The real economy: May 2003


The last fifteen years has been one of the most remarkable periods in economic history. But the American model on which most economic thinking and policy making has been based is not only unattractive, it is inaccurate – both about human motivation and how socially embedded markets actually operate

In 1979, Margaret Thatcher became British Prime Minister and a year later Ronald Reagan was elected President of the United States. With these changes of government came a reversal of the trend to greater government economic intervention and higher state spending which had been characteristic of most of the twentieth century and had continued uninterrupted since the Second World War.

This change of direction was reinforced by the collapse of the Russian Empire and the disintegration of the Soviet Union. The fall of the Berlin Wall in 1989 symbolised Western victory in the cold war. One of the most extraordinary episodes in the economic history of the world followed.

It was an American decade. As the Berlin Wall came down Francis Fukuyama proclaimed ‘the end of history’. Fukuyama’s article in the National Interest extended into a best-selling book. The collapse of communism was prelude to convergence on a common model of economic social and political organisation, based on liberal democracy and lightly regulated capitalism. The model bore, of course, a strong relationship to late twentieth-century America.

The triumphalism expressed in Fukuyama’s careful prose was overtaken by more assertive accounts from business people and popular commentators. Walter Wriston, former chief executive of Citicorp, wrote of The Twilight of Sovereignty. Wriston claimed that markets should and would undermine the traditional role of governments. By the end of the decade, this diagnosis of the subordination of government to market was shared by those – like Naomi Klein – who deplored it as well as those – like Wriston – who applauded it.

For Reagan and Thatcher, reducing the economic role of the state involved a deliberate political choice. In the world Wriston described a decade later, there was no longer any choice. International trade and capital flows made the decline of national government inescapable. Through the 1990s the term ‘globalisation’ took over from ‘privatisation’ as the label for market-oriented reforms.

Wriston provided an articulate account of one view of how market economies work. Self-regarding materialism is the principal determinant of economic behaviour. Financial markets are the main regulator of economic activity. The economic role of the state should be confined to the protection of property rights and the enforcement of contracts. I shall call this the American Business Model. (ABM)

The greatest admiration for the American Business Model has been found in the American business community. Arbitrariness and disparities in the distribution of income are justified – even morally justified – simply because they are market outcomes. What could be more congenial to executives and successful entrepreneurs than the discovery that their good fortune not only benefits them but is essential to the welfare of society as a whole? Thus fortified, they greatly enlarged that good fortune. As the 1990s rolled on, an increasing proportion of the profits of US corporations was diverted into the pockets of its senior managers.

Wriston anticipated the emerging consensus of the 1990s: the global dimension of markets and the importance of new technologies. His themes of internationalisation and technology were taken up more stridently by later commentators. Thomas Friedman’s introduction to The Lexus and the Olive Tree (1999), based on his New York Times columns, asserts that ‘the world is ten years old’.

Friedman’s theme was globalisation but there could be no doubt where the centre of this new world was found. ‘If 100 years ago you had come to a visionary geo-architect and told him that in the year 2000 the world would be defined by a system called ‘globalisation’, what sort of country would he have designed to compete and win in that world?’ The answer is that he would have designed something that looks an awful lot like the United States of America’.

The US economy performed well in the 1990s. Business Week proclaimed the ‘new economy’ – technology had transformed American’s long-term growth potential. This strong economic performance was translated into an extraordinary stock market boom. In 1996, the Chairman of the Federal Reserve Board, Alan Greenspan, warned of ‘irrational exuberance’. As he spoke the valuation of stocks was at the highest level ever recorded in American history – surpassing the records of 1929. But far more was to come. Belief in the magical commercial properties of the internet provided the pretext for the greatest speculative bubble in economic history. The NASDAQ index of technology stocks doubled in value, and then doubled again.

Europeans always displayed some scepticism about the universality of the American business model. The G7 group of the world’s largest industrialised nations met in Denver in 1997 and was subjected to a diet of what the Financial Times called ‘effusive self-praise’ from Clinton. The paper went on to quote one European official as saying ‘they keep telling us how successful their system is. Then they remind us not to stray too far from our hotel at night’.

