Capitalism's Toxic Assumptions

Redefining Next Generation Economics

Eve Poole

• Publisher: Bloomsbury Information
• Year: 2015
• ISBN:
  9781472916808
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

In Science, no-one believes the earth is flat any more. Economists, on the other hand, haven't budged from their original worldview. Market Capitalism depends on seven big ideas: competition, the 'invisible hand', utility, agency theory, pricing, shareholder value, and limited liability. These served the world well in the past, but over the years they have become cancerous, and are slowly killing the system as a whole. Eve Poole argues that if you zoom in on any of these firm foundations, they start to blur and wobble. Here she offers alternative views for a healthier system. And looking at them together, it becomes clear why we're so stuck. The capitalist system masquerades as a machine programmed by experts, with only Economists and Governments qualified to tinker with it. But the market is just a mass of messages about supply and demand. The rich world shapes the market in its image, because it has more 'votes'. So if we want to change the way things are, we don't need to wait for the experts, we can start now. In each chapter, Poole shows how quiet action by consumers, investors, employees and employers can make big changes, by shifting behaviours and adjusting the way financial 'votes' are cast in the market.

Chapter 1

The assumption of competition

Perhaps one of the most familiar quotes from The Wealth of Nations is this one: ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.’ For hundreds of years, this spectre has been used to reinforce the central idea of competition in market economics, without which we fear that the system would descend through price-fixing into monopoly, and the customer would suffer. Indeed, this core pillar of capitalism is the most compelling argument that economists have against Communist-style centrally planned economies, because they replace competition with centrally agreed prices and result in a stagnating market.

The idea of competition is fundamental to the way we think. At school we are encouraged to try to beat the other children in tests and at sports, and there is an annual revolt in the tabloid press when schools are too ‘politically correct’ to award prizes at sports days. We are encouraged to view other schools as rivals, and at home our parents are as worried about ‘keeping up with the Joneses’ as we are about having the latest cool gadget of the day in the playground. Whether through sports or music or clubs and hobbies, we learn early how to compete and are rewarded for winning. While losing is ‘good for the character’ we also learn that it is the price to be paid for trying, and we resolve either to quit, or to win next time round. After leaving school, we compete with others to win a place at college and then get a job, where we learn about ‘competitors’ and become skilled at second-guessing their strategies in order to outwit them. Even in fields where traditional competition is not evident, we compete in league tables or for funding. And every weekend there is sport to watch, the central drama of which is the competition.

Competition is taken not only to benefit the customer by driving down prices, but also to drive improvement in goods, services, processes and performance over time, so it is upheld by a complex array of law and regulation, all designed to keep the market healthy. However, on closer examination, this assumption of absolute competition between similar firms is flawed on at least two counts. The first is to do with maths, and the second is to do with gender. These will be examined in turn, before looking at a better way of understanding when competition is useful and when it is counter-productive.

First, the maths, and specifically game theory. Game theory, a method of studying strategic decision-making, is a branch of mathematics that looks at situations where the success of one party’s choices depends on the choices made by another party. Mathematicians have reduced these situations of conflict and co-operation between rational decision-makers, which they call ‘games’, to their mathematical skeleton for the purposes of analysis and comparison, and their findings have been applied to politics, computing, psychology and biology, as well as to economics. An example of one famous type of ‘game’ is called the ‘prisoner’s dilemma’. This scenario involves two suspects being arrested and imprisoned by the police. Because the evidence is insufficient for a conviction, the authorities need at least one of the suspects to confess in order that both might be implicated. The prisoners are placed in separate cells, and the police visit each in turn to persuade them to confess. Obviously, if both prisoners remain silent, both will go free. If both confess, both will be sentenced. If only one confesses, they could negotiate a reduced sentence in return for their co-operation. Given that the prisoners have no way to communicate, they have to guess how the other will act, and respond accordingly. Simple scenarios like this one are used by game theorists to spot patterns and rules about how we interact with others, and can be used in a wide variety of settings. For example, the prisoner’s dilemma is the basic ‘game’ behind the arms race, in many trade and treaty negotiations, and in any situation where co-operating or defecting are the basic choices available. Such ‘games’ can be modelled as one-off interactions, or can be iterated over time to see how strategies change in the light of past behaviour and experience.

