Why Economists Can't See the Economy

"The purpose of studying economics is not to acquire a set of of ready-made answers to economic questions, but to avoid being deceived by economists." -- Joan Robinson, Cambridge University

On page one of The Wealth of Nations, Adam Smith illustrates the central principle of his economics with an example taken from, in his words, a "very trifling manufacture": the making of pins. Smith goes to some effort to describe the process. "One man draws out the wire," he writes, "another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head." In all, Smith counts 18 different "operations," then estimates that such specialization boosts productivity at least 240 times over what the same number of men, each working alone, could accomplish.

Smith's pin factory has served economists ever since as an organizing vision of what economics should work toward. "Specialization is wealth" is the idea that, to greater or lesser degree, orders the thinking of all economists. And due to the immense influence of economics within our society, this vision has come to shape how we view our world and organize the industries on which we all rely. America's promotion of free trade, at the most simple level, is just the vision of the pin factory supersized into national policy. If specialization across the factory floor is good, and across the nation's breadth is better, then across the face of the globe is best. But what does it mean when such a dream comes true, and the dreamer does not realize it?

Look closely at today's global production system and you will see shockingly high degrees of specialization, in terms of both geography and ownership. More and more activities take place in only one or a few places on earth, and within one or a few companies. This is especially true in electronics: Taiwan produces more than half of the world's vital customized chips. But it is also ever more true of heavy industries, like automobile manufacturing, even of agriculture and food processing. One of the crowning conceptions of the Enlightenment has been achieved, yet economists appear entirely unwilling to recognize the fact, let alone begin the task of examining how this revolutionary event might alter the purposes and pathways of their work.

For America, this is a big problem. As Adam Smith understood 230 years ago, decisions on how to divide the tasks necessary to produce pins are based not merely on questions of efficiency but also of engineering. If anything, the engineer's work naturally precedes that of the economist. Americans would never ask an economist to design a suspension bridge or a new jetliner, though we wisely insist that engineers give the economists a seat at their table. Yet when it came time to design the most amazingly complex system ever devised by human beings -- the global production machine -- we relied only on principles that spring from the mind of the economist. We did not insist that economists offer the engineers a single stool at the table; we did not insist they even invite the engineers into the room.

Our brand-new global factory does look awfully efficient. But it is an efficiency purchased through the destruction of all flexibility, and hence sustainability. What we should be fretting about now is what happens when, one day soon, we awake to find that war, revolution, disease, or natural disaster has cut us off from some one of the increasingly scattered pockets of workers we rely on to produce keystone industrial components or to process vital back-office information; what happens when, for want of access to one or a few of the links that make up the global assembly line as a whole, our entire industrial system breaks -- pins, electronics, pharmaceuticals, food, and all.

One of the more fascinating academic exercises in America these days is to sit down with an industrialist to discuss the growing brittleness of our production systems, then raise the exact same points with an economist. The industrialist grasps the idea of fragility immediately, and often offers up fresh tales of production shutdowns and close calls. Indeed, industrial fragility has quietly emerged as perhaps the single biggest operational concern of business today, reflected in a boom in programs to study supply chain risk at places like MIT's Sloan School of Management and Penn's Wharton School.

The economist, by contrast, just as swiftly rejects the idea of such fragility outright. Why? Because no industrialist, the economist will declare, would ever take such a risk. Industrialists who say that market pressures force them to take too much risk are simply seeking protection. They are selfish, or lazy. To understand why economists will so audaciously dismiss the words of industrialists like Intel's former Chairman Andrew Grove -- who a few years back warned that any break in trade between Taiwan and China would precipitate the "computing equivalent of Mutually Assured Destruction" -- it helps to look at how the engineering of today's global production system differs from the engineering of the previous production system. Because to the extent that economists' thinking is based on the real world, it is the world that existed in mid-20th-century America.

Through most of our nation's history, the industries on which America depended were organized and managed in a radically different manner than they are now. The biggest difference was that industrial activity was doubly "compartmentalized." Production took place within discrete, vertically integrated firms, located within a largely self-reliant nation. This isolation of production -- inside a box inside another box -- made it relatively easy to identify risk and contain disaster.

