Every couple of years, the popular press muses whether the research conducted at Business Schools has any practical relevance. It looks like it’s time again (see Value of B-School Research).

According to the Economist:

Most MBA students will never read an issue of Administrative Science Quarterly, a well-regarded business-research journal…A recent issue included “Forging an Identity: An Insider-Outsider Study of Processes Involved in the Formation of Organisational Identity” and “Socioemotional Wealth and Corporate Responses to Institutional Pressures: Do Family Firms Pollute Less?”

Don’t worry if you can’t make heads or tails of the research from the titles. Truth be told, you’re not supposed to, and sometimes, neither can I. But I’m ok with that.

Anyhow,

If vapid bestsellers like “Who Moved My Cheese?” are at one end of the spectrum of management writing, then the typical ASQ article is resolutely at the other. The task of a business-school professor is to meet students somewhere in the middle. Over the last decade, there has been a chorus of critics proclaiming that they have not done a good enough job.

This year’s Sumantra Ghoshal Conference, held at London Business School, debated whether strategy research has become irrelevant to the practice of management. The late Mr Ghoshal published a paper in 2005 castigating business schools for heaping “bad theory” on their students.

I have attended several of the Ghoshal Conferences and have written about my experiences (see On Managerial Relevance, Initial Thoughts from LBS Conference, and Final Thoughts from LBS Conference). I was unable to attend the conference this year due to scheduling conflicts, but I still think the conference is a wholly worthwhile endeavor, …and I look forward to returning in coming years.

But back to the Economist article:

…Warren Bennis and James O’Toole, both at the University of Southern California, published an article in the Harvard Business Review [similarly] criticising MBA programmes for paying too much attention to “scientific” research and not enough to what current and future managers actually needed. Business schools, they argued, would be better off acting more like their professional counterparts, such as medical or law schools, nurturing skilled practitioners as well as frequent publishers.

But since, according to Bennis and O’Toole, Business Schools don’t act like medical or law schools, the question then becomes:

…should a prospective student worry about a faculty’s research prowess when applying to a school?

I have argued YES (see Should Students Care About Research, Impractically Relevant and On Managerial Relevance).

Although I understand (and even agree with) some of the criticisms of Business School research, I believe current, and future, executives can benefit from being exposed to research emanating from Business Schools.

And it’s not only research exposure that students receive in the classroom. Many professors are imparting critical-thinking skills by applying that research to real-world problems. For example, in Impractically Relevant I wrote:

I believe that we, as professors, …play an important role in bringing current research into the classroom. It is up to us to expose students to state-of-the art research, to discuss the important questions of the field, to synthesize the existing findings, to explain those findings in an accessible way, to impart received wisdom, to identify remaining gaps and unanswered questions, and to honestly acknowledge the shortcomings of our work. If we can do all these things, we (and our students) gain a better appreciation for the complexities of the real world. In fact, I believe so strongly in this charge that I feel that if we are not bringing research into the classroom, then we are failing our students. We owe them the best education possible, and it doesn’t mean spoon-feeding them “the answers”, but rather, engaging them in intellectually stimulating discourse and debate so that they can come to their own (informed) conclusions.

In addition to our function as translators, dissemenators, and synthesizers of scientific knowledge inside the classroom:

We also impact practice in other ways too. For example, hardly a day goes by that I see a newspaper without a quote from business school faculty. We are constantly asked to give our opinions on current events. What’s more, business school faculty are often asked to inform policy – whether  by proffering opinions to politicians or testifying on business practice. In this sense then, we help shape the game and inform the agenda – helping decide which issues are important and which are not.

[Further], ask the folks from the investment community and hedge fund universe if business school professors have had any impact on their practice. Ask government employees at the Justice Department whether business school economists have had any impact on the cases they bring and/or the outcomes of those cases. Ask CPA’s whether accounting faculty have had an impact on how they practice their craft.Although the full impact of our research on practice varies depending upon the business school discipline (accounting, finance, economics, marketing, strategy, organizational behavior, operations management, etc.), I’m sure I could find an example of some profound impact that an academician from each discipline has had on practice.

So my reaction to this article is consistent with that which I’ve expressed in the past: I think the stories of our demise have been greatly exaggerated. I think we do have a profound influence on practice, although not always in ways that are widely recognized, and in ways that are often difficult to quantify.

