Why Most Things Fail: Evolution, Extinction and Economics Hardcover - 2006

Excerpt

The Edwardian Explosion

The period from around 1880 to 1910 saw the emergence of radically diVerent ways of organizing and carrying out economic activity. The consequences both for economic well-being and the wider sphere of political economy were dramatic, so we will begin by exploring the developments during this period in some detail.

The eminent biologist Stephen Jay Gould coined the phrase 'the Cambrian explosion' for the period some 550 million years ago when, suddenly, dramatic new life forms surged into being. After an immense length of time during which life had existed in only its simplest forms, far more complicated creatures came into existence. Most prospered for a while and then failed. But the legacy was the path of evolution which has led eventually to humanity.

Similarly, in the economic world, the decades around 1900 saw massive companies emerge for the first time, bringing entirely new management problems in terms of co-ordinating and organizing the operations of these vast entities. In British social history, this is known as the Edwardian period, after Queen Victoria's son who himself reigned in the opening decade of the twentieth century, a period when the British Empire dominated the world. So perhaps I might be permitted a trace of nostalgia in describing the events of this period, so important to the future development of capitalism, as the 'Edwardian explosion'.

During these few decades, we can see forms of organizing economic activity fall by the wayside as firms struggled to understand and adapt to the rapidly changing environment. Yet, at the same time, the survivors from this turbulent age were successful on a scale entirely without precedent. The modern world of huge multinational companies, so familiar to us now, was essentially created during this period. Globalization is a hot topic in the early twenty-first century, but its foundations were laid a century before.

The single most useful and productive legal invention in the past few centuries has been that of the commercial firm. Individuals have banded together and pooled their resources in the pursuit of business since time immemorial, but the massive economic expansion of the past two hundred years is based on the modern concept of the company. Financed by outside shareholders and facing limited liability, this new way of organizing the production of goods and services has transformed the world. The firm is the Tyrannosaurus rex of economic activity, a hugely successful species that sweeps all before it.

We can identify two features of the company which make it qualitatively diVerent to all previously existing ways of conducting business. Each is important in its own right, but combined their joint impact is greater than the sum of the individual components. Both had been invented prior to the final quarter of the nineteenth century. But it was during this period that the overall conditions became right for a dramatic transformation of the economic environment based on them.

The first feature is the idea of attracting outside investors into the venture. By itself, this is not particularly new. Wealthy individuals have always been willing to put money into the ideas of talented and resourceful people known to them. Much of the world's great art and music, for example, was financed by private donations from the rich. What is diVerent about the modern firm is that the investment is essentially anonymous. Shareholders do not need to know personally the entrepreneurs in order to part with their money. Of course, with start-up companies or small firms looking for finance to expand, a prudent investor will insist on finding out a great deal about the individuals concerned, while a fund manager looking to move a big block of shares between, say, Microsoft and GM may well think quite hard about the key individuals on the boards of these giant companies. But there has been a massive expansion in the amount of information available to investors about what is on oVer. Companies can and do solicit new funds from individuals who are completely unknown to them at the time, and this new form of organization increases dramatically the potential funding for any individual enterprise.

The second feature, or evolutionary step as we might think of it, is the invention of limited liability. Individuals no longer need risk personal bankruptcy when they organize a commercial venture. Indeed, one may feel that this particular quality has recently taken an evolutionary step too far. Managers, facing no personal risk whatsoever, reap spectacular rewards for failure- failure with other people's money. A form of corporate theft has been perpetrated in many cases.

But this latter is a very recent phenomenon, and the contribution of the concept of limited liability has been hugely positive. All business decisions involve risk. The degree of risk may vary enormously, but no one knows for certain what will happen once a decision is taken. The limit placed on liabilities facilitated an explosion of innovation and entrepreneurial activity. Individuals were released from the constraint of, quite literally, having to bet the family ranch on a new business venture.

Of course, out in the thickets of the commercial world, diVerent species, diVerent forms of corporate organization survive, each with its own niche. Some can be very successful. Goldman Sachs, for example, has been one of the most profitable, dynamic and innovative financial institutions in the world in recent decades. And for most of this time, it was an antiquated partnership, fashioned on the same organizational principles as those of the bankers who financed Europe's monarchs in medieval times. In both cases, the potential rewards were huge. On the downside, however, the entire personal wealth of each individual partner was, in principle, at risk every single day.

