TransactionJlh, • • ® , 0,, c, ocnezy AND MODERN

(Volume 44, Number 3)

There is No Substitute for Profit and Loss Jeffrey Friedman

A s I read Howard Husock's brilliant essay, I began to wonder whether my response might achieve the writer's ultimate dream, not to

mention the reader's: a one-word essay. The word, I thought, might be Amen. Husock points out, against the conventional wisdom about Americans' small- government conservatism, that in reality "government action is...the default mode .... The polity expects it; the mass media often demand it." Amen. Therefore, "the election of professed small-government presidents is far from a guarantee of smaller government." Amen. Most important of all, "performance measures for many [social] services are frequently difficult to devise or to agree on." Amen.

It was only in reading the concluding section of Husock's essay, on "A Nonprofit 'Stock Market,'" that I realized I would need to say more than one word in response. Stock markets work well, at least compared to the alternatives. But what makes stock markets work, contrary to the apparent belief of Robert Steel, the investment banker cited by Husock, is not the degree to which the firms whose stocks are traded have (1) clear mission statements; (2) succinct busi- ness models; (3) good managers; (4) attentive board oversight; (5) an affinity for regular progress reports; nor even, crucially, (6) "measurements" showing that their "work leads to good outcomes"--except in a very misleading sense.

The misleading sense stems from the fact that there is one "outcomes measurement" alone that matters in markets: profits. Now, profits are numbers. This may encourage investors like Steel to assume that what makes stock markets work is the measurability of their investment success. This assumption can lead to the conclusion that successful nonprofit outcomes, too, should be quantitatively measurable. Then begins a wild goose chase for proxies of the very thing that, by their nature, nonprofits cannot make: profits.

The notion that nonprofit outcomes should be quan- tifiable is of a piece with the business-oriented model that is clearly at work in Steel's first five metrics for nonprofit success, which have to do with processes rather than outcomes. Steel's procedural metrics rest on yet another misunderstanding of what makes equi- ties markets work: accountability to shareholders, by means of transparent intentions (mission statements, business plans) and bureaucratic oversight (of em- ployees by management, of managers by boards, and of boards by shareholders) to see that these intentions are executed.

The commercial sector doesn't "work" because of brilliant business plans, mission statements, or the close monitoring of agents by principals. Let me consider this last point first. Economic theory tells us that the princi- pal-agent problem is due to departures of markets from the competition that is their norm. Firms are islands of bureaucratic hierarchy in an ocean of one-on-one contracting. These islands are necessary because of the transaction costs involved in contracting with the best among a variety of competing bidders who might perform every task that might arise. It is more effec- tive, within limits that will vary from case to case, to have "employees" rather than independent contractors on hand. Employees can perform unanticipated or dif- ficult-to-describe tasks, with the employment contract ensuring that they will be there, ready to do whatever their managers demand. But the degree and type of this management, and its depersonalization in the form of bureaucratic regulation, is inherently constrained, in markets--unlike in governments and nonprofits--by the diseconomies inherent in layers of managerial personnel and initiative-killing red tape, which may ultimately counteract the advantages of lower transac- tion costs. In for-profit firms, too much bureaucracy, or the wrong kind, will lead not to profits but to losses. So bureaucracy is kept under control in markets by the

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all-important profit-and-loss mechanism. The idea that markets are effective because of their bureaucratization is as wrongheaded as the notion that profits can be mimicked by some alternative quantitative measure.

Because of the absence of profits or losses, donors to nonprofits are, of course, only metaphorically "inves- tors." Any future revenues that flow from their present outlays are incidental to the goal of the nonprofit; other- wise, it would be a for-profit. While comparisons of the market sector and the nonprofit sector are very important, too much literalism in such comparisons can efface the differences between the sectors, leading to pernicious attempts to model nonprofits after for-profits.

Thus, I also say "Amen" to Husock's complaint about the donor fad of trying to make nonprofits "self- sustaining," which is a contradiction in terms (if they could be truly self-sustaining, they would not be non- profits)--an impossible dream with nightmarish side effects. The latter include the unintended consequence to which Husock points: that nonprofits seek to become "self-sustaining" through government support. Another unintended consequence is to spur on the takeover of privately supported nonprofits by their "development" departments. This is true not just in the obvious sense that the staff of the development office grows bloated in proportion to the organization it is supposed to serve, but in the more insidious sense that fundraising becomes the real purpose of the whole organization, instead of being an adjunct to the goal for which funds are supposed to be raised. The search for "self-suste- nance" leads, in practice, to a retooling of the gears of nonprofits so that they become development rather than problem-solving machines, whose comparative advantage is to sell donors the sizzle rather than the steak. For example:

Public-policy nonprofits whose main "product" is a stream of policy proposals, position papers oppos- ing undesirable policies, and op-eds favoring the proposed policies or opposing the undesirable ones. These products give donors to the nonprofits the illu- sion of success, even though what the nonprofits are supposed to be producing--the actual adoption (not just the proposal and discussion) of good policies, or the actual repeal or rejection of bad policies--never seems to materialize.