A second big difference was that self-conscious actors with clear goals managed both the nation-state and the vertically integrated firm. The U.S. government wanted to maintain a robust industrial base for use in war; it therefore ensured that certain industrial capacity be located in America, and that American industry have access to the necessary supplies of materiel, technology, and skilled labor. Top managers at individual firms, meanwhile, had an interest in ensuring that no one ever shut down their firm. This meant structuring production systems in ways that guaranteed the assembly lines would always function, no matter what happened in the United States or abroad.

Over the last generation, however, Americans busted open both these boxes. We merged our national industrial system with the industrial systems of many other nations, in the process we know as globalization. At the same time, we encouraged our vertically integrated firms to blend their operations together, through outright merger and through the process of disintegration we call "outsourcing." Add these two processes together, and the result is a single, global, networked system of production marked by extreme and growing specialization of activity. More and more, certain things are made, and certain services located, only in certain places.

In theory, there is absolutely nothing wrong with a networked system of production. On the contrary, we can easily imagine industrial networks -- even ones global in scale -- that are not merely more efficient but actually more safe, both economically and politically, than the compartmentalized systems of the past. The catch is to understand that networks are not safe by nature, but by design. A network will organize into dispersed compartments that isolate risk only if humans program it to do so.

This is what we did with the Internet, the basic architecture of which was designed by the U.S. government during the Cold War to ensure a deeply resilient system of communication. This is true also of the global monetary system, which is compartmentalized by currency and regulated by central banks. Indeed, this is true of all complex systems built by humans. Sometimes by initial design, sometimes after a period of trial and error, human beings act to make a system resilient and flexible by building in some redundancy and compartmentalization. Human beings come to realize that a system can become too specialized, too efficient, to be really safe.

This is not, however, the path we have taken with our global production system. Over the past two decades, we have destroyed the old compartments and kept the engineers from building new ones.

In January, Britain's competition commission released several reports on consolidation within the country's grocery industry. Four firms control at least 75 percent of the total U.K. market for groceries; one, Tesco, controls a phenomenal 30 percent. Looking at the ability of a market owner like Tesco to dictate terms to suppliers, the researchers concluded that the industry had witnessed a qualitative shift from what they called a "market framework" of organization, characterized by numerous buyers and sellers, to what they called a "bargaining framework," in which "prices and other terms are negotiated bilaterally by a few giant powers." Their data also showed a huge shift of revenue away from such small suppliers as independent dairies, and a sharp reduction in the number of these suppliers.

Consider also the ongoing battle between Delphi and its hourly workers, or more accurately the three-way struggle among Delphi, the United Auto Workers (UAW), and General Motors, which for decades owned Delphi but which cut loose the parts unit in 1999. The fight is one of the best illustrations of how American capital has reorganized ownership and production to better concentrate its power. Two decades ago, the fight would have been largely an internal GM affair, worked out in negotiations between company managers and UAW leaders. Since then, however, GM succeeded in placing two barriers across that relationship.

It created one barrier when it spun off the parts unit, thereby turning an intra-firm relationship into one governed by semi-adversarial contracting procedures. This barrier, bolstered by the fact that GM is by far Delphi's No. 1 customer, has allowed GM since 1999 to reduce what it pays Delphi for a particular component by an average of 2.1 percent every year.

The other barrier is really a couple of barriers: the border with Mexico and the de facto border with China. These barriers enabled first GM and then Delphi to pit workers in distant lands against workers in the United States, in order to drive down wages in a relatively orderly fashion. As recently as 1999, 60,000 of Delphi's 180,000 workers labored at unionized assembly-line jobs in the United States. Today, the number of these U.S.-based workers is below 22,000 and falling fast, as Delphi shifts work abroad at the exact pace that best serves its needs.

What we see here are two variations on the business model refined over the last two decades by Wal-Mart. In the case of the U.K. grocery system, we see the replacement of a relatively free and open market system by one characterized by hierarchy and the top-down exercise of authority. In the U.S. automobile industry, we see the creation of wage-lowering arbitrage inside what was already a hierarchical and authoritarian system. In both cases, the result has been a massive increase in the top-down exercise of power over suppliers and workers who have nowhere else to go.

Now let's consider how the most basic theory of economics compares with what exists in today's real world. The most fundamental assumption of mainstream economics today is that the natural state of an economy is perfect competition among many small actors. The average marketplace is viewed as free, open, and politically neutral. For our purposes, this theory is especially important because it allows economists to assume away the exercise of power within the economy, and hence any need to understand the effects of how power is exercised down -- on to, for instance, the English dairy farmer or the American assembly-line worker.

