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Capitalism and Its Divided Critics

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
September 2, 2010
Financial Times

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Capitalism has spawned two great organising mechanisms: markets and firms. The ideas behind these mechanisms are opposed to one another. Markets involve arms-length transactions among disparate actors; the company promotes linked-arm collaboration among teams. But, somewhat curiously, these contradictory approaches are under attack simultaneously. If the assailants would only pause to note this irony, they might perhaps calm down.

The assault on markets has been especially loud, thanks to the financial bust. Now that complex securitisation appears to have been discredited, it is harder to have faith in arms-length transactions as a way of allocating capital. Collateralised debt obligations, credit default swaps and the whole paraphernalia of tradable financial promises have been called into question. Some critics appear to believe that, if only markets in derivatives had been regulated, the world would have been spared the bust.

But if markets are out of fashion, the alternative organising mechanism--the company--is equally under fire. Leaf through the management journals and you will soon learn that imprisoning capital and talent inside large organisations is an outdated way of doing things, forcing otherwise creative people into a bureaucratic arm-lock. Critics of the company complain that, time and again, incumbent corporations are caught flat-footed by the rapid technological shifts of modern life. Managers fail to anticipate Facebook and Twitter; they back cinemas in the age of the downloadable home movie. For all their fancy MBAs and spreadsheets, company bosses don't always allocate resources where the pay-off will be highest.

Each school of criticism advances solutions that the other ridicules, though neither side appears to notice this fact. Financial commentators who are sceptical of markets tend to wish that risk could be absorbed instead by companies--precisely the entities that management commentators despise. In place of securitised credit, the critics want loans to be originated by financial companies and retained on their books, on the theory that the risk-management department of a bank or auto-finance outfit will assess risk better than market traders. Similarly, the critics want banks to hold loans at face value until wise teams of managers judge that it is time to write them down. They shudder at the alternative of marking loans to their market price.

Meanwhile sceptics of the company advance the opposite critique. Unimpressed by bureaucratic managers, they wish that capital could be allocated in a more market-driven fashion. In place of company investment committees that parcel out resources clumsily within a lumbering behemoth, why not unbundle the company, free its creative people, and let competing venture capitalists decide whom to back? The economist Ronald Coase answered this question in 1937, observing that by pooling ideas, capital and workers, the company reduces the transaction costs of bringing all three together. But the critics of the company retort that modern communications have reduced transaction costs to a fraction of their former level, rendering Coase's rationalisation of the company anachronistic. A much-hyped book called Wikinomics even suggests mass collaboration can be an alternative to the firm. "This may be the birth of a new era, perhaps even a golden one, on par with the Italian Renaissance, or the rise of Athenian democracy," the author immodestly proclaims.

The point is not that markets or the company are above criticism. The shortcomings of both are widely recognised, not least by the thoughtful people who work in them. The most dripping contempt for efficient market theory tends to come from market practitioners: George Soros, the celebrated hedge-fund speculator, is a leading critic of speculation; and professional investors would not get up in the morning if they believed that markets were too perfect to second guess. Likewise, the most scathing attacks on the bureaucratic corporation come from corporate bosses. Jack Welch mercilessly fired legions of GE salarymen. Lou Gerstner shook IBM like a toy tambourine, then entitled his self-congratulatory memoir, Who Says Elephants Can't Dance?.

Rather, the point is that critics of markets and critics of the company should pay more attention to each other. Financial commentators should not denounce securitisation without acknowledging the point that is obvious to management commentators: bureaucratic risk controls are also flawed. Management commentators should not write off the company without acknowledging the point that is obvious to financial commentators: the alternative of arms-length, market-based co-ordination is fraught with asymmetries of information, herding by not-quite-rational investors, and fraud.

Moderate criticisms of markets and the company are entirely justified. The "CDO squared" really did push financial innovation beyond the point of absurdity; and corporate reformers are right to challenge deadening bureaucracy with websites that harvest customer suggestions and "internal markets" for allocating company resources. But when markets and the company are attacked simultaneously and sweepingly, reasonable people should remember: both assaults cannot be right.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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