. The susceptibility of donors to confusing the size of a nonprofit with its problem-solving success. Calcula- tions of their low marginal impact be damned, most

donors can be relied on to contribute to organizations that have large staffs housed in impressive buildings, where they throw banquets at which their donors celebrate the organization's success. This "success," however, amounts to the size of the organization, which is akin to treating the growth of the organiza- tion as an end in itself.

. The herd mentality. Donors are often prey to the notion that the legion of other donors who enable a nonprofit to pay for such trappings as large staffs and impressive buildings must know what they are doing. So new donors follow the crowd of old ones.

There is, I think, a larger lesson here. We can learn it by considering how markets, including stock markets, deal with similar tendencies.

Equities investors are famous for following the herd right over a cliff. And businesses can falsely but suc- cessfully advertise the merits of their products--both to consumers and to investors. It doesn't take much imagination to envision firms that attract enthusiastic investors by means of impressive mission statements, business models, managers, boards of directors, and quantitative metrics, but which lack the one thing needed: a product that, in the event--not just on pa- pe r -consumers actually want to buy, at prices that consumers are willing to pay. On the other hand, plenty of fortunes have been made by investing in firms whose mission (other than to make a profit) was never clearly stated or even stateable; whose only "plan" was to adapt to unpredictable circumstances as they arose, in whatever seemed to be the best way possible; whose managers were unremarkable; whose boards of directors were nonexistent, pro forma, or distracted; whose progress reports were scarce or desultory; and whose quantitative metrics--other than profit--were unimpressive.

Capitalism does not work, systemically, because of the vision, forthrightness, or foresight of investors, or their use of fashionable metrics to judge the viability of the enterprises in which they invest. It works be- cause, whatever the metrics investors use, those that prove inadequate will produce negative returns on their investments. Thus, investors can often make money by investing in enterprises that make profits through serendipity, blind luck, or the application of "knowl- edge" that the entrepreneurs, managers, or employees of the enterprise don't even know that they have--let alone that could have been put into a mission statement

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or business plan, or anticipated in reports to boards of directors or investors. A restaurateur may think that the reason for his success is his superb chef, when it may actually be the ambience of the room. Another restaurateur may have the most surefire business plan that anyone has ever read; but in the event, his theory of what will make for a successful restaurant may prove to be wrong, and investors who relied on the business plan as a metric will go bust.

If not by relying on some list of metrics, such as the one that Steel provides, how can investors know how to invest? Obviously, they cannot. That's why so many of them lose money.

If there were some magic formula for profitability, we could take the investors who know this formula, put them on a government planning commission, and let them make decisions about where to deploy scarce resources. That was, as a matter of fact, an implication of the "market socialism" that became popular among economists in the 1930s. Their ideas were rooted in the neoclassical economic assumption of perfect knowledge on the part of market participants. Market socialism might have worked- - i f only there were a process that could figure out who the omniscient investors are.

Each prospective investment entails a (tacit or ex- plicit) formula, or theory, about how to make money in a given time and place. Unlike market socialism, capitalism throws different theories into competition with each other in the form of competing finns backed by competing investors. The investors are--let 's face it--guessing at which entrepreneurial theory will prove to be profitable. The resulting process of trial and er- ror wastes a lot of resources on failed ventures. But it has the underrated advantage of leaving room for the inscrutability of whatever combination of factors may, in a given instance, end up serving investors well--by serving consumers well.

The clicM is true: in capitalism, the consumer is king, and that alone is, in the final analysis, what makes markets work as well as they do. For consumer sovereignty is translated, through prices and thence the balancing of income and expenditure, into profits and losses; and profits and losses, not clever investment metrics, are all that count.