The idea that the economy is characterized by perfect competition has been questioned, and sometimes ridiculed, both inside and outside the academy for ages. Until recently though, there were still many real-world examples of open markets comprising small actors such as farmers, storekeepers, and garage owners. Economists could continue to claim that their theory was valid in the real world, and hence of value to anyone seeking to understand the workings of the real world, because of the relative openness of these markets.

Such competition, though, is less and less the case in any major American marketplace. The radical changes in antitrust law imposed in the early 1980s by the Reagan administration unleashed forces that played out in the enclosure of many previously open markets. By limiting antitrust's scope to policing against concentrations intended to raise consumer prices, and by ignoring the effect of concentrated power on suppliers and employees, the Reagan Justice Department gave the rich individuals who control corporations carte blanche to control entire American marketplaces and to exercise near-absolute power within those systems. In market after market, private monopoly has returned -- or, as in retail and agriculture (with the rise, for instance, of Perdue and Tyson, in the 1980s and 1990s, or Smithfield Foods' recent takeover of Premium Standard), consolidated power for the first time.

Over the last 25 years, this concentration of the economy has resulted in the emergence of an entirely new hierarchy of power. We see this most clearly in the displacement of the old producer oligopolies that dominated the American economy during the 20th century by newer firms like Wal-Mart and Dell, built from the ground up to retail other companies' products, and ultimately to dominate and manage entire systems. We see the emergence of this new hierarchy even more dramatically in the transformation of erstwhile manufacturers like GM and Boeing into firms that derive their profit increasingly from their ability to trade in goods and services produced by others. GM's spin-off of Delphi is just one small case. More dramatically, Boeing plans to turn to outside contractors for some 90 percent of its new 787 jetliner.

The emergence of this new hierarchy affects almost every aspect of American life. It amounts to the spread of private governance to a far wider swath of the U.S. political economy than was the case in the recent past, as exemplified by Wal-Mart's ability to set wage standards not only in its stores but, by dictating to its suppliers, on the roads and in the factories as well. The most important economic aspect of this new hierarchy is how it changes the nature of competition. Competition still exists, of course, but it takes place less and less within the open marketplace and more and more inside closed, authoritarian, corporate-controlled networks. In consequence, competition tends to become ever less creative in nature and ever more destructive.

Not all hierarchical systems are self-destructive. The vertically integrated firms of the past were extremely hierarchical in nature. But the structure of the old industrial system tended to prod managers to take care of their machines, workers, and technologies. In part, this was a function of loyalty: Everyone was part of a single enterprise. In part it was a function of law: Workers had the right to organize. In part it was a function of self-interest: The 20th-century enterprise had to compete in the marketplace with other vertically integrated firms, and hence its managers placed some value on skills, knowledge, and capacity.

Today's hierarchies, by contrast, are the result of consolidation and outsourcing working in tandem. Consolidation means that top-tier firms fear competition from business rivals less than they did in the past; outsourcing, as we saw with Delphi, means firms feel less loyalty to the people and suppliers who actually do the work. In combination, consolidation and outsourcing result in top-tier firms assuming ever more freedom to exercise their power down onto the system itself (and, unlike the old producers, ever more freedom not to concern themselves with the total amount of revenue within a system -- as measured not merely in profits but in wages and benefits and R&D investment -- but rather only with the amount that the leading managers and shareholders can take away).

Nor, as we have seen, are all networked systems self-destructive. What makes our present networked system of production so dangerous is that, due to consolidation, more and more of its component operations are unique in nature. As we saw in the Soviet Union, systems defined by a high degree of monopoly tend over time to erode any sense of ownership or responsibility. Even those managers and engineers who want to care for the system, perhaps improve it, increasingly can't. Any system in which gain is personalized and pain collectivized makes it more and more tempting for an individual to take risks that result in personal profit even if they imperil the system as a whole.

