manner of the lumbering industrial giants of the 20th century, with a focus on profit maximization and a philosophy of controlism, couldn't keep up.

The Fundamental Flaw Of Shareholder Value Thinking

How did so many people get so much so wrong? Shareholder value thinking misses a key aspect of the fabric of reality: the Principle of Obliquity. As pointed out by John Kay in his book, Obliquity: Why Our Goals Are Best Achieved Indirectly (Penguin, 2011), in complex situations, objectives are often best accomplished obliquely, not directly. Central planning is not the most effective way to run an economy. And in business, the single-minded direct pursuit of profit isn’t necessarily the best way to make a profit.

The history of business and economics over recent decades came to resemble a concerted effort to ignore complexity and use linear thinking to discover direct shortcuts to success. Businessmen and economists embraced the embryonic psychology of mainstream economics and missed counter-intuitive peculiarities of the human mind and heart. They assumed that the best way to get to a complex goal is to head for it directly. It isn’t.

Complex settings operate in a non-linear fashion. The actions and intentions of others and their reactions to our actions and intentions are key components that we have to take into account what we plan and do. The articulation or communication of a direct goal can lead to behaviors that prevent the achievement of that goal.

Where explicit articulation of a goal will result in a complex environment pushing back in the opposite direction, an oblique goal will generally be more effective. An unrestrained pursuit of making money at the expense of customers and society will generate push back that prevents its accomplishment.

Dynamic Capabilities

The perceived tension between stakeholder and shareholder theory in microeconomics is said to fade away in “some models of strategic management, which focus on long-run value creation and capture. In particular, the Dynamic Capabilities framework sees long-run evolutionary fitness as requiring attention to a changing kaleidoscope of constituencies and stakeholders that are important to building and maintaining a competitive advantage. It is astute investment, private and public, in technological and organizational innovation which animates economic development and growth.”

Similar insights, albeit expressed differently, are also visible in management thinking. Three dynamic capabilities, in particular, have come to the fore, in part due to their role in the emergence of the five largest and fastest growing firms on the planet. Known in management circles as Agile management, the three main principles comprise:

  • Customer obsession—a capability to identify, deliver and measure value to customers as the be-all and end-all of the organization.
  • Small Teams—a capability to have all work carried out by small self -organizing teams, working in short cycles and focused on delivering value to customers, and:
  • Operating as a Network—a capability to obliterate bureaucracy and top-down hierarchy so that the firm operates as an interacting network of teams, all focused on working together to deliver increasing value to customers.

These dynamic capabilities embrace both operational agility (making the existing business better) and strategic agility (generating new products and services and so bringing in new customers). These dynamic capabilities are also independent of terminology, labels, specific proprietary processes or particular brands.

What's unusual about these dynamic capabilities is their wide applicability. Although they emerged primarily in software development, they are showing relevant to almost all sectors, except pure commodities.

Economics And Innovation

In general, academia has yet to make much of a contribution to the challenge of reshaping capitalism. Business schools are not by and large renowned  for rethinking their disciplines.

Mainstream economics has failed to keep up with the rapid pace of digital transformation, says Professor Diana Coyle of the University of Manchester. The characteristics of the “weightless” digital technology pose fundamental challenges to the entire discipline. The instinctive framework for thinking about public policy questions–-static competition, fixed preferences, rival goods as the norm, competition solving most problems, no ownership of data—no longer fits our situation.

Macro-economists themselves declare that they are “stumped” by the “mystery” of stagnant wages: “We're all drunks looking under the lamppost,” declared Aviv Nevo, professor of economics, the University of Pennsylvania at a European conference in Sintra, Portugal.

“From Smith on,” writes Professor Richard Nelson of Yale University, “economists have recognized that discovery or invention of new ways of doing things and new things to be doing was the driving force of economic progress. However, if administrative parsimony, responsiveness, and innovativeness are the hallmarks of economic organizations, they have little basis in mainstream micro-economic theory."

Although future prosperity is recognized to depend on innovation, mainstream economics lacks a coherent theory of innovation, says William Lazonick.

The neoclassical theory of perfect competition has as its roots a firm that has the characteristics of an overcrowded sweatshop in which workers are unable and unwilling to be productive. Economics is in need of a theory of innovative enterprise to replace this neoclassical theory of the firm, and thereby recognize the centrality of organizations to the economy’s operation and performance, while exploding ‘the myth of the market economy.’”

Above all, the balkanization of academic disciplines—entrenched sector-specific systems of accreditation, the difficulties of rethinking fundamental assumptions and the phenomenon of each profession promoting its own solutions—has limited the free flow of ideas and the intellectual cross-fertilization that characterized Adam Smith’s Edinburgh. All too often, macro-economists, micro-economists, management experts, executives, moral philosophers, and political theorists talk among themselves and miss essential inter-connections that could have led to breakthroughs.

If the Edinburgh conference is to be successful, delegates must come ready to listen and willing to reexamine their own fundamental assumptions.

And read also:

How To Solve The Problem Of Wealth Inequality

Understanding Fake Agile

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