Markets do not work perfectly, though, and among many examples of their imperfection is the fact that consumers often buy unsatisfactory products. They, being as fallible as investors or donors, are as liable as

investors or donors to mistake the sizzle for the steak. But Joseph Schumpeter explained the market's (in- complete) solution to this problem through a different metaphor: "The picture of the prettiest girl that ever lived will prove powerless in the long run to maintain the sales of a bad cigarette." The consumer, hav- ing experienced dissatisfaction with the advertised product, can experiment with a competing product. The net result of this ongoing experimentation is to constrain the fallible theories of investors and the entrepreneurs whom they back. The products that do not result in consumer satisfaction produce losses; the ones that do produce profits. The result is that more resources are allocated to firms that are serving consumers well, and fewer are allocated to firms that are serving them ill. The beauty of it is that nobody--even the successful entrepreneurs or inves- to r s -needs to understand why one firm is succeeding and another is failing.

Given the littered landscape of entrepreneurial failure, one may be tempted to lionize the success- ful entrepreneur, and his financial backers, as men of genius. But as the restaurant example is intended to suggest, the sources of their success may be obscure even to them. Therefore, it is a mistake to think that capitalism works because its participants know what they're doing--let alone that they know it so well that they can put it into the form of missions, plans, reports, or any "metric" Any such metric is a mere ex ante heuristic for profitability. Market competition subjects the heuristics of investors and entrepreneurs to the acid test of consumer satisfaction without anybody--inves- tors included--having to be very well informed. Even consumers need only know that they like or dislike the cigarette, or the steak. They don't need to know why it does or doesn't taste good.

There is no similar test in the nonprofit or political sectors; thus, in these sectors, as Husock points out about politics, intentions come to matter more than results.

The intention to solve a social problem is linked, in the political sector, to plausible-sounding legisla- tion establishing a bureaucracy intended to solve the problem. In the nonprofit sector, good intentions are nowadays packaged in the form of mission statements, and they can be linked to plausible-sounding "business" plans that justify nonprofit bureaucracies intended to solve problems, But all this market mimicry is re- ally symptomatic of the lack of the thing that makes

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markets work: a bottom line. As Husock points out, in politics the difficulty lies in evaluating whether the well-intended bureaucracy is actually getting anything done (apart from growing larger). A like difficulty, it seems to me, plagues nonprofits, and the source of the problem is the same.

The source of the problem is human ignorance. We are always groping in the dark. In the economic sphere, however, this problem is alleviated by the profits and losses that stem from consumer experimentation. As in the scientific realm, where the flawed theories of imperfect scientists can be subjected to experimental refutation, profit and loss transcends, or bypasses, and thereby mitigates human ignorance and the of- ten-foolish heuristics to which it leads. By contrast, human decision makers in the political and nonprofit sectors have nothing to go on but their often-foolish heuristics--such as the conflation of good intentions, impressive processes, and quantitative metrics with problem-solving success.

This puts both the nonprofit and the political sector at a disadvantage when compared to the for-profit sector. Politics, after all, is the attempt to influence govern- ment, and government is the ultimate nonprofit. The key difference between the political and the nonprofit sectors is that government is a monopoly nonprofit.

By sheer luck, if not human expertise, some non- profits may end up mitigating the problems they are trying to address. Most of them, it is true, may fail to solve any problem except that of raising funds. Unlike failed commercial firms, such nonprofits may continue to impress their donors because of the flawed heuristics for success that the latter employ. But these only-appar- ently-successful nonprofits' lack of monopoly powers may enable other nonprofits that actually are effective to emerge, if donors are willing to gamble on them. Donors, being imperfect human beings, will often place bad bets. But a hundred sizzling failures do not negate one good steak.

In this view, the plurality of nonprofits accounts for their occasional success. Among the enemies of pluralism is the aspiration to universal solutions that Husock rightly deplores, which leads to the use of the monopoly powers of government to solve social prob- lems. Another enemy, however, is what I will call the myth of professional social-service expertise, which is a natural upshot of monopoly provision.

Calling social-service expertise a "myth" may sug- gest that there is a widespread belief in it. I take Husock

to be saying that there is such a belief, and that the belief has much going for it. My view is the opposite. What I know of the American political landscape since the end of the Progressive Era reveals ever-fewer appeals to the notion that "the experts know best." And I think this is a salutary development.

The reliance on expertise is, I think, more an in- evitable consequence of attempts to legislate universal solutions to social problems than it is a conscious doctrine, as it was among the Progressives--let alone a widely accepted doctrine. It is not so much that there are hordes of voters who think that social-service professionals are all knowing, as that there are hordes of voters who endorse legislation that promises magic solutions to social problems. Once the legislation is passed, a bureaucracy has to be set up that devises the programs through which the imagined solution is supposed to be made real. Who else can design such programs but those who claim to be experts about the causes of the problem to be solved?

