Role of regulation – Page 2 – Escondido Framework

Markets, State and People by Diane Coyle

Rousseau observed that “Man is born free but everywhere is in chains”. Many people in business, politics and media talk about markets in a similar way, as though “free markets” are the natural state and desirable order and any intervention by an agency of the state or collective popular action is represents an undesirable fettering of enterprise.

Economists since Adam Smith have recognised that markets can fail and may need to be subject to intervention. Even figures as inspiring to simplistic supporters of free markets as Milton Friedman recognise that there are proper roles for the state where markets fail.

Diane Coyle starts in much the same place as other economists who look at limits of markets and the place of government intervention in markets. She starts with conventional analysis of market failures, listing seven instances of failure in the conditions required for free markets to be efficient. She returns these seven types of failure throughout her examination of the relationship between markets, the state and people, and description of the appropriateness of state intervention or collective action to address.

In cataloguing the failures and the responses to them, Coyle assists the reader, from the economics or politics undergraduate or MBA student getting their first exposure to welfare economics and public policy, through to the general reader seeking a better understanding of how the world works. She draws on and explains clearly the work of people like Coase, Ostrom and Thaler who have broadened and deepened our understanding of how people both cause and respond to the seven types of failure she describes. The book is furthered enriched, and the lessons consequently rendered more accessible, by a peppering of case studies illustrating the core arguments.

Coyle also tackles government failure, highlighting the shortcomings in bureaucracies (or among public servants) and as a consequence of political failures (or failures of politicians) that result in the application of the wrong policies to address the market failures. The text seems to peter out in the final chapter where she addresses what she appears to hope is the solution to the problems of government failure, which is the application of evidence to economic policy. In this chapter that she reveals the limitations of her experience as a career academic and regulator, with a rather slight addressing of the use of statistics and cost benefit analysis. This doesn’t detract from the power (or readability) of the previous nine chapters, but point to the opportunity for someone else to write something of similar tone and quality to fill the gap on how to test public policy initiatives to address market failure.

Investors should look below the bottom line – says the FT

“This newspaper has welcomed the shift among corporate leaders from a narrow focus on shareholder value to the pursuit of a broader purpose — for a hard-headed reason: when business takes a broad perspective, it can leave everyone more prosperous, including shareholders. Rejecting the dogma of shareholder primacy is not a question of bleeding hearts, it is a matter of enlightened self-interest.” So says the FT editorial board in a powerful opinion piece today, before going on to argue that investors should follow suit.

The FT argues that there are two reasons for the investors to look beyond the bottom line and consider the impact of business decisions on climate and the environment and on workers and the communities they operate in. The first is that by ignoring the impending crises facing us, a corporate focus on shareholders alone contributes to the political neglect of the problems and can stand in the way of solutions. The second relates to the way that many investments are held by shareholders, through diversified portfolios intermediated by managed funds. The result of this is the ultimate investors (people like me with investment through pension funds, insurance policies and ISAs[1]) are in effect “universal investors” exposed to hundreds or thousands of individual companies, fortunes. As the FT team observe: “Their returns depend on that of the private sector overall. When one company profits by “externalising” its costs, that may flatter its bottom line only by losing investors more money in other companies which pay the price.”

Consequently, investors and company leaders both have an interest in internalising the externalities rather than ignoring them. But the FT finds that both company and investment managers feels constrained in doing so, and it argues that government should look at ways of changing the legal frameworks that shape behaviour by corporate leaders and fund managers.

My own belief is that there is evidence that some corporate leaders and some fund managers (notably Baillie Gifford who I got to know well over a period of nine years as the finance committee chair of an asset rich charity) do take the wider perspective and longer term into account and, in the UK at least, what is at issue is not so much the legal framework but the career paths, knowledge bases, incentive mechanisms, cultural biases and social norms in the City and in our board rooms.