The dominant life form for more than a century, however, has been that of the limited liability company. Like the dinosaurs, this took time to reach its full evolutionary potential. The massive dinosaurs that ruled the world did not spring up entirely from nothing. In the same way, the concepts of anonymous outside investors and limited liability were not invented in the final quarter of the nineteenth century. But, suddenly, underpinned by these concepts, the conditions became right for a massive step forward in the evolution of firms. Companies grew stupendously, to sizes that were entirely without precedent in human history. At the turn of the nineteenth century, large corporations were being built on an enormous scale, mainly due to a massive wave of mergers and acquisitions. By the first decade of the twentieth century, for example, US Steel employed more than 200,000 workers, a number simply beyond the imagination of previous generations.

US Steel was admittedly by far the largest company in the world at that time. Its total assets in 1917, for example, were no less than $2,449 million. Translating this into modern prices is not straightforward because so many things have changed since then, but an approximation would be a value of some $400 billion. For comparison, the value of Microsoft is currently around $300 billion. So US Steel was big by any standards.

But many other American companies had assets of over $100 million, with eleven more companies in exactly the same industrial sector as US Steel-'primary metal industries' in the dry jargon of economic statistics. The industry of 'transportation equipment' had been made up of locomotive and ship manufacturers until the beginning of the twentieth century, but as early as 1917 the largest firm in this sector was already the new Ford Motor Company, with assets of $165 million. In third place in this list was another familiar name, that of General Motors. Elsewhere in the economy, giant corporations had sprung into existence. The food sector, for example, was headed by Armour and Co. and by Swift and Co., each with assets of over $300 million. Both of these became extinct as independent firms in the 1970s and 1980s, respectively. Du Pont and Union Carbide were the largest producers of chemicals, and Standard Oil of New Jersey the biggest oil company, with assets of over $500 million.

The success of the large company, far more eYcient and productive than anything that had gone before, was instrumental in consolidating the political success of capitalism, itself a relatively new form of economic life, which had evolved gradually from its feeble initial stirrings in the Europe of the sixteenth and seventeenth centuries.

Living standards had been improving gradually during the nineteenth century. There is a bitter and intense debate, seeming to stem as much from ideology as from objective scholarly dispute, about whether average living standards rose or fell in the early decades of the Industrial Revolution, up until around 1840. But all are agreed that from around that time life improved. The number of hours worked per week were reduced, health began to improve along with life expectancy as people could aVord to buy more food and hence consume more calories, and more and more products appeared in the shops which came within the reach of ordinary people.

Nonetheless, life was undoubtedly still pretty grim for most people. Again, comparisons across such a long period of time are diYcult to make, since the whole structure of the economy and the mix of goods and services which are now available have altered dramatically. Most of the purchases made today are of products which simply did not exist a century or more ago. Air travel is an obvious example, but the inventiveness of capitalism knows no bounds. As I write these words, I read in the newspaper of a German savaged almost to death by his pet Rottweiler. He was attempting to give it fresher breath by brushing its teeth. Confronted by doctors telling him he was lucky to be alive, the man moaned plaintively, 'I can't understand it, I used a special canine toothbrush.' We can be certain that special canine toothbrushes were not generally available in the shops of the late nineteenth century.

Despite the diYculties, economists and economic historians have made great eVorts to compare living standards over time. As a broad generalization, we might say that the average person in western Europe in 1880 was as well oV as, say, the typical Indonesian today. If anything, the European of that time was slightly worse oV, but the comparison is not unreasonable. The threat of famine, persistent for millennia, was starting to fade into memory and surplus cash was becoming available to spend on things other than the bare necessities of life. But work was long and hard, support from the state at times of personal hardship was weak or non-existent, and the environment in the cities was badly polluted, far more so than it is today.

If living standards had not improved any further, it is easy to believe that the appeal of a political platform dedicated to the revolutionary overthrow of capitalism would have grown. The stupendous cornucopia that capitalism was to unleash in the twentieth century in terms of material standards of living, health and life expectancy across the planet could scarcely be imagined. In any event, that was just speculation about the future rather than the bleak reality of actual experience.

