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6 mins
March 27, 2019
Dr Ganesh Nana (Former Research Director)

Poverty, economics & economists

Economics and economists – it’s not the economy, it’s the models, stupid.

Poverty is an outcome caused by the economic mechanism adopted at the behest of economists and the economic discipline. Hence, it is incumbent on economists and the discipline to forward a solution to counter this negative outcome. If economists cannot forward a solution to the existence of poverty, then that is an indictment of the discipline.

It is pertinent to remember that the discipline retains substantial power, with policy and business choices and decisions continuing to put great store in the pronouncements of economic analysts and commentators. This continues despite the stark evidence that such analysis drove the global economy to the brink of disaster and remains at sea in explaining the cause, consequence, and recovery from the so-called Global Financial Crisis.

Similarly, do not forget that since the 1980s we have been following (almost religiously) the prescription of the pure market economy soothsayers. That’s closing 40 years.

And over that time there has been a concentration of power and financial wealth in the upper-deciles and percentiles of the financial distribution.

And, in contrast, the existence of a sizable underclass of poor has become embedded in the mechanism. This ‘normalisation’ of poverty in otherwise prosperous economies and nations is, arguably, the most worrying of developments over these 40 years – especially with the consequential impacts on inter-generational embedded poverty and their disconnection from wider community structures.

How the problem arises

Poverty arises from the economic model we accepted some 40 years ago, as economists and its profession prescribed a course of medicine given its diagnosis of the malady. Alarmingly, this model continues to be the accepted received wisdom. Despite the continued lack of success of the discipline to explain its failures, the model endures despite the inherent failures of the model itself (let alone that of the discipline).

The economic model rests on few core assumptions. One is that firms/businesses will pursue strategies to maximise their profits. A couple of critical points arise.

  • Over what time period is the maximisation of profits to be pursued – the textbook remains deafeningly silent on this.
  • Definition of profits – return to the owners of the capital invested in the firm – but which owners? – today’s owners? tomorrow’s owners?

The importance of time

Why is the time period so critical? Firstly, and in particular, the owners of capital in an enterprise change as time progresses. Whether through equity buybacks, capital issues, debt restructures, mergers or takeovers, CEO remuneration packages, or just daily stock market transactions, changes in the nature, number, and composition of the owners of capital in an enterprise are not negligible. So, secondly, there is a prospect (probability?) that maximising profits for capital owners now may have diametrically opposite impacts for the capital owners of the firm in another future period of time.

Maximising profits over one year is different to maximising profits over one quarter. Additionally, though, maximising profits over one period of time (e.g. one year) likely requires a totally different strategy for the business enterprise than one that is tasked with maximising profits over sequential periods of time (e.g. over five (or 10?) lots of one year periods).

To get past this complication the business model was proposed, where the strategy focuses on maximising shareholder value. This development had potential, as we could have tackled fundamental questions on the definition of ‘value’. That is, what do we (business and community) – mean by the term ‘value’. In particular, could it go beyond the conventional perspective of financial returns?

But that opportunity was missed and the business model was pretty much a glorified rehash of the narrow profit maximisation economic model. Returns and value were synonymous with profits. But, if we’re maximising shareholder value, the question remains: which shareholders, today’s or tomorrow’s; and over what time period do we need to maximise value; one quarter? one year? the election/appointment cycle of the Board Chair? (or, of the CEO?); perhaps the five-year restructuring plan?

The consequence of the business model sidestepping the criticality of the time period alongside a growing emphasis on regular reporting to enforce accountability, the pressures towards a shorter time horizon accelerated to become almost unavoidable. The time period over which shareholder value was to be maximised became, by default, the short term.

The race to the bottom

In which case, the value maximising strategy quickly transforms into a financial model where cost minimisation takes priority. One of the biggest cost ticket items in most business operations are wages. Hence, the race to the bottom. Almost by definition, so it seemed, the firm that could employ people at the least cost could promise to be the most successful in maximising profits and value. And so maximise its return to (today’s) owners of capital.

A lot hinges on the timing – as long as only the current owners of capital were relevant then things would be fine. And the profit over the current quarter, (or year at most) would suffice the desires of those current owners. The impact of the race to the bottom on the capital owners, say, five years hence became irrelevant (or is – implicitly – assumed to be unimportant). This also assumes that the current owners of capital were also not part of the current workforce of people employed in the enterprise.

But with the paramount status of the financial model driving shareholder value maximisation there are few alternatives to a cost/wage minimisation strategy.

This financial model, in turn, drove the business model. So governance functions effectively became subservient to today’s owners, and management finance operated to satisfy accountability and reporting requirements.

The consequence of the race to the bottom is an increasing and embedded distance from any sense of prosperity for a sizable proportion of the populace. But that reinforced the position of the economic model. The original economic model promised prosperity (as well as productivity and profitability) with its efficient allocation of resources and equilibrating markets satisfying consumers and produces alike. But the perspective of economic prosperity went missing in action, as the financial model of cost minimisation took precedence.

Countervailing forces

In the original economic model consumers, or households, were the countervailing force acting as a brake on firms and businesses profit maximising efforts. Simply put, firms could only sell as much as consumers were willing to buy – therein constraining any race to the bottom. This countervailing force, or invisible hand, was the key in ensuring the economic mechanism had embedded self-correcting (i.e. equilibrating). These aspects would lead us to a situation where all participants (firms and consumers) were suitably rewarded for their endeavours.

Not surprisingly, the power of individual consumers acting alone was always going to be an insufficient counter-balance against business enterprise and industry when combined in the pursuit of its sole profit maximisation/cost minimisation goal.

Role for government

Enter the role of government. Acting on behalf of consumers, the role of government was traditionally seen as ensuring a countervailing power to that of industry/enterprise. Government’s role was to ensure the invisible hand was not incapacitated by overzealous corporates exerting their power to extract monopoly rents. Or, governments would act to improve the flow of information (where, in the jargon, information asymmetries were prevalent) to ensure consumers were better placed to make informed decisions.

The language of “justified intervention where there is a proven market failure” were well embedded in the Treasuries and Economic ministries and departments around the globe as the core rationale for government policy proposals and programs.

But we lost our way

But then governments lost their way. Or, more sinisterly, were subsumed into the primacy of business growth, productivity and profitability objectives over other national or community goals. Rectifying market failures and ensuring the presence of appropriate countervailing powers in the market took a backseat. They were replaced by the overpowering emphasis on ensuring investors were attracted into the business sector through appropriately investor and business friendly policy settings.

And the financial model made its way into the workings of government itself. The language of fiscal responsibility was used to circumscribe the role of government. Financial surpluses and public debt reduction were symbols of prudence and virtue. Questions about over what time period were silenced by calls for accountability, which inevitably centred on short-term indicators of budget revenue, spending, fiscal balance, and financial debt.

And so the race to the bottom intensified, with limited countervailing forces alongside a severely emasculated invisible hand.

And now

This has left us with an economic model subservient to the prevailing financial model. This has entrenched the primacy of short-term financial results (returns to current capital owners). This, in turn, has justified their strategic business models based on low-cost materials and, in particular, low-wage labour. The results are demonstrable: entrenched poverty and widening inequality in otherwise rich and well-resourced nations.

The unsustainability of existing business models and their consequent instability is showing through across the globe.

The burning platforms of inequality, climate change, community dislocation, gig economy, nationalistic jingoism, robotics, energy insecurity, and more reflect that unsustainability. The response of the economics discipline and its adherence to the corporate financial and business models will be central to whether it forwards a viable response to these burning platforms and, in particular, to the ‘normalisation’ of poverty in communities both here and abroad.