As I concluded several years ago:

Do I believe that business schools  ought to be relevant? Absolutely. Do I believe that rigorous research serves an important role in our field? Absolutely. Do I think that we are failing in our goals to be both relevant and rigorous?

Not necessarily.

Although I will be the first to acknowledge that there is room for improvement, so far, I continue to believe that research-oriented Business Schools are providing a public good.

Fordham University hosted the W. Edwards Deming Memorial Conference last week at which the participants addressed the future of the MBA degree (see MBA Under Siege: Reimagining Management Education). The speakers who presented were truly impressive scholars who have been among some of the most vocal critics of the MBA degree. Given my interest in the business of Business Schools (see, for example, Op Ed on Business Schools and the Financial Crisis), I was extremely disappointed that I was not able to attend.

Thankfully, one of my colleagues, Seth Freeman, was there. He was kind enough to share his notes from the conference. They can be found below the break.

Seth has asked me to make clear that with the exception of his thoughts that appear in parentheses below, his account of the events describe the panelists’ perspectives as they were conveyed, not his own.

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The Tragedy of B-Schools and the Danger of Lost Legitimacy

The sense of the conference was that B-schools bear significant responsibility for the 2008 financial crisis by emphasizing a myopic and selfish approach to business crystallized by Agency theory.

This emphasis, and the damage it has done to the economy, has called the very legitimacy of the MBA into question, several panelists argued.

B-Schools Train Loose Individuals; the Tragedy of Toyota

Rakesh Khurana,  Professor of Leadership Development at Harvard Business School, warned that such a perspective, has bred a generation of ‘Loose Individuals’ who do not feel constrained by social norms of fairness or equity; who lack any sense of moral responsibility, and for whom the very idea of a larger duty to community and society seems alien or communistic, a sentiment most panelists (though not all) amplified.

Andrea Garbor, Chair of Business Journalism, Baruch College, noted that Toyota recently admitted the cost of this myopic and self-interested approach. Until recently, it was  a very profitable firm that made great cars led by old-school process experts who applied the systems principles of Edward Deming. But it’s become a troubled, highly criticized firm led by MBAs who myopically focused on finance and quick growth.

A Norm of Wall Street Arrogance?

Several panelists noted that an ‘MBA’ has come to mean a shallow, self-seeking, and arrogant person. Khurana reported that student-led studies at Harvard Business School found that graduating MBAs mostly felt less competent after going through the program, unless they fit into the subculture of white, male, American born New York investment bank financial types.

Kill the MBA

Henry Mintzberg, Professor of Management Studies at McGill, argued that the MBA promises something it simply cannot deliver and that it actually makes business worse by falsely encouraging 25 year-olds to think they can manage anything. Management, he said, is a practice, not a science or profession- a practice you can only nurture once someone is out there doing it.  So teaching inexperienced students is a waste of time, or worse.

Mintzberg also challenged the case method for the pretense that one can speak insightfully about a business after reading facts for a couple of hours, and that it overlooks the point that gathering facts is one of the key tasks of management.

He described a program he leads where managers largely learn by talking with each other around tables in class about how their work interacts with their training.

He argued for reform in several ways:

1. Shift classroom teaching from a ‘sage on stage’ approach to a ‘guide on the side’ approach, and help managers learn from each other mainly
2. Do not attempt to teach 25 year-olds how to manage.
3. Offer different training for 25 year-olds (who know little) than you offer to 40 year-olds (who know a lot and best learn from each other)
4. Replace the MBA with the more truthful ‘Master of Managerial Science’ and ‘Master of Science in Business’ degrees. Or keep it but stop calling it ‘management’ training, since it’s mostly about specialized training in finance and economics and not administration.
5. Look to second tier English business schools for truly exciting, innovative programs and courses.

Authentic Leadership

Michael Jensen, Emeritus professor at HBS,  spoke about his effort to go beyond the Agency theory he championed and to teach Authentic Leadership at Harvard, an approach which emphasizes the centrality of Integrity, Personal Authenticity, and Passionate Commitment.

(Ironically, Prof. Jensen did not respond to the claim by other panelists that his past advocacy for Agency theory may have hurt our society. And he was hard-pressed to offer examples of leaders who rose to the top following the principles he advocates now.)

