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Monday, March 30, 2009

The Private Sector Always Allocates Resources More Efficiently: Myth or Fact?

If you listen to conservative talk radio (and in the market I currently live in there’s not much other choice), you’re likely hearing the likes of Rusty Humphries, Glenn Beck, and Rush Limbaugh continuing to preach against an active role of government in managing the economy, based on the long-held premise that “the private sector always allocates resources more efficiently.”

But I don’t think one needs a PhD in economics to realize that this premise isn’t one that deserves serious credence anymore, if it ever really did. Like governments, businesses are run by people, with the same human failings. And the bigger businesses get, the less they become about money and efficient resource allocation, and the more they become about other things like the egos of their owners and management. If the efficient resource allocation premise were unconditionally true, then every company car would be a small hybrid. No executive would drive a company-owned Mercedes.

Having said that, I also believe that there’s nothing inherently wrong with businesses making decisions on criteria other than efficient resource allocation. Other things being equal, if a business that is legally and fairly making enough of a profit to float something like a $1.2 million office renovation, then so be it. If it’s okay with the ownership, senior managers, or shareholders, and if it’s not done by a company in the process of being rescued by taxpayers, then it’s okay with me. But it’s almost an insult to one’s intelligence to suggest that it’s an efficient allocation of resources.

When I saw former Merrill Lynch chairman John Thain on television trying to explain
away his $1.2 million office renovation, I had, on one level, the same visceral, “how dare he” reaction that most people probably did. When he tried to explain the issue away by saying that the office in its previous form just wouldn’t have been effective for him to use, there did seem to be an element of condescension and entitlement in his tone. It was almost as if he was saying, “You little guys just can’t possibly understand how essential a $1.2 million office is to a high-powered executive like me.” In the current context of economic calamity, rising unemployment, and huge corporate bailouts, Thain’s press appearance was surreal, a bit like a latter-day version of the “let them eat cake” incident.

But at another level, I also couldn’t help but feel a little embarrassed for the guy. There was something almost pathetic about his hopeless effort to explain himself. In a way, it was almost like a scene you could imagine of some poor schleb who’d managed to claw his way into middle management trying to explain to his boss an excessively pricey dinner on an expense report.

The whole incident seemed to confirm the idea that Thain had risen to his position in an environment that encouraged executives to think of such extravagances as perfectly acceptable. As Nick Foulkes wrote in a column in the April 6 issue of Newsweek, “John Thain's $1.2 million office refurbishment spree would probably have been regarded as perfectly unremarkable 18 months ago.” That’s exactly the point. Numerous factors that have nothing to do with efficient allocation of resources can drive private-sector entities to a point where excess is not only tolerated but encouraged.

The executive compensation question is similar. The AIGs of the world have defended lavish bonuses and compensation packages by asserting that they are essential to recruiting and retaining top talent. By extension, this argument follows the efficient allocation of resources line of reasoning – the fat paychecks go to the talented business geniuses who deserve them.

But, again, there’s a strong case for the fallaciousness of this argument. As Seth Godin puts it eloquently in a March 23 blog post on “The Myth of Big Salaries,” “Sometimes markets get stuck because there is a disconnect between what something costs and what you get.” Godin argues that at compensation levels above $1 million per year, the game has become about things other than money. And, by extension, I would argue that it has also become about something other than allocating resources efficiently.

When corporations reach a certain size and level of power, they tend to take on quasi-government attributes and become prone to many of the same pitfalls, such as inefficient, bureaucratic management structures and self-serving motivations of the people that run them. So it’s naïve to believe that the “invisible hand” of resource allocation choices made by businesses as “rational decision making units,” a self-regulating mechanism, is the only regulation that is ever necessary. Like individuals, businesses don’t always act rationally. So checks and balances are as essential to businesses as they are to governments.

Where those checks and balances should come from – shareholders, boards, associations, governments, etc. – is of course a highly fluid and context-dependent question. But let’s get real and stop swallowing the simplistic notion that everything would be fine and dandy if we just stepped out of the way and let the self-regulating mechanisms of the free market run their course. Sphere: Related Content

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