‘Models are a way of organising thought about the economy,
not a crystal ball, and what you get out of one is a direct reflection
of the analysis,the perception, and the judgments that you put in’.
Daily Telegraph, 21 March 1994
The key to my own judgments is a firm belief that markets are embedded in a social context, and that this is central to an understanding of how they work Fukuyama, borrowing Nietzsche’s striking phrase, wrote of the end of history after the fall of the Berlin Wall. In late 20th century American progressive opinion, in a combination of lightly regulated capitalism and liberal democracy we have arrived, once and for all, at the right answers to problems of social and economic organisation.
I believe that this description of how market economies function is certainly superficial, and even wrong. I share the commitment to market economics and market economies. But I see the social context of markets not as a sideshow but as an integral part of how these markets work. With the widespread view, sometimes called the ‘Washington consensus’ that well-defined private property rights, active capital markets, and free internal and external trade, are necessary and sufficient for economic success. I believe it is the absence of an appropriate social context that provides the explanation of why the ‘Washington consensus’ has so often failed, just as socialism failed: both ideas rely on principles deduced in abstraction from the reality of the environment within which it was intended to function.
This social context is essential because
- modern economies need and process complex information. Asymmetry of information in transactions can only be handled by a range of rules, conventions and relationships between traders
- small group interactions frequently have pathological properties which need to be handled by contracts and conventions, by participation in hierarchically structured organisations, and by the development of sustained relationships
- many markets for risks do not and cannot exist: since the cost of insecurity to individuals may be very high, social as well as economic institutions for risk sharing and risk pooling are needed and are found in all societies
- property rights are not, in any but the simplest of economies, obvious or natural: they are social constructs and there are many different possible property rights régimes.
Such reasoning denies the possibility of a single model, or blueprint, for economic systems. Properly functioning businesses, and markets, are particular products of specific social contexts and cannot easily be created outside of these contexts. These themes are developed in The Truth about Markets (2003) (published in the US as Culture and Prosperity).
My conviction that markets operate in this way derives from my business experience. That persuaded me that firms should not be regarded as instrumental institutions; I therefore reject the “transaction cost market versus hierarchy” approach to the business organisation described by Ronald Coase and Oliver Williamson in favour of the resource based view, initially described by Edith Penrose.
The resource based theory is one of the principal strands of thought in business strategy today. My own contribution to it is contained in Foundations of Corporate Success (1993) or Why Firms Succeed (1995): for a briefer version see the FT’s introduction to “Mastering Strategy”.
Resource based theory sees the firm as a collection of assets, or capabilities. In the modern economy, most of these assets and capabilities are intangible. The success of corporations is based on those of their capabilities that are distinctive. Companies with distinctive capabilities have attributes which others cannot replicate, and which others cannot replicate even after they realise the benefit they offer to the company which originally possesses them.
Business strategy involves identifying a firm’s capabilities, putting together a collection of complementary assets and capabilities, and maximising and defending the economic rents which result. The concept of economic rent is central in linking the competitive advantage of the firm to conventional measures of performance – read more in Foundations of Corporate Success in an article first published in Finance Director.
The idea of a firm as a collection of capabilities contrasts with two common and more individualistic views of the firm. One, prevalent in US business journalism, is that companies are essentially extensions of larger than life chief executives – General Electric is Jack Welch, Microsoft is Bill Gates. The other, more widely held amongst economists, is that we can ‘look through’ firms to the individuals who have relationships with them. In this reductionist view shareholders, too numerous and too busy to manage firms themselves, hire managers to run the firm on their behalf. These managers then make contracts with employees, suppliers, and customers.
But companies which could be satisfactorily characterised in either of these ways would not make profits. Successful firms have distinctive capabilities. The value these firms add results from this particular identity and their characteristics cannot simply be defined by the contracts they have made. In a profound sense – a sense which is commercial and moral as well as legal – such companies have a reality, and a value, separablefrom the individuals who contribute to them.
From this perspective, it hardly makes sense to talk about the ownership of a modern company. A large, successful corporation is necessarily a social institution, and would not survive if it were not. This position has political as well as economic implications. This leads to the economics of “stakeholding” – see Prospect and my inaugural lecture at the Said Business School.
Firms are not the product of grand designs. The same is true of economic systems. Attempts to establish economic systems on the basis of abstract blueprints in Eastern Europe, Russia and the third world have led to lamentable failures. In the last decade this failure of rationalism has been as true of the blue prints of the right as it was previously true of the blueprints of the left.
In other disciplines, the modernist view that systems and knowledge can be derived from entirely general first principles has come and gone. In architecture, for example, the twentieth century view that ‘a house was a machine for living in’ – entirely rational, functionalist – has given way to post-modernism. Architectural rationalism discarded much that was valuable, but tacit rather than explicit, in the classical tradition and the emphasis on functionality in modern architecture proved ultimately not even to be functional. (You can read more in an article I wrote in the Financial Times on 29 April 1998.)
Yet economics and business are today the last bastions of modernism. There is still a firmly rooted belief that there are right ways of organising firms and economies, not just for here and now, but as universal maxims: and that in matters of business and economics sensitivity to culture, context, tradition and history are unaffordable sentimentality.
I disagree profoundly with this modernist position. Social phenomena can never be successfully understood or analysed in this way. There are many perspectives – literary, anthropological, economic – on the ways in which we behave and in which our society is organised. Each of them has a measure of truth, neither is the whole truth.
This thinking provides the basis of my forthcoming book Obliquity on the theme of how complex goals are best pursued indirectly. It will be published by Profile in March 2010.
Since the credit crisis, many questions have been asked about the future of the subject of economics: questions still raised more often by those who are not professional economists than by those who are. But I suspect in the medium to long term, very large changes will have occurred: that the focus of the subject will be considerably different from the dominant paradigm which I have learnt, taught, written about (and, for many years, subscribed to) during my career.
Financial economics is today the subject of a pincer movement. On the one hand, softer behavioural approaches derived from psychology and anthropology supplement or displace models which impose assumptions of supposed validity on complex individual behaviour: on the other hand, heavier duty mathematics than that used in the traditional equilibrium and optimisation frameworks of economists can be helpful in the understanding of market prices. To a surprising degree, these approaches turn out to be two sides of the same coin, since the processes implied by the first approach may often be best represented by the second.
I conjecture that economics will develop in much the same way, becoming more inter-disciplinary – not in a woolly sense, but better rooted in a psychology which is itself more firmly based on neurophysiology and an appreciation of both cultural and biological evolution, and drawing on a range of scientific techniques rather than the too vigorous pursuit of analogies with classical mechanics. But these are matters for – perhaps – another book.