Beyond Agency Theory- Greater Emphasis on Community, Society, Ethics…Even Theatre Arts

Most emphasized the need to move away from a myopic and self-defeating focus on narrow personal self-interest emphasized by economics and finance, and the need to train students to see the effects of their decisions on other stakeholders. Ed Freeman, a Professor of Business Administration, at Darden, though a self-described libertarian, shared this view with other panelists.

Several emphasized the need for stronger ethics training; others challenged the idea.

Several spoke of other changes to cultivate breadth, depth, and social awareness, arguing for inter-disciplinary training, combinations of design and business, liberal art education, even teaching B-school students to produce and act in plays.

MBA as Value Creator

Though few spoke positively about MBAs and B-Schools, some noted toward the end that B-School can and sometimes does even now cultivate socially aware, value creating leaders.

Change? It Will Likely Come from Outside Pressure

Change, several argued, will have to come from the outside, because even now, schools, deans, and even the AACSB have strong incentives to maintain the status quo.  Look for pressure from for-profit schools, corporate training programs, and recruiters who stop hiring MBAs.

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Interesting. Thanks for sharing Seth!

The Economist ran an article last week reviving the decades-old debate between models of shareholder wealth maximization and stakeholder wealth maximization (see A New Idolatry).

The basic idea behind the shareholder wealth maximization model is that a firm’s sole purpose is to maximize shareholder value (i.e., share price). The stakeholder view offers a different (although not necessarily contradictory) perspective.

According to stakeholder theory, the aim of the firm is to maximize value by taking the concerns of all its stakeholders, not simply its shareholders, into consideration. That is, firms ought to incorporate stakeholder – shareholder, supplier, customer, employee, community, and any other constituency with a “stake” in the firm – interests into their decision calculus, thereby generating value not just for shareholders, but also for society at large. It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties). Wikipedia provides a and brief overview of stakeholder theory for anyone interested in reading more (see Stakeholder Theory).

Oh yeah, back to The Economist article:

The economic crisis has revived the old debate about whether firms should focus more on their shareholders, their customers, or their workers.

[The shareholder maximization model] has dominated American business for the past 25 years, and was spreading rapidly around the world until the financial crisis hit, calling its wisdom into question.

…Roger Martin, dean of the University of Toronto’s Rotman School of Management, charts the rise of what he calls the “tragically flawed premise” that firms should focus on maximising shareholder value, and argues that “it is time we abandoned it.” The obsession with shareholder value began in 1976, he says, when Michael Jensen and William Meckling, two economists, published an article, “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure”, which argued that the owners of companies were getting short shift from professional managers. The most cited academic article about business to this day, it inspired a seemingly irresistible movement to get managers to focus on value for shareholders. Converts to the creed had little time for other “stakeholders” …[and] American and British value-maximisers reserved particular disdain for the “stakeholder capitalism” practised in continental Europe.

I have long been a proponent of a more stakeholder-oriented approach. However, I admit that it might be a bit difficult to advocate for European versions of “stakeholder capitalism” given the recent problems in the PIIGS nations.

That notwithstanding, I think the shareholder-stakeholder divide speaks to one of the fundamental criticisms of the field of financial economics, and its dogged adherence to the shareholder wealth maximization paradigm (see The Future of Financial Economics and Part Deux for criticisms of that approach). Back in March of 2009 I wrote:

…I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

Although I have been an advocate of a more stakeholder-oriented approach, this is not to say that there are not valid criticisms that can be leveled at stakeholder theory. The shareholder maximization approach is appealing precisely because profitability and share price are quantifiable, and easily measured. However, concepts from stakeholder theory defy quantification in a conventional sense. It’s not always clear which are the right stakeholders to pay attention to, and even if you can identify the appropriate stakeholder set, how do you weight their interests accordingly? In addition, how do you quantify, for example, when firms are effectively meeting the needs of their local communities, and what those needs are to begin with?

Admittedly, the stakeholder view of the firm is still in its infancy, but given its broader social implications, and in the wake of the financial crisis, I think it is well worth the effort to try to advance the field.

In recent years I have worked with Michael Barnett of Oxford on ways to better quantify stakeholder performance, and on how to bridge the stakeholder-shareholder divide. Other scholars in strategy, management, and finance are likewise devoting increasing attention to this topic. I am therefore hopeful that we, as a field of organizational scholars, will come to some new understanding in this respect.

