The victory of market forces over central planning is complete (Social Market Foundation)

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The victory of market forces over central planning is complete. The communist regimes of Eastern Europe collapsed under the weight of their own economic mismanagement. Capitalist West Germany out-performed socialist East Germany on every indicator of economic performance, and as a result out-performed it in most other indicators – social and environmental, as well. Thirty years ago, the newly independent regimes of the third world saw central planning as the route to growth and progress. Thirty years later most of Africa is an economic disaster and the most rapidly growing economies of the world are the countries in South East Asia which embraced capitalism. In the Western democracies, industrial policies are discredited, and privatisation and deregulation are in progress everywhere.

And with the triumph of markets comes the triumph of the individualistic economic philosophy of the New Right. Private property is the most important of social institutions. Selfishness is the most important of human emotions. Government is inherently coercive and corrupt. Fairness means respect for property rights. Goodness is something we confine to our family life and our charitable activities, since the social responsibility of the corporation is to maximise its profits. Insecurity is the engine of progress.

Perhaps Ivan Boesky went over the top when he proclaimed that “greed is good”, and the courts certainly thought so when they sent him to prison. But he still represents the spirit of the age. Three or four decades ago, no one imagined that we would again tolerate high levels of unemployment, or large numbers of homeless people sleeping in the streets. But we do. Senior executives award themselves massive salaries, and defend their “fairness” by references to the operation of market forces. When Barings Bank collapsed, its management seemed as concerned to ensure the due payment of their bonuses for exceptional performance (sic) as to protect the company’s depositors. The most successful new product of the decade is the National Lottery, which promises a return of £20 million for picking six numbers.

It is an unappealing package. Maybe economic efficiency, market forces, selfishness, insecurity and progress go hand in hand. Uncertainty, homelessness and poverty are the price we have to pay for high and rising output. The best way to protect our savings and get our cars and pot noodles is to satisfy the demands of greedy executives and financiers. If there is to be a role for nobler human emotions, it is outside business. We all wish it were otherwise; but experience has shown that appeals to altruism are not enough to fill the shelves of the supermarket or load the video recorder. We must just be thankful that there is more to life than economics.

Although we may find it difficult, New Right economists, with a mad glint in their eye, argue that individuals commit suicide when the discounted expected present value of their future life is non-positive, paying careful attention to the option value of remaining alive. (In layman’s terms, if you don’t kill yourself today you can always do it tomorrow, but if you do kill yourself today you can’t change your mind. (Hammermesh and Soss, 1974.)) The behaviour of St Francis of Assisi is explained by his desire for after-life consumption (Azzi, 1975). Despairing moral philosophers have been forced to invent the concept of “blocked exchanges” to argue that some territory should be off limits for economists – that market forces should not be applied to organ transplants or personal relationships.

And yet there is a paradox in all this. If we look at successful market economies around the world, we find that many of them are not very individualistic societies at all. Japan is certainly not an individualistic country, yet it has embraced capitalism with extraordinary fervour and economic success. Switzerland is the richest economy in the world, and is held together by a network of collective institutions and activities impenetrable to the outsider. Singapore’s economic miracle is associated with an all-embracing authoritarianism. Norway combines high living standards with unusual social cohesion and a share of government expenditure in national income which most New Right thinkers would associate with economic collapse.

In contrast, unbridled individualism does not appear to be a successful economic system. In Nigeria, opportunistic behaviour is so endemic that commercial relationships are very difficult to establish. The collapse of established and reliable social and political institutions does not help business; it makes business impossible. We see something similar in modern Russia.

The equation of markets and individualism is simply a mistake. Markets are essentially social institutions and operate in a social context. There is no incompatibility between markets and concepts of fairness, the shared valued of groups and of society as a whole, and collective activity and institutions. Not only is there no incompatibility. Concepts of fairness, shared values, and collective activities and institutions are essential to making markets works.

Individualism is not a particularly efficient economic system. Its weaknesses are of three principal kinds. The first is that the costs of defining and defending individual property rights is high. It leads to litigation, and the need to protect against it; it leads to crime, and the need to protect against it; it leads to a grossly excessive expenditure on financial services activities. The second is that individualistic societies do not manage well activities which need to be collective, or which usually are undertaken collectively. Commodities such as education and environmental services are inefficiently provided and inadequately supplied. The third is that individualistic societies often fail at commercial activities that demand trust and co-operation between individuals and firms. This undermines their international competitiveness.

