Quality in an Abstract Economy
An exploration into the disorienting nature of today’s economy and how quality systems can serve to properly orient decision-makers towards Quality.
When I refer to Quality, as I explore in other writing, I am referring to anything that facilitates human prosperity. This can also be thought of as the measurement of profit over an eternal time horizon and considering all externalities. If Quality is synonymous with profit and decision-makers within organizations are tasked with maximizing shareholder value (i.e., profit), why is it so difficult to convince them to invest in Quality? Why is it that when they hear the “Q” word, they envision their profit margins disappearing? The answer to these questions is straightforward, even if the explanation for why is complex: The way these decision-makers are measuring profit diverges from the concept of prosperity. They are not considering all externalities or measuring it over the appropriate time horizon.
Understanding why decision-makers have an inability or unwillingness to ensure Quality requires an investigation into human nature and the nature of the economy we live in. In the following sections, I will explain the base nature of humans, the role civilization has had in delaying gratification, the relationship between capital creation and Quality, the disorienting nature of an inflationary economy, and the role tools such as quality systems play in reorienting decision-makers.
Human Nature
The best place to start is right at the beginning: the essence of human nature. Carl Menger, the founder of the Austrian School of economics, highlights man’s base instinct in his Principles of Economics. He identifies that “men often esteem passing, intense enjoyments more highly than their permanent welfare, and sometimes even more than their lives.” He is talking about man’s propensity to prioritize immediate gratification. For example, the urge to consume a sugary treat over a nutritious meal. This is a natural instinct that all individuals are fighting against. Saifedean Ammous describes the same concept in his version of Principles of Economics, making the point that man has a “universal preference for earlier over later satisfaction” based in the reality that “no person knows with certainty how long they will live, or when they might die.” It is important to recognize this as the starting point for all economic decision making.
Although economists recognize the base nature of man being one that prefers satisfaction now to satisfaction later, humans do have the capacity to delay gratification. This is often referred to as economizing and some individuals have a greater capacity to economize than others, just like some people have a greater ability to deny a sugary treat than others. Quality is simply the act of economizing with an expanded scope. Historically, society has had filtering mechanisms to ensure that the decision-makers with the most power and influence (i.e., presidents, CEOs, etc.) are the individuals with the greatest capacity for economizing. Once selected and given authority, they implement tools and create processes to facilitate economizing for the rest of society. This is known as the process of civilization. Menger says that “civilized societies” are responsible for “individuals plan[ning] for the satisfaction of their needs, not for a short period only, but for much longer periods of time.” Civilization can be thought of as the implementation of processes at a societal level that encourage and incentivize the delay of gratification for all people, so as to overcome their base nature. Humans are not born with the propensity to save for the future. When there is uncertainty around how long they will live or when they will eat next, they prioritize immediate satisfaction. The incentive to think about the future is created by the security born from civilization.
There are two possible explanations for why decision-makers operating in a “civilized society” are prone to deprioritize Quality. Either they no longer have a greater than average capacity for delayed gratification, or they are no longer incentivized to do so. It is likely a combination of both, but to understand it better, we need to first understand the nature of economy we live in.
Abstract Economy
We live in a macroeconomic environment created when an economy is abstracted from the real world, or an abstract economy. An abstract economy is created from the implementation of various economic tools that decouple the currency from money and confuse the nature of capital creation. These tools generally have good intentions, such as stimulating economic growth or protecting a society from the capital destruction resulting from natural disasters. Whether it is artificial stimulation or artificial protection, they are two sides of the same coin, and what they share in common is that they are both forms of economic manipulation that violate natural law. The intentions that cause humans to utilize these tools may be good, but as they say, the road to hell is paved with good intentions.
The best way to understand an abstract economy is to first understand what makes a real economy. In The Natural Order of Money, Roy Sebag defines a “real” economy as one that “is beholden to a natural standard of measure and reward,” one that “generates energy embodiments,” and one that respects “ecological accountability.” In simpler terms, a real economy is one that can be measured by showing growth related to improvements in productivity and shrinkage related to a degradation of productivity.
To understand the real economy, it is important to understand the nature of capital creation. Capital is a store of labor value into the future, and it can only be created with productive labor that exceeds the amount of value consumed. Imagine a man airdropped on an isolated island. He spends all day collecting enough coconuts and water to survive the day. Since the next day he knows where to look, he is more productive, and is able to collect enough coconuts and water for a day and a half. The extra half day of coconuts and water can technically be considered capital, although is not a great store of value, as it will degrade quickly. On the third day, he spends half the day collecting coconuts and water and consumes what he saved from yesterday, freeing him up to use the second half of his day to build a fishing rod. On the fourth day, he uses the fishing rod to collect enough fish in an hour to sustain him for the whole day, giving him the rest of his day to do whatever he wants. He was able to store half a day’s labor value in a productive asset, which is an example of capital creation. The man in this example takes a series of actions to generate profit and improve his long-term prosperity. This is intended to be an example with very succinct time horizons and no externalities, but nonetheless these are examples of how capital is created through Quality actions. As is also shown in the example, when capital is created in the form of a productive asset, it generally has a compounding effect on Quality.