These "experts," however, tend to be charlatans, because they draw their conceptual frameworks from social science. Unlike in natural science--and unlike in markets--there is almost never the possibility of controlled experimentation in social science. This places all the onus on social scientists' powers of cogent theorizing, unchecked by reality. It is still conceivable that social scientists could be rigorous and careful theo- reticians, but I will assert peremptorily that this has not been the norm during the last century of social science, when such doctrines as positivism, functionalism, and Marxism have held sway.

That is why I find it useful, if potentially mislead- ing, to refer to the "myth" of social-service expertise. I think that such expertise is largely mythical, but that the myth is not widely accepted. It runs against the American grain.

One reason that I think so is the prevalence of volunteerism in America, which so deeply impressed Tocqueville. A nonprofit volunteer does not typically view himself as carrying out the mandates of all-know- ing experts, or he would leave it to them to deal with the problem. I agree with Tocqueville that America's democratic ethos tells, in fact, against almost any claim to expertise. Americans tend to think that despite their "amateur" status, they are the only real experts: that's why they so freely volunteer their solutions to the prob- lems they perceive as being important. The democratic ethos thus encourages a pluralism of theories about

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how to solve problems, and a pluralism of nonprofits to embody those theories. I am not saying that "the common man" is inherently a better theoretician than the social scientist or the social-service professional who drinks from social-scientific waters. But I hold out more hope for occasional success among the theories of common men than I think is justified by familiarity with the actual theories favored by social scientists.

The democratic ethos goes with a skepticism about expertise that conflicts with the need for a government bureaucracy to impose the fight solution to a problem if it is to fulfill the magical legislative promises made to voters. This need, not some widespread worship of expertise per se, is what I think leads to the staffing of government social-service bureaucracies by profession- ally certified "experts." Thus, I do not share Husock's conviction about the political futility of relying on small, non-universalist, amateur-staffed or -funded nonprofits. But what about the problem of universal- ism itself?

Pessimism about this problem gives rise to Husock's proposal to work with universalism by channeling it into huge nationwide nonprofits that have produced results of proven worth--as shown by the fact that they have survived the faux "market test" of donor satisfaction. But I fear that this proposal would further encourage the bureaucratization of the nonprofit sector. I also fear that its premise of donor expertise would be both self-defeating and damaging in an important, larger sense.

It would be self-defeating because I don't think the public will buy the notion that the nonprofits that have attracted the most donors have somehow passed a "market test." I do not attribute any degree of sophisti- cation about markets to the public, but I do think most people don't confuse popularity with effective social- service provision. People can tend to get caught up in popularity contests without being persuaded that the concept of a popularity contest is a good way to solve social problems.

Even if I am wrong about that, though, why wouldn't the "stock market" idea invite the question of why we shouldn't just put all the resources in the hands of the alleged donor-experts (akin to market-socialist planning boards) and let them impose their solutions universally?

At the substantive level, I disagree with what I understand to be Husock's answer: that government service is less "likely to attract committed employees

and volunteers" than nationwide nonprofits. I don't see why that would be the case, since I know of many com- mitted government employees--and many time-servers who work in nonprofits. And there are still volunteer fire departments and unpaid small-city councils that suggest that governments can attract committed ama- teurs. On the other hand, it seems to me that a pluralistic nonprofit universe would be far likelier than either big government agencies or big nonprofit agencies to attract committed participants, amateur or paid, since the smaller the nonprofit, the more likely that it would be attempting to put into practice its personnel's own enthusiasms about how to solve problems.

At the political level, if nonprofits come to be pri- marily big national organizations of "experts," then I suspect that the public will (rightly) wonder how they differ from government except that in principle, gov- ernment has the resources and the "accountability"that such nonprofits would lack. Expos6s of the "gaps" in nonprofit social service, and revelations of scandal, would lead to calls for government takeover or regula- tion (leading, in turn, to even more bureaucratization). This already happens, but the only arguments for (and good reasons for) resisting government takeover or regulation--namely, the pluralism and lack of "expert" pretense among small, atomized nonprofits--would be lacking.