It is not, of course, an accident that this catalogue corresponds closely to a list of the principal economic and social problems facing the United States. The US is by far the most individualistic of successful economies, and by far the most successful of individualistic economies. It suffers from high levels of crime, and overblown legal and financial services sectors. Its public school system is in disarray, and large parts of its urban environment are intolerable. US firms have encountered extreme difficulty in matching the flexible manufacturing capabilities, or levels of component quality, which have routinely been achieved by Japanese companies.

Nor is it an accident that the list identifies the areas in which market economies, which are not very individualistic, score. The absence of lawyers in Japanese business practice is as remarkable as their presence in the United States. Japan, Norway, Switzerland and Singapore are all renowned for the low incidence of crime; and while two of these countries are famous for their financial services sectors, the business they do is largely for export and is based on the fact that foreigners trust the institutions of Switzerland and Singapore more than those of their home country. All of them have outstanding education systems and, with the partial exception of Japan, the quality of their infrastructure is famously high. The streets are clean, transport is efficient and universally available. Each of them, and particularly Japan and Switzerland, has a reputation of the quality of its manufactured goods.

This analysis may sound like an anti-American tirade. That would be to miss the point. The US economy has its own extraordinary strengths. Its record of both technical and organisational innovation puts it far ahead of any other country, and it is easy to see how that innovative capability is closely associated with its individualistic culture. The United States is wonderfully open to new ideas and there is little social or behavioural resistance to change. Both individuals and organisations are free to experiment, and there is no disgrace and little penalty in failure. The key point is that the United States is at one extreme end of the spectrum of successful market economies. The mistake economists have made is to universalise a stylised version of the US economic system as a general model of how markets operate everywhere.

The individualistic model of markets, based on the primacy of private property, is not even a very compelling description of how the US economy functions. To see that, simply observe the difficulty which the model has in coping with the most important of modern economic institutions – the large private corporation. The trouble is that the obvious reality – that such corporations are collectivist undertakings with life, character and personalities of their own, social organisations as well as structures of co-operative relationships – fits extremely uneasily into a model based on the individual ownership of private property.

There are, too, largely incompatible responses. One treats the company as the private property of its shareholders. These shareholders, too busy and too numerous to manage their property themselves, hire salaried managers to run the corporation on their behalf. It is true that the growth of hostile take-overs in the 1980s has given shareholders in American and British companies far more power over managers than they enjoyed before. As a result, senior executives frequently talk of the power of shareholders, and the devotion they have to the interests of the shareholders. But that is about as far as it goes.

The alternative rationalisation treats the company as an extension of the personality of its chief executive. So Microsoft is Bill Gates, General Electric is Jack Welch. All that goes on within the corporation is a manifestation of the vision of these extraordinary individuals. Each new CEO, like a new prophet, is expected to bring to his company (rarely in the UK) a new sense of strategic direction.

Neither of these models bears any relationship to the reality of how large corporations operate. If that is true of US companies, it is even more true of those in other countries. No Japanese manager thinks for a moment that he is the agent of the shareholders, and Japanese chief executives are not encouraged to take a high public profile. In that environment – which does appear to contain many successful companies – the company is clearly seen as a social institution in its own right and the manager is the servant, not the master, of that institution.

Successful market economies, without exception, rely on the effectiveness of collective institutions – groups of people bonded together for a common purpose. I use the word collective to emphasise that they need not be, and mostly are not, political, in the sense in which we normally use the term; they are not governed by systems of ritual debate in which the clash of opposing interests is resolved by popular vote. Most of them are not democratically accountable in any recognisable sense at all. The most important of these collective institutions are firms, but there are many others, ranging from local play groups to the networks of co-operating units, manufacturing commodities ranging from ties to tiles, which form the basis of the economic success of Northern Italy.

Now no one on the Right ever doubted that it was unrewarding to play cricket on one’s own. They saw that eleven potential cricketers came together each Saturday, and made mutually advantageous contracts with each other for the coming match. Perhaps, in order to avoid the complexity of 11 x 10 bilateral contracts, each made an agreement with the team captain, and they may even have given the club a formal legal status and contracted directly with it. Finding the game enjoyable, the players met again the following Saturday and re-established contact with each other. But in seeing that, they missed the essence of what was going on. The successful teams were always those in which the club took on a life independent of the identity of its individual players. In these teams players (and often the spectators) came to feel a loyalty to the club which reinforced, but also transcended, their obligations to their fellow players. The same is true of successful firms, or successful play groups.

So the efficiency of market economies depends, to a substantial degree, on the success with which these economies manage these collective institutions. And these institutions neither are, nor should be, trying to maximise anything. The objective of the cricket club is to be a good cricket club. That means many things. It means success on the playing field. It means a style of play that is enjoyable for participants and spectators. It means having fun after the match. A good cricket club is one which finds an attractive balance between all these things, and will attract players who like the balance which it strikes.

