In Praise of the Corporation? [Rough thoughts]

Back at the end of March I came across the following, written by Jesús Fernández-Villaverde,  online [cross-posted by Alex Tabarrok at Marginal Revolution] …

“… Those who deny the problems of large bureaucratic organizations, and how deeply irresoluble those problems are, have not seen how not-for-profits work. I have never seen more acrimonious fights than within not-for-profit organizations, where some shared sense of the common good unites members. The fights are fierce precisely because profits play no role.

I have been reading about these issues for nearly 40 years, and I have seen plenty of proposals to address the problems of large bureaucratic organizations. A favorite among many is “participation” or “more democracy” within the organization. No, sorry, more “participation” or “more democracy” only makes things worse. Yugoslavia taught us that you cannot run a large bureaucratic organization based on democratic participation (well, you only need to know some basic economics; Arrow’s impossibility theorem, anyone?).

Large bureaucratic organizations are essential to modern life, and they are full of problems, with or without “capitalism.”

This is what Weber understood and what Marx, who had an incredibly naïve view of the future, never grasped. Weber saw that bureaucracy is not a feature of “capitalism” but the institutional form modern society uses to coordinate large-scale tasks under rational, impersonal rules. Hospitals, ministries, armies, universities, and, yes, corporations all converge on the same form because it works at scale. The iron cage is not capitalist. It is modernity.”

Well of course.

This echoes the thoughts of anyone who has seriously examined the history of the past century and a half.  Go back into the late 1800s and one of the most important innovations of that era was the modern corporation along with its sprawling bureaucracy.  Long reviled as inefficient and unresponsive, the corporation is, in fact, central to our modern prosperity.  Brad DeLong, in his “Slouching Toward Utopia”  accords it a central role in propelling us all forward.  The modern corporation is essential to our current economic success.  That it comes with some seriously unfortunate side-effects is something we need to mitigate through our political processes — that mitigation is the purpose of political democracy because as Jesús Fernández-Villaverde points out democracy within the corporation complicates and dulls the benefits of hierarchical management.

The central simplification that a corporation offers us, and which thus generates its social benefit, is its focus on profit.  The search for profit, once embedded in corporate information flows, provides a central direction to its decision making and thus reduces potential conflicts that impede the creation of the processes necessary for production.

That hurts, doesn’t it?

It hurts because the distribution of profit has become so waywardly lopsided that we muddle the conversation.  Those of us who want more equable societies often often end up underestimating the social value of corporations precisely because of this lopsidedness.  And we forget that the contemporary focus on the purpose of a corporation being to create profits exclusively for its shareholders is a separate and very contestable argument from the efficacy of the corporate form itself.

Corporations were not always the piggy banks they are now for the speculators we know as shareholders.  It is only with the advent of what Branko Milanovic calls “Cold War” economics and its political manifestation as neoliberalism that the corporation became the playground of shareholders.  As a side comment: I do wish we would stop calling people who speculate by buying corporate shares in a secondary market “investors”.  They are speculating.  They are not investing.  They are allocating wealth to the pursuit of financial gain and not the creation of productive resources.  They are playing financial games not taking risks in the real economy.  But that’s just me complaining.

In many ways, the rise of the shareholder focus in modern corporate life is an iconic example of how economics  itself drifted into its current parlous state.  The theories that support the distortion of corporate function and move it away from its social purpose are all consequences of a determined effort to re-situate economics as a distinctly non-social social science.  The over-emphasis on a search for efficiency, the alignment of incentives, and rational action all undergird the steady obscuration of the corporation’s social role.  Modern finance and microeconomics drew a veil over why firms  exist in the first place.  So it’s refreshing to read Jesús Fernández-Villaverde say what he does: bureaucracy is essential to modernity.  Bureaucracy solves a great social problem: it allows us to coordinate large-scale, complex, and thus risky activities that cannot be coordinated any other way.  Including, as it turns out, by what economists call “markets”.

This conundrum, that we need bureaucratic and hierarchical coordination outside of the marketplace, still befuddles many economists, raised as they are, on the total supremacy of the market as a coordination device.  Even when they acknowledge the plentiful and manifest “market failures” they prefer to imagine the world as if such failures were the exception and not the rule.

