Tag Archives: Douglass North

Applying Public Interest Capitalism to the health insurance industry

Former health care executive Wendell Potter has been calling attention to how health insurance companies increase shareholder value at the expense of their customers and the broader public interest.  Potter left an executive post at CIGNA to become a senior fellow at the Center for Media and Democracy.  His descriptions of how insurance firms short-change their customers and cynically manipulate the political process to serve there masters on Wall Street are a powerful indictment of the shareholder value maximization ideology.  Potter’s interview with Bill Moyers, below, is well worth watching.

Wendell Potter interview with Bill Moyers from YouTube

From a Public Interest Capitalism perspective, one of the most interesting characteristics of the interview is that neither Moyers nor Potter ever questions the ideology of shareholder value maximization–Milton Friedman’s doctrine that a company exists only to make as much money as possible for its shareholders.  So we have only two choices: healthcare managed by greedy corporations who will (metaphorically) throw their customers under the bus to boost profits, or healthcare managed by the government.  Although I have nothing against healthcare managed by the government, my research on Public Interest Capitalism suggests another possibility: restructuring capitalism so that corporations seek to balance private profits and the public interest.

The idea of such enlightened corporate management may seem far-fetched, and it is far-fetched when economic institutions create overwhelming incentives for management to increase shareholder value regardless at any social cost.  But these incentives can be changed.  We could start by prohibiting compensation linked to share price (stock options and stock grants) in publicly traded companies.  Capping executive compensation at a multiple of the compensation of the lowest-paid employee–perhaps forty times–would probably help, too, by limiting the ability of senior executives to profit personally from abusive tactics.  Then limit dividends and voting rights to shareholders who have owned shares for at least five years, thereby reducing the influence of activist investors and hedge funds while protecting the legitimate interests of long-term shareholders.  Requiring that insurance companies disclose, in a standard and easy-to-understand format, performance metrics related to patient satisfaction, recision rates, and so forth would help the public identify abusive firms.

In light of our shareholder-oriented corporate governance institutions, it’s easy to understand why health insurance companies behave the way they do.  Institutions determine whether we can cooperate productively, or whether we slip into wasteful and socially injurious redistributive conflicts, as in the case of the American health insurance industry.  But just because we have developed pathological institutions doesn’t mean that managers necessarily want to behave this way–Potter obviously did not–or that we have to stand idly by as these institutions wreak havoc on our healthcare system and our government.  As Nobel-prize-winning economist Douglass North points out in his book Institutions, Institutional Change, and Economic Performance, institutions are “humanly devised constraints that shape human interaction”.  Humans devised them, and humans can change them.

Another critique of market fundamentalism–by the chairman of a major bank

In my research on Public Interest Capitalism, I argue that markets and self interest do not necessarily serve the public interest.  This research draws on theoretical work by the respected economist Douglass North, who argues that institutions (i.e., values, social norms, and regulations) determine whether economic actors engage in wasteful redistributive activities, or productive value-creating activities.  When resources are squandered on redistributive activities, societies decline.  Recently, similar concerns have been echoed by Yukio Hatoyama, Japan’s prime minister to be.  Today, the Telegraph reports on a remarkable speech by Stephen Green, the chairman of HSBC.  The following are quotes from his speech, as reported by the Telegraph.

At their worst, financial markets can be engines of destructive excess. In recent years, banks have chased short-term profits by introducing complex products of no real use to humanity.

capitalism generally, and banking specifically, needs to reaffirm its commitment to contributing to social and economic development

There is no question that the markets – in the form of investors and traders – have often put pressure on boards to pursue short-term strategies and profits.

The results of that pressure are now plain to see in the broken businesses and weakened economies around the world. This was the basic failure of corporate governance.

Legislation is not and can not be sufficient without a culture of values in our industry

If this crisis leads to a genuine reassessment of the role of business and banking in market economies, it may come to rank as one of the great turning points in history of the modern world.

These points closely parallel the arguments that my colleagues and I make in our research on Public Interest Capitalism, so it’s encouraging to see these views articulated by a senior bank executive.  North would surely applaud Green, too, for recognizing that values are an essential complement to legislation (see also my discussion of Why Greed is Bad).  Finally, I think that Green could be right about the potential historical significance of reassessing the role of business in society: if businesses seek to profit through contributing to the general welfare, instead of seeking to profit at its expense, we may enjoy more equitable, sustainable, satisfying, and rapid economic growth.

I doubt that Green or any of his close associates will stumble across this blog, but I invite anyone at HSBC to contact me to discuss Public Interest Capitalism.

The limits of self interest

When I visit Tokyo, I teach an ad hoc, voluntary seminar to Japanese university students.  Each time, we meet for three hours and discuss an assigned text.  The students read the text in Japanese, I read it in English, and we discuss in Japanese.  Last year, we met three times and worked our way through John Kenneth Galbraith’s Affluent Society.  This year, we have been reading Douglass North’s excellent book Institutions, Institutional Change and Economic Performance.  We had our second meeting of the year this afternoon.

During our discussion today, I was particularly struck by North’s conclusions regarding third-party enforcement of contracts and property rights.  He posits capacity for effective third-party enforcement to be a necessary condition for a sophisticated market economy.  This turns out to be problematic:

Third-party enforcement means the development of the state as a coercive force able to monitor property rights and enforce contracts effectively, but no one at this stage in our knowledge knows how to create such an entity.  Indeed, with a strictly wealth-maximizing behavioral assumption it is hard even to create such a model abstractly.  Put simply, if the state has coercive force, then those who run the state will use that force in their own interest at the expense of the rest of the society.  (North, 1990: 59)

North identifies an important limitation of neoclassical economic theory.  In a sophisticated market economy, competition by self-interested agents yields efficient outcomes only given effective third-party enforcement.  Conveniently, the theory assumes both self-interested agents and effective third-party enforcement.  However, North argues that self interest undermines effective third-party enforcement.  If so, then the assumptions of neoclassical theory are mutually contradictory.

To explain the economies of the advanced nations, North suggests that the theory must take into account non-wealth-maximizing human motivations including values and ideologies.  Such internal restraints on self interest appear to be an essential ingredient in the even-handed third-party enforcement that makes possible sophisticated market economies.  With respect to the successful development of third-party enforcement in England during the seventeenth century, North says:

although that story describes a successful outcome, it does not give a definitive answer to the question of how it was achieved.  It was surely a mixture of formal and informal constraints.  Both respect of the law and the honesty and integrity of judges are an important part of this success story.  They are self-enforcing standards of conduct, and I believe that they are important. (North, 1990: 60)

Though the importance of non-wealth-maximizing motivations may seem obvious, they are ignored by most of mainstream economics.  (Sometimes the utility function is said to incorporate non-wealth-maximizing motivations, but this is disingenuous: they are implicitly excluded by the structure of most mainstream models.)

These passages are deeply disconcerting, because they indicate how poorly we understand the foundations of our prosperity.   Moreover, by teaching models that legitimate the pursuit of self interest without regard for social consequences, mainstream neoclassical economics may be weakening those foundations.