Of course, the Economist article that I quoted does not break any particularly new ground in this respect; nevertheless, I am glad that folks in the mainstream media are finally starting to pick up on the shareholder-stakeholder debate. I am convinced that it remains an important one, and the truth is: It is a debate well worth having.

It’s been a whirlwind few weeks of travel for me – beginning in Holland, then on to Paris, followed by a trip to DC. But I am now back in New York, looking forward to getting back to a more regular, regimented schedule.

In the meantime, I thought I’d share some articles that I’ve enjoyed reading over the past few weeks.

1. Canadian Pension Organization to Buy UK Lottery – Details how a Canadian Teacher’s Pension organization is trying to acquire a British lottery operator. Can someone please explain to me the logic of a pension fund running a lottery company, …in a foreign country no less? This defies just about all corporate strategy logic regarding M&A activity. What do pension funds know about running lottery companies?? And if they’re simply a financial buyer, what business discipline will they be able to impose, especially since the owners get only a small portion of the profit? Also, I can’t help but wonder how Canadian teachers will feel about owning a gambling operation.
2. The Celebrity Effect – Details research on the financial impact of appointing celebrities to a company’s Board of Directors (e.g., Evander Holyfield at Coca Cola; Michael Jordan at Oakley; Billie Jean King at Philip Morris; Gerald Ford at American Express). Although the research suggests that firms benefit from announcing celebrity directors, I remain skeptical. I have brought board members from various large public corporations to speak in my class, and they have expressed disappointment with the celebrity members of their boards, sharing stories about celebrities who typically do not pull their weight. I can understand if a celebrity has a particular expertise that lends itself to the business or if a former politician joins the board of a firm that operates in the government sector and/or for which political connections are especially important. However, by and large, I think that many of these appointments are ceremonial, and likely do not create value.
3. The Panda has Two Faces – A story from the Economist on the perils of doing business in China. They stress the political, economic, and cultural quandary facing foreign entrants (see also So You Want to Do Business in a Developing Country). A choice quote from the Economist article, “[China] regards foreign investment as a mechanism for acquiring foreign know-how rather than just jobs and capital; hence the insistence on joint ventures…political difficulties are piled on top of cultural difficulties. The Chinese emphasis on personal connections (guanxi) makes it hard to distinguish between business-as-usual and corruption. And the weakness of the legal system means that companies operate in a confusing half-light. Transparency International’s most recent Corruption Perceptions Index ranks China 79th out of 180 countries…”
4. Relax, We’re Fine – The future of the US economy according to David Brooks. Although the title of the article might be viewed as insensitive to the plight of the millions of Americans who are currently unemployed, I think that David is rightly optimistic about the long-term prospects of the US economy. And it’s nice to remind ourselves of that sometimes, …especially when things don’t feel so great at the moment. A choice quote, “…the U.S. remains a magnet for immigrants…the U.S. is among the best at assimilating them (while China is exceptionally poor). As a result, half the world’s skilled immigrants come to the U.S. As Kotkin notes, between 1990 and 2005, immigrants started a quarter of the new venture-backed public companies. The United States already measures at the top or close to the top of nearly every global measure of economic competitiveness. A comprehensive 2008 Rand Corporation study found that the U.S. leads the world in scientific and technological development. The U.S. now accounts for a third of the world’s research-and-development spending. Partly as a result, the average American worker is nearly 10 times more productive than the average Chinese worker, a gap that will close but not go away in our lifetimes.” This is exactly why I find it hard to believe some of the predictions that China will soon overtake the US as a technological super-power (see also China Attracting High-Tech Research).
5. The Return of History – A David Brooks two-fer. This Op-Ed is his critique of the field of economics. These are not necessarily new arguments (see Future of Financial Economics, Future of Financial Economics Part Deux, and Krugman on the Future of Economics). Moreover, I am not so sure I agree with David’s prediction with respect to Act V. Nevertheless, it was thought-provoking and provided an entertaining read.

Anyhow, I hope you find these articles well worth your time to read. Enjoy!

I was delighted to hear that Oliver Williamson was awarded the Nobel Prize in Economics (shared with Elinor Ostrom). Oliver Williamson is recognized for his contribution to the field of Transaction Cost Economics, building on the path-breaking work of scholars like Ronald Coase.