[1] Individual Saving Accounts – the UK tax sheltered scheme for smaller retail investors

Lessons for capitalism from the East India Company

William Dalrymple has helped people who don’t have the time to wade through 576 pages (or perhaps already have backlog of doorstep sized items of reading matter on the bedside table already) by writing an extended article on the subject of his new book about the East India Company in the FT. However, it is a compelling article and means that I may add “The Anarchy: the Relentless Rise of the East India Company” to my list for Santa this Christmas.

This is a company of superlatives, starting out as a joint stock company operating under charter arising from a petition by entrepreneurs and investors to Elizabeth I, growing to become an empire with 60 million subjects, its own army of 200,000 men , accounting for half of the trade of the leading trading nation. It’s global impact was enormous, from the fears about its reach – as well as its role in the tea trade – that contributed to the revolution in the Thirteen Colonies, to the part it played in the Opium Wars. Microsoft, Amazon, Google, Apple and before them the oil majors – they were clearly nothing to this behemoth.

Dalrymple brings out in the his article the complex relationship of the Company to British state, from its original charter, through the continuing lobbying into government, the corruption in the relationships between the Company and the establishment (for example, in 1693 shelling out £1,200 a year to prominent MPs, described by Dalrymple as the first corporate lobbying scandal), and the final demise of the Company in the wake of the Indian Rebellion.

Dalrymple’s article has the effect of drawing attention to is the inadequacy of conventional theory, both “Microeconomics 101” and the Theory of the Firm, to describe one of the greatest commercial entities the world has ever known. Some of things at work are the complex interfaces with the British state and its politicians, and also its deployment of its own naval operations (envisaged in its original charter) and an army to deliver a return to its joint stock holders, as well creating an entity became transformed into the biggest single component of Britain’s empire.

As I write this, I think he has done the job with his teaser article to promote the book. Perhaps I should ignore the size of the unread pile by my bed and add “The Anarchy” to the letter to the bloke with the reindeer and sleigh.

“A slow dawning that most companies are run pretty badly”

Sarah Gordon has written a memorable reflection today on her 20 years writing for the FT.

She reflects on a career with the paper that started with writing about what were in the early years of the millennium breaking technologies but which have been mainstream for so long that we can’t imagine life before them, which continued through the years of the Financial Crash and the great depression and bull run that has followed. She writes about the routine reports of company news stories and mind-numbing performance data, and the occasional more gossipy pieces that appear to have been what the readers found more engaging than the hard news.

She found clearing her desk brought back memories of the events and personalities that have filled the business and company pages of the paper of the past two decades, and anyone reading the article be a share in the trip down memory lane.

Reflecting on these years, she reaches very strong conclusions about shortcomings in governance in response to the accretion of overweening power at the heart of companies. She cites Dick Fudd at Lehman Brothers. He is an easy target, but her description of what went wrong is compelling: “board members neither delved deeply enough into the real activities of the bank, nor did they challenge the person running it sufficiently. Being on the Lehman board, it seemed, was a social honour rather than a fiduciary responsibility.” Writing of people like Martin Sorrell, who spent 33 years at the top of WPP, she observes: “Business bosses who enjoy too long a tenure lose self-awareness. They become reluctant to promote people around them who will challenge their point of view. Meanwhile, questioning a boss who enjoys such stature becomes all but impossible, encouraging hubris, and leading to bad business decisions.”

Gordon reflects that such problems, with accompanying shortcomings in governance, are not restricted to the private sector. She cites the example of Camila Batmanghelidjh and the failure of Kids Company in 2015. I reflect also on the ignominious departure of Sir Leonard Fenwick would was finally dismissed for Gross Misconduct by the board of Newcastle upon Tyne Hospitals NHS Foundation Trust, where he had been chief executive since 1998 having previously led one of its predecessor organisations since 1992.

She also reflects on the poisonous value destruction in so many big corporate deals, which appear to be motivated by executive greed and supported by a flawed network of advisory institutions corrupted by perverse incentives.