Excess labor value can be stored in many different things, creating capital with varying degrees of degradation. Livestock, tools, equipment, art, and buildings are all used as a store of value, but the apex store of value came with the adoption of gold as money. In a real economy, humans are able to delay gratification by storing excess labor value for use in the future as money. Given its immutable characteristics, gold gave humans the ability to store capital basically forever, even passing it along to future generations. Since money is a form of capital, it cannot be created out of thin air. Think back to the man on the island. If someone had airdropped a pile of gold with him, would it have helped him survive? Money cannot be created out of thin air, but currency can. In an abstract economy, the amount of currency exceeds the amount of money that has been naturally generated by the productive labors of the real economy. This divergence from “ecological accountability” is enabled by various tools that manipulate the economy, but I will focus on what I believe are the two most important: fractional reserve banking and fiat currency.
Fractional Reserve Banking:
As civilization advanced, larger quantities of capital were generated and stored as money. This necessitated the creation of banks to protect from loss or theft. Banks issued depositors paper notes (IOUs) that allowed depositors to reclaim their money. People soon realized that the IOUs were significantly easier to trade and started to use them as a surrogate for money (i.e., currency). Since the underlying money didn’t have to move for ownership to change, banks soon realized they could issue more IOUs than they had in deposits. This expanded the currency supply in excess of the monetary reserves and further abstracts the economy with every loan made. It is what we call monetary inflation.
If the excess currency is utilized in productive ways, it can stimulate the economy by generating enough excess value to pay back the loan, interest, and generate a profit. If it is squandered or consumed, the debt will be defaulted on, leaving the bank without the ability to make their depositors whole and destroying the capital they trusted them to protect. There is technically no limit to the amount of excess currency a bank can create out of thin air and loan out, but this can only happen so many times in a free market before depositors choose to store their capital somewhere less risky.
Fiat Currency:
The word “fiat” is a Latin word that means “let it be done” and it generally refers to an order issued by a legal authority, such as a government. Fiat currency is essentially the centralization of a country’s commercial bank IOUs, by order of the government. This is necessarily accompanied by the creation of a central bank (i.e., the U.S. Federal Reserve). The central bank issues the centralized IOUs (i.e., the U.S. Dollar) to the commercial banks in exchange for their monetary reserves.
Under a fiat currency the central bank utilizes an assortment of economic tools to enable and encourage the inflationary actions of commercial banks. These tools allow them to manipulate the reserves of the commercial banks and therefore their ability to issue loans. A fiat currency is not inherently inflationary, but it is inherently manipulative and opens the possibility of inflationary practices. Additionally, rather than allowing the free market to set the price of money (i.e., interest rates) the central bank can do so by fiat, increasing or decreasing the loan demand at will.
Fractional reserve banking inflates the currency supply in excess of the monetary reserves. Inflation means more dollars chasing the same amount of goods, which necessarily results in an increase in price. Fiat currency supercharged the problem by utilizing the power of the government to solidify a permanent inflationary environment. Currency inflation has the natural consequence of shortening the time preference of those impacted. If you are guaranteed prices will be higher tomorrow, you are incentivized to spend your money today.
The base nature of humans is to prioritize immediate gratification. The process of civilization incentivizes humans to sufficiently delay gratification to enable long-term prosperity for a society. The abstract economy layers a filter over society that disorients humans and causes them to behave as long-term irrational economic actors. This environment decreases Quality by increasing the propensity of decision-makers to misallocate capital into nonproductive ventures that result in its destruction.
Warring Economic Theories
There is a debate in economics over whether humans are rational or irrational. Behavioral economists, such as Richard Thaler, claim that humans are irrational and therefore need to occasionally be “nudged” to make rational decisions. They claim to have identified several observable areas where humans are not acting in their best interests, particularly with regards to prioritizing short-term satisfaction over long-term prosperity. So, they work to develop tools to incentivize humans to delay gratification. Probably the most famous of these is the program for auto-enrollment in 401(k) plans. Austrian economists, such as Saifedean Ammous, object to this assessment and claim that humans, left to their own devices, are rational economic actors. Ammous, in particular, in his Principles of Economics, refers to behavioral economics as “pseudoscience” and makes the point that the “criteria of rationality” are “arbitrar[ily]” defined. He also objects generally to the conclusion that “coercive intervention” is the appropriate response to this so-called “irrationality.” At its core, he is claiming that their paternalistic manipulation of incentives is akin to the manipulation that creates an abstract economy.
I am sympathetic to the Austrian position, in that coercion should not be required to ensure Quality decision making. After all, the process of civilization occurred naturally; however, I don’t believe that the behavioral economists’ findings