Transaction Cost Economics is a central theory in the field of Strategy. It addresses questions about why firms exist in the first place (i.e., to minimize transaction costs), how firms define their boundaries, and how they ought to govern operations.

In Transaction Cost Economics, the starting point is the individual transaction (the synapse between the buyer and the seller). The question then becomes: Why are some transactions performed within firms rather than in the market, as the neoclassical view prescribes.

The answer, not surprisingly, is because markets break down.

As a consequence of human cognitive limitations, coupled with the costs associated with transacting, the basic assumptions associated with efficient markets (e.g., anonymous actors, atomistic actors, rational actors, perfect information, homogeneous goods, the absence of liquidity constraints) fail to hold. For these reasons it is often more advantageous to structure transactions within firms. And this is why firms are not just ubiquitous in our society, but also worthy of study in their own right. This contrasts with the typical view of firms in neoclassical economic theory as, at worst, a market aberration that ought not exist, and at best, a black box production function.

Williamson’s contributions to the field of Transaction Cost Economics complement, and extend, those of Coase. First, Williamson started with an explicitly behavioral assumption of human behavior (bounded rationality). Second, he recognized that transacting parties sometimes behave opportunistically and take advantage of their counterparties. Finally, he identified features of transactions (e.g., specificity, uncertainty, frequency) that cause markets to fail; and hence, are likely to lead certain transactions to be organized within firms (hierarchies) rather than markets.

I was pleased to see Oliver Williamson recognized not just because of my inherent intellectual bias — my research has drawn on, and contributed to, the field of Transaction Cost Economics and I have worked with students of Williamson (see my research page for details) — but also because of what his selection implies for the broader field of economics. It implies that the field is moving in the direction of greater inclusion of economic perspectives that are based more on behavioral theories (see Krugman on the Future of Economics).

It was also fun to watch establishment economists make sense of the selection (see the Economists View post for some perspective). For example, Steven Leavitt writes:

When I was a graduate student at MIT back in the early 1990’s, there was a Nobel Prize betting pool every year. Three years in a row, Oliver Williamson was my choice. At the time, his research was viewed as a hip, iconoclastic contribution to economics — something that was talked about by economists, but that students were not actually trying to emulate (and probably would have been actively discouraged from had they tried to do so). What’s interesting is that in the ensuing 15 years, it seems to me that economists have talked less and less about Williamson’s research, at least in the circles in which I run.

MY COMMENT: I think Leavitt underestimates the impact of Williamson’s work because he is neither a Strategy scholar, nor is he in a Strategy or Management department. Go to any Strategy or Management department and you will find oodles of researchers (and doctoral students) working on Transaction Cost problems. It is a dominant paradigm.

Paul Krugman (in his post An Institutional Economics Prize) writes:

The way to think about this prize is that it’s an award for institutional economics, or maybe more specifically New Institutional Economics.

Neoclassical economics basically assumes that the units of economic decision-making are a given, and focuses on how they interact in markets. It’s not much good at explaining the creation of these units — at explaining, in particular, why some activities are carried out by large corporations, while others aren’t. That’s obviously an interesting question, and in many cases an important one.

…Oliver Williamson’s work underlies a tremendous amount of modern economic thinking; I know it because of the attempts to model multinational corporations, almost all of which rely to some degree on his ideas.

MY COMMENT: Krugman gets it partially right, but he does a lot of handwaving with respect to Williamson’s specific contributions. But with all due respect, he certainly makes no claim to be a Strategy scholar. He is right in the sense that the award speaks volumes about New Institutional Economics, broadly defined. However, in the case of Williamson, the specific contribution is to the field of Transaction Cost Economics. Moreover, the contributions of Williamson’s work extend far beyond the field of international business (or international strategy), but I agree that Transaction Cost Economics has been influential in those fields as well.

Nevertheless, my congratulations to Oliver Williamson, and to his students (many of whom I know well), who have long carried the torch for this important, yet underappreciated, branch of economics.

I have long had an interest in what the financial crisis means for the future of the fields of economics and finance (see Future of Financial Economics and Future of Financial Economics Part Deux). So I was incredibly pleased to come across Krugman’s abbreviated history and thoughtful criticisms of the field of economics in the New York Times Magazine (see How Did Economists Get It So Wrong).

