Monday, November 9, 2009

Who Bears Risk?

Anyone who has been exposed to an introductory course on Economics will be familiar with the four factors of production, land, labour, capital and enterprise.

These - we are told - serve as the basic inputs for all economic output. Thus to produce any economic good or service, some unique combination of the factors of production is required. Likewise associated with each of these factors is a characteristic payment. Indeed all income that is generated relates to payments to these respective factors.

Associated with land we have rent, with labour, wages (salaries and other earnings), with capital, interest and with enterprise, profits.

However the 4th of these i.e. enterprise, is quite problematic especially in light of the recent financial crisis. I am not the first to raise queries regarding the nature of profits!

For Karl Marx "value" attributed to enterprise in capitalist societies properly belonged to the workers who produced the commodities.
And major communist societies such as the Soviet Union and China for many years attempted to organise production without proper recognition of the special contribution of enterprise.

However, while acknowledging the important role of enterprise, it is still valid to raise important issues regarding its interpretation.

The entrepreneur in capitalist society is viewed as the person who, in attempting to initially set up a business, takes a special risk.

In economics the characteristic payment for this risk is referred to as "normal profits". However due to the many uncertainties typically involved actual returns may exceed the normal return (leading to supernormal profits) or fall below (resulting in supernormal losses).

In large publicly quoted businesses e.g. banks, these risks are spread out among a wide number of shareholders. Typically a shareholder might expect a characteristic dividend payment (as measurement of normal profit). However in good times extra rewards might arise through substantial capital gain in share values and/or extra generous dividend pay-outs. However - sticking with banks for the moment - there is a big problem with this view of risk, as taxpayers in countries, such as Ireland, are now financing the massive losses of banks resulting from reckless mismanagement.

The point I am making is that we need to distinguish as between risk (as narrowly defined), applicable to shareholders and a more general risk that is shared by all society. The narrow risk in this context relates to the possible losses that accrue directly to bank shareholders. The more general risk relates to possible misperformance - and perhaps ultimate collapse - of the banking system generally that would cause huge losses for taxpayers.

For example this is very obvious in my own country, where taxpayers are rightly indignant at being asked to provide for the attempted "clean-up" of the major banks while business also suffers other losses due the the continuing lack of liquidity in the system.

Given that this is patently the case i.e. that the losses of the banks are being generally borne by society as a whole, it makes little sense therefore in good times to associate profits exclusively with bank shareholders. It is precisely this lack of symmetry in the way that we view the matter that is leading to such a strong sense of injustice worldwide. It indeed represents a fundamental problem with the capitalist system.

Thus there is a holistic collective irreducible nature to rightful reward in any society that is blatantly ignored in present market economics.

The collective nature of risk also extends to the setting up of new businesses. Now, in the normal course of events many such businesses are doomed to fail (often within a relatively short time frame). The risk here does not merely extend to the prospective owners of such failed businesses but also to unpaid creditors and loss of resources generally to society. Given that this clearly is the case then it makes little sense to identify the profits of successful surviving businesses merely with their owners!

Another strong example of this problem arises from the fact that millions of workers are now losing their jobs in the private sector. Once again there is a narrow and general risk involved in running a business. If a large business fails, the shareholders clearly will suffer (representing narrow risk).

However the workers employed by that business will also suffer. And because in a recession the possibility of obtaining alternative employment is greatly reduced the loss that is thereby suffered by the workers may be much greater that that pertaining to the shareholders.

Once again the logic of this is that in a very real sense as workers are exposed to - perhaps - the greatest risk (in terms of possible job loss) that have a right to participate in the profits of a business when it prospers.

The failure to recognise this fact therefore exposes the lack of any true collective dimension in our treatment of economic society.

I will give just one more example. If we look at a highly successful company e.g. Microsoft we can see that enormous profits have accrued to its owners especially to founding member Bill Gates. However we cannot properly view a successful innovation such as a seminal new software product solely with its producers!

In fact, the success of any product entails a complex relationship involving both producers and consumers. Therefore there is a much more general aspect to risk with respect to any new product or service that involves the wider group of consumers as essential partners. Therefore the attempt to associate all risks narrowly with the producer is strictly invalid.

What we need therefore is a radical change in perspective.

The success or failure of any product pertains ultimately to society as a whole (and not just narrowly to initial producers who are never independent of consumers).

When we recognise this essential collective dimension, profits from economic production accrue ultimately to society as a whole and thereby should be distributed much more equally than in present circumstances.

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