Her time at the FT was a journey of personal discovery and growing disillusion (albeit one shared by most of in parallel in other parts of our lives) : “As a child, lucky enough to grow up in comfortable circumstances in London, I simply assumed that the world was run efficiently by the grown-ups. It has been a slow — and sometimes painful — dawning that in fact most companies are run pretty badly.”

Gordon is hardly less critical of other institutions, regulators and politicians. She also appears to despair that the wider lack of economic and financial literacy, and the gullibility of much of the general public. She suggests that a public that feels exploited and even robbed by corporate excesses does, in some part, have itself to blame.

But she stresses that it is not business itself, as opposed to individual businesses, to blame, but it is within the power of business to improve popular understanding and dispel the blame:

“Many businesses are badly run, but business is not bad. Most people running companies whom I have met over the past 18 years care about the people they employ. Most entrepreneurs believe that there is a purpose to running their company which is greater than just making money.

“The voices of big business, and the big business baddies, too often drown out the stories from the millions of small companies that make up the bulk of employers in the UK and across the globe. I’ve interviewed many of them in the past few years, in Scotland, outside Cambridge, in Bilbao and Munich. Many are family-run, on the second or third generation, focused on building sustainable businesses. Unlike the UK’s big supermarkets, gouging dairy farmers with ever lower milk prices, they have long and mutually dependent relationships with their suppliers. They look after their staff, turning apprentices into engineers and keeping people on their books during extended periods of illness.

“The popular caricature of business, filled with profiteering bankers and gig economy exploiters, simply does not reflect the reality. But it is up to business to dispel it.

“…… business needs to do more than change its culture. It must challenge itself on what its purpose really is, not just what its investors want. It must be prepared to tackle the great ills of our time, such as climate change or modern slavery. And it must be louder in explaining why it matters.”

Revisiting Colin Mayer’s “Firm Commitment”

I first read Firm Commitment[1] when it was first published in 2013 and found the opening chapters – which include a well-constructed critique of the shareholder value paradigm – offered the tantalising prospect that Colin Mayer might be about to expound a theory similar to the Escondido Framework description of the firm occupying a solution space bounded by market interfaces. Unable to recall where his diagnosis of the failings of the modern firm and his prescription for addressing them departed from my own, I recently revisited his book.

Returning to Firm Commitment, I rejoiced again at much of the description in the early chapters of the shortcomings in the classical model of the firm, in which share ownership is linked to provision of investment capital and the assumption of risk. In common with the Escondido Framework, he describes the company as an structure independent of ownership and sees one of its purposes being long term survival, delivering value to society at large. He comes close on occasion to describing some of the other risk bearing parties, the market related transactional considerations and the interests of different stakeholders. In particular, he bemoans the failure of corporations to engage with wider social and environmental concerns.

But rather than continuing down the path developed in the Escondido Framework he focuses on the shareholder and sees the failure of the modern corporation lying in the lack of commitment of shareholders to the company. His prescription is reform to tie in shareholders to the company, to increase their commitment to the firm – hence the book’s title. In contrast to our model, Mayer remains committed to a view that shareholders “own” the company, rather than owning pieces of paper that entitle them a share in the profits of the company and which have a value reflecting a market perspective on the discounted value of the expected future cash flows. What he is unable to explain is how tying in shareholders in this way will improve the quality of decision taking by managers, enhance their accountability, or contain their ability to extract economic rent in the form of salaries, bonuses and equity incentives.

[1] Firm Commitment, Colin Mayer, Oxford University Press 2013

It takes a village to maintain a dangerous financial system – and a corporate governance system too

Hillary Clinton popularised the African proverb “It takes a village to raise a child” when she adopted it as the title for her 1996 book. A lawyer representing victims of abuse by Catholic priests in Boston extended when interviewed in 2015 by observing that “If it takes a village to raise a child, it takes a village to abuse a child.” Anat Admati, George G.C. Parker Professor of Finance and Economics at the Graduate School of Business at Stanford University, translates this sentiment to the financial sector in her in chapter in Just Financial Markets? Finance in a Just Society, a collection of essays edited by Lisa Herzog, published by Oxford University Press[1].

