A lot of people think the chief executives of big companies – say, one of the four big banks – would be highly qualified to tell them how high interest rates should go and what higher rates will do to the economy over the next year or two.
Don’t believe it. What a big boss could tell you with authority is how to run a big company – their own, in particular. Except they wouldn’t be sharing their trade secrets.
Treasurer Jim Chalmers.Credit: Alex Ellinghausen
No, in my experience, when bosses step away from their day job to give Treasurer Jim Chalmers free advice, their primary objective is to tell him how to run the economy in ways that better suit the interests of their business (and so help increase their annual bonus).
But when it comes to keeping our banks highly profitable, our treasurers and central bankers are doing an excellent job already.
Of course, it’s just as true the other way around: don’t ask an economist to tell you how to run a business. It’s not something they know much about.
Running big businesses and running economies may seem closely related, but it’s not. They’re very different skills.
One of the ways the rich economies have got rich over the past 200 years is by what the father of economics, Adam Smith, called “the division of labour” – dividing all the work into ever-more specialised occupations. By now, managing businesses and managing economies are a world apart.
But as Free Exchange, the economics column in my favourite magazine, The Economist, explains in its latest issue, there’s more to it than that.
Conventional economic theory sees the economy as composed of a large collection of markets. Producers use resources – labour, physical capital, and land and raw materials – to produce goods and services, which they sell to consumers in markets.
Producers supply goods and services; consumers demand goods and services. How do producers know what to supply and consumers what to demand? They’re guided by the ever-changing prices being demanded and paid in the market.
So economists see economics as being all about markets using the “price mechanism” to ensure the available resources are “allocated” to the particular combination of goods and services that yields consumers the most satisfaction of their needs and wants.
It wasn’t until 1937 that a British-American economist, Ronald Coase, pointed to the glaring omission in this happy description of how economies work: much of the allocation of resources happens not in markets but inside firms, many of them huge firms, with multiple divisions and thousands of employees.
Inside these firms, the decisions are made by employees, and what they do is determined not by price signals, but by what the hierarchy of bosses tells them to do. A key decision when something new is wanted is whether to buy it in from the market, or make it yourself.
The Economist says another gap between economic theory and the world of business is the economists’ assumption that firms are profit-maximising. Well, they would be if they could be.
Trouble is, contrary to standard theory, they simply don’t have the information to know how much they could get away with. Gathering a lot more information would be expensive and, even then, they couldn’t get all they need.
Businesses are owned by their shareholders, with everyone employed in the business – from the chief executive down – acting merely as agents for the owners.Credit: James Brickwood
As the American Herbert Simon – not really an economist, which didn’t stop him winning a Nobel Prize – realised, businesses live in a world of “bounded rationality” – they make the best decision they can with the information available, seeking profits that are satisfactory rather than ideal. They are “satisficers” rather than maximisers.
It took decades before other economists took up Coase’s challenge to think more about how companies actually go about turning economic resources into goods and services.
The Economist says a key idea is that the firm is “a co-ordinator of team production, where each team member’s contribution cannot be separated from the others.
One of the ways the rich economies have got rich over the past 200 years is by what the father of economics, Adam Smith, called “the division of labour” – dividing all the work into ever-more specialised occupations.
“Team output requires a hierarchy to delegate tasks, monitor effort and to reward people accordingly.”
But this requires a different arrangement. In market transactions, you buy what you need and that’s pretty much the end of it. But, because a business can’t think of all the things that could possibly go wrong, a firm’s contracts with its employees are unavoidably “incomplete”.
Without these legal protections, what keeps the business going is trust between employer and employee, and the risk to both sides if things fall apart.
Another problem that arises within companies is ensuring employees act in the best interests of the firm, and are team players, rather than acting in their own interests. Economists call this the principal-agent problem.
In law, and in economic theory, businesses are owned by their shareholders, with everyone employed in the business – from the chief executive down – acting merely as agents for the owners. Who, of course, aren’t present to ensure everyone acts in the owners’ interests, not their own.
Economists came up with the idea of ensuring the executives’ interests aligned with the owners’ interests by paying them with bonuses and share options.
Trouble is, these crude monetary incentives too often encouraged executives to find ways to game the system. Ramp the company’s shares just before you sell your options and let the future look after itself.
Elsewhere, linking teachers pay to exam results encourages too many of them to “teach to the test”.
More recently, economists have decided it’s better to pay a fixed salary and avoid tying rewards to any particular task – which could be achieved by neglecting other tasks.
But whatever economists learn about how to manage businesses, it’s hard to see them supplanting management experts any time soon.
As The Economist observes, when a business hires a chief economist, it’s usually for their understanding of the macroeconomy or the ways of the central bank, not for advice on corporate strategy.
Ross Gittins is the economics editor.
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