-- John Maggs, NationalJournal.com

There is no crisis of capitalism when investors refuse to invest in assets that they cannot value, or at least resell. There is no crisis of capitalism when governments pour money into mortgage finance, but don’t care about the quality of the loans they are stimulating. And there is no crisis of capitalism when governments attempt to control private decisions about value and compensation, but find that human beings won’t work on those terms. Capitalism takes its licking and soldiers on; government, like everyone else, is simply trying to live off its fruits.

But there will be a crisis of capitalism if the lessons we draw from this crisis are that there is something better--perhaps a world in which really smart people decide what the factories will produce, what books can be published, what products are worth our money, and how financial institutions will be allowed to behave. Then we’ll have a true crisis of capitalism, when everything that has been created thus far by the hand of man will be run until it breaks down, when imagination cannot get the financial support to turn itself into reality, and when the purpose of life is not to create or improve, but to make it to the end in the easiest possible way.

Cassandra was always right. But nobody ever believed her, and  this is the position of the dissident in academic economics today.  Will anything be done about it? The question poses an interesting test  –  not only for academic economics, but in some ways, also, for the future of capitalism itself.
 

JG

*(For example, click here: http://www.networkideas.org/featart/oct2008/Galbraith.pdf)

For practical reasons, day-to-day control over publicly traded corporations is placed in the hands of company managers rather than the shareholders who own the company. Managers have wide latitude on how to organize production, allocate investment funds, and select and market the products the company sells. Writing in late 18th century, Adam Smith pointed out the weakness of this arrangement: “… being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery [partnership] frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” A crucial problem is that the interests of the company’s managers are not the same as those of people who own the firm.

A solution to this problem is for owners to establish a compensation schedule that aligns managers’ interests with those of shareholders. Whether this is possible remains an open question, though recent experience should give one pause. Defenders of American capitalism claim that the generous stock options, bonus pay arrangements, and rich deferred compensation schemes that have been become common in recent decades achieve their intended goal: Managers’ incentives are closely aligned with shareholders’.

As a labor economist, I am skeptical of this claim. The compensation arrangements that helped pave the way to the current crisis offer plenty of evidence to justify my skepticism. The senior company managers of Bear Stearns, AIG, and Lehman Brothers did not perform their jobs in a way that would suggest they had exclusive concern for the long-term interests of company shareholders. This is true even though most of the managers were shareholders in their companies. Their compensation schedules gave them rich rewards for short-term financial results but failed to impose heavy penalties for the long-term harm their actions might inflict on shareholders -- and on the wider economy.

The current controversy over the bonus pay of AIG managers highlights one aspect of the problem. Some of these managers contributed importantly to one of the most spectacular business failures in history. Without the credit extended by the U.S. government, their employer would already be bankrupt. Even with a huge infusion of federal credit, the shares of long-term investors in AIG are worth a tiny fraction of their value two or three years ago. It is hard to see how a sensibly written compensation schedule would give failing managers rich bonus payments after it is plain their decisions contributed to the destruction of their company.

The more general problem is that senior managers have huge power to determine the terms of their own compensation agreement, including the payoff schedule that links their compensation to the success or failure of the business. Often the compensation agreement contains crucial provisions that do not seem intended to link the interests of the manager to those of shareholders. For example, stock options become more valuable to a manager when there is a general rise in stock prices, even if the stock price of the manager’s firm has lagged the price increase of other companies in the same industry. The manager’s performance may have been sub-par, but the general rise in the stock market nonetheless provides him rich rewards.

An unresolved issue of corporate capitalism is how company shareholders can negotiate compensation terms with senior managers so that the interests of the managers are the same as those of shareholders. Analysts such as Lucan Bebchuk have documented how senior managers often negotiate with themselves over the terms of their compensation. The interests of shareholders are only weakly represented in these negotiations. Unfortunately, a badly designed compensation agreement can provide rich payouts to managers who not only fail advance shareholders’ interests but actually harm the long-term prospects of the firm.