Admati’s focus is on the banking system. Her thesis is that the failings in the system, illustrated by the 2008 crash, are a result of the failures of a wide range of players, not just those working within financial institutions, but a host of regulators, commentators and other stakeholders. Very powerfully, she comments on the contrast between the finance industry and other industries (eg aviation) where safety is paramount and all consequently all the stakeholders work together to design effective regulation and where the case for compliance is compelling. But, as she points out, even the most obvious case for regulation to drive safety may require disasters and egregious failures before regulation and compliance catch up with the need (eg in nuclear power and the motor industry).

Her chapter provides a compelling account of the “wilful blindness” of principals, stakeholders, regulators and commentators on the financial system and suggests that even after the dangers inherent in the design, operation and lack of necessary regulation of the banking system were revealed in the crisis, the underlying problems remain unaddressed.

Her arguments are applicable far more widely. She has written an important paper about that should be read with an eye to how her observations can be applied to other industries and, indeed, beyond the commercial enterprises into public sector organisations and not for profit bodies.

[1]Chapter 13, It Takes a Village to Maintain a Dangerous Financial System. Abstract: I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate.

“You can’t have it both ways, Prime Minister”

“we should never forget the immense value and potential of an open, innovative, free market economy which operates with the right rules and regulations” (Theresa May, at an event to mark 20 years of the Bank of England’s independence)

With the Leader of the Opposition due to demonstrate his lack of understanding of markets in his keynote speech to his party conference yesterday, it was only natural that the prime minister should use the opportunity given by an invitation to speak at an event to mark the granting of independence by, ironically, a Labour chancellor of the exchequer to the Bank of England, to mount a defence of the market economy.

But what conclusion are we to reach about someone who manages to contradict herself so thoroughly, not just from speech to speech, or within one speech, or within a paragraph, but within a single sentence. When does oxymoronic become plain moronic?

Wikipedia helpfully spells out the roots and origin of “oxymoron”, and its evolution. “An oxymoron is a rhetorical device that uses an ostensible self-contradiction to illustrate a rhetorical point or to reveal a paradox. A more general meaning of “contradiction in terms” (not necessarily for rhetoric effect) is recorded by the OED for 1902.” There is no possibility that the sentence from her speech, quoted at the head of this posting, is a rhetorical device. Markets are either regulated or they are “free”. Definitionally, they cannot be both at the same time.

One of the axioms underpinning the Escondido Framework is that, in the absence of a raft of elusive conditions (perfect information, symmetry, “unbounded” rationality, perfect competition etc), regulation is always required to make markets work sustainably. Mrs May has indicated clearly since becoming prime minister that she appreciates this instinctively. Am I being too generous to her in wondering whether her apparently casual use of language is a calculated sop to appease the more bone-headed in her party (which gathers for its own conference in Manchester later this week) and they will only hear the word “free” and not notice the reference to “rules and regulations”?

I can’t help wondering what was going through the civil servants’ minds when they inserted the heading “A well-regulated free market” into the published text[1] of the speech. Cock-up or conspiracy? While stepping through the black door of Number 10 feels a bit like stepping through a looking glass and tumbling down a rabbit-hole simultaneously and, in serving their political masters, civil servants are required to “believe impossible things” [2], the combination of “well-regulated” with “free” is so impossible that conspiracy seems more plausible than cock-up. If so, to paraphrase the Queen of Hearts,“Off with their heads!”

[1] https://www.gov.uk/government/speeches/pm-speech-at-20th-anniversary-of-bank-of-england-independence-event

[2] “Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.” Alice in Wonderland.

The Uber employment tribunal decision through the prism of the Escondido Framework

How does the Escondido Framework interpret the impact of the decision of an employment tribunal in London that Uber drivers are not self-employed?

The Escondido Framework describes an organisation as both the solution space that exists between the external interfaces, or markets, and the structure, systems and processes within the solution space that mean that it creates value above and beyond what would exist in the absence of the organisation.