A bit of a teaser:

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth…the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

Krugman follows that introduction with a fascinating, and well-informed, account of the history and development of the field of economics, with a focus on macroeconomics/finance and the longstanding debate between so-called freshwater (Free-Market) economists and saltwater (Keynseyian) economists. Although Krugman and I are in different academic fields (Krugman is an international macro scholar and I am an international business strategy scholar), our conclusions with respect to the future of financial economics are more or less aligned. Krugman suggests:

If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What’s probably going to happen now — in fact, it’s already happening — is that flaws-and-frictions economics will move from the periphery of economic analysis to its center.

There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance [economics].

Krugman’s article is a fairly long (hence its placement in the magazine), but well worth your time to read. So carve out a bit of time, visit the NY Times Magazine website, pour yourself a drink, and enjoy the read.

After my recent posts on university enrollments and affordability (see Enrollment Drops at Private Colleges and The Future of U.S. Higher Education), I received an email from Marc Scheer, author of No Sucker Left Behind: Avoiding the Great College Ripoff. On his site I found a link to a recent Wall Street Journal article (see Weighing Price and Value when Picking a College) that describes some of the very same effects that I anticipated in my earlier posts.

According to the Wall Street Journal:

Facing shrunken savings and borrowing options, parents and students are making some tough trade-offs in choosing and paying for college, suggesting some shifting attitudes toward higher education may endure beyond the recession.

Old dreams of adult children earning degrees from elite, door-opening colleges or “legacy” schools attended by relatives are falling away in some families, in favor of a new pragmatism. Other parents and students are doing a tougher cost-benefit analysis of the true value of a pricey undergraduate degree.

…Joseph Losco, an expert on the history of education, calls “one of the strange things” about the economics of higher education: “Universities and colleges don’t compete on price.” In fact, some college administrators fear lowering their sticker price will hurt their image…

Consumers have been complicit, largely because…“the baby-boomer notion that parents should give it all up for the kids.” In a May 2008 survey of 720 parents of college students by Gallup and Sallie Mae, a student-loan company, 46% said they had never, at any point, ruled out any colleges for their kids based on costs.

But now, “families are much more price-conscious and value-conscious,” Dr. Losco says. A soon-to-be-released Sallie Mae-Gallup study of 1,600 college students and their parents, conducted in March and April, says parents are increasingly anxious about tuition—and students are more skeptical about the value of a degree, compared with the survey from a year earlier.

Such thinking bucks the cultural view that an elite college degree is “the gold standard for both parents and students … validating their worth in society,” Dr. Losco says. Now, more “parents are saying, ‘I don’t have the money to get you where you want to go,’ ” he says.

Even when the economy picks up, some of this new price-consciousness is likely to endure. The engines that have enabled college costs to soar—easy credit, home-equity loans and growth in savings—have stalled. Total college costs are already up 67% in the past decade at private colleges and 84% at public four-year universities, based on College Board data, and graduates’ wages haven’t kept pace.

The percentage of students from middle-income households who are attending state schools is rising, and more lower-income students are enrolling at community colleges, the study shows. “We would expect to see an even greater shift” next year, a Sallie Mae spokeswoman says.

Interesting stuff! Check out the full article.

Back in March I suggested that an open discussion about the future of financial economics seemed warranted (see Future of Financial Economics). I wrote:

Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?

The first assumption that I took issue with was that of complete markets. In fact, as I suggested:

One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down.

Markets break down largely because humans do not behave as “rational” actors typically assumed in our most celebrated models.

In addition to the view of markets as complete, I took issue with some of the other assumptions underlying the efficient market hypothesis.

…associated with the [efficient market hypothesis] EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail.

I concluded by calling for greater inclusion, and an openness to contributions from behavioral economics and other social science disciplines.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

With that as background, I was pleased to come across a fascinating set of articles from this week’s issue of the Economist entitled “Economics: What went Wrong?” This collection of articles asked fundamentally important questions about the future of the field of economics (see Economics: What went Wrong?, Other-worldy Philosophers, and Efficiency and Beyond).

On the field of economics:

Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

…two central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined. There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

On financial economics:

In 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics.