Most neo-classical economists will anxiously attempt to translate all this into an objective function which is a complicated weighting of the preferences of the individual. Such a translation is possible, although not particularly easy. And in doing it, we are twisting reality to conform to the model, rather than using the model to illuminate reality. It is better, as well as simpler, to recognise that the committee is simply trying to strike a balance between the various things that make a cricket club good.

Tom Wolfe’s novel, The Bonfire of the Vanities, is a brilliant satire on modern American society. Its hero, Sherman McCoy, is a self-proclaimed “Master of the Universe” – a well-rewarded Wall Street bond trader. Accidentally, he crosses the line between the law-abiding white Manhattan society of which he is part and the vast lawless back communities of New York from which he has to be protected. He becomes a victim of a series of preposterous legal suits which, although he is largely successful, lead to the destruction of his career, his marriage, and his life. Wolfe focuses unnervingly on the three principal groups of costs which individualism imposes on society – the over-expansion of financial services, the division of a crime-ridden society into social groups at war with each other, and the burgeoning costs of litigation and protection against litigation. I deal with each of these in reverse order.

The essence of the New Right position is that incomes depend on the initial distribution of property rights. There are no criteria of fairness or justice other than those implied by respect for these property rights themselves. If we ask whether it is fair that Michael Eisner should earn $100 million dollars while hobos are starving on the street, the only question is whether each have the opportunity to offer their services in a competitive labour market. If the answer to that question is yes, then there is nothing more to be said. You cannot appeal to the reasonableness of the outcome, but only to the legitimacy of the process, since legitimate process is the only admissible guide to the reasonableness of outcome.

I do not wish to focus, for the moment or indeed at all, on the morality status of this position. I simply wish to observe some of its economic consequences. If the initial distribution of property rights is of overriding importance, it is essential to be clear what they are. Unfortunately, becoming clear about what they are is often a difficult and expensive process. Contracts need to be specified in considerable and costly detail, and any ambiguity of term can legitimately be disputed. New property rights can be invented and, may, or may not, be accepted by the Courts. That allows judges, legislators and most often juries to determine the distribution of property rights, and hence the distribution of incomes. The result, as for Sherman McCoy, is that a rights and income distribution governed by private contract are not, in reality, more secure than those determined by social consensus. They are less secure, because the interpretation of contract is more uncertain, and undoubtedly more expensive, than a mature society’s social consensus.

It is now rare for weeks to pass without reports in European newspapers of another ludicrous case conducted in American courts. A woman who spills a cup of Mcdonald’s coffee wins $3 million because the coffee was too hot; a child sues his parents for his inadequate upbringing; a Wal-Mart employee is awarded damages in excess of the top prize in the National Lottery because fellow workers made lewd remarks.

How do these things happen? In most European countries, all these claims would immediately be dismissed as ridiculous. Their legitimacy would be determined, not by the terms of some implied contract but by their reasonableness. Do they accord with prevailing social values? None of these demands come within rules of meeting that test, and the Courts will respond accordingly.

The first problem, then, is that the only question that the individualistic model allows the Courts to ask is whether the property right does exist; not whether it ought to exist. That opens the way to absurd claims. The second problem is that once it is conceded that if a property right exists it is legitimate to exercise it. McDonalds offered no warranties about the temperature of its coffee. Parents make no contracts with their offspring. Wal-Mart does not guarantee how other employees will behave. All these supposed contractual terms were asserted by lawyers and inferred by the Courts.

It is reasonable to argue that children have a right to be brought up well and that workers have a right to be free of sexual harassment . It may even be true (though it is straining the concept of rights) that we will enjoy a right to be served a cup of coffee at the appropriate temperature. In most societies, there are social mechanisms (not political or legal mechanisms) for achieving these results. Communities help children whose parents cannot cope, employers and workmates come to the aid of employees who are upset by their colleagues behaviour. Well respected restaurants try to serve their coffee at the right temperature, and if an accident happens the restaurant and fellow diners rush to help before they call their attorneys.

We are right to expect care and devotion from our parents. We ought not to be subject to sexual harassment. We should expect that restaurants will serve us coffee at a suitable temperature. Yet none of these things seems to convey rights of ownership akin to the property rights I have over my house, my investments, and my toothbrush. The creation of these supposed property rights is the achievement of inventive lawyers and economists. Yet we are all potential victims. Who knows what rights may be inverted against us? Who knows what implicit contracts we have inadvertently become party to?