If anything, in an unregulated network, competition will tend increasingly to play out as a race to sack the system. A network is, after all, a sort of commons, like a fishery. As we see in poorly regulated commons, the lack of enforceable rules encourages even people who know better to grab what they can when they can, because they know that if they don't, someone else will. What the most powerful people strip from the system are pockets of accumulated wealth. From the point of view of the workers, these pockets of wealth are called pensions and good wages. From the point of view of society, these pockets of wealth are what make up a sound industrial structure marked by variety, new technology, redundancy, and flexibility.

And so, every day, the divide between economist and engineer grows wider. The economist -- reclining upon the ancient verities -- remains supremely confident that the system is structured to identify and isolate risk, and to punish those people and firms who take too much risk. The engineer -- who acts in the real world, within a framework of "markets" reconstructed over the last generation to reward power, encourage destruction, undermine community, and limit the scope of individual action and responsibility -- grows ever more fearful.

Economists did not always live in the clouds. Adam Smith based The Wealth of Nations on a close study of the processes and history of industrial activity and its relation to state policy. David Ricardo, who introduced the concept of comparative advantage, worked on the London Stock Exchange, where he made a fortune as a financier and speculator. The French economist Leon Walras studied to be a mining engineer, then worked as a journalist. Vilfredo Pareto spent more than 20 years as a civil engineer for two Italian railway companies.

Even after the academy began to emphasize the use of mathematics, it was by no means clear that economists would one day find themselves so completely divorced from the world. On the contrary, many in the profession seemed, in the early 1930s, to be developing the tools necessary to muck around in the real world, where economics collides with politics and power. To understand what economics is now, take a moment to look at one of the more important pathways economics did not take.

In 1932, Adolf Berle, a professor of corporate law at Columbia and one of Franklin Roosevelt's original three brain trusters, teamed up with Gardiner Means, a young economist at Harvard, to write The Modern Corporation and Private Property. This book showed that just a few firms dominated the U.S. economy, and that they were controlled not by old-fashioned owner-entrepreneurs but by professional managers. A year later, another Harvard economist, Edward Chamberlin, published The Theory of Monopolistic Competition, and the Cambridge economist Joan Robinson published The Economics of Imperfect Competition. Together, these works showed how such large firms hugely distorted basic market functions. At a time when the Depression had shattered the old certainties of laissez-faire economics, the effect of the near-simultaneous appearance of these three volumes was sensational, both within economics and among the general public.

For many economists, the works promised a future in which they would study and model the power of large firms and trace the effects of these concentrations of power on such factors as pricing and employment. This approach implied that markets are, at least indirectly, the products of law acting on or through the corporation and other institutions. It also implied that the concentration of economic power, especially through a public institution like the corporation, transformed the affected marketplace into a largely if not entirely political realm.

For mainstream economics, these works added up to nothing less than a direct challenge, from some of the most gifted economists and legal scholars of the era, to the core theory of economic dynamics: that all markets are perfectly competitive and perfectly neutral. For the citizen, they added up to nothing less than an argument in favor of bringing economic interactions more fully under the rule of law.

There are many reasons why this movement, often called "Institutionalism," did not become the branch along which the mainstream of economic thinking flowed. One was simple politics. Conservatives inside and outside economics rose in opposition to the new ideas, which, after all, did savor more than a little of Marxist analyses of "monopoly capitalism." (Even three decades later, in the book that launched him on his political career, Milton Friedman labeled the Berle and Means approach to the corporation one that threatened to "thoroughly undermine the very foundations of our free society.")

A second reason was war. As the United States prepared to fight Germany and Japan, even many left-wing economists felt compelled to work more harmoniously with the nation's industrialists.

A third reason, and what proved perhaps the most damaging one over the long run, was the emergence of Keynesian economics, which swiftly attracted many of the economists most enamored of Institutionalism, including the young John Kenneth Galbraith. Compared with the task of remaking the economy at the level of the firm, reform through broad fiscal policy seemed politically simpler and -- because it allowed reformers to operate at the "wholesale" level -- far more efficient.

Yet even without a platform within the academy, Institutionalism remained very much alive. It survived in law, especially in the philosophy and practice of antitrust. And thanks largely to another Harvard economist, Edward S. Mason, dean of Harvard's Graduate School of Public Administration, it survived in the public mind, flourishing again in the late 1950s and early '60s.

