Sunday, November 9, 2008

Fixing the Economy--Efficiency Vs Security

So, what the heck went wrong with our economy?

In business school you're taught that the purpose of a business is to increase shareholder wealth by maximizing efficiency. Efficiency here is defined as the difference between your income and your costs. In other words: profit.

The flaw of this definition is that your costs are also your neighbors income, so the short-term benefit you get by cutting costs may come around to bite you in the end when you're able to sell less to your neighbor.

Henry Ford showed a remarkable understanding of this reciprocal nature of business when he decided to raise his employees pay to the point where they could afford to buy a car. His peers cursed him because they had to raise wages as well, but Ford's decision remains as a real watershed moment in the history of American Business--and he sold a heck of a lot more cars.

The second point to consider is that any engineer will tell you, the most efficient structure can also be the least secure and often the only way to increase security is to increase redundancy. In this way, a bridge made of six regular steel beams is more secure and more easily repaired than a bridge made of two mega steel beams.

American business has been on a thirty year efficiency binge. Down-sizing and mergers and out-sourcing became the rule of thumb. Profits rose for a while, but now we find ourselves in a heck of a lot of trouble.

Nowhere is this lack of security more evident than in the financial sector. Ronald Reagan assumed that interest rates would go down if banks became more efficient and more competitive, but what good is low interest rates if banks are so unstable nobody can get a loan?

With a new president and a new understanding of our economic problems my advice is to think small and think local. If we work to foster and promote and protect more smaller, local businesses then we introduce redundancy into the system. This will decrease profits for a while, but it will also increase security.

With many banks having to reduce their scope in the wake of the credit/mortgage crisis, this may be the perfect opportunity to rebuild the concept of local banks. There will always be room for interstate and regional banks, but local banks have to be the backbone of the system if we're ever to regain the stability we once had.

Should an era of financial instability hit again, it's a heck of a lot easier to deal with if you have more smaller banks than fewer giant banks.

I'm not saying we should abandon the idea of efficiency all together, but for us to prosper in the long run, we must find a balance between efficiency and security. For thirty years we pushed and pushed and pushed for efficiency, now, unless you want to lose everything, we have to push and push and push for security until we find ourselves back in balance.

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