The first consequence of the employment tribunal was to address as matter of law as opposed to economics what Uber buys and sells. Uber hitherto has maintained that it provides a platform that brings together drivers and passengers – ie it provides a service that facilitates the provision of rides by self employed drivers to would be passengers who log on to the platform – rather it provides a transport solution to passengers using drivers that it employs. The judgement challenges the first model by effectively establishing that framework of the contract between the Uber and its drivers means that are being treated as though they were employees rather than self employed at arms length by the company.

The Escondido Framework is helpful in understanding how a judgement by lawyers considering employment lawyer can apparently transform the relationship between an Uber driver and Uber. Uber describes a relationship with the driver that makes them a customer of the company – a self-employed person who pays 25% of the fare secured to Uber in recognition of his or her use of the Uber platform. The Employment Tribunal found that, because of the constraints on the driver under the contractual relationship with company, the Uber driver is a supplier of labour – “an employee” – a factor of production in the provision of a minicab service by Uber to passengers.

The Escondido Framework is essentially neutral between the parties to a transaction: each is a customer of the other and is subject to terms that agreed in a contract of one sort or another, either explicit or implicit. Uber has certainly created value in creating and operating the platform, and thereby has created an organisation that occupies a virtual space bounded by market interfaces with drivers and passengers. Other interfaces bounding Uber’s virtual space include: those with its other employees – programmers and software engineers for example[1]; with its investors; and, as illustrated by this dispute and others with city transport authorities that license taxis, with the political and legal interfaces.

Given the restrictions on drivers, meaning that they cannot simultaneously be attached to multiple platforms, and that the passenger, although able to make choices among available drivers and vehicle classes, has relatively little ability to discriminate between drivers (I see a considerable contrast between Uber and other internet platform businesses such as eBay in this regards) it is hard to see Uber as a company selling a platform to users as opposed to selling journeys to passengers with drivers as employed labour, or at the very least suppliers that allow it to provide those journeys. In this interpretation, Uber is a very conventional organisation providing taxi services, with a highly efficient and well developed set of systems and processes that has created a lot of value, and in Escondido Framework language “solution space”, between the market interfaces of supplier/labour and customer.

Visualising the organisation within the Escondido Framework, in its most simple form as a Reuleaux Tetrahedron, one interpretation of the employment tribunal decision for Uber is that the interface with the labour market has moved and changed in shape. Alternatively, the judgement could be interpreted as a movement of the interface with the regulatory and political market place that reduces the solution space by limiting the parts of the labour market interface that are available to Uber (ie the self employment part of the interface is no longer available to it).

The outcome is indisputable. The solution space available to Uber is smaller, with a consequence that the latitude in terms of strategy available to its management is reduced, along with the amount of economic available for capture by the management and any other interested parties being reduced.

But assessing which of the market interfaces has changed to reduce the size of the solution space is more complex. Is it that the consequence of the legal judgement is that drivers will no longer be willing – as a consequence of the protection of rights arising from the employment tribunal decision – to work on the mix terms that they would previously have accepted? If so, this would represent a change in the position and shape of the market interface. Or is it that the market interface – which is collection of points representing an acceptable mix of terms of “employment” to drivers (payment, sick pay, holiday pay, employer imposed restrictions on availability, ability to take other work, ability to turn down rides, access to tips from passengers, discretion about routes to take, condition of the car that they driver must maintain etc) has not changed, but that the movement of the interface with the political and regulatory world (the market for political influence, which in Uber’s case may well have been influenced by other aspects of the company’s conduct), has moved in way that has removed some of these points from being available (see illustration below)

Impact of new regulation to reduce solution space

[1] Subsequent to this post some very interesting issues arose surrounding the way that Uber has positioned itself against this market interface, giving rise to repeated charges of sexism and sexual discrimination

“Irresponsible behaviour in big business” – “Unacceptable face of capitalism” remastered?