Financial crises occur for many reasons. Investors can become over-optimistic and bid up the prices of assets above the level that is sustainable based on economic fundamentals. As asset prices decline to a sustainable level, investors who purchased inflated assets with borrowed funds face ruin. In the current crisis, many of the decisions about asset purchases and extensions of credit were made by senior managers who had financial interests that differed substantially from the long-term interests of the shareholders for whom they supposedly worked. As experience shows, this misalignment of incentives can contribute to terrible decision-making and economy-wide ruin.

This belief is not just some random notion that happens to be in vogue. Rather, it lies at the heart of today’s prevailing economic doctrine: neo-classical economics.   Indeed, since the late 1970s neo-classical economics, with its belief in the primacy of markets and the inherent limitations of government, has been the dominant economic doctrine shaping most of Washington’s thinking and action on the economy. Whether it’s the conservative version (supply-side economics) or the liberal version (sometimes called “Rubinomics”), the neo-classical doctrine has become so prevalent that for many it has become synonymous with scientific truth. Whether it’s the conservative neo-classicalists who hang their hat at places like the American Enterprise Institute, the Heritage Foundation, or the Cato Institute, or the liberal neo-classicalists who find their homes at places like the Brookings Institution, the Peterson Institute, or the Council of Foreign Relations, neo-classicalists not only shape but also enforce the Washington consensus on economic policy. 

Four key principles of neo-classical economics have been called into question by the activities of the last year: 1) it is the accumulation of capital, not innovation, which drives growth (capital was certainly not in short supply); 2) growth is achieved by ensuring that goods and services are allocated most efficiently according to natural market price signals (price signals led capital to pour into unproductive investments in housing and financial instruments); 3) markets tend toward equilibrium (a market that falls dramatically in a very short period is not in equilibrium); and 4) individuals and firms are rational maximizers who respond to incentives (if anything this experience has shown us that individuals operating in markets can be anything but rational).  When this is the doctrine shaping policymakers’ thinking, and enforced by a cadre of neo-classical economists ever ready to attack any apostates with a well placed sharply worded op-ed taking the uninitiated to the proverbial economic woodshed, government is less likely to intervene in markets to ensure they achieve public goals, and they did not do their job.

So it’s not that capitalism is needs reexamining, its economics that does.  The current crisis is, or least should be, beginning to shake the neo-classical foundations. But without a compelling alternative, policy makers will be left with no place to turn for guidance. Fortunately as David Warsh illustrates in Knowledge and the Wealth of Nations to do so, within the last 15 years a new theory and narrative of economic growth based on an explicit effort to understand and model how technological advance occurs has emerged. This new doctrine of “innovation economics” reformulates the traditional model of economic growth so that knowledge, technology, entrepreneurship, and innovation are positioned at the center of the model rather than seen as independent forces that are largely unaffected by policy. Innovation economics is based on two fundamental tenets. 

First, the major goal of economic policy should be to spur higher productivity and greater innovation. Innovation economists believe that what drives growth is not capital accumulation, as neo-classicalists claim, but innovation. Second, markets relying on price signals alone will always be less effective than smart public-private partnerships in spurring higher productivity and greater innovation. Innovation economists recognize that innovation and productivity growth take place in the context of institutions. Indeed, it is the “social technologies” of institutions, culture, norms, laws, and networks that are so central to growth (and as we have learned yet again, central to stability), yet are so difficult for conventional economics to model or study. Innovation economists view innovation as an evolutionary process where organizations act on imperfect information and where what economists call “market failures” are in fact actually the norm. 

Washington policymakers need to understand the limi­tations of today’s prevailing economics doctrines and appreciate the potential offered by the emerging doc­trine of innovation economics. In addition, they need to embrace an innovation economics agenda that places spurring organizational innovation and productiv­ity at the center of U.S. economic policy. For unless the current playbook of economics doctrines changes, the plays available to policymakers will remain the same. Given the new challenges facing the U.S. economy, we need both new plays and a new playbook.