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.