Devastating Mistakes of Economics

In 1792, William Pitt told parliament that Adam Smith’s “extensive knowledge of detail … will …furnish the best solution to every question … of political economy.” Since then it’s been downhill all the way. For Smith, the industrial firm (his famous pin factory) was the key to economic progress, with the market only serving to enable the division of labour. But economists have always given primacy to the market, almost ignoring the industrial firm, because they don’t begin to understand it. In late nineteenth century, economists adopted differential calculus to model the economy, which meant describing the firm as a “production function” comprising two variables, price and quantity, and seeking to maximise profit. This was not just stupid, but hugely damaging. Maximising one thing requires the neglect of everything else, which has done great damage to Anglo-Saxon industry. Finally, in the 1980s, still completely unable to conceive of what a firm involves, they adopted the agency idea, claiming that the managers of a firm were the agents of its shareholders and should not therefore be maximising profit but maximising shareholder wealth. It is a lie. Managers have no contract with shareholders, but with the firm which is a legal entity in its own right. Shareholders do not own the firm – if they did they would not enjoy limited liability. They own shares which entitle them to dividends and capital growth, both at risk. Maximising shareholder wealth, as required by Friedman and followers, requires neglecting everything else. When specific decisions have to be taken, notably in the case of hostile takeovers, this is crucial. It has destroyed much of what remains of Anglo-Saxon industry, the latest British example being Cadbury. It has also justified the obscenity of top executive share option bonuses, which unless reversed will be the source of what is called euphemistically, social unrest.

11 thoughts on “Devastating Mistakes of Economics”

  1. An interesting concept, firms are more than just wealth generators for shareholders, but as entities in their own right, they should follow the values which are dear to them. Something I’d agree with, and firm’s Managers should appreciate. However managers aren’t to blame for the conversion of Cadburys from a firm whose foundation was built on providing a great environment for their workers, to a cash generator for pension schemes. This corruption of a firms values will always exists in business whose shares are openly traded to the highest bidder. The “attitude” of managers is irrelevant in such cases.

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  2. The problem is that managers, who may well have the best interests of the firm and all its stakeholders, very much as their original focus, are fairly easily corrupted by vast sums of money, deliberately offered to them in such a way as to convert them from managers to shareholdrs. Once corrupted, they happily pursue shareholder wealth, and accept as inevitable, what Drucker referred to as the hatred and contempt of ordinary human beings.

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  3. I have always been of the opinion that before criticising other disciplines and gratuitously insulting colleagues, including accusations of telling a “lie” – a deliberate manufactured untruth – one should at least be seen to be familiar with their subject.

    The production function is the relationship between levels of physical output of a production process and the amounts of physical inputs that are used in the process, like land, labour, machines, etc. It is not the relationship between price and quantity produced, as you state: this is the supply curve (or function). See any introductory Economics text. I anyway wonder why you have such a problem with economists’ ideas (lies?) about this area of the theory of the firm. Do you really believe physical output can be increased without limit in the absence of increased inputs of labour and/or machines etc, which is the basic story of the production function? Do you really believe an increase in the market price of a product, say, carrots, would not encourage market gardeners, say, to increase their production of the product (carrots) instead of other possibilities (turnips) – which is the basic story of the supply curve in a competitive environment? Properly employed, economics as a discipline provides a valuable means of viewing and understanding many aspects and details of markets, firms and society, and does not rule out critical approaches. Thank you for inviting comments.

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  4. I sincerely apologise for any gratuitous insult – none was intended. But all disciplines should be open to, and welcome, criticism. Do you really believe managers are the agents of shareholders? That was the specific lie referred to. Moreover, do you really believe in the orthodox neo-classical economics’ portrayal of markets and firms? Thanks very much for taking the time and trouble to comment.

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  5. Regarding the agency lie, both of the most cited papers on which it is based were well aware of the problem. Alchian and Demsetz tried to sidestep the inconvenient truth of the firm being a legal fact, by describing it as a ‘centralised contractual agent in a team productive process’. Jensen and Meckling were more forthright, describing it as a ‘legal fiction’ and explaining that what they meant was an ‘artificial construct under the law which allows certain organisations to be treated as individuals.’ I find it difficult to regard that as anything other than deliberate untruth. The simple fact is the firm is a legal entity in its own right. The untruth was important, not just for opening up a fertile field for publication (a recent review article identified over 900 agency theory publications), but, more importantly, as the basis for the change of focus from profit maximisation to shareholder wealth maximisation. That has done a great deal of damage, for example, in providing justification for ‘hostile’ takeovers such as Cadbury.

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  6. Well, I am not too mollified by an apology immediately followed by a repeat of the remark that was complained about.

    As to the rest of your reply, I am not sure I can help much. I am sceptical as to the methodological validity of “belief” in judging a vast body of theory and approach like “orthodox neo-classical economics’ portrayal”. Asking whether I “believe” it is like asking whether I believe in Inorganic Chemistry.

    As for Principal-Agent modelling, I remain puzzled by your hostility to the approach: it explains and predicts (though does not seek to endorse) stuff like profit-sharing incentives, bonus payments and share-option schemes in contracts between owner-principals and manager-agents.

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  7. My point was that modelling the shareholder as principal was a deliberate untruth. Publication based on that untruth is therefore falsely based. Explanations are similarly false. Predictions may well be of a self-fulfilling nature, as Ghoshal, Khurana and many others have pointed out. My hostility is irrelevant.

