When Feedback Fails 2: The Economic System

A country that displays an almost ruthless commitment to efficiency and performance in every aspect of its economy, a country that switched to Japanese cars the moment they were more reliable, and to Chinese T-shirts the moment they were five cents cheaper, has loyally stuck with a health-care system that leaves its citizenry pulling out their teeth with pliers.

– Malcolm Gladwell ¹⁾Malcolm Gladwell, “The Moral-Hazard Myth,” The New Yorker (2005), accessed October 25, 2013.

In When Feedback Fails (1), Nevinomics addressed four reasons why feedback fails at an individual level and some suggestions for how to address this (although not nearly at the systemic level required for such an important issue. As Nevinomics develops, I hope we can build a robust and systematic set of policy requirements).

As critical as individual failures of the feedback mechanism are, however, Nevinomics believes there is a much deeper failure at the level of Complex Economic Ecosystems,²⁾CEE is defined in Article 1-3, “Create Vs. Capture…”, Note 1: Create vs. Capture one that cannot be solved with individual upskilling and better self-awareness. At the Complex Economic Ecosystem (CEE) level, even when individual actors respond in a sensible and rational way to feedback, the CEE’s performance can be poor and will often deteriorate. In other words, responding appropriately to feedback is not the self-correcting mechanism that leads to the better outcomes at the CEE level that it can be at the individual level. Nevinomics conjectures, in fact, that feedback fails in fundamental ways more often than not and that feedback failure is a pervasive feature of complex, modern economies and societies, just as it is for individuals with limited perspectives and information.

To take one example, the modern payment ecosystem is a wonder in complexity. Large and massive creatures (the global clearing banks), co-exist with small niche players (who supplies the chips for chip and pin cards?), alternative payment systems (the Western Unions of the world), non-profit consortiums (SWIFT, for interbank payments), card providers (Mastercard, Visa, American Express), upstarts (Paypal), and mobile money operators (such as the fabulously successful M-pesa in Kenya). It is cacophony of species, business models, and technologies.

In this CEE, only those who can carve out and defend their space survive and prosper, and competition is ferocious.

Every actor in this CEE is continuously gathering and reacting to feedback, trying to determine what are the implications of other actors’ moves, of improvements in technologies, and demands by the end-customer. Incredible efforts are expended to interpret what the environment is telling the actor (which is, of course, why the strategic consulting profession exists). But does all this competition and innovation result in lower costs and faster, more secure payments? Economic orthodoxy would tell you it should – Smith’s invisible hand plays it role.

In the case of the payments system, the answer is that the US has the highest charges of any advanced economy.³⁾Fumiko Hayashi, “Payment Card Interchange Fees and Merchant Service Charges – An International Comparison,” Payments.com, accessed October 27, 2013. Interchange Fees and Service Charges This is a disquieting result and there are all sorts of industry rationalizations of it. But at the end of the day, the US has the world’s largest economy, with massive economies of scale and ferocious competition, all factors that should lead it to having the lowest cost and most efficient system.

This research – and my own experience with the payments industry – suggests that the payments ecosystem is certainly sub-optimal – too expensive, with too many competing technologies. The feedback mechanism is not applying the right pressure to improve system performance over time.

If we give a little thought here – doing some systems thinking as Principle 3 of Nevinomics tells us to  – this result at odds with economic orthodoxy should not really surprise us. In any CEE, the company’s (or the individual’s) objective is to create or capture a defensible and highly profitable niche, and since there is no overall optimization of the system, a priori you would expect that the CEE would over time become less and less fit-for-purpose (in this case: low-cost, secure, with fast payments) – essentially a Gresham’s Law⁴⁾Investopedia defines it as follows: “A monetary principle stating that “bad money drives out good.” In currency valuation, Gresham’s Law states that if a new coin (“bad money”) is assigned the same face value as an older coin containing a higher amount of precious metal (“good money”), then the new coin will be used in circulation while the old coin will be hoarded and will disappear from circulation.” Accessed October 27, 2013. Gresham’s Law at the CEE level where structures that deliver less (versus the purpose of the system) drive out superior systems.

We have been using the ecosystem analogy but of course our economic ecosystems have one further important feature – the actors have purpose and intent, and can adapt. So this makes them even more capable of creating these defensible and profitable niches that prevent the system from being fit-for-purpose and drive system deterioration.

As we look around at our major CEEs, using the obvious US examples,⁵⁾Apologies to my US friends and readers. There are of course many examples from other countries – the UK’s dysfunctional housing market comes to mind – but I employ examples that are familiar to readers from many countries. it is hard not to conclude that many of our most important economic ecosystems are going backwards:

• Health – It is difficult to find a more dysfunctional economic (and social) ecosystem than the US Health Care system. Costs are massively higher than those in other developed nations and outcomes poorer (as is well known). Analysis from every political angle comes to the conclusion that the system is severely broken as each actor responds to feedback in its part of the system. Doctors order too many tests in fear of litigation and to increase revenue. Individuals consume too much health care because insurance covers it and pricing is opaque. Insurance companies deny coverage ex post to manage costs. And the system continues to deteriorate, as it consumes an ever larger part of the US GDP with no discernible outcomes benefits versus other developed nations. This healthcare system has in fact an entire economic sub-system (private health insurance covering core medical needs) that essentially does not exist in other developed countries.⁶⁾Uwe E. Reinhardt, “Why Does US Health Care Cost So Much?” The New York Times, November 14, 2008. Accessed on October 27, 2013. Why Does Health Care Cost So Much

