macroresilience

resilience, not stability

Organisational Rigidity, Crony Capitalism, Too-Big-To-Fail and Macro-Resilience

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In a previous post, I outlined why cognitive rigidity is not necessarily irrational even though it may lead to a loss of resilience. However, if the universe of agent strategies is sufficiently diverse, a macro-system comprising of fragile, inflexible agents can be incredibly resilient. So a simple analysis of micro-fragility does not enable us to reach any definitive conclusions about macro-resilience - organisations and economies may retain significant resilience and an ability to cope with novelty despite the fragility of their component agents.

Yet, there is significant evidence that organisations exhibit rigidity and although some of this rigidity can be perceived as irrational or perverse, much of it arises as a rational response to uncertainty. In Hannan and Freeman’s work on Organizational Ecology”, the presence of significant organisational rigidity is the basis of a selection-based rather than an adaptation-based explanation of organisational diversity. There are many factors driving organisational inertia, some of which have been summarised in this paper by Hannan and Freeman. These include internal considerations such as sunk costs, informational constraints, political constraints etc as well as external considerations such as barriers to entry and exit. In a later paper, Hannan and Freeman also justify organisational inertia as a means to an end, the end being “reliability”. Just as was the case in Ronald Heiner’s and V.S. Ramachandran’s framework discussed previously, inertia is a perfectly logical response to an uncertain environment.

Hannan and Freeman also hypothesise that older and larger organizations are more structurally inert and less capable of adapting to novel situations. In his book “Dynamic Economics”, Burton Klein analysed the historical record and found that advances that “resulted in new S-shaped curves in relatively static industries” do not come from the established players in an industry. In an excellent post, Sean Park summarises exactly why large organizations find it so difficult to innovate and also points to the pre-eminent reference in the management literature on this topic – Clayton Christensen’s “The Innovator’s Dilemma”. Christensen’s work is particularly relevant as it elaborates how established firms can fail not because of any obvious weaknesses, but as a direct consequence of their focus on core clients’ demands.

The inability of older and larger firms to innovate and adapt to novelty can be understood within the framework of the exploration-exploitation tradeoff as an inability to “explore” in an effective manner. As Levinthal and March put it, “past exploitation in a given domain makes future exploitation in the same domain even more efficient….As they develop greater and greater competence at a particular activity, they engage in that activity more, thus further increasing competence and the opportunity cost of exploration.” Exploration is also anathema to large organisations as it seems to imply a degree of managerial indecision. David Ellerman captures the essence of this thought process: “The organization’s experts will decide on the best experiment or approach—otherwise the organization would appear “not to know what it’s doing.”"

A crony capitalist economic system that protects the incumbent firms hampers the ability of the system to innovate and adapt to novelty. It is obvious how the implicit subsidy granted to our largest financial institutions via the Too-Big-To-Fail doctrine represents a transfer of wealth from the taxpayer to the financial sector. It is also obvious how the subsidy encourages a levered, homogenous and therefore fragile financial sector that is susceptible to collapse. What is less obvious is the paralysis that it induces in the financial sector and by extension the macroeconomy long after the bailouts and the Minsky moment have passed.

We shouldn’t conflate this paralysis with an absence of competition between the incumbents – the competition between the incumbents may even be intense enough to ensure that they retain only a small portion of the rents that they fight so desperately to retain. What the paralysis does imply is a fierce and unified defence of the local peak that they compete for. Their defence is directed not so much against new entrants who want to play the incumbents at their own game, but at those who seek to change the rules of the game.

The best example of this is the OTC derivatives market which is the benefits of TBTF to the big banks are most evident. Bob Litan notes that clients “wanted the comfort of knowing that they were dealing with large, well-capitalized financial institutions” when dealing in CDS and this observation holds for most other OTC derivative markets. He also correctly identifies that the crucial component of effective reform is removing the advantage that the “Derivative Dealers’ Club” currently possess: “Systemic risk also would be reduced with true derivatives market reforms that would have the effect of removing the balance sheet advantage of the incumbent dealers now most likely regarded as TBTF. If end-users know that when their trades are completed with a clearinghouse, they are free to trade with any market maker – not just the specific dealer with whom they now customarily do business – that is willing to provide the right price, the resulting trades are more likely to be the end-users’ advantage. In short, in a reformed market, the incumbent dealers would face much greater competition.”