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  8. Surely the fact that something may be wrong or result from a misunderstanding does not make it a ‘lie’. Les Rosenthal is quite right to pick you up on this. The point about economic theory is that it is just that and as with all theory simplifies in order to get at the essence of particular relationships. It also makes simplifying assumptions. All theory does that. Where, for example, does Drucker get his 20:1 ratio from? Maybe it’s 25:1, as one website has it, maybe it’s 30:1. Maybe less well paid employees at Reckitt Benckiser don’t mind their CEO pocketing £93m. Meanwhile what we do know is that if employees feel valued they perform better and this doesn’t mean they need to be paid more, though it often acts as a signal of their value being recognised. It is however very difficult to believe that people don’t have pride it what they do, company loyalties and all sorts of other things that, holding pay constant, make them perform to their maximum. So Economic theory can’t explain everything and can’t predict as accurately as it may wish, but does offer a set of theories that are out there to be tested.

    By the way, I am not convinced that industrialists paid any attention to industrial economists and certainly if they did, there are a lot of other factors which damaged UK manufacturing and made it uncompetitive -poor management linked with equally poor industrial relations for a start. Also, the simple theory of the firm allows for different maximisation objectives, but starts with maximisation of profits because that seems a sensible objective for a firm to have, all other things being equal. But economic theory also takes care of monopoly, duopoly and oligopoly and proposes different solutions with different behaviours. Assumptions can be relaxed. The body of economic theory derived from neo-classical foundations is not the same as ‘free-market’ economics and does not justify the policy prescriptions deduced from its naive versions on offer from contemporary neo-conservative/liberal proponents.

    Enough!

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  9. You are right about what doesn’t make a lie, but silent about what does! It is clear from what they wrote that Jensen and Meckling knew exactly what they were about when they made that false connection. If it was only theory it wouldn’t matter a hoot, but as Keynes said “we are ruled by little else.” That particular falsehood lies at the heart of Friedman’s dictum: “corporate officials have no other social responsibility than to make as much money as possible for stockholders”. It has been taught in Universities and Business Schools to succeeding generations of business people, politicans and acadmics alike, and has done untold damage to Anglo-Saxon industry these last 30 years – Cadbury being the latest British casualty. Is it a lie? I wish someone would explain to me why it isn’t. Many thanks for your comment.

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  10. I prefer to think of Friedman’s statement as part of the rational choice ideological framework that abstracts from reality in order to model behaviour. I don’t agree with it and like you do not believe that corporate social responsibility ends with the value of the share and the shareholder’s dividend. However, these two variables are pretty good indicators of company success (though stockmarkets can get over-excited and over value shares from time to time. There is no contradiction in principle between maximising shareholder value and being a socially responsible corporate player with good management practices and employee relations. The latter might well help to achieve the former.

    As for what constitutes a lie, I agree with Les that it has to be something known to the authors to be untrue. If you are right and it is clear from what was written by Jensen and Meckling that they knew they were making a false connection, then why would anyone believe them, or maybe better, they understood that this was a hypothesis that might not always apply. Economists offer many different objective functions – maximising shareholder value is only one of them.

    One comment on agency theory. It is applied quite widely where there are relationships which are implicitly or explicitly contractual. Managers do not have an explicit contract with shop floor workers – both have a contract with the enterprise as an impersonal entity. But enforcement of the workers’ contracts lies with managers and enforcement of managers’ contracts with CEOs and enforcement of CEO’s contracts with the board of directors, which represents the company as a legal entity as well as the interests of the shareholders. It may represent those interests by considering the interests of all stakeholders but ultimately it is responsible for the company and has to keep all its stakeholders sweet. So one way of doing this would be to aim to maximise profits subject to keeping workers, suplliers and buyers happy with what they get. This is roughly the proposition of the economics of the firm. Aency theory simply formalises the question of how you get each link in the firm’s chain of employees, to fulfil that aim.

    In other words, economists are not as simplistic as you make out (well this one isn’t anyway).

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  11. The answer to why people accepted the Jensen & Meckling agency argument, even though it is clear they knew they were making a false connection, lies in your opening sentence. They “abstract from reality in order to model behaviour”, possibly as “part of the rational choice ideological framework.” Which is fine for building theory and achieving academic publication. But it has also fed back to shaping behaviour in the real world, where maximising shareholder value has, what the Institute of Driectors refers to as ‘primacy’: it dominates all other objectives.
    Re your comment on agency theory, I have only a couple of minor quibbles with whhat you say and I’ll leave those aside. In the normal course of events the misapplication of agency matters not a lot. But when a particular situation arises, like a hostile takeover bid, then all that you say goes out the window. At that time share performance has little to do with fundamentals, and everything to do with the bid situation and particularly expectations of tomorrow’s price. At that time directors are persuaded by the agency falsehood that they have to focus on maximising shareholder wealth ie on maximising the bid price, when they should be saying we’ll ‘fight, fight and fight again’ to preserve the company’s autonomy and long term prosperity. After all that’s their duty spelled out in companies act after companies act. The primacy of shareholder value, which is wholly based on the agency falsehood, has successfully overridden the law.
    Finally, I don’t think economists are simplistic. I think in the main they are more concerned with developing theory and perhaps insufficiently careful of the practical consequences when some of that theory gets successfully hi-jacked by a few of their number, with dire practical outcomes.

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