McKinsey is Wrong: Capitalism Is Not About Innovation

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What are the true nature and purpose of capitalism? In the U.S., a nation that considers capitalism close to a religion, the answer may seem obvious to many people: it is a social and legal system in which individuals (entrepreneurs) compete for wealth using capital (their own or that of investors). Yet, that traditional view, and the “classical” economic theories that formed its historical foundation, have come under increasing scrutiny and debate in academic circles of late.

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The McKinsey Quarterly has a good recap of this debate in its latest issue. The piece’s authors, Eric Beinhocker and Nick Hanauer, start out by noting this reconsideration of the role of capitalism was already underway before the latest meltdown in the world’s financial system:

In the years before the crisis, a new view of economics began to stir. Since the crisis, it has begun to blossom.2 This view holds that the economy is a constantly evolving, interacting network of highly diverse households, firms, banks, regulators, and other agents, more like Haldane’s wild herd than a rocking horse. The economy—a complex, dynamic, open, and nonlinear system—has more in common with an ecosystem than with the mechanistic systems the neoclassicists modeled their theory on. The implications of this emerging view are only just beginning to be explored. But the two of us believe it has fundamental implications for how people think about the nature of capitalism and prosperity.

Significantly, this view shifts our perspective on how and why markets work from their allocative efficiency to their effectiveness in promoting creativity. It suggests that markets are evolutionary systems that each day carry out millions of simultaneous experiments on ways to make our lives better. In other words, the essential role of capitalism is not allocation—it is creation. Life isn’t drastically better for billions of people today than it was in 1800 because we are allocating the resources of the 19th-century economy more efficiently. Rather, it is better because we have life-saving antibiotics, indoor plumbing, motorized transport, access to vast amounts of information, and an enormous number of technical and social innovations that have become available to much (if not yet all) of the world’s population. The genius of capitalism is that it both creates incentives for solving human problems and makes those solutions widely available. And it is solutions to human problems that define prosperity, not money.

The authors expand on this idea that the true role of capitalism is solving problems and not wealth creation, per se, or, more classically, the efficient allocation of capital. These phenomena, wealth or efficiency, are by-products of capitalism’s primary function, they argue, which is making life better for people.

Their next hypothesis is that, if problem solving is capitalism, then growth is the increase in the availability of solutions within a given population:

Going from fearing death by sinus infection one day to having access to life-saving antibiotics the next, for example, is growth. Going from sweltering in the heat one day to living with air conditioning the next is growth. Going from walking long distances to driving is growth. Going from needing to look up basic information in a library to having all the world’s information instantly available on your phone is growth. 

In other words:

Growth is best thought of as an increase in the quality and availability of solutions to human problems. Problems differ in importance, and a new view of growth must take this into account: finding a cure for cancer would trump many other product innovations. But in general, economic growth is the actual experience of having our lives improved.

Of course, this is not what growth is today nor do measurements of “solution availability” exist, so the authors address this issue as well:

Can the rate at which solutions appear and their availability be measured? While such a measure has not been tried yet, we believe it is possible. Inflation is measured by looking at changes in the prices of goods and services in a “basket” typically consumed by households. Similarly, it’s possible to look at how the actual contents of such a basket are changing across time or how they differ across countries or levels of income. What kind of food, housing, clothing, transport, healthcare, education, leisure, and entertainment do people have access to?

Finally, they come to their major conclusion, which is the need to redefine and reorient capitalism to what is essentially a social function, rather than an economic one:

We believe that a reorientation toward seeing businesses as society’s problem solvers rather than simply as vehicles for creating shareholder returns would provide a better description of what businesses actually do. It could help executives better balance the interests of the multiple stakeholders they need to manage. It could also help shift incentives back toward long-term investment—after all, few complex human problems can be solved in one quarter.

This is not to say that shareholders or other owners are unimportant. But providing them with a return that is competitive compared with the alternatives is a boundary condition for a successful business; it is not the purpose of a business. After all, having enough food is a boundary condition for life—but the purpose of life is more than just eating.

The article’s thesis is a seductive one, of course. And many people would surely prefer to live in a world where MBAs are prepared for innovation and problem solving, rather than wealth accumulation. That idea sounds good at first glance, and the authors add a feel-good ending to their argument at the end of their piece:

Today our culture celebrates money and wealth as the benchmarks of success. This has been reinforced by the prevailing theory. Suppose that instead we celebrated innovative solutions to human problems. Imagine being at a party and rather than being asked, “What do you do?”—code for how much money do you make and what status do you have—you were asked, “What problems do you solve?” Both capitalism and our society would be the better for it.

After reading the piece, it’s tempting to agree with the authors and conclude that business schools should rethink their curriculum to focus primarily on innovation and idea solving, rather than “old” ideas like finance and shareholder value. But is this really the case? To answer that question, we have to ask, as the authors are right to do, what is the fundamental role of the capitalism system? When you take earned capital and put into a savings account (indirect capitalism) or invest it in a start-up (direct capitalism), are you doing so because your are hoping some problem will get solved or are you doing so because you hope your capital will grow? Put another way, how many investors would pass up a 15% return in a non-problem-solving investment for a 7% return in an investment that, say, reduces traffic congestion? My opinion js that most real people invest for wealth creation and will chose the higher return option up until such time as they think they have sufficient wealth. Once they exceed this point, they may start to chose lower-return/socially improving options but not before it. Indeed, ask most emerging economy poor which would they rather have: more wealth or quicker access to a health clinic, and I’m pretty sure most will vote for the latter. Why is that? The answer is because specific solutions or innovations do not provide choices, which is what wealth represents to most people: the option to work or not work, the ability to buy or not buy, the option to give or not give.

The genius of classical capitalism is that its focus was on creating wealth so that capitalists could decide for themselves what was valuable. Having some social scientists or “innovators” chose for me what I should want is not the system we need. If I want more solutions, then I can invest my wealth in innovation companies. If I want more leisure, then I can invest my wealth in a way that gives me more time. That is not to say the authors are wrong on all points, for they are right that capitalism needs to be refocused away from speculation and back toward real investment. The many financial crises of the last twenty years — most of which, by the way, were created by “innovators” inventing new “solutions” to problems, such as derivatives to offset risk — demonstrate that capitalism has lost its way and needs to return to its core mission. That core mission is not making better water fountains or lightbulbs. That mission is making you and me wealthier, so we can decide what to do with that wealth for ourselves. This was, is, and should be the only goal of the capitalist system. Adam Smith’s invisible hand works most of the time: rather than handcuffing it to a lab bench, we need to let it get back to work.

Read more:

http://www.mckinsey.com/Insights/Corporate_Social_Responsibility/Redefining_capitalism?cid=mckq50-eml-alt-mip-mck-oth-1410

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2 comments on “McKinsey is Wrong: Capitalism Is Not About Innovation”

  1. I would be tempted to say that capitalism is about rent seeking and that innovation is a means to that end that will be employed only when cheaper or less risky avenues are closed, the latter requiring constant vigilance and action by antitrust and competition authorities.

  2. {The many financial crises of the last twenty years — most of which, by the way, were created by new “solutions” to problems, such as derivatives to offset risk — demonstrate that capitalism has lost its way and needs to return to its core mission.}

    this is a very important point – I’d say it is lost on most people – well said.

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