Innovation in the financial sector is also hampered because of the outsized contribution it already makes to economic activity in the United States, which makes market-broadening innovations extremely unlikely. James Utterback identified how difficult it is for new entrants to immediately substitute incumbent players: “Innovations that broaden a market create room for new firms to start. Innovation-inspired substitutions may cause established firms to hang on all the more tenaciously, making it extremely difficult for an outsider to gain a foothold along with the cash flow needed to expand and become a player in the industry.” Of course, the incumbents may eventually break away from the local peak but an extended period of stagnation is more likely.

Sustaining an environment conducive to the entry of new firms is critical to the maintenance of a resilient macroeconomy that is capable of innovating and dealing with novelty. The very least that financial sector reform must achieve is to eliminate the benefits of TBTF that currently make it all but impossible for a new entrant to challenge the status quo.

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Written by Ashwin Parameswaran

May 2nd, 2010 at 3:48 pm

11 Responses to 'Organisational Rigidity, Crony Capitalism, Too-Big-To-Fail and Macro-Resilience'

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  1. The “universal bank” concept and the conglomerate financial institution, which owns, and strategically directs an array of subsidiary firms, with various functions and business models, poses an “ecological” threat that may have few good analogies in biology.

    The “competition” in any industry/market is likely to be both horizontal and vertical. Horizontal competition comprises rivalry with firms with similar business models and strategies, as well as strategic competition against firms with differing business models, strategies and resource bases. Vertical competition — strategic interactions with customers and service vendors and suppliers — is also an important discipline.

    If we imagine a relatively atomistic structure, in which autonomous firms are organized around possession of rent-yielding assets and business models centered on technically-efficient control of business processes, then the system as a whole may be resilient and adaptive, with firm birth and growth compensating for the hazards of firm contraction and liquidating bankruptcy.

    I’d risk a discursion to draw attention to the importance of control, in the sense of technical control of business processes to achieve administrative or technical efficiency. Competition, financial reporting and financial leverage contribute to achieving effective control and technical efficiency.

    Submersion in conglomerate structure threatens all these sources of incentive pressure. Leverage, which for the autonomous firm, can be a way for investors to overcome asymmetric information problems with the management, is lost to the larger entity. The conglomerate may well mandate modifications to both vertical and horizontal rivalrous relationships. It is not uncommon, to have the same conglomerate on both side of what was once an arm’s length, “market-mediated” relationship. Financial reporting, which might have once exposed the autonomous firm to a fair appraisal of risk and performance, is now an exercise in obscuring the performance of operating units in the larger whole. And, the management of the operating unit, instead of grappling directly with the feedback from markets, is directed by an internal score-keeping system, which can acquire its own biases and quirks; gaming the score-keeping system can replace more realistic market-oriented management strategies.

    The universal bank, like the giant hydra in any industry, can begin to deliberately shape the ecology, which is the economy. Just as Wal-Mart manages its prescription prices to discourage drug stores in its vicinity, so a CitiGroup may be in a position to decide whether a neighborhood should have a CitiBank, or a CitiFinancial office, with implications for promoting thrift or financial degeneracy, as the case may be. WaMu, as I recall, at one point, bought a real estate appraiser; do we have to ask where that was headed?

    There have been somewhat comical instances of the same bank granting first and second mortgages on some big commercial real estate project, and then the bank has to sue itself in a “dispute” over the conflicting rights, when the deal comes apart. But, really, what happened when the deal was being put together? How much honest negotiation takes places, when the same giant corporation, sits on both sides of the table?

    The corrosion has the potential to spread like a slow cancer through the whole political economy, as the networks of universal banks spread out to entwine in alliances with the networks of other conglomerated industries, such as Big Media.

