We have a fundamentally flawed model of capitalism perpetuated by extremely bad proxies that were foisted upon us by deluded economists.
In 1997 Marilyn Strathern, an anthropologist, restated what has been called Goodhart’s law with the adage, “When a measure becomes a target, it ceases to be a good measure.” The adage says that all metrics of scientific evaluation are bound to be abused. When one measure is picked as an indicator it ceases to function as an indicator because people start to game it.
A measure is an indicator, also referred to as a proxy. The measure becomes a substitute for that which it is supposed to be measuring, usually progress towards some objective. As an example, Gross Domestic Product (GDP) is a measure that is widely regarded as a measure, or proxy, for the performance of an economy.
The example of GDP demonstrates the risk that people start to game a measure — to suggest the economy is doing better than it is. And, because this has happened with GDP, it confirms Strathern’s view — “when a measure becomes a target, it ceases to be a good measure.”
As soon as you start looking you will see such measures being used everywhere, and they are often very bad proxies. Many businesses and organisations used very poorly conceived of sets of Key Performance Indicators (KPIs), providing little evidence of the likely future performance of that organisation, for example.
As another example, accountants use measures, often based on projections with embedded false assumptions, and based on nonsense economic theories, plus equally stupid management theories.
Even when they have proven to be incorrect and dangerous, proxies often remain in use. This is because such fallacies can be so deeply embedded they get applied unseen and unquestioned — unconsciously.
Roger Martin talks about this problem quite extensively in his most recent book “When More Is Not Better”, which I reviewed in two-parts. He argues, “we need to reexamine our theories about what “improves” the economy as well as the proxies we use to employ to measure progress and guide further action.”
He goes on to say, “proxies are important because without proxies for measuring progress, it is not possible to know whether one’s pursuit of a model is succeeding or failing”.
Whilst important, he warns “there is a profound chain of imperfection from desired outcome to model to proxies. And the chain of imperfection can cause the use of proxies to undermine the model’s ability to make progress towards desired outcomes.”
There are several ways of explaining this problem and it’s consequences but, first, let’s give the problem its name, surrogation, which Martin defines as “a process whereby a measure for a desired outcome becomes a surrogate for that outcome”.
He notes that in business and policy making proxies are used widely and “have become indistinguishable in the minds of their users from the efficiency they are supposed to measure.”
They are associated with models and, “after we develop and begin using a given model, we become inclined to think that the maps is the territory. The model is reality — it is the way. We close our minds to potential flaws and to alternative, potentially superior models.” And we “compound the problem by mistaking the proxies for the desired outcome of the model.”
As a result, “the means become the ends”. I have just published my review of Invent and Wander: The Collected Writings of Jeff Bezos which will be published by Harvard Business Review Press. It includes re-prints of his annual letters to shareholders. In one of those letters, and in presentations he has given, he warns of this problem.
Bezos says, “As companies get larger and more complex, there’s a tendency to manage to proxies. A common example is process as proxy. Good process serves you so you can serve customers. But, if you’re not watchful, the process can become the thing. This can happen very easily in large organizations. You stop looking at outcomes and just make sure you’re doing the process right”. This is the trap that companies must avoid as they move from what he calls Day One to Day Two.
Martin explains how using proxies as surrogates for desired outcomes can, and does, lead to bad behaviours in business and in modern capital markets.
In the latter case he notes, “stock price is considered the true and complete manifestation of the value of a company. The job of executive management, therefore, is to increase the stock price in order to maximise shareholder value.” And “the logical imperative of this surrogation is to tie executive compensation to stock-price performance.” With the use of an illustration he shows that, “instead of providing an incentive to improve the value of the company over time, the surrogation of today’s stock price for long-term value provided an incentive to produce stock volatility at the expense of long-term value”.
The example used to illustrate the case was that of John Chambers whilst CEO at Cisco Systems (1995–2015). Whilst Cisco shareholders experienced a “pretty wild ride” (losing 27 percent of their stock price and experiencing two periods of 60% drops) Chambers was able to pick up attractively priced stock-based compensation and see his return appreciate by 18 percent. Had it not been for the volatility during that period Martin calculates Chambers would have lost around 20 percent in the value of his stock, not gained 18 percent.
Recently I published the first part of a two-part review of Accountable: How We Can Save Capitalism. In it the authors, both investors, make the following point in the introduction; “Too often profit is confused with value” (their emphasis). They add, “Profit is what happens today. Value is the long-term prosperity driven by strong customer, employee, and supplier relationships; positive community involvement; sustainable production; and cooperation with government in problem solving. We will make out corporations more valuable when we focus them on these things.”
I will conclude with the following thoughts. First, Martin is correct to say, “there is a profound chain of imperfection from desired outcome to model to proxies”, so we should consider the current model of capitalism in this context.
We have a fundamentally flawed model of capitalism perpetuated by extremely bad proxies that were foisted upon us by deluded economists, with the support of accountants and business schools as willing accomplices.
As a result, our progress towards sustainable widely shared prosperity has been severely impaired by several crises. And it will continue to be impaired so long as we continue to use bad proxies and deluding ourselves into thinking there are no better models of capitalism to which we might evolve.
Our measures became our targets and they ceased to be a good measure long ago — assuming they ever were good measures, which is debatable. we must stop deluding ourselves and start questioning the models, the proxies and the implicit assumptions built into them.
In launching a number of major inquiries, the Enlightened Enterprise Academy aims to expose these and related issues on a large-scale and in an open and multi-disciplinary way. For details: Enlightened Enterprise Academy