Friday, December 19, 2014

Hard and Soft

The backers of most ways of thinking think of their approach at its best. Whether you call yourself a Communist, Socialist, Capitalist, Scientist or you are Religious, I think we all aspire to the good life and I haven't ever met someone who is malicious in their belief.

Capitalism at its best is similar to Science at its best. It is not an answer. It is a recognition that we don't know and things are complex, so we follow a process that needs continual tweaking. This recognition that no one actually has the answer is what lead to a devolvement of central control that along with the Industrial Revolution has helped in making an incredible dent in poverty. Poverty remains not because there isn't enough to go around, but because of some of the negative side effects. In absolute terms it is hard to find groups of people who are worse off.

Capitalism at its worst is similar to Religion at its worst. Once you have found something that works, you can become more resistant to change and more entrenched. When your business model becomes about defending something that used to work, or slowing progress in order to eek out extra profit. The thing is this isn't Capitalism in the same way that Science isn't a defence of anything. If it turns out to be wrong it should be changed. Any reluctance to challenge the status quo can't be defended by anyone proclaiming to be a 'Capitalist' or a 'Scientist'. This is the same as Muslims who are abhorred by ISIS and argue for people to stop even referring to them as Islamists. Good Capitalism, Good Science and Good Religion evolve as our needs change, understanding improves and morality progresses.

Here are four interrelated problems that people who defend Capitalism will be very aware of. The point is the solution is still being figured out.

1. Incentives
The fingers pointed at 'Evil Bankers' presume that investors in banks are happy about the situation as well. Capitalism is good at figuring out through supply and demand what the price should be for products and so shifting around resources effectively. What is still being figured out is how to motivate and compensate people. Money can lead to quite dysfunctional behaviour as the single, objective, bottom-of-the-line measure of what you think of someone's performance and how they are rewarded. Since there is normally no internal 'market mechanism' for what someone gets paid, it ends up being a poker game with their boss. Pay them enough so they don't leave, but not enough that they get lazy. If you can get a sense of how much value they are adding, you still want to be paying them quite close to that is slightly above what would make them leave. This means money ends up being focused on far too much in remuneration discussions and in most jobs where value is even slightly subjective, it will likely be a source of unhappiness.

2. Risk
This is also linked to 'Evil Banker' accusations. The heart of what makes a good businessman is the ability to manage risk. Risk is at once an insanely complicated thing and ridiculously simple. The complicated bit is that we actually really don't know what is going to happen in the future. That is the point of creative destruction. Things work till they stop working, there is a little chaos, you lose some fat, and you move on. There may be lots of pseudo-science that goes into pretending we can manage risk, but actually it is really the Black Swans* that blow you out of the water. The problem with 'Evil Bankers' is connected to the incentives issues and risk management. As an investor, approaching banks is a nightmare. You know that the incentives end up being focused on short term gains while ignoring long term risks. Designing the correct incentive structure is an unsolved problem. A lot of investors don't touch banks because of their size and complexity and think it is a problem. Banks are really useful things and part of the destruction of mass poverty. That doesn't mean all internal problems are solve. The simple bit is that if you guard against putting your eggs in one basket, but keep focused enough investments that are in productive assets, you can have decent control over risks and sleep easy. You. Have. To. Keep. It. Simple.

Two ways at looking at risky Black Swans. Portman is hotter than Taleb obviously.
*A Black Swan is a very high impact, very low probability event

3. Waste
This is an example of both the incentive problem and the 'like religion at its worst problem'. Once a company is successful, clients are comfortable, and staff are comfortable, the incentive is to milk the cash cow for all it is worth rather than being on the edge and risking new competitors. There is a lot of work for works sake. Go to a hairdresser and he will tell you you need a haircut. Go to a plastic surgeon and she will tell you you need some wrinkles removed. Ask a website designer if your page needs a refresh and there is very little chance they will say, 'actually, everything is fine'. The answer isn't that central planning would reduce the waste. It is just that friction still exists. Companies like Uber, ZipCar and AirBnB are examples of how eventually, forces do exist to eat away at that fat.

4. Agency
This one drives me nuts. The agency problem comes about because you need to delegate. If you are going to guard against the risk of having your eggs in one basket, you have to hand some of your eggs to someone else. The person running the business and doing the work is different from the person whose resources are being used to do the work. It is good that you can separate your own resources from your own labour in order to manage risk and play to your skills. But this separation means you need to get the incentives right so that there is less waste and the risk is controlled. Your eyes can't be on all the eggs so you have to trust the person you have given the other eggs to. Their eyes are obviously primarily motivated by what they get paid or other things (power, prestige etc.) . Capitalism has allowed the globalisation of the world which has huge benefits in terms of things getting done by the people who are best at them. But it also means that there is distance between you and the people who are doing the things for you. Distance and trust are unhappy bedfellows. There is still nothing better than looking someone in the white of their eyes, knowing their name, and perhaps even knowing where they live (that sounds a bit creepy).

So those who argue for Capitalism are not saying it is perfect. There are lots of unsolved problems. What we actually need is for more of the people who 'hate money' to get involved and understand the challenges. The solution to many of the softer problems lies on the other side of the hard problems. We aren't going to get to them if we define ourselves as soft or hard. The external problem is also that we actually get very upset by relative wealth disparity even if we are richer, and it becomes tougher and tougher to accept absolute poverty in a world where there is already enough to go around.

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