    Bruce Wilder

    6 May 10 at 6:53 pm

  2. Interesting discussion overall, thanks for the thoughts and the introduction to the sources and concepts, all of which are new to me. I’ve been thinking about “resilience” in the context of recovery from failure. In the late 1830s, a few of the 7 brothers in the Cheney family of my hometown, Manchester, Connecticut, became involved in the nascent silk production industry; many of the farmers in the area had taken to raising silkworms in their homes as a second business. The Cheney brothers tried to begin an industrial silkworm-raising mill business, but soon figured out that the real money was in mulberry leaves (to feed the silk worms). They shuttered the mill, and bought hundreds of acres land in New Jersey (near where I live now), where they raised hundreds of thousands of mulberry trees, along with some other producers. By 1841, the mulberry tree bubble had burst, and the Cheneys had lost all their land via sheriff’s sale. But by 1843, they were up and running again in their formerly shuttered mill building, this time as finishers of raw silk imported from Europe. It made my head spin to read about it, because they not only had to change the considerable mechanics of their business 3 times within perhaps 5 or 6 years; they had to change their lobbying approach 3 times as well (i.e., they lobbied, successfully, for 3 different, and conflicting, types of tariff protection over that short period). The third time was the charm, and they built an empire that lasted into the 1930s. What struck me was the speed with which they recovered from each prior failure. At least in those early years, they had no opportunity to ossify via too much focus on core clients’ demands: they didn’t even figure out who their “clients” were until the 3rd time around.

    David Larsson

    11 May 10 at 8:41 pm

  3. Thanks for the comment Bruce. I still hold some hope that the “cancer” can be cured.

    admin

    16 May 10 at 2:56 am

  4. David – glad you found the note interesting. As you said, the ossifying is really a byproduct of prolonged success and unlikely to happen in the early “exploration” phase.

    admin

    16 May 10 at 2:57 am

  5. “if the universe of agent strategies is sufficiently diverse, a macro-system comprising of fragile, inflexible agents can be incredibly resilient.”

    This is the situation with cancer, which can be seen as the somatic evolution of massive diversity of strategies for cells. Cancer cells are individually much less resilient than normal cells but can outcompete as a group of “cronies”.

    The tragic irony is that the treatments we tend to gravitate towards in medicine create selective pressures that enhance rather than diminish the effectiveness of this carcinogenic cronyism.

    Rafe Furst

    22 May 10 at 10:06 am

  6. Rafe – Again thanks for the comment. I think the “systems biology” approach has a lot to offer in medicine. Hopefully will have a few posts in the not too distant future incorporating some systems biology insights.

    admin

    30 May 10 at 8:15 am

  7. [...] Evolvability is defined as the ability of the system to generate novelty and innovate thus enabling the system to “adapt in ways that exploit new resources or allow them to persist under unprecedented environmental regime shifts” (Whitacre 2010). At first glance, evolvability and robustness appear to be incompatible: Generation of novelty involves a leap into the dark, an exploration rather than an act of “rational choice” and the search for a beneficial innovation carries with it a significant risk of failure. It’s worth noting that in social systems, this dilemma vanishes in the absence of irreducible uncertainty. If all adaptations are merely a realignment to a known systemic configuration (“known” in either a deterministic or a probabilistic sense), then an inability to adapt needs other explanations such as organisational rigidity. [...]

  8. [...] risk inherent in such an exploration. The central message in my previous posts on evolvability and organisational rigidity is that this process of exploration is dependent upon the maintenance of a dynamically competitive [...]

  9. [...] the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot [...]

  10. I came across your site while thinking about topics related to my own thoughts:

    http://franksz.wordpress.com/2010/11/30/why-large-organisations-often-seem-to-be-so-disorganised-and-inefficient/

    I wonder if Mr Burton Klein isn’t engaging in circular arguments. Large organisations do innovate, just that they are unlikely to be able to invoke exponential growth once they have reached such a size. A small organisation may exhibit exponential growth and in the context of share-price/investor feedback loops is therefore more likely to induce alterations in the overall fabric. I also wonder what percentage of those innovations were somehow driven by ex-employees of large companies, who are incentivised in a free market to establish their own business around innovations, rather than offer the ideas up for free to unrewarding employers.

    Frank Sz

    19 May 11 at 3:06 pm

  11. Frank – Burton Klein does not claim that large firms do not innovate, just that they do not engage in exploratory innovation without being constantly prodded by new entrants into the industry to do so. This is a milder claim than say those of Clayton Christensen or James Utterback who essentially say that in almost all cases, it is new entrants that undertake disruptive innovation.

    The empirical case is on Christensen and Utterback’s side, a fact that Klein also acknowledges. But Klein’s milder thesis is sufficient for the macroeconomic implications that he goes on to derive in his work and which I use in my writings.

    Ashwin

    20 May 11 at 10:22 am

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