Applying game theory to economics is not new, and game theory is not as esoteric as it used to be, since the Oscar-winning film A Beautiful Mind popularized it by telling the story of the famously schizophrenic game theorist John Nash. But game theory offers a serious challenge to received wisdom about competition. According to this received wisdom, the working assumption is that companies operating in the same markets are in conflict with one another, in a battle for market share. This is encouraged by the regulatory framework, because of the damage collusion can do to the interests of the customer. However, in gaming terms, the solution to a game will not materially alter if the parties co-operate rather than compete, and defection is only a superior strategy when the interaction is a singular event and the players will never see each other again. This flatly contradicts the usual argument that competition automatically produces better outcomes. Indeed, there is a positive value attached to the fact of co-operating. This is because a period of co-operation essentially reduces risk by allowing the parties to test beforehand a wider set of bargaining options than they might have had the chance to use in the actual game, as well as to learn about their opponent’s gamesmanship, thereby increasing the amount of information available and enhancing the set of possible outcomes.

One of the scenes used in A Beautiful Mind serves to illustrate this concept. John Nash and a group of male friends are in a bar when a beautiful blonde enters, accompanied by a bevy of brunettes. Hollywood has Nash’s mathematical brain analyzing the available outcomes, thereby formulating his Nobel Prize-winning Nash Equilibrium Theory, the original ‘win–win’ strategy. In the film, Nash realizes that in order for all of his friends to end up with a girl, the best strategy is for all of the guys to choose a brunette. That way, everyone gets a girl. If not, those who fail with the blonde are likely to be rejected by the brunettes for having regarded them as second best, so there is a high degree of risk that no one gets a girl. By playing this ‘game’ co-operatively, all players win. This ‘strategic sub-optimization’ (no one gets the blonde) in mathematical terms increases the range of possible outcomes, shifting the focus from a win/lose arrangement about sharing the ‘pie’ to one that tries to identify a larger pie, so that all parties emerge better off.

This simple idea, that increasing the amount of information available generates better outcomes, is particularly intriguing in the context of the market, where it is often by taking advantage of imperfect information that one party gains over the other. This is encapsulated in the so-called Grossman–Stiglitz paradox, which holds that if a market were informationally efficient, such that all relevant information was reflected in market prices, then no single agent would have sufficient incentive to acquire the information on which prices were based. This would mean that there would be no point in seeking advantage through superior market knowledge, i.e. taking positions and trading securities, and any sort of market that traded on asymmetries of information would essentially cease to exist. This is perhaps a reductio ad absurdum, but information as a commodity in and of itself is becoming increasingly important, both to companies and to states. Eric Schmidt, former CEO of Google, once estimated that the total of all human knowledge created from the dawn of man until 2003 would total five exabytes (10¹⁸). A recent report by Cisco, however, suggests that by 2015, internet traffic will reach 966 exabytes, and the US National Security Agency is currently building a facility in Utah with the aim of storing a yottabyte (10²⁴) of global information, the equivalent of one million exabytes, or 500 quintillion pages of text. Such projects, and the increasing processing power of computers, brings a business strategy based on maximizing information within reach, particularly given the mathematical arguments in its favour. Incidentally, this would also remove one of the arguments against state control of assets, whereby central planning is seen to be less efficient than market pricing because of the information this generates about supply and demand.

There have been numerous books seeking to introduce thinking about co-operation and information-sharing into the mainstream. In 1984 the political scientist Robert Axelrod produced The Evolution of Co-operation, building on an earlier paper he had written at the University of Michigan with the evolutionary biologist William Hamilton. This book described a competition established by Axelrod to evaluate alternative strategies for playing the prisoner’s dilemma ‘game’, expressed as 62 different computer programmes, to enable a grand tournament that could be iterated over time. The most successful strategy was also the simplest. The winning strategy, TIT FOR TAT, co-operated on the first move and mirrored the other player’s moves thereafter. Axelrod developed this tournament into a mathematical model to show how co-operation based upon reciprocity emerges even in a population of egoists. His model showed that with only a small cluster of reciprocators, such a population can resist ‘invasion’ by mutant strategies. Further, the only time when defection is a superior strategy is when the interaction is a one-off and the players will never meet in future. His collaboration with William Hamilton to investigate precedents for this behaviour in evolutionary biology resulted in an article in Science in 1981, which won them the American Association for the Advancement of Science’s Newcomb Cleveland Prize.

Axelrod’s work led him to suggest four properties for successful strategic behaviour. First, players should avoid unnecessary conflict by co-operating for as long as their opponent does. Second, players should retaliate in the face of an uncalled-for defection by their opponent. Third, players should ‘forgive’ their opponent after responding to a defection. Fourth, the player should display clarity in their behaviour, so that their opponent can learn and respond to the strategy deployed. Because it is the prospect of meeting again that encourages the instinct to co-operate, Axelrod also suggests that clever strategists ‘enlarge the shadow of the future’. In society this has traditionally been achieved by making transactions public through ceremonies, speeches or contracts. Other gambits involve the use of deals or tie-ins so that the person has an incentive to trade with you again in the future, or the breaking down of interactions into smaller transactions so that the parties can build familiarity, confidence and trust over time.