What ultimately killed off Institutionalism was the rise of the Chicago School of economics, organized loosely around Friedman's political writings, in the 1960s and '70s. Like the Institutionalists a generation earlier, the members of the Chicago School understood viscerally that economics and law -- and hence economics and politics -- were one and the same. Their goal could not have been more different from the Institutionalists', however. Rather than illuminate the political nature of market relationships, their aim was to push the politician entirely out of the realms of business and finance, and to push "market concepts" into the realm of politics.

Unlike the Institutionalists, moreover, the Chicago School was highly organized and very well funded. In public, members repeated ad nauseam their mantra that markets are perfect, and for that matter perfectly wise -- which meant that politicians should never interfere in any market whatsoever, and that the state itself was, to at least a certain degree, an immoral entity. From behind this rhetorical cloud, in both Democratic and Republican administrations since the mid-1970s, members of the school oversaw the radical rewriting of the three main pillars of American economic regulation -- the laws governing trade, competition, and the corporation -- in ways that steered power and profit upward rather than down.

The Chicago School did not, of course, seek to chase the engineer from the factory floor. Its goal was merely to chase the American people -- whether organized into unions or organized through Congress -- from the realms of business and finance. But it does not much matter whether the death of industrial engineering was premeditated or merely an unintended accident. What matters is that, going forward, we can apply fresh engineering principles to our radically new global industrial network only by altering, in fundamental ways, the laws that govern trade, competition, and the corporation.

To the degree that we trace economics to Adam Smith, we trace it to a man who sought through his writing to encourage the exercise of reason by human beings condemned to live in a complex, dangerous, ever-changing world in which the interest of the nation and of the community sometimes trumped that of the individual. Mainstream economics today, by contrast, has degenerated into a purely materialistic and atomistic philosophy, fixed monomaniacally on the pursuit of efficiency as measured by the manufacture of objects and, increasingly, raw cash. Mainstream economics today strives not merely to restrict the realm made subject to reason but to replace the responsibility of the individual citizen to pursue ethical outcomes through politics with abject worship of an automatic mechanistic "market," which is really just a sham for private directorship of the political economy by the immensely rich.

Just how dangerous such a materialistic and deterministic way of thinking can be when applied to the real world is clear if we consider what Tom Friedman and other radical globalists conclude from the fact that we have scattered our pin factories and all of our other factories across the face of the earth. Their line of reasoning is beautifully simple.

Once human beings understand that our production system is so specialized geographically that it will stop working in the absence of any one of a number of major industrial regions, all rational people and right-thinking nations will naturally avoid any actions that might disturb the functioning of the system. The inescapable, predetermined result of making our industrial system fantastically fragile, they conclude, is a world of peace and harmony forever more. If anything, the more precarious the system, the more secure the peace.

To accept this global-market utopianism ultimately amounts to accepting the economist not merely as the engineer of our global industrial system but also as the engineer of an entirely new human nature. Isn't that what is implied by the idea that fear of disrupting our global materials and food-processing systems guarantees that people will soon cease entirely to even threaten the use of force against one another? What moral arguments have failed for millennia to achieve, what the still-living memory of the Holocaust and Hiroshima has not yet effected, the fear of crashing our high-definition-television supply chain will now make manifest. War, revolution, politics itself -- all reduced to vague and unpleasant memories by the global division of labor.

For those who harbor even a slight doubt that our global production system will automatically build for us all a world-spanning Zion (if only we keep our hands out of the gears), there is a wiser course, one that requires no radical shift in our politics. On the contrary, it requires merely a return to our nation's traditional approach to organizing government among human beings, which is to assume that human nature is deeply and irretrievably flawed, and that the best way to control such flaws is through the construction of carefully calibrated, interlocking, counterbalancing, and ever-evolving political institutions. It requires, as James Madison wrote in "Federalist No. 51," pursuing a "policy of supplying, by opposite and rival interests, the defects of better motives," and the will to trace this approach "through the whole system of human affairs, private as well as public."

Most immediately, it requires recognizing that the average American economist is not fit to understand, let alone design, the complex networks of our 21st-century economy in ways that result in the most minimal amounts of redundancy, resiliency, flexibility, and survivability, and that we'd better act fast to put someone on the job who can. It requires doing just what Adam Smith would surely do: Turn the task back over to the engineer.

Barry C. Lynn is a senior fellow at the New America Foundation and the author of End of the Line: The Rise and Coming Fall of the Global Corporation.

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