However, the success of the newly evolved life form of the large company gave a huge boost to the quality of life in the period from 1880 to the First World War. The average standard of living in America rose by 50 per cent. In France and Germany the increases were 50 and 60 per cent, respectively, and in Britain, the wealthiest of the major countries in 1880, incomes rose by a further 40 per cent. As a result, the attraction of a revolutionary change faded away. Apart from brief insurrections in the aftermath of the First World War, capitalism has remained unchallenged in the west throughout the twentieth century. Only in Russia in 1917 do we have an example of the overthrow of the system.

This period of immense political and economic significance for the future of both the west and the world in general also saw the rise of a new political species, namely the social democratic party. Despite the rhetoric, these parties were eVectively committed not to the elimination of capitalism, but to a modified version of the system. Their true nature was revealed for all to see by the First World War itself. A small minority urged the workers of Europe to resist the war. In contrast, the great majority of social democrats everywhere threw themselves with enthusiasm into their national struggles. A leading revolutionary, Rosa Luxemburg, attacked the role of social democratic parties in vituperative terms a few days before her assassination in the turbulent political atmosphere of Germany of December 1918: 'In all previous revolutions, the combatants faced each other openly, class against class, programme against programme. In the current revolution, the troops protecting the old order are not intervening under the banner of the ruling class, but under the flag of the social democratic party.' But from the perspective of the people they represented, the social democratic leaders were acting in an entirely rational way. Capitalism was delivering the goods.

Returning to the purely economic aspect rather than the wider political economy of this period of dramatic change, our knowledge of the emergence of the massive company in the decades around 1900 has been expanded enormously by the work of Alfred Chandler, an economic historian at Harvard. His magnum opus, Scale and Scope: The Dynamics of Industrial Capitalism, charts in great detail the development of large firms in America, Britain and Germany, the three biggest economies of the world at the time.

The pace of innovation and evolution of economic organization was rapid, matched by a wave of extinctions as older, less eYcient structures failed to survive in the new environment. Consumers today are quite accustomed to the idea of the prices of new products and services falling dramatically; for example, computer hardware, software and telecommunication products have all seen sharp falls in price combined with better-quality products. Exactly the same phenomenon was observed in the cutting-edge industries of the late nineteenth century. Their products were distinctly less exotic than the electronic-based wave of today, but then, as now, new ideas revolutionized production. The German dye manufacturers Bayer, Hoechst and BASF were able to reduce the price of a new synthetic dye from 270 marks a kilo in 1869 to just 9 marks by 1886. Less eYcient producers were simply swept aside.

The period saw a veritable explosion of diVerent types of industrial structure. Managers and owners searched and explored a wide variety of strategies in the pursuit of success in the rapidly changing environment. Many were tried, only to be discarded rapidly. Large-scale investment in new machines and factories and rapid technological innovation in many industries in the 1870s and 1880s brought success for some and great benefits to the consumer. But success came at a price to the companies themselves. Competition intensified and prices fell. The example of synthetic dye is an extreme example of what happened in what was then a very high-tech industry. But even in well-established industries such as textiles and iron, innovation led to lower prices. And lower prices meant lower profits.

Media reviews

Praise from Great Britain for Why Most Things Fail:

“This is a fascinating analysis. Few economists have such a sure grasp of physics and biology . . . [Ormerod’s book] deserves a wide readership.”
–The Times

“Paul Ormerod begins construct[ing] a new way of looking at human affairs . . . The real importance of what he is saying goes far beyond economics.” –New Statesman

“This engrossing and entertaining book is much more than a mordant moan on mortality. It is a careful, comprehensible analysis of the limits of human rationality’s ability to control the world and of the implications for public policy of the failure of most rational calculation to produce its intended results.” –The Sunday Telegraph

“Ormerod writes fluently, with a merciful lack of equations . . . [He offers] an intriguing argument, well explained.”–Financial Times

“Interesting and entertaining . . . The scale and breadth of Ormerod’s analysis deserve commendation.” –Nature