Axelrod has a caveat. Apart from a tendency for people to behave less altruistically if there appears to be no prospect of repeat business, in a zero-sum game (one where, by definition, one party wins at the expense of the other losing) it is in fact useful to keep the other player guessing, and therefore to be more covert than Axelrod would otherwise suggest. This is because the doubt such a move introduces renders your opponent less efficient, which can only be to your benefit. But Axelrod would argue that genuinely one-off zero-sum games are comparatively rare, particularly as far as reputations are concerned, and making the wrong diagnosis means that the outcome of any future meeting is jeopardized by bad behaviour at the outset. This is why your mother told you never to be rude to strangers, in case they turn up on a future interview panel. When this thinking is applied to markets, there are so few genuinely one-off transactions or relationships that assuming the kind of zero-sum model that underlies a need for absolute competition is simply an inaccurate rendering of the situation.

In 1996, Barry Nalebuff and Adam Brandenburger, at that time at Yale and Harvard respectively, wrote a book called Co-opetition. It extended this logic of strategic co-operation into business, which generally obliges parties to interact over time. Their title was designed to capture the dynamic interplay between co-operating (to create or expand the pie) and competing (to divide it up). Their aim was to assist businesses in applying game theory to corporate strategy, drawing particular attention to the role of ‘complementors’, or those parties who may also be competitors, suppliers or customers, but whose products and services enhance the value of your own when both are acquired together. This particular sort of collaboration is already enshrined in many joint ventures and partnership agreements, but game theory would argue for its extension into the adoption of a co-operative mode more generally, because the more information that is available, the better the set of available outcomes. To the traditional executive, this sounds very dangerous, and immediately conjures up images of Smith’s warning about price-fixing meetings in dark rooms filled with cigar-smoke, a serious and potentially devastating claim to which we shall return.

But before we return to the danger of price-fixing, why, when the maths is widely accepted and has been popularized through a number of well-received books, is co-operation not a more central part of the DNA of business? The reason for this is my second objection to an unquestioning acceptance of competition as the only game in town, and is based on gender. The sociological observation that men are keen on sport has spawned endless caricatures. While this is endearing, it has a dark side. The police report a sharp increase in domestic violence when favourite teams lose key games. This phenomenon has everything to do with the reason that competition is still the default in market economics. Markets are invariably run by men, and men are biologically conditioned to respond to perceived threats by competing to win. While this was biologically necessary when we were prehistoric, it is only sometimes necessary in the modern world, and less necessary in the modern business context than could be assumed from its ubiquity as an axiom.

The biology is simple and widely understood. In dangerous situations, the body responds in ‘fight-or-flight’ mode, producing adrenaline to boost performance. Among other things, adrenaline raises the heart rate to increase blood flow, dilating the blood vessels and air passages to increase the likelihood of survival either through physically combatting the threat or fleeing from it. While this has often been explained as a binary choice, the body in fact defaults to ‘fight’ and resorts to ‘flight’ only if the person involved does not feel adequately resourced to prevail. Indeed, this is why the primary stress reaction is so alluring, because the ‘fight’ mode is characterized by a temporary enhancement of both physical and neuro-biological functioning to give us the best possible chance of surviving. It is only when it becomes apparent that all is lost that the body prepares for flight, and brain functioning reduces to focus on physical exit. Many performers both in sports and the arts rely on this enhancement, and the low brought on by the adrenal hangover is notorious. This idea that a certain amount of stress enhances performance has given rise to the terminology ‘eustress’ or good stress, as opposed to ‘distress’ or bad stress. This state also gets called the ‘stretch zone’, and current theory suggests that it can be extended by increasing the range of situations in which a person feels either physically or psychologically resourced to prevail. The downside of being in an aroused state is that the body thinks it is straining to survive, and under pressure we may perceive threats to survival that actually do not exist. As the body moves into flight mode, cognitive functioning shuts down, and we overestimate our abilities to overcome a threat just when our ability to make this judgement becomes seriously impaired.

What is less well understood is that this response is not a universal one. It is a male one. Before 1995, only 17 per cent of test subjects in this field were women, and the ‘fight-or-flight’ theory was originally based on studies on male rats. When these studies were carried out on humans, results from female subjects were discounted because variations in hormone levels caused by female reproductive cycles meant that their data was often confusing or difficult to interpret. But Shelley E. Taylor and her colleagues at the University of California became curious about why the data from females didn’t fit, and wondered if it was the theory that was at fault, rather than the test subjects. When the tests were rerun, it became apparent that the ‘fight-or-flight’ theory was predicated on the existence of testosterone. When women were involved, the stress response triggered the release of oxytocin instead, the ‘love hormone’ associated with peer bonding, affiliation and motherhood. Their paper, published in the Psychological Review in 2000, contrasted the male ‘fight-or-flight’ response with the female response which they dubbed ‘tend-and-befriend’.