And that leads directly to the third problem: the search for the deep pocket. The ability to determine and re-determine property rights makes the Courts a major engine of redistribution. That was the problem for Sherman McCoy; and it is even more clearly the problem for McDonalds or Wal-Mart. Faced with an opportunity, posed by the inevitable imprecision of property rights, to leave money in the hands of large corporations or to transfer them to the public at large, juries plump unhesitatingly for the public, and legislators and judges follow not too far in the rear. It is a good deal easier to see that McDonalds has a lot of money and the customer who spilt the coffee does not then interpret the implied contract between the restaurant and its patrons, and the verdict goes accordingly. That outcome invites further essentially frivolous litigation.

The fiasco of Superfund illustrates the problem at its worst. Over the course of the century, corporate and political America made a grave mistake. Competition between states to offer the honest standards of regulation had the result that some of its finest environments were despoiled by pollution. In search of the deepest pocket, Congress legislated that anyone involved – however tangibly, as with the banks that had funded the projects – was responsible for the totality of the costs. The practical outcome is that almost all of the billions of dollars expended on Superfund have been devoted to litigation and virtually none to cleaning up pollution.

The vast majority of human misfortunes are not, in any real sense, anyone’s fault. When a foolish woman tips a cup of McDonald’s coffee over herself, the correct response, viewed from the narrow standpoint of economic efficiency, is that no one is to blame but everyone tries to help her out. Under the property rights approach, you bear the full consequences of an accident yourself unless you can find someone else to blame; the practical consequence is that most people get nothing at all while a small minority feel as thought they have won the National Lottery.

Social market economies are not, in the main, litigious societies. Contracts are brief and enforced, not by the Courts, but by mutual expectations about the nature of the relationship. Gross violations of these expectations are punished, not by damages, but by social and commercial ostracism. These mechanisms are not ideal, and are strongly biased towards traditional patterns of behaviour. They are, however, both cheap and effective.

Crime

If the distribution of income and wealth is defined by the initial distribution of property rights, some people, lacking either inheritance or talent, begin with no rights of any value at all. It is difficult to see what incentive they have to subscribe to the system. Having no property rights themselves, they have little reason to respect the property rights of others. As rich people dispute that initial distribution by litigation, poor people dispute it by violence and theft.

The conventional response to this problem is that it is a matter for education in the first instance and for the police in the second. If people who have no property rights fail to understand the justice of an individualistic income distribution based on property rights, then the merits of that position need to be explained to them. Sadly, the works of Robert Nozid and Ayn Rand appear to command a wider sale in the rich suburbs than the poor ghettos. Before dismissing such activity as a waste of breath, we should notice that in most countries, for most of human history, it was effective. Poor people accepted the legitimacy of the social order in which they were poor. But they accepted it because they could not conceive that it might be otherwise. Once it is clear, or at least arguable, that their poverty was the result of a choice between systems of social organisation rather than an unavoidable state of affairs, poor people cease to have any reason to support that system of social organisation.

The school master having failed, the task is handed to the policeman; respect for property rights is a matter of coercion and enforcement. With sufficient policemen, and adequate penalties, respect for property rights can be imposed. And, indeed, this is true, so long as the disputed minority remains small. There are very few criminals in Japan or Norway, in Switzerland or Singapore, and the population is more or less unanimous in its readiness to identify criminals to the authorities and to support their punishment.

In societies such as these, where the distribution of property is determined by widely accepted notions of fairness, the minority who dispute it will be small and unpopular. It is easy to impose penalties on them, but mostly unnecessary, since detection is very probable and the adverse consequences are social as well as legal. Once dissidence grows beyond a certain point, it finds supportive communities. So Northern Ireland terrorists can vanish into a background of people who might not wish to be terrorists themselves, but are not inclined to denounce terrorism.

In extreme cases, such disaffection degenerates into “no-go” areas, where the state and the legal system is unable to enforce property rights because of widespread refusal to accept the legitimacy of that authority. Such areas are common in the major cities of the United States. In Britain they are found in Northern Ireland and, to a smaller extent, on the mainland; similar enclaves can be found in Paris, Berlin and southern Italy.

The question of whether it is cheaper to pay the Danegeld or to fight the Danes has along history. And it has no easy answer. On the one hand, it is necessary to extricate the net present value of future Danegeld; or the other, to assess the probability of victory over the Danes and the length of time for which that victory will influence behaviour. As Kipling noted, payment of Danegeld will never get rid of the Dane; but that does not necessarily make it a bad buy. The strictly economic question is that a society which does not seek to defend its income distribution by reference to generally accepted concepts of fairness will incur costs in criminal damage, in prevention and enforcement, and in greater insecurity for the affluent; and that these costs are largely avoided in states which seek a degree of consensus on the distribution of income and property rights.