A new wind is blowing down Downing Street. The leadership of the Conservative Party has skipped back a track, with a generation born in the 1960s whose ideas were shaped by the Thatcher era replaced by one born in the 1950s that emerged into political consciousness in the years of Heath, Wilson and Callaghan. The young Theresa Brazier – later to become Mrs May – was studying for her A levels when the first of these branded Tiny Rowland as “the unacceptable face of capitalism”.

Tiny Rowland was engaged in a battle with his own non-executives at Lonrho at the time, dismissing them as “Christmas Tree Decorations”. Theresa May is now sharing the popular outrage at the conduct of Sir Philip Green and Mike Ashley and calling for changes to address “irresponsible behaviour in big business”, in particular to protect the interests of employees and to challenge excessive executive pay. It is interesting to compare the targets of the two prime forty three years apart: Heath was criticising the chief executive of a company whose non-executive directors were standing up to him, whereas Theresa May’s challenge is to behaviour exemplified by a former chief executive who owned, or rather whose wife principally, owned the company, and a second chief executive who is a majority shareholder but who appears to have the chairman and board in his pocket.

Mrs May’s pronouncements, aided by such high profile cases as BhS and Sports Direct, help to change the climate. But is this sustainable, and are the solutions being canvassed the right ones? Philip Augar, writing in the FT on 22^nd August, noted

In her last major speech before entering Number 10 as prime minister, Theresa May eerily echoed remarks made by the former Labour premier Tony Blair 20 years earlier: “Transient shareholders are not the only people with an interest when firms are sold or closed,” she said. “Workers have a stake, local communities have a stake, and often the whole country has a stake.”

Mr Blair, in a speech delivered in Singapore shortly before he took power, asserted that it was “time to assess how we shift the emphasis in our corporate ethos . . . towards a vision of the company as a community or partnership in which each employee has a stake”.

Augar went on to point out that “what had promised to be a defining philosophy for New Labour was scarcely heard of once he was in office”. Admittedly, section 172 of the 2006 Companies Act did shift the ground by requiring directors to:

have regard (amongst other matters) to—

the likely consequences of any decision in the long term,

the interests of the company’s employees,

the need to foster the company’s business relationships with suppliers, customers and others,

the impact of the company’s operations on the community and the environment,

the desirability of the company maintaining a reputation for high standards of business conduct, and

the need to act fairly as between members of the company.

Nonetheless, Augar’s point about lack of delivery is well made, given precisely the types of issue that the new prime minister has declared that she wants to address.

Her ambition to reform corporate governance is admirable. But are they right solutions? The FT reports today (25^th July):

The prime minister’s allies say that a package of measures to improve corporate governance are being drawn up and will be published in the coming weeks.

Mrs May this month promised to broaden the pool of non-executive directors, so that they were no longer drawn from “the same narrow, social and professional circles as the executive team”.

“If I’m prime minister, we’re going to change that system and we’re going to have not just consumers represented on company boards but employees as well,” she said.

The idea is opposed by some corporate leaders, who fear that “worker directors” would end up being selected by trade unions. Mrs May’s team say they would act as a deterrent to the “appalling” working practices adopted by Sports Direct, which were heavily criticised by MPs this month.

Mrs May’s reforms are also expected to include a requirement for more transparency on pay, including making shareholder votes on corporate pay not just advisory but binding. “Pay multiple” data would also be published to show the gap between a chief executive’s pay and those of workers.

The new prime minister has also talked about toughening competition law to protect consumers and a further crackdown on corporate tax avoidance and evasion. “It is not anti-business to suggest that big business needs to change,” Mrs May said at the launch of her leadership bid.

There is some very good stuff here, including ideas about widening the pool of non-executive directors, but a lot more thought is required about how this should be done, and what would be the most effective way of ensuring that what is done addresses the problems identified. For example, appointing a token employee director may be a less effective way of addressing the need to represent employee’s interests than having an effective workforce or HR director on the board whose job it to take into account the need to meet the needs and desires of all the workforce, and couple this with greater protection of employee rights, not least around working conditions and pensions.