Saturday, February 11, 2012

Time to shake free of 'runaways'

CAPITALISM, as it is practised in rich countries, has taken two brilliant ideas too far. The first is return on equity (ROE), one way of measuring value creation that has managed to eclipse many other, and broader, ones. The second is competition, which has come to be seen as an end in itself rather than as a tool for promoting growth and innovation.

By Christopher Meyer & Julia Kirby
Both ideas began as effective solutions to a pressing problem - how to allocate resources to produce, as Jeremy Bentham would have it, 'the greatest good for the greatest number'. Centuries on, advanced economies cling to these approaches, but the problem has changed. The mismatch has caused difficulties of such urgency that many are now declaring capitalism a failure.
It isn't true. Capitalism remains the most powerful, flexible and robust system for driving society's prosperity and enhancing quality of life. But keeping it on track will depend on our ability to rethink the priorities that guide everyone in the system, from entrepreneurs to regulators to investors. Together the practitioners of capitalism will need to throttle back the headlong pursuits of ROE and competition, and that process begins with recognising those ideas for what they are. They are runaways.
The concept of 'runaway' selection comes from the field of evolutionary biology, and to explain it biologists most often cite the peacock's tail. That ornamental feature has grown ever more flamboyant across the centuries thanks to a simple fact: Peahens show a preference for large-tailed peacocks. In the earliest days of the species, this made sense. A showy tail was a marker of a healthy male that knew how to feed himself. Consequently, well-feathered males had more frequent opportunities to breed and pass along that trait. The next generation had, on average, larger tails. Initially, this would have weeded out the weak, but after many generations, it created a problem for the strong. That tail is expensive. It requires nutrients to grow and maintain. And it's heavy, slowing down its owner and making him easier prey. Past a certain point, the peacock population began to decline, even as the tails kept getting longer.
There is no more powerful question in a United States corporation than 'What's the ROE on that?' Social media spending? Wellness checkups? Better working conditions? Return-on-equity hurdles threaten them all. Conversely, why market cigarettes? ROE justifies the means.
A hundred years ago, squeezing every drop of return out of equity capital made great sense. As the industrial revolution progressed, society was enjoying enormous benefits from mass production, which brought luxuries within reach of the middle class. Just as electronic commerce would later transform business, mass production swept into one industry after another. But, unlike websites, factories were capital intensive. The revolution ran on equity capital, which was in short supply. Any manager would have been right to conclude that allocating capital according to expected return on equity would produce the greatest good.
This doesn't mean that ROE was the point of business - the overall objective of commerce in society was then, like now, to better people's welfare. But the opportunities to put capital in the service of that goal were numerous. Investors, playing the role of the peahens and determining which enterprises would continue to the next generation, needed a proxy variable with which to quickly and objectively size up their options for financial mates, and ROE filled the bill very well.
The fixation on competition
IT'S true, of course, that competition can spur innovation - witness the battle between Apple and Android, which actually has buyers excited about how one will outdo the other next. It's also true that lack of competition stifles innovation: Verizon and AT&T, essentially a duopoly, have no one excited about anything. It's easy to conclude, therefore, that competition is a good-enough proxy for innovation and therefore a prerequisite for economic value creation.
And at the dawn of capitalism, it was surely a better proxy than it is today. In Adam Smith's world, 'atomistic competition' - to use the economists' term - yielded steady increases in the value consumers got for their money. Competitors were price takers, because the market was large relative to producers. Technology changed slowly and capital was scarce, so innovation was less of a driver of growth than were the efficient allocation of resources and the tendency of prices to fall because of that investment. And the scope of a business was circumscribed within a small organisation - the hostler and blacksmith were distinct businesses, dealing at arm's length, unlike GM and DuPont.
But that era ended when, as chronicled by Alfred Chandler in 'The Visible Hand', industrialisation allowed organisations to reach unprecedented scale. Producers became price makers, raising profits and reducing output. When they grew so powerful that society rebelled, legal action broke up the trusts. The newly created competitors, however, encountered the same incentives, and learnt to signal and collude to limit markets to two or three oligopolistic 'competitors'. In many industries these players have become sufficiently large and powerful that they influence not just markets but policy.
Capitalism's changing environment
HERE'S how capitalism will shake free of its runaways: Capitalists can be relied on to follow the money, which means that, no matter where they're from, they will find themselves doing business in emerging economies, where much of the world's growth will occur. Because those economies are growing rapidly, they will convert much sooner to modern infrastructure; because they are youthful, they will become digital native cultures before the ageing societies of the West. They are poised to discover the economic rules that will define the information age. But they will make their choices unfettered by many of the assumptions taken for granted in the West - the two runaway fixations described here among them. They will be the first to fully embrace new technologies, and they will be the ones to develop the rules for exploiting them. And because these economies will have so much clout, their rules will spread.
The importance of the emerging economies for capitalism, then, turns out not to be that they are a source of lower-cost labour for global firms, or even that they are exciting markets in which those firms can grow revenues. It is that they will reveal what kind of economy is suitable for an information technology world. As trade is increasingly conducted in new lands and by new hands, new mechanisms for measuring and learning from new successes will emerge. Those of us who believe capitalism can adapt and should not succumb to the excesses that are crippling it will keep looking for the new markers of fitness and sharing the new rules.
Collectively we are capable of setting a new course for capitalism. We are, in the end, not peahens.
The first writer is the founder of Monitor Talent. The second writer is an editor at large at Harvard Business Review. They are the authors of 'Standing On The Sun: How The Explosion Of Capitalism Abroad Will Change Business Everywhere'.