Capitalism at crossroads

Capitalism’s Toxic Assumptions, which says the seven tenets on which the economic system stands are faulty, adds a fresh dimension to economic thinking

AFTER THE financial crisis, there has been a tendency to highlight capitalist greed. A part of the critique has to do with the unethical nature of the system, which helps the rich get richer at the expense of society. But have we ever stopped to consider whether the capitalist system per se is faulty or whether the way it has evolved has made it less than perfect?

This is important because it’s largely believed that the market mechanism is the most efficient one and does not show partiality. This is where Eve Poole brings in her contribution by questioning the basic assumptions of capitalism in her book Capitalism’s Toxic Assumptions. We have all learnt that there are some fundamental principles of capitalism based on assumptions such as the ubiquitous invisible hand, market pricing, self-interest and so on. And in economics, as long as we have assumptions, the logical fallouts cannot be questioned. This, as per the author, is where we are completely wrong.

Poole argues that there are seven tenets on the foundations of which capitalism stands. However, these assumptions actually do not hold and are flawed. The first idea is competition. We are taught that in this system there is perfect competition. Here, Poole puts forward two arguments. One is from the point of view of math, where the assumption of large number of sellers and buyers competing independently to produce an optimal solution never exists. Game theory dominates the way business is conducted in real life and strategic behaviour moves on the basis of cooperation rather than competition. If we view the airlines loyalty scheme, the OPEC cartel, clearing houses and systems in markets, etc, the approach is one of collaboration.

The other argument put forward here is, interestingly, a biological observation, which involves greater participation of women in the system, which, in turn, guides the way business is done. Men typically respond through the ‘fight or flight mode’, which is competitive, but women follow the policy to ‘tend and befriend’, which is a collaborative approach. The greater participation of women has changed or modified the overall approach to compete. Poole’s corollary argument is that if this female mode of response had pervaded boardrooms during the financial crisis, it would have been resolved faster. This line of thought definitely sounds novel and is worth pursuing.

The second assumption relates to the existence of an invisible hand. This presumption, as per the author, though convenient for everyone, does not exist in the manner in which it was conceived by Adam Smith. The dominant players justify their unequal power by saying it’s the result of the invisible hand, even though they manipulate the markets to stay on top. The government accepts the invisible hand theory, so that it does not have to do much. The actual working of the market shows that it is never fair, is heavily loaded towards the rich and never delivers the theoretical benevolent outcomes. An example given is how the ‘invisible hand’ is loaded against developing countries—they have to open their markets to the West, but the western markets remain closed, with huge farm subsidies given to domestic markets to eschew free movement of goods.

The third assumption relates to utility or the premise that we work on the basis of self-interest. In practical life, however, we are not rational and don’t choose an optimal solution. Further, as we cannot read the future, we end up making the wrong choices, which models cannot capture. So the assumption that we are rational is an exception rather than a rule. The fact that we can be wooed by advertising to purchase goods defies rational behaviour. Another rudimentary example of how we end up not behaving rationally relates to how doctors are influenced by pharma companies when prescribing medication.

The fourth assumption of capitalism of the Smithsonian variety talks of the agency problem, where the management has to align itself with the interest of shareholders to take care of the principal-agent relationship. While we have a board of directors to guard the shareholders, they have no real interest. Does the board really guard the interest of the owners is a question that’s being asked today. The McGregor theory of motivation has been used by the author to explain why it’s necessary to turn Theory X workers (who have to be coerced to work and need supervision) into Theory Y workers (who are self-driven and address the issue of principal-agent). Giving stock options helps to align the management with owners, but drives a wedge with those in the lower-income echelons.

Next, capitalism assumes that market pricing is just. Do demand and supply always match? And second, is price always based on cost plus margin? Dan Ariely had shown that demand is driven by supply—as his experiment with shampoo showed that the ‘shampoo-rinse-and-repeat’ formula actually doubled demand—which then justifies a higher price. Further, the fact that the cost of tea varies in various locations such as cafes, hotels, etc, explains why the pricing is not perfect. Again, for goods where money is the basis of valuation, prices are no longer linked to costs. Here, examples of designer labels are given, where externalities, which are the order of the day, hold. Therefore, this assumption of price being determined by an invisible hand through market forces of demand and supply rarely holds.

The sixth assumption is the supremacy of the shareholder. This is whimsical and never really holds in practice, though all statements refer to working for the shareholder. This assumption has ended up fuelling an exponential rise in boardroom pay and encouraged a narrow view of corporate performance. These shareholders are actually elusive and cannot be identified. And often, all appeals made are actually for the well-being of the management. This has led to short-termism and a narrow definition of responsibilities.

Last, the assumption of the legitimacy of the limited liability model has been questioned by Poole. This makes shareholders bother more about gains than losses because their risk is limited. This makes them encourage aggressive risk strategies supported by incentive packages to maximise their returns. This means that both shareholders and senior management are aligned with share price maximisation with all accompanying dangers of the ‘get-rich’ strategy.

Poole is definitely not against capitalism, but only goes about proving that the classic system, as envisaged by Smith, does not exist. It has deteriorated to one, where the management works around the system, while the demand-supply mechanics are distorted, thus bringing about sub-optimal solutions—the breeding grounds for crises. This balanced view from another side certainly adds a fresh dimension to economic thinking on capitalism.

Capitalism’s Toxic Assumptions: Redefining Next Generation Economics  
Eve Poole
Pp 187
Rs 499

Madan Sabnavis is chief economist, CARE Ratings

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First published on: 20-09-2015 at 00:11 IST