• Higher Education – Nevinomics believes that the US has been in a massive post-secondary education bubble, with a CEE of self-reinforcing factors: ideology that favours university for all at any cost, a student loan system that feeds the education bubble but saddles students with enormous debt that cannot be discharged through bankruptcy, a university system that has borrowed from an outsourcing model such that  ⅔ of Professors are low-cost adjuncts, or “contingent faculty,” with understandably limited commitment to the institutions,⁷⁾Alexandra Bradbury, “Adjunct Faculty, Now in The Majority, Organize Citywide,” Labor Notes (May 20, 2013), accessed October 27, 2013. Adjunct Faculty Organize and a standardized test sub-ecosystem that has acquired its own logic with little evidence that is related to developing students capable of functioning well outside the test-taking environment. Again, individual actors in the education CEE are responding to the feedback they see (at least those with the power), with massive efforts in fundraising and fee hikes beyond inflation to keep up with the nuclear arms race of improving dorms, gyms, and other student amenities; wealthy students purchasing experiences (building orphanages in Africa, for example) to increase the chance of acceptance at top schools; and for-profit universities exploiting the student loan system but with a poor record of students actually completing university and finding well-paid employment. So there is lots of feedback, but is this CEE fit-for-purpose? This is a complex question, but as far as I can see, few commentators think that it is, and one very tangible outcome of this CEE is that the huge levels of student debt are delaying entry into adulthood, with a negative effect on the economy as indebted adults postpone purchases of houses, cars, and appliances – and delay marriage. If the feedback mechanism were working properly, students would be able to measure the investment required and likely returns, thereby regulating the bubble propensity of the higher education system. But this does not seem to be happening effectively.

The elephant in the room is the financial system⁸⁾The failure of the Labour market – another critical CEE – is discussed in 2 Nevinomics articles, The Labour Market: The Greatest Market Failure Ever and The Labour Market: The Greatest Market Failure Ever: Part – it is not hyperbole to say that the financial system is the genesis of all our CEEs, since none of modern economic relations function in the absence of the financial system.

In light of the GFC, can the western financial system be defended as being in any way fit-for-purpose, with the purpose here being to ensure that this system contributes appropriately to the success of the real economy? Have the financial innovations of the past 30 years made this process any more effective, or have they just added costs and complexity and moved risk from insiders to more naive actors such as the public and less active investors such as pension funds?

Again, from an a priori perspective, you would in fact expect the system would be less and less fit-for-purpose as these insiders with superior information and incentives find more and more creative ways to grow and defend their ecological niches. And I believe there is ample empirical evidence to support this view.⁹⁾There are many excellent analyses, but I would recommend Robert Kuttner’s treatment of it.

There has been so much ink spilt on this topic since the last GFC and there is little value to rehashing that here (none of what I have said about the financial system is original); however, this recent quotation from Joris Luyendijk summarizes the problem as well as I have seen and is worth reproducing in its entirety:

The reality is that global high finance is de facto a set of interlocking cartels that divide the market among themselves and use their advantages to keep out competitors. Cartels can extract huge premiums over what would be normal profits in a functioning market, and part of those profits go to keeping the cartel intact: huge PR efforts, a permanent recruiting circus drawing in top academic talent; clever sponsoring of, say, an ambitious politician’s cycling scheme; vast lobbying efforts behind the scenes; and highly lucrative second careers for ex-politicians. There is also plenty of money to offer talented regulators three or four times their salary.

Capitalists have an expression for this, and it’s “market failure.”¹⁰⁾Joris Yulendijk, “Our banks are not merely Out of Control. They are Beyond Control.” The Guardian, June 19, 2013, accessed on October 27, 2013. Banks Beyond Control

In a nutshell, the financial CEE works just fine for many of the actors in it. And they are responding continuously to the feedback they receive from the system. But it is not fit for the purpose that society would ascribe to it. And I see little evidence that it is getting better, as loose monetary policies and massive quantitative easing continue to create major imbalances with no discernible benefit in economic growth. Feedback fails.

This should be extremely worrying for us. Since at least the Renaissance, the western world has been animated with the idea of progress. We have come to expect that our CEEs will perform better and better over time, combining improved business models and ways of organizing with massive technology leaps.

So to find that the major CEEs are in fact deteriorating should be a call-to-arms.

Nevinomics will return again and again to this theme. What Luyendijk captures so well is that correcting the perverse outcomes of the financial CEE will not happen through minor tinkering around the edges. And this applies also to other major CEEs – health, education, housing, food. It will take clear thinking about what the system is for, understanding of how the ecosystem fits together, admitting that we have a problem and, finally, ferocious courage from political leaders to put in motion the changes required to build the CEEs we need to support Flourishing.

Photo: El Neill