But the inexorable rise of the American business model provoked a loss of European self-confidence. In Britain and in Germany, speculation in technology stocks paralleled the bubble on Wall Street. At Lisbon in February 2000, European leaders signed up to a ‘new economy’ agenda – the market liberalisation supposedly required by globalisation and new technology.

This was, however, the end of the affair. When the World Trade Organisation met in Seattle in November 1999, rioters filled the streets and the conference ended in disarray. Similar demonstrations accompanied every subsequent international economic meeting. The stock market bubble burst in March 2000. Three years later, world stock markets had, on average, halved and the iconic NASDAQ index had lost three quarters of its value. Enron and WorldCom, widely admired creations of the great 1990s’ boom collapsed amid allegations of fraud and false accounting. The exposure of rampant displays of personal greed on the part of its senior executives was rapidly followed by the disintegration of Andersen, its auditors. Investment banks were forced to acknowledge that they had known all along that many of the shares they had promoted so vigorously were worthless.

There was less outright fraud in Europe. And although executive remuneration grew, especially in Britain, it did not, as in the United States, reach levels at which senior executives appropriated a significant share of the earnings and assets of the businesses which employed them. But Britain’s two largest industrial companies at the collapse of the Berlin Wall – ICI and GEC – became mere shadows of their former selves following ill conceived restructuring and the assumption of debt to finance overpriced acquisitions. Jean-Marie Messier used his position at French water company Vivendi to reinvent himself as media mogul, complete with glitzy Manhattan apartment

At the height of the bubble in early 2000, the British government raised £23.5 bn from the sale of licences to operate third generation mobile phone services, and the German government even more. These licences were probably worth nothing at all: one of the ‘successful’ German bidders has already handed its licence back. Established fixed link operators in Britain, France and Germany were brought close to financial ruin by their expenditures on licences, overpriced acquisitions, and the installation of capacity which would not be needed for decades, if at all.

Despite these humiliating fiascos, the ABM, somewhat bruised and battered, nevertheless continues to play the role in political economy that socialism enjoyed for so long. All political positions, even hostile ones, are defined by their relationship to it. Globalisation and privatisation have displaced capital and class as the terms of discourse. Through the twentieth century, the vocabulary of politics was determined by the left, but by its end the right had defined the language of political debate.

For its adherents, the ABM meets the same need for simple, universal explanations that Marxism offered its devotees. Its supporters display the same ingenuity in attributing all problems to government that socialists employed in characterising all issues in terms of class interests. In a bizarre reversal, the claims of economic determinism and historic inevitability, once characteristic of the political left, are now made by the political right.

John Williamson coined the phrase the ‘Washington consensus’. A decade later, he was to write that ‘a term intended to describe a technocratic policy agenda … came to be used to describe an ideology embracing the most extreme version of Reaganomics … the practices being challenged in 1989 had been much more statist than was by then regarded as advisable… This need for liberalisation did not necessarily imply a swing to the opposite extreme of market fundamentalism and a minimalist role for government, but boring possibilities were repressed in the ideological debates of the 1990s’. In poor countries, the IMF was the agency of the Washington consensus. Certainly the Fund promoted a consistent set of policies through the 1990s – privatisation, the opening of financial markets, free capital movements, combined with restrictive monetary and fiscal policies. And in the coded language of international agencies, ‘structural reform’ came to mean a move towards the principles of the ABM. As Robert Wade has noted, other policy changes do not qualify as ‘reform’. After September 11, George Bush was even to identify ‘structural reform’ in Europe as a central national security interest of the United States.

The philosophy of the ABM, as articulated by Milton Friedman, is of government as referee. ‘It is important to distinguish the day-to-day activities of people from the general customary and legal framework within which these take place. The day-to-day activities are like the actions of the participants in a game when they are playing it; the framework, like the rules of the game they play….. These then are the basic roles of government in a free society: to provide a means whereby we can modify the rules, to mediate differences among us on the meaning of the rules, and to enforce compliance with the rules on the part of those few who would otherwise not play the game.’

The claims of the American business model are of four kinds.

§ self interest rules – self-regarding materialism governs our economic lives

§market fundamentalism – markets should operate freely, and attempts to regulate them by social or political action are almost always undesirable

§the minimal state – the economic role of government should not extend much beyond the enforcement of contracts and private property rights. Government should not itself provide goods and services, or own productive assets.

§low taxation – while taxation is necessary to finance these basic functions of the minimal state, tax rates should be as low as possible and the tax system should not seek to bring about redistribution of income and wealth.

Both supporters and opponents see moral and economic issues as inseparable. Many friends of the ABM see government action in economic matters as an attack on liberty, an improper use of the coercive power of the state. Freedom of contract requires a minimal state; market fundamentalism and low taxation are immediate corollaries.

Some American neo-conservatives go further. It is a mistake to deplore materialism and regard selfishness as a vice. Greed is good: nice guys finish last. The rambling but strident philosophy of Ayn Rand, Alan Greenspan’s former mentor, proclaims the virtues of selfishness under the title of ‘objectivism’. Concern for others is an emotion which can properly be called on only to the extent that we feel it spontaneously. Private charity is the only proper mechanism of redistribution, and any further claim by the community would infringe our autonomy.

Even more moderate friends of the ABM, for whom self interested rationality is a harsh fact of life rather than a moral imperative, acknowledge that this thesis has a public relations problem. Yergin and Stanislaw – the brilliant chroniclers of worldwide privatisation – acknowledge regretfully that ‘few people would die with the words ‘free markets’ on their lips. But it is not difficult to explain why people will die with Stalin, Heil Hitler, or Jihad on their lips, but will not give the same accolade to free markets. Stalin, Hitler and Bin Laden recruited followers by demonising other people. The American business model demonises itself. We dislike the American business model most of all for its unattractive account of our behaviour. It requires us to applaud the very characteristics of human behaviour we are brought up to despise.

Sympathetic but concerned admirers of the market struggle with this issue. For some ethical issues which puzzled great thinkers from Aristotle to the present day disappear in a haze of confusion and goodwill. Advocates of ‘corporate social responsibility’ and well meaning business people claim that if only self interest is interpreted sufficiently widely, there can be no conflict between self interest and the public good. As when Charles Wilson asserted that ‘I used to think [note the past tense] what was good for our country was good for General Motors, and vice versa’. History interpreted his remark as malign, but it was simply naïve.

A more plausible argument is that there is simply a dichotomy between economic life and public morality. The values appropriate to business are just different from those appropriate to our private lives. As Goethe observed at the beginning of the industrial revolution, ‘everything which is properly business we must keep carefully separate from life’. Goethe’s position mirrors Milton Friedman’s: ‘the social responsibility of business is to maximise its profits’. This position also has appeal for both left and right.

It is acceptable to many business people because it puts few restrictions on their behaviour. The corollary is the general contempt amongst intellectuals for business and those who engage in it. The dichotomy between economic values and ordinary values achieves sophisticated expression from philosophers like Michael Walzer, who identifies ‘spheres of justice’: criteria for distinguishing the proper boundaries of the market.

But the primary objection to the description of human behaviour in the ABM is not that its values are immoral, but they are not, in fact, the prevalent values of economic life. Greed is a human characteristic, but not, for most people, a dominant one.

Production systems designed on purely instrumental lines proved, in the end, unsuccessful in the market economy’s own terms. The piece rate systems of automobile manufacturers were abandoned because they destroyed social relationships in the workplace, provoked endless negotiation and confrontation, and established a working environment in which no one cared about the quality of the product. We learn to distinguish the synthetic ‘ have a nice day’ from genuine commitment to customer service.

And this is as true of bosses as of workers. Bill Gates may be the world’s richest man, but, if you read his books, and I cannot recommend you do, you can be in no doubt that his ruling passion is information technology, not money. That is, after all, why he is still in an office at Redwood rather than on the beach. Building businesses demands talent and hard work, and is not attractive to the truly greedy. Even in the financial services sector, Donald Trump begins his autobiography by asserting ‘I don’t do it for the money. I’ve got enough, much more money than I’ll ever need. I do it to do it. Deals are my art form’. For legendary investor, Warren Buffet ‘It’s not that I want money. It’s the fun of making money and watching it grow.’

There are people who are obsessed by financial returns. Politics is their natural home, because it rewards position, rather than effort or talent, and government as kleptocracy still ravages many poor countries. The political systems of modern Western democracies have, however, mostly been effective in excluding such individuals. But the idea that greed was an acceptable, even admirable, value in business attracted such people to financial services and to senior positions in corporations. In every era of excess, greedy financiers have preyed on naïve but legitimate business people and gullible investors. What was new was the opportunity for salaried managers of big businesses to divert a substantial proportion of corporate earnings to their own account.

Concern for status – always a strong economic motivation – was translated into concern for money, because, as never before, money was the measure of status. The overriding aspiration of the unattractive characters at Salomon Bros described by Michael Lewis was to be regarded by their peers as a Big Swinging Dick. ‘What really stung the traders … was not their absolute level of pay but their pay in relation to the other bond traders.’

Expectations of behaviour are self reinforcing, because environments attract people who conform to the behaviour patterns they encourage, and encourage adaptation by those whose instincts are otherwise. The adulation of greed attracted the greedy: and so the denouement of the American 1990s was a speculative bubble of extraordinary proportions and an outburst of corporate fraud and misrepresentation. The oversimplified view of motivation in the ABM not only undermined the legitimacy of the real market economy, but came to undermine the operation of the market economy itself.

This is not to deny that self-interested materialism is an important feature of economic life. Economic systems based on appeals to work for the common good will fail. But self interest is necessarily hedged by the complex institutions of modern economic, social and political life – formal regulation and implicit rules, mechanisms of reputation and coordination, instincts and structures of cooperation, feelings of solidarity. Modern societies did not develop ethical norms to restrain self-regarding materialism out of perverse desire to restrain entrepreneurial spirits.

Economic motivations are complex, multi-faceted, and not necessarily consistent. The study of human behaviour should be an empirical subject. It cannot rely solely on introspection and a priori assumption. The best starting point is to expect that behaviour will be adaptive – people will behave in the way they are normally expected to in the circumstances in which they find themselves. This expectation will sometimes be false. The occasional falsification of that expectation is an essential dynamic of a market economy.

Concern about the moral values at the heart of the ABM is closely associated with doubt about the legitimacy of the distribution of income and wealth that results from it. But if differences in income and wealth result from differences, in talent, effort and productivity, then interference with that distribution may imply a high price in economic efficiency. This leads directly to the fourth pillar of the ABM: redistribution of income and wealth should not extend beyond the provision of a modest safety net.

Yet differences in income and wealth in the world economy are not completely, or even mainly, explained by differences in effort, talent and skills. There are many talented and hard-working people in poor countries whose economic circumstances are the result, not of their own deficiencies, but of the deficiencies of the institutional structures within which they operate. Differentials in talent and effort explain only a small part of the distribution of income within rich states. Are the effort, talent and skills of Gates really so exceptional? Do they justify an income many thousands times greater than that of – say – Alan Turing – who actually invented the modern computer and never received more than an academic salary?

And what of those Big Swinging Dicks, the Masters of the Universe? They are valuable to their employers, which is why they receive multi-million dollar bonuses. But the social value of their activities is small if positive at all. And corporate executives are paid a lot not because of their productivity – which is impossible to measure – but because of their bargaining power. They take a slice of the economic rents which pass through their hands.

The complexity of the way in which market rewards are determined makes it impossible to argue that such rewards are necessarily just or efficient. Thoughtful conservatives do not make that claim: they assert instead that interference with the process that gives rise to them would be unjust, because it would involve illegitimate state coercion.

Some people might agree with this argument. But many would not. And that disagreement is itself a problem. If the distribution of income and wealth in the market economy does not meet widely shared notions of legitimacy, that distribution will be expensively disputed. The costs of litigation and crime may be a serious burden on the market economy. Worse still, in many Latin American countries and modern Russia, basic questions about the nature, origin and legitimacy of property rights are associated with corrupt and confrontational structures of politics which have blocked effective economic development.

The ABM emphasises the central importance of property as an institution: so central that its defence is the principal function of the state. This assumes that the nature of property rights is obvious. But they are not. Property rights are socially constructed: they can be defined in many ways, allocated among individuals, households and firms in many ways, and the definition and allocation are the product of social and political mechanisms.