On macroeconomics:

In many macroeconomic models…insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. “The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance,” its designers admit. The present crisis is, unfortunately, one of those issues.

…Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter. It is, for example, often convenient to assume that markets are “complete”—that a price exists today, for every good, at every date, in every contingency. In this world, you can always borrow as much as you want at the going rate, and you can always sell as much as you want at the going rate.

The benchmark macroeconomic model…suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance…nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.

On behavioral economics:

…[a] branch of financial economics is far more sceptical about markets’ inherent rationality. Behavioural economics, which applies the insights of psychology to finance, has boomed in the past decade. In particular, behavioural economists have argued that human beings tend to be too confident of their own abilities and tend to extrapolate recent trends into the future, a combination that may contribute to bubbles. There is also evidence that losses can make investors extremely, irrationally risk-averse—exaggerating price falls when a bubble bursts.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”.

The Economist concludes:

Add these criticisms together and there is a clear case for reinvention…Economists need to reach out from their specialised silos…

I could not agree more.

However you may feel about the future of financial economics, I encourage you to read the articles in full:

• Economics: What went Wrong?
• Other-worldy Philosophers
• Efficiency and Beyond

I’ve had a series of interesting conversations with thoughtful, articulate, and intelligent academics who span disciplinary boundaries (finance, economics, sociology, and psychology) about what the future of the field of financial economics should/will/might look like. In light of the financial crisis, this has been a popular topic of conversation.

There have been two recurring themes:

1. Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?
2. Is shareholder wealth maximization the appropriate objective function?

With respect to the former, I have been engaged in conversations with folks who echo some of Willem Buiter’s concerns. In a brilliant blog post (see State of the Art Uselessness) Buiter contends:

The most influential…theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity – both funding illiquidity and market illiquidity – are also impossible…

[The] complete markets…theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’…is a much better one than that of ‘complete markets’.

My Comment: One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down. But back to Buiter:

In…approaches to monetary theory…the strongest version of the efficient markets hypothesis (EMH) was maintained.  This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.

My Comment: I would go one step further and suggest that associated with the EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail. Buiter alludes to that as well, although he does not come right out and say it:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH…are not models of decentralised market economies, but models of a centrally planned economy.

My Comment: Interesting, so in treating human behavior as governed by the tenets of homo economicus, our agentic models actually obviate agency.

In one of the conversations that I had with a prominent game theorist and a well-regarded entrepreneurship scholar, some of these issues came up. For example, we discussed the importance of incorporating the varying belief-structures of the participants in a market into the value equation. The participants themselves may have such varying beliefs about the market that, in effect, they might actually be playing different games governed by different rules. In such a circumstance it might be better to analytically treat assets as not having an intrinsic (fundamental) value, but rather, to treat the “value” of the assets as contingent upon participants’ subjective beliefs – i.e., the value of the asset is only worth what the next guy is willing to pay for it.

With respect to the second issue (shareholder wealth maximization), I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

As an alternative, a group of scholars in strategy have offered a Stakeholder view of the firm. Stakeholder Theory, most closely associated with Edward Freeman (see wikipedia for a brief overview), suggests that firms ought to incorporate the interests of various stakeholders into their decision calculus, and not simply what’s best for shareholders. They argue that this would result in a firm that generates value not just for shareholders, but also for stakeholders (suppliers, customers, employees, communities, etc.). It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties).

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

In a previous post, I discussed some of the virtues of globalization and the dangers of what I saw as increasing protectionism in the United States (see Globalization and Its Discontents).

A colleague of mine called my attention to a more recent article in Foreign Affairs on the topic (see A New Deal for Globalization). The article is authored by Kenneth Scheve (a political scientist from Yale) and Matthew Slaughter (an economist from Dartmouth). I do not know Kenneth personally, but I have met Matthew on several occasions and I am familiar with his work. In my opinion, Matt has done some excellent work at the interface of international business and international economics.

But that is neither here nor there. The issue at hand is their article. I quite liked the piece, and our opinions converge on many issues. Kenneth and Matthew likewise raise concerns about increasing protectionist sentiment in the U.S., and they agree that policymakers must address those issues.

I suggested that a well-implemented trade adjustment assistance (TAA) program might go a long way in addressing those challenges. I think they agree that TAA programs help, but they believe that TAA programs alone are not the solution. Practically, they argue, it would take too long to retrain displaced workers. That makes sense. As an alternative, they raise a novel solution – countering protectionist sentiment through changes in tax policy.