So it seems to me that the myth of expertise and the aspiration to universal solutions should both be resisted, and that resistance to one goes with resistance to the other. My optimism about resistance to universal- ism would be almost as great as my optimism about resistance to the myth of expertise if, as in the latter case, I were confining my attention to mass public opinion. For as with the myth of expertise, American volunteerism strikes me as strong evidence against the notion that universalist aspirations are deeply rooted. The volunteer must know that his efforts can, at best, incrementally solve even a local problem. So he can hardly believe that the only solutions worth pursuing are total and national.

Unfortunately, our attention here should not be confined to mass public opinion, because a great deal of power lies in the hands of highly educated elites, and they have been taught that social problems are due to systemic deficiencies of capitalism that require systemic--universalist--government solutions. This, I think, accounts for the ridicule that proposals for "a thousand points of light" receive from the best and the

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brightest. The reality, however, is that all the social pro- grams in the world combined--nonprofit and govern- mental, local, national, and international--have done far less to solve social problems than have the ongoing processes of capitalism. Capitalism lifts hundreds of millions of people in the Third World out of poverty every few years, as it has already done for most of us in the First World. Our top priority as would-be improvers of the human condition, then, seems to me to lie in understanding and fostering capitalism even more than in understanding and fostering nonprofits. The two priorities can be compatible--but not if our efforts to foster nonprofits lead us to suggest that investors' expertise, or anyone else's, is the source of capitalism's success. Here is where, I fear, the model of markets implicit in the stock-market proposal risks doing real harm.

Loose reasoning about capitalism is already rife, particularly in the universities that train those who will lead public opinion, and those who will write and administer the laws. We need to demystify the operation of the market sector--stripping it not only of its mythically evil powers, but of its mythically expert financiers--not merely because of the lessons that should (and shouldn't) be drawn by future donors about how much like a B-school case study nonprofits should look; but because of the lessons that should (and shouldn't) be drawn by future political elites about how big the state sector should be, and how small the market sector should be.

There is already a myth afoot, in highly educated precincts, that the success or failure of capitalism rests on the personal qualities of capitalists. Market propo- nents have succeeded, unfortunately, in creating the impression that capitalism works to the extent that it does, primarily because of the self-interest of capital- ists. This idea has been proven to run too deeply against the grain of Western, Christianized culture to be accept- able to political elites, If we add to that myth the notion that capitalism works because capitalists are experts in devising formulae for organizational success, then the case for relying on expertise in the state sector becomes compelling. That way, we could get the organizational expertise without the selfishness.

However, I don't really think elites will buy the no- tion of investor wisdom, since so many investors--even initially successful ones- -make mistakes and lose

their shirts. If ideas like Steel's gain currency, then each black day in the equities markets will encourage the intellectuals' already over-cultivated suspicion that apologists for capitalism are defending an emperor without clothes. The case for capitalism should be modest. Capitalism is not perfect, and nothing like perfection should be ascribed to its personnel, lest the case seem--and be--unrealistic.

A persuasive case for either the for-profit or the nonprofit sector will not be made by vesting heroic personal traits in the human beings who populate the real world. But a convincing--and accurate--case for capitalism, at least, can be grounded in the low cogni- tive expectations that it places on its participants. In a skeptical age, this is a message that is begging to be conveyed to the intelligentsia. And the same message, by underscoring how politics lacks the check on human ignorance exercised by profit and loss, may suggest--as I have tried to suggest here--an argument for a plural- ist nonprofit sector to deal with some of the problems capitalism cannot solve.

This epistemic defense of the for-profit and non- profit sectors requires us to accept that there is nothing like a real market that will weed out failed nonprofits or weed in successful ones. But we needn't idealize nonprofits in order to see that they may be better than governments--because successes may be hiding amid the thousand points of light, while the reliance of state bureaucracies on social-scientific "expertise" is a virtual guarantee of failure. Still, and without idealizing for- profits, it seems to me that the situation in the nonprofit world is worse than that in markets, where through profit and loss, firms that are successful in satisfying the test of consumer experimentation gain control over more resources, while the unsuccessful ones lose resources and ultimately go bankrupt. This isn't to say that the nonprofit sector shouldn't be defended. But I think the def?nse must be epistemically minimalist if it is to be consistent with a like defense of capitalism--and with Husock's identifica- tion of the main problem plaguing human endeavor in all fields: the problem of knowing what works.

Jeffrey Friedman has taught political theo~ and social-sci- ence methodology at Barnard, Dartmouth, Harvard, and Yale. He is the Max Weber Senior Fellow of the Institute for the Advancement of the Social Sciences, Boston University, and the editor of Critical Review: An Interdisciplinary Jour- nal of Politics and Society.

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