Maybe in a male-dominated world it is not surprising that the paper has received scant attention (except in the women’s magazine Marie Claire), and that funding to pursue these experiments has been slow to materialize. Its findings suggest that men are conditioned to react to stressful situations by reading them as zero-sum games and meeting them head-on as a matter of life and death. This is usually explained as a difference in role from our cave-dwelling days, when the men were responsible for hunting and defence and the women for tending the fires and the children. In these conditions, ‘fight-or-flight’ would give cavemen an evolutionary edge. Similarly, a stress response in women that was more about ‘tend-and-befriend’ would enhance their ability to carry out their role under pressure. A protective response towards offspring, and the seeking out of social contact for mutual support and protection, would help to keep the fires and the children safe while the men scared off the sabre-toothed tigers. Today, this response is pilloried in adverts about women gossiping on the phone, which only shows how intuitively we have understood this difference all along, even if we have not always understood its social function.

Of course, we are not prisoners of our biology, and many women who have spent their careers working alongside stressed men may find that over time they have developed a Pavlovian ‘fight-or-flight’ response, and can no longer remember experiencing ‘tend-and-befriend’ instead. But it is interesting to wonder whether, given free rein, a ‘tend-and-befriend’ response in the boardroom would not be more useful than a ‘fight-or-flight’ one, given theories about the usefulness of co-operation. As an example, the particular trigger for the recent credit crunch was banks refusing to lend to each other. We have since learned that this was made all the more complex because the banks were manipulating the LIBOR inter-bank lending rate anyway. The resulting impasse locked the system, triggering the liquidity crisis that toppled so many institutions. Given statistics on gender balance in the boardroom, most of the senior people involved in the situation were men, likely trying to make good decisions in enormously pressured conditions. And it is highly probable that the long working hours they were putting in over that period, and the effect this had on the quality of their sleep, let alone the impact of the crisis on diet and exercise, would have primed their body chemistry for ‘fight-or-flight’ no matter how rational they thought they were being about it. It would have involved quite staggering amounts of self-control to override such strong biological instincts to protect their own bank at all costs, in what must have seemed a very extreme zero-sum game environment, particularly when formal economic theory about competition would provide them with a rational defence for self-interested action. Perhaps a group of women would have acted in the same way. But suppose ‘tend-and-befriend’ had kicked in instead. The instinct to pick up the phone to discuss it with the others might just have offered the banking community an opportunity to share information and to work together to keep the system functioning, given that a collapse in confidence in banking affects the system as a whole.

This hypothesis would be supported by the work of Cambridge’s John Coates, himself an ex-trader, whose research shows the magnifying effects of testosterone and cortisol on male trader behaviour, and that, under stress, the weighting of probabilities becomes more distorted among men relative to women. This argues for the involvement of more women, as well as older people whose testosterone levels have diminished, in order to smooth the risk profile of trading, particularly under stress. More generally, the 2011 Davies Report on women on boards included the finding that companies with more women on their boards significantly outperform their rivals, with a 42 per cent higher return in sales, 66 per cent higher return on invested capital and 53 per cent higher return on equity. The 2010 data from McKinsey on top-quartile companies also shows that the return on investment (ROI) of those with the highest proportion of females on their executive committees exceeds by 41 per cent the ROI of those with wholly male executive committees. Similarly, the operating results of those with mixed-gender boards exceed their male counterparts by 56 per cent. Additionally, the economist Mikko Manner has shown that having a female chief executive is positively correlated with superior corporate social performance, and a recent study for a UK asset management firm, reported in New Model Adviser in 2011, found that FTSE-listed companies with at least 20 per cent female representation at board-level achieved significantly higher operational and share price performance, both in the short and the medium term, than those with lower percentages of fema...

Table of contents

• Cover
• Dedication
• Title Page
• Contents
• Acknowledgements
• Foreword
• Introduction
• 1 The assumption of competition
• 2 The assumption of the ‘invisible hand’
• 3 The assumption of utility
• 4 The assumption of agency theory
• 5 The assumption that market pricing is just
• 6 The assumption of the supremacy of the shareholder
• 7 The assumption of the legitimacy of the limited liability model
• Conclusion
• References and further reading
• Index
• Copyright