Financial services

Societies which emphasise the central role of property rights have to spend money defining property rights. They have to spend money defending property rights. They also have to, or choose to, spend surprisingly large amounts of money trading in property rights. That is largely what the financial services sector is about.

There are three ways to be rich in an individualistic society. One is to inherit property. There is nothing most of us can do about that. The second is to own an exceptionally valuable talent. The third is to buy assets cheap and sell them dear.

The amounts people earn from even the most remarkable of talents are limited. Consider Lunis Rauling, twice winner of the Nobel prize; Jack Nicklaus, the greatest golfer in history; Luigi Pavarotti, the greatest opera singer of his day. These men are rich, but not, in City language, seriously rich. The way and the only way, to become seriously rich is to sell assets for more than you paid for them.

Sam Walton was a founding shareholder in a company and still owned some of these shares when, thanks in part to his abilities, became the largest retailer in the world. He became a billionaire. Bill Gates bought an operating system, MS-DOS, for $125,000 and managed to keep ownership of it when IBM adopted it as standard for its personal computer. He is alleged to be America’s richest man. Warren Buffet, the “sage of Omaha”, also became a billionaire by taking large stakes in seriously undervalued companies. The Reichmann brothers made a fortune in property trading and lost it again in property trading. George Soros, according to press reports, made a billion dollars by understanding that the pound was worth less than 2.95 Dm even though the Chancellor of the Exchequer thought otherwise.

All of these are talented people although – in contrast to Rauling, Nicklaus and Pavarotti – none of them is demonstrably and unquestionably more talented than others engaged in similar activities. All of them provided services of some social value, although the value diminishes as we go down the list. Walton helped to change the face of US retailing, although these changes would have occurred, perhaps more slowly, if he had never been. Gates’ operating system was no worse, and no better, than others available at the time, but he supplied the one that IBM adopted. The Reichmanns helped to finance some useful and even distinguished buildings. Buffet identified the true potential value in the Coca-Cola corporation, although the value was created, and exploited, by the Coca-Cola company itself. Soros helped to bring exchange rates in Europe to more realistic levels.

What is true of all on that list, however, is that the amounts which were earned through trading in assets bore no relation either to the value of the services which the individuals concerned provided or to the amount which they would have needed to be paid to persuade them to perform them.

The underlying market problem is that seeing that an item is worth $2 when it is priced at $1 is as profitable as making it worth $2 when it is priced at $1, although the service involved has only a small fraction of the value. Since information is itself the subject of private property rights, these profits are entirely legitimate.

The consequence is that very large quantities of resources, and talent, including many of the ablest individuals in the economy, are attracted to the pursuit of these arbitrage gains. Participation is not only a possible means of becoming rich; it is the only method of becoming very rich. And as is true of all gambling activities, the exceptional gains of a few continue to attract many players to the tables even though the vast majority lose.

And as is true of all gambling activities, the most certainly profitable role is that of the bookmaker. Win or lose, fees are collected, and it is not usually necessary to offer to share the customer’s losses to persuade them to be generous when they win.

In confirming the suspicion of the man in the pub that most of what goes on in the financial services industry is of no social value, it is important not to go too far. There is a clear need for financial intermediation – the process of bringing together individuals and firms who have more money than they need with those who have less money than they need. There is also a role for secondary markets, which enable investors to provide long-term capital to firms while allowing them to realise their capital if they require it. But the overwhelming majority of transactions in modern financial markets – in bonds, shares and currencies and in derivative instruments based on them – are not of these kinds. They reflect differences of opinion about the value of a security – the buyer thinks the bond, the share, the currency is worth more than does the seller. Since one opinion is right and the other wrong, the process is necessarily a zero-sum game, in which one player loses slightly more (by virtue of the costs of the transaction) than the other gains. The majority of actively managed equity portfolios do worse than a random selection of shares. And although major corporations mostly claim to make money on currency trading, this simply cannot, in aggregate, be true.

The problem posed by the over provision of financial services is not simply that too much money is spent pursuing second hand paper from one account to another. Because of the size of the rewards available in financial services, and the magnitude of the differentials between the successful and the unsuccessful, financial services have a strong attraction for exceptional talent. Most of this talent is devoted to activities which are largely useless.

Bibliography

Azzi, 1975

Hammermesh and Soss, 1974

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