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some reality about really big “rational actors”

June 3, 2010

An excellent recent blog by an industry insider is timely for turning a spotlight onto the fact that large organizations, whether governmental or private, are not necessarily rational or efficient. The author of the blog is a financial executive. However, as he rightly points out the revelations from a different industry of systemic failure at, and over promising-under delivering by, BP come as no surprise at all because such problems are perhaps inherent in almost all large organizations.

Despite a wealth of evidence to the contrary, much debate about regulating markets still proceeds on an assumption that market participants are rational actors who will make decisions that are genuinely optimal to their interests and that the aggregate forces of the market will correct for individual mistakes, ultimately leading to an efficient outcome. The assumption of rationality, though not necessarily fundamental to the efficient market hypothesis because irrationality and efficiency are two different things, is nevertheless dangerous in the debate about how to regulate very large institutions. When large companies like the biggest banks and oil companies make mistakes the market does not correct adequately. On the contrary, we all end up being on the hook, whether as taxpayers, unemployed workers, or fishermen in the Gulf.

One critique of the efficient market hypothesis tends to focus on the fact that market participants act irrationally from a cognitive perspective. In other words, evidence demonstrates that we do not make rational decisions but often (perhaps always) act on the basis of impulses we do not even perceive until after we have acted. I am not a behavioral psychologist so I won’t presume to expand on this science. But there is another dimension to market actor dysfunction that deserves more attention, namely that considerable inefficiencies, ranging from “groupthink” to outright chaos, tend to develop within many large, rapidly growing organizations. Those of us with experience of the actual operations of such organizations are sometimes struck by the naiveté displayed by some theorists who seem to assume that large and complex organizations act as “rationally” as individual persons. While such theorists are indeed aware that different incentives within organizations lead to inefficiencies the attention accorded these inefficiencies is thin indeed given all the things that really happen inside such organizations.

In a working paper I have elaborated in much more detail on what leads to dysfunction in large financial institutions. Companies develop serious dysfunction as a result of many factors. They often grow too rapidly through lateral “hyper-combinations” rather than through planned and carefully developed, organic growth. They diversify into areas in which the management is not sufficiently versed. Their technology platforms sometimes have to be converted within unreasonable timeframes. Often, because of cost constraints or the purse vanity of the acquiring company, the conversions are made to unsuitable and less efficient platforms. Employees with essential knowledge get laid off as part of the “efficiencies” promised from mergers. New combinations can drift without any coherent culture for years and even when the culture is established is carries with it the danger of groupthink and, in the case of regulators, “cultural capture.” Executive egos (and compensation) can grow faster than their abilities as their companies acquire grandiose proportions. So-called “agency costs” begin to accumulate: executive incentives begin to diverge from the interests of shareholders and they can also become out of touch with the facts on the ground. Promises to shareholders are often unfulfilled because they were unrealistic in the first place. Perhaps worst of all, the regulators cannot keep up and the new organizations simply become too complex to regulate, at least with the resources currently available to regulators. In the financial world this leads inevitably to the creation of risk-generating behemoths that, ultimately, become too big to fail as well.

So in the real world size, and how such size is attained, really does matter. As unAmerican or “parochial” as this might sound to some, regulating this path of growth is a vital public interest. It is naive in the extreme to assume that the natural forces of the market can ensure that such growth will be regulated without externalizing much of the corresponding dangers onto the public at large.

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