They write:

Given that globalization delivers tremendous benefits to the U.S. economy as a whole, the rise in protectionism brings many economic dangers. To avert them, U.S. policymakers must recognize and then address the fundamental cause of opposition to freer trade and investment. They must also recognize that the two most commonly proposed responses — more investment in education and more trade adjustment assistance for dislocated workers — are nowhere near adequate. Significant payoffs from educational investment will take decades to be realized, and trade adjustment assistance is too small and too narrowly targeted on specific industries to have much effect.

The best way to avert the rise in protectionism is by instituting a New Deal for globalization — one that links engagement with the world economy to a substantial redistribution of income. In the United States, that would mean adopting a fundamentally more progressive federal tax system. The notion of more aggressively redistributing income may sound radical, but ensuring that most American workers are benefiting is the best way of saving globalization from a protectionist backlash.

The economic gains from globalization are immense. In the United States, according to estimates from the Peter G. Peterson Institute for International Economics and others, trade and investment liberalization over the past decades has added between $500 billion and $1 trillion in annual income — between $1,650 and $3,300 a year for every American. A Doha agreement on global free trade in goods and services would generate, according to similar studies, $500 billion a year in additional income in the United States.

International trade and investment have spurred productivity growth, the foundation of rising average living standards. Gains from globalization have been similarly large in the rest of the world…lifting hundreds of millions of people out of poverty.

I absolutely agree.

They go on to argue that while the gains of globalization to the U.S. have been great, they view those gains as having been unevenly distributed. Specifically, they contend that globalization has resulted in a widening gap between rich and poor because poorer, low-skilled workers are at greater risk of having their jobs outsourced to low cost countries, resulting in decreased real wages for low-skilled workers compared to high-skilled workers (where real wages have been increasing).

They claim that the reason sentiment is becoming more protectionist is because:

Individuals are asking themselves, “Is globalization good for me?” and, in a growing number of cases, arriving at the conclusion that it is not.

I agree that more people now believe that globalization is not good for them. However, I have one minor quibble with their argument in this respect. Although it may be true that people believe that globalization is not good for them, it may not be the case that it is actually bad for them. The authors argue:

If workers in a sector such as automobile manufacturing lose their jobs, they compete for new positions across sectors — and thereby put pressure on pay in the entire economy.

While it is true that if workers lose their jobs in one sector they may have to look for jobs in others, it is not necessarily true that they put pressure on the pay of the entire economy as a result. This is true in a static world where the number of jobs and opportunities in the world are fixed; however, one job lost in the automobile industry might result in one ADDITIONAL job created in the robotics industry – a higher margin, higher value-added industry. In this scenario, if labor coming into an industry leads to greater innovation and greater future growth for that industry, it’s not necessarily clear that salaries will go down for all.

I raise a similar objection to those who argue that outsourcing jobs to developing countries necessarily leads to bad outcomes for those displaced workers. Generally, I believe that we tend to outsource low value-added activities. If we outsource low value-added activities to other countries, this may allow us the flexibility to re-deploy existing resources (people) to alternative, high growth, high value-added activities.

In Kenneth and Matthew’s defense however, they recognize that:

Economists do not yet understand exactly what has caused this skewed pattern of income growth and to what extent globalization itself is implicated, nor do they know how long it will persist.

In my opinion, determining this is the key!!

Nevertheless, they do offer one novel alternative solution to protectionism through tax policy. They offer:

…policymakers should remember that workers do not pay only income taxes; they also pay the FICA (Federal Insurance Contributions Act) payroll tax for social insurance. This tax offers the best way to redistribute income…A New Deal for globalization would combine further trade and investment liberalization with eliminating the full payroll tax for all workers earning below the national median…67 million workers would receive a tax cut of about $3,800 each.

At the end of the analysis, I think this is an interesting proposal, provided that it is a complement to (and not a substitute for) TAA and retraining programs. By the authors’ estimates, the total program would cost around $256 Billion per year to implement. But then again, with the potential gains from Doha alone around $500 Billion per year, it might just be worth a try.

I’ve simplified their arguments for the purposes of this blog, but for those of you interested, I would encourage you to read the entire piece.