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May


System failure

Mon, 2nd Apr 2012

Deming was categorical. You can’t optimise a whole by optimising the parts. If you optimise the parts, you suboptimise the whole. If you optimise the whole, some of the parts will not run as fast or as intensively as they could.

Yet optimising the bits without allowing for unexpected consequences at the level of the whole remains the besetting sin of management, not to mention politicians who interfere in management. At the level of the firm performance-related pay, targets, outsourcing and privatisation of functions, shared services are all examples of the fallacy of composition – the idea that what’s good for the part is automatically good for the whole.

As John Kay remarked in a recent artlcle, ‘Although it is essential that they do, policymakers and business people have difficulty thinking in terms of systems. The common sense of everyday observation has an appeal that analytic, evidential reasoning can never match.’ So it is still believed that making individuals work harder will automatically produce better results, that targets will improve medical or other outcomes, ignoring the interaction of the local ‘improvements’ with the rest of the entity.

Unlike the fallacy of composition, however, failure to think in systems holds true at whatever level you look. Capitalists are especially bad at thinking of capitalism in these terms.

Take the economy. An economy, like an organisation, is not a machine, it is an ecosystem, whose different components are co-dependent, each living off and supporting the others. Thus a vibrant economy consists of a constant interplay of markets and organisations, each necessary but insufficient on its own. By definition organisations are different from markets, since otherwise there would be no reason for them to exist, and they have different functions and operating rules.

What is it that companies do that markets don’t? In brief, they innovate. Companies come up with new products or services, or better versions of old ones; markets sort out the good from the bad and eventually compete the advantage of the successful innovator away, passing on the benefit to society in the form of lower prices and, just as importantly, a more capable and resourceful economy. It’s Schumpeter’s creative destruction in action. Apple is a perfect illustration of how the relationship works. With each innovation – iPod, iPhone or iPad – it cannibalises an existing market segment and creates a new one out of a fresh set of resources. Already music players are in relative decline as they are commoditised and their capabilities incorporated into phones, and in time the same thing will happen to smartphones and tablets, building the pressures on managers to do the same thing over again. The company proposes, the market disposes.

Innovation is what companies are for. Over time they can’t outcompete the market (although Apple’s unparalleled differentiations skills allow it to outrun its rivals in the short term) – already it is possible to pick up all the parts to make up a competent music player on the open market. Apple is so large and profitable because it is set up to do what companies do better than anyone else. Now we can see why trying to make organisations behave more like markets is such an egregious mistake – a classic error of composition. Markets are about competition and efficiency. But they can’t innovate, any more than a shark can: their beauty (if that’s what it is) is that their discipline is impartial and intentionless. They prevent companies getting too big (or should). They decide which survives and which doesn’t. Companies, on the other hand, do have intention and purpose, and unlike markets can strategise to fulfill them. They can choose to take one step back in order to jump two steps forward. Instead of cashing in all their returns, they can decide to spend time and money on R&D to develop new and more profitable projects, enabling the cycle to start all over again.

In the past – up till the 1980s – some companies did important amounts of basic research. Between them, AT&T’s Bell Labs and Xerox Parc generated the transistor, lasers, cellular telephony, the Ethernet, fibre optics and the graphical interface for computers. In the UK Glaxo was sometimes described as a quoted university. All that changed with the advent of the shareholder maximisation ideology of the 1980s under which managers were able to shrug off any wider responsibilities to the ecology as a whole. Innovation rates in the private sector slumped as companies obeyed the summons to boost shareholder returns in the short term.

The slack was taken up by another element in the ecosystem, the public sector. Companies have always needed inputs from state-owned organisations to transform into economic growth, including the social (education, health, law and order) and physical infrastructure. To these was now added the basic research on which their innovations were based. Google’s algorithms, hypertext, the key components of Apple’s iPhones, the internet itself – all these originated in government laboratories. This, again, explains why private-sector (and government) exhortation to universities and research institutes to focus on near-term applied research is wide of the mark. It is in companies’ interests to do that. The system is optimised when each part concentrates on what makes it unique and what it does best.

To adapt and thrive, the economy needs different kinds of organisation inhabiting different niches and making different contributions to the health of the whole. In this light, the UK economy is an ecosystem that is badly out of balance. As Will Hutton’s
Ownership Commission has obligingly noted, it is monolithic and unresilient, having become overdependent on giant, uniquely shareholder-focused PLCs which account for over half of economic activity.

The consequences are clearest in the banking sector, where companies that were too big and massively overextended have been artificially kept alive, and they are now bending the whole system to their requirements rather than the other way round. The same is true in less extreme form of many other sectors, where a few oversized firms have overwhelmed the system’s immune and regulatory defences: having no regard for the ecosystem as a whole, they are like cancers growing pathologically out of control. To change the metaphor, the world being reengineered to keep the dinosaurs alive. By contrast, other organisational forms such as coops, employee mutuals and medium-sized family firms are grossly underrepresented.

Ironically, for the market to work as capitalists pretend to believe it should, they have to learn that the power and influence of capitalists need to be severely curtailed in the interests of capitalism as a whole. The lesson of the financial crash was that just as individual optimisation blows up companies, unrestrained corporate optimisation has the potential to blow up the entire ecosystem. Nothing has changed since then. Unless we learn how to think and act systemically, the same thing will happen, over and over again.


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