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Sunday, September 17, 2006

The Gospel According to Adam Smith?

Looking back over just one week's worth of news in the Wall Street Journal regarding corporate management and malfeasance turns up the following stories:

Briston-Myers Board Urged to Fire CEO and General Counsel - Bristol-Myers had been operating under a deferred-prosecution deal (isn't THAT a neat concept?) after fraudulently boosting earnings by stuffing sales channels with extra product. The firm has been subsequently found to have conspired with others to delay introduction of generic drugs that would have competed against one of its big moneymakers. (9/12/2006)

Dell Delays Filing Financials -- The largest computer maker by units confirmed it would not file its current quarter financials on time because of irregularities associated with recognition of expenses in the form of "cookie jar reserves." One auditor found a tax calculation on repatriated foreign income that produced an extra $65 million in booked expenses that were not incurred, allowing the extra cash on hand to be used to smooth some other unexpected shortfall in a later quarter. (9/12/2006)

Hewlett-Packard Chairman Resigns after Illegal Private Investigations -- Patricia Dunn resigned from H-P after details of a private investigation she initiated came to light and indicated H-P illegally obtained phone records to/from board members in an attempt to identify the source of leaks about board deliberations. (9/13/2006)

Federal Reserve Official Voices Concern About Margin Requirements on Hedge Funds -- A WSJ story cites comments from a speech Timothy Feithner, President of the Federal Reserve Bank of New York, made in a Hong Kong conference about the danger of large hedge funds operating with small or zero margin terms banks typically offer their best customers. The problem is that large hedge funds are NOT typical customers, but businesses specifically designed to operate "on the edge" and leverage relatively small market fluctuations into profits, making them highly volatile when unexpected market conditions arise. (9/15/2006)

Former Senator Alfonse D'Amato Likely to be Ousted from Board of CA (Computer Associates) -- D'Amato is currently the longest serving board member of a company that has been under investigation for accounting irregularities for at least 3 years. D'Amato, if you recall, was subjected to investigations by the Senate Ethics Committee in the early 90s and also made a hefty profit on a intra-day stock sale on shares made available to him by a brokerage firm under investigation by the SEC at the time. (9/16/2006)

The "Big Three" or the "Dead Three"? -- Ford announced yet another massive restructuring of both its blue collar and white collar ranks as it continues to bleed cash. At the same time, Chrysler announced it has estimated its current quarter loss at $1.5 billion. (9/16/2006)

The common thread among all of these business fiascos involves a combination of a sense of invincibility / immunity and corporate decisions warped by prior business success or lack of proper oversight.

I've written before about the "faux conservatism" that has led many people to vote for policies that, properly and fully understood, are definitely NOT in their best interest. One concept that has taken on the weight of gospel with many conservatives is the famous "invisible hand" from Adam Smith's 1776 book The Wealth of Nations. When applied without context, blind faith in the invisible hand of the market can produce (and has produced) major problems, yet many faux conservatives retain an unquestioning, unqualified faith in the concept.

The Invisible Hand

Most Americans have heard the term "the invisible hand" and, if quizzed about it, would probably say it has something to do with economics and business and basically means consumers and business know best, so less regulation is generally better than more regulation.

Not bad for an answer on "Jaywalking" but like many other concepts separated from their context by vast amounts of time and oversimplification, the paraphrasing leaves quite a bit of valuable insight behind. Here are the two paragraphs from The Wealth of Nations that frame the original reference to the idea of an "invisible hand":

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote and end which was not part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

Smith's idea seems intuitively obvious but the political and economic environments that existed in the mid-1700s that influenced his thinking bring with them major caveats. First, the decentralized decision making Smith described implies a market with a large number of sellers and buyers where no one seller or buyer affects enough of the market to materially affect supply or demand. This concept has evolved into the basics of standard price theory in economics. Second, Smith's examples in explaining market forces affecting buyers and sellers involved simple industries and basic tax and tariff policies with direct, measurable costs that each buyer and seller could see and incorporate into their individual decisions.

In short, "the invisible hand" is a useful concept when analyzing markets where no buyer or seller can individually control the market and where buyers and sellers all have "perfect" information about prices and where prices accurately reflect all costs.

From the "Invisible Hand" to Laissez-faire

Smith's concepts influenced politicians and economists throughout the world but the United States and Great Britain did more to incorporate specific policies reflecting these ideas than most countries. Industrialization produced even larger gains in wealth for western countries, eventually changing perceptions about Smith's theories from useful theory to something resembling a law of nature that always produced what was "best" for society.