  Retro-fitting the corporation into free-market economics has taken a great deal of fancy footwork.  After all, if the market is supreme why do firms exist?  It wasn’t until the 1930s and in response to Ronald Coase posing that exact question, that economics began to concern itself with the corporation.  The result was an interesting kluge that provides us a telling insight to the economic mind-set.  Rather than focus on the need for localized management within complex systems to link together the disparate pieces needed for production, economists do what they do best: they trained their attention on transactions.  Economics is, at its heart, the study of the logic of exchange which makes a transaction something economist are familiar with.  They are not so comfortable with processes which are less tractable to those famous two-dimensional graphs and equilibrium thinking that has dominated the trajectory of economic thought.  It turns out that, for economists, firms exist because transactions have costs associated with them, which is like throwing grit into the celestial gearing of the market.  So a firm denotes the presence of phenomena that get in the way of market purity.  Firms are thus reduced to aberrations that would never exist were it not for that pesky grit.

Well I never.  Who knew?

With transaction cost economics in place, economists could get back to fantasizing about equilibria, rationality, efficiency, and all the other key components of their increasingly abstract world.

But, as I mentioned, one side-effect of that return to abstraction was the invention of all various, and nefarious, theories that were then imported into modern finance — things like agency theory — that ended up obscuring the essentially social nature of the corporation.  Such an importation of ideas built on abstractions unassociated with the real-world is one way in which economics is both performative and ideologically biased.  The unfortunate distributive effects of the single-minded focus on the shareholder benefits of the corporation are a responsibility of economists who gave intellectual cover to those in society who speculated in financial markets in order to gain disproportionate power and wealth.

Which gets us back to the beginning.

The corporation is central to modernity.  It solves a major problem: it allows us to wrangle into shape otherwise intractable processes.  Bureaucracy is the name we give to the melange of roles and routines needed to gather and deploy the information that constitute the fundamental ingredient of management, and thus of production.  In this view, a corporation is a localized information processing system.  The cost that impels us to use the corporate form is not that of transacting, but of managing.  This may sound semantic, but is profound because of its ongoing rather than transactional nature.  More to the point, as the steady ongoing division of labor adds more interdependencies into the already highly complex modern economy the corporation plays an ever more important role in providing the local clarity needed to keep activity rolling.

Or will it?

There is, perhaps, hope yet for economics.

Information, conspicuously and sadly absent as a factor in economic thinking, but central in reality, is the focus of management attention, and  itis becoming more easily accessed, moved, assembled, and otherwise manipulated.  Modern information technology up to and including artificial intelligence presents a challenge to the corporation.  

This raises the possibility that bureaucracy can be replaced, or at least highly supplemented, by the density of information becoming available as a consequence of information technology.  The corporation’s ability to produce profit depends not just on its bureaucratic ability to process information, but also on its ability to own the key components of that information.  Firms are concentrations of information within the much less dense general socio-economic setting.  They protect their information by using all the usual legal equipment of the modern world — patents, copyrights, non-disclosure agreements etc..  They are like islands standing proud of the surrounding ocean.  Information technology has begun to raise the ocean level and thus threatens the legal and practical boundaries that firms use to create their identity.  Increasingly accessible and malleable information reduces the space for costly management and manipulation of it.  Which, by implication, gets us back to Ronald Coase: why do firms exist?  

Or: is AI the salvation of market base economic theory as a real-world rather than abstract phenomenon?  Or will increasing complexity keep the fever dreams of economists out of reach?  The race seems to be between the increasing pace of information production and our ability to organize it usefully to produce work.  

In any case, history will record, as Jesús Fernández-Villaverde so rightly points out, that modern economic growth and capitalist reality are both dependent on the corporation.  The step up in prosperity humanity has experienced since the 1800s could not have happened without the information processing prowess of the corporation.  The simple market could never have accomplished the same result.  The question, as we move increasingly into an information-centric rather than material-centric socio-economic environment, is whether the corporation will continue its dominant coordination role.  

Has bureaucracy had its best days in the sun?