Milton Friedman, unlike many of his less sophisticated followers, understands this: ‘what constitutes property and what rights the ownership of property confers are complex social creations rather than self-evident propositions.’ But, he goes on ‘in many cases, the existence of a well specified and generally accepted definition of property is far more important than just what the definition is.’

But Friedman produces no evidence for this conjecture, and experience of economic history and geography demonstrates the opposite. The invention of agriculture and of limited liability companies – key developments in the creation of the modern economy – represented an evolution from one form of property rights to another. The very different economic histories of Argentina and Australia, reflect the different ways land rights were determined in countries of settlement. We continue to argue over the scope of intellectual property and the nature of media regulation in a pluralist society. It is not easy to see how the current coevolution of technology and institutions in the internet and genome will play itself out. But no one could think that the outcome of these debates doesn’t matter.

‘They are stealing absolutely everything and it is impossible to stop them. But let them steal and take their property. They will then become owners and decent administrators of this property’ said Anatoly Chubais, mirroring Friedman. Post-communist Russia’s economic failure is an enduring reproach to those who claim that the only requirement of a market economy is a system of private property rights. The quality of economic institutions – which it is too simple to characterise as property rights – is the most important difference between rich and poor states.

The ABM supposes that the market economy is defined and described by the activities of greedy people endowed with vigorously defended property rights, but otherwise free of restriction or regulation of their actions. The problem is not simply that this account is not true: it is that the attempt to make the world conform to the model has been deeply damaging, both to the effective functioning of the market economy and to its political legitimacy. By misunderstanding the nature of the American victory in the cold war, the ideologues of the ABM have undermined it.

Yet an obvious question remains. If the American business model is not a plausible description of how market economies function, why is the American economy so successful? The answer, of course, is that the ABM does not describe the American economy. As Tocqueville understood over a century and a half ago, association – the creation of social and economic institutions which mediate between individuals and community – was a distinguishing feature of American society from its very beginnings. ‘The most democratic society on earth is found to be the one where men in our day have most perfected the art of pursuing the object of their common desires in common and have applied this new science to the most effect. The most important of these institutions today is the corporation. Corporate man, the epitome of the American submergence of the individual in the company, was once the butt of jokes. But corporate men and women are the social individuals who make the economic lives of Americans rich and fulfilling.

The deep seated failure of the ABM is that it does not recognise the fundamental complexity of the social institutions of the market economy, and the degree to which these economic organisations are necessarily embedded in the society, politics and culture of productive economies. That embeddedness extends to every aspect of economic life.

Information in complex modern economies is necessarily incomplete and imperfect. Competitive markets fail when there are major differences of information between buyers and sellers. Transactions usually take place within a social context. We prefer to deal with people we know. Or we rely on trusted suppliers, or trusted brands. This social context develops, and is necessary, to deal with these differences of information.

Markets for risk work poorly, despite the overblown financial services industries of all advanced economies. Most of the important risks we face are not handled through the market, but in households, among communities, and by government. Securities markets are better described as arenas for sophisticated professional gambling than as institutions which minimise the costs of risk bearing and allocate capital efficiently among different lines of business.

Most economic activity cannot be, and is not, organised by negotiations between large numbers of potential buyers and potential sellers in impersonal markets – the perfectly competitive, markets of economics.. We need to work in organisations and in teams, and to cooperate in small groups. Self-interested individuals would often fail to cooperate with each other, even when it was in their mutual best interests to do so. Corporate cultures, ethical values, and the blending of working and social lives are the mechanisms which make cooperative productive activities possible.

Knowledge and information are key products in complex modern economies. They cannot be produced in competitive markets in which there are many buyers and sellers of each commodity. Non-materialist motivations – the thrill of discovery and the satisfactions of philanthropy – have been more important stimuli to innovation than profit seeking.

Economists frequently describe the issues raised by asymmetric and imperfect information, coordination problems, and the inadequacies of risk markets as examples of ‘market failure’. But this phrase entirely misses the point. There are failures of a model of the market economy, not failures of the market economy itself. Much of the strength of modern economic institutions comes from the social mechanisms which have evolved to handle these issues: market economies function because, and only because, they are embedded in a social context. The intellectual paradox of the last two decades is that the legitimacy and efficiency of modern capitalism has been undermined by an account of how it works that is at once repulsive and false.

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