In that sense, The Wealth of Nations has interesting parallels to the ideas published 100 years later in Charles Darwin's The Origin of Species which described how natural selection influences the development of biological species without a centralized, coordinating mechanism other than the mechanics of biology. However, unlike many who extrapolated Smith's theory into a value judgment, Darwin did not state that because evolution works the way it does, it is "best" in some absolute sense. It just is. It simply reflects the result of simple micro-level rules followed individually billions of times over billions of years. Darwin's theories don't preclude the possibility of conditions temporarily favoring an organism's growth to the extent it can completely dominate it's environment, only to be wiped out completely by a sudden change in climate.

With a few possible exceptions (railroads, banking, oil refining), practical limitations on communications technologies and international transportation kept most industries reasonably close to the "linear" range of the economic spectrum where modest regulation produced the benefits predicted by laissez-faire believers. However, it is safe to assume that Adam Smith and most economists in the 1800s and early 1900s could not have foreseen the concentration of economic power in multinational companies common in today's economy. Today's economy literally has individual companies whose profits exceed the GNP of many COUNTRIES, yet many adherents of laissez-faire policies are reluctant to recognize any upper bound in the "optimal" size of a company.

Another Hand on the Wheel

There's a reason economics is called the "dismal science." Virtually everything in economics involves:

* simple concepts that, at first, make obvious, intuitive sense
* formulas involving factors with seemingly easy to obtain, specific values
* human behavior acting upon information presented by the economy

The first two factors tempt many into using a theory that explains behavior in a limited range to extrapolate the outcome of the idea applied to a much broader problem. The human factor is the undoing of any large-scale application of otherwise simple theories. Anytime human psychology is involved, no formula can hold true in all cases because human behavior cannot be quantified. It's a widely accepted fact that humans often become crazy when presented with unbounded inputs (money, power, fame, you name it).

The news stories cited at the beginning of this piece are prime examples of the consequences of huge corporations concentrating enormous economic power and operating with insufficient public oversight and transparency. All involve businesses which at times generated enormous profits, commanded large market shares, and provided lavish compensation to executive management. Some cases (Dell, CA, Bristol-Myers) involve situations where executives were either over-incented to grow a business that due to its size could not be grown organically any further without fraud. Some cases (Ford, Chrysler, GM) involve situations where the business successfully "captured" its regulators to insulate itself in the short term from the consequences of bad long term decisions. Some cases (HP) involve executives possibly inhabiting some twilight zone of morality where the "rights" of the company to get what it wants outweigh the rights of its employees and third parties not even tied to the company.

The most important takeaway from these stories is their illustration of the danger of concentrating too much economic decision making power in a smaller and smaller gene pool of management talent. With the stratospheric levels of compensation being given these managers, it is pretty obvious that normal financial motivations are no longer driving their actions. If you make six million dollars a year, can money really be a driver or do other factors such as power or prestige begin to dominate? Is it really wise to have a single company whose direct or first tier impacts affect two or three percent of the entire country's economy being led by someone motivated by these factors? A team of 20-30 top managers at a huge company may have the brainpower to steer the firm through ninety percent of the economic scenarios that arise. What about the other ten percent of the time? What if the financial controls of a company so large cannot be clearly understood by more than one or two people? What if one of those people begins manipulating the books? These aren't hypothetical questions. These scenarios have occurred and destroyed HUNDREDS OF BILLIONS of dollars overnight.

Pro-business conservatives often support laissez-faire regulatory policies by claiming any other approach will lead to big government, reduced consumer choice and a reduction in income and wealth for the country. No reasonable person would suggest the adoption of a communist or socialist style command economy is an appropriate solution to correcting problems in our economy or the larger global economy. No reasonable person is arguing that no company should be allowed to become as large as GE, Cisco, etc. if they make good products and compete fairly. In fact, no reasonable person is even arguing that the majority of the economic levers in our system are broken. Most are working quite well. As soon as a hard drive shrunk to the size of a credit card, Americans had iPods to wear to the gym so they could listen to the Backstreet Boys while doing Pilates. (OK, maybe the music industry is broken…)

Moderates DO have a legitimate claim that unchecked corporate power resulting from blind faith in the "gospel according to Adam Smith" and resulting hands-off regulatory policies are leading to big problems in key industries with profound effects on all citizens. No one is arguing for removing the invisible hand from the steering wheel of the economy. However, it's clear another hand is needed as a counterbalance in some scenarios. Applying this balance isn't "anti-business", it's actually pro-business because it allows the economy to benefit from the efficiencies of the invisible hand in those scenarios where the market DOES know best while allowing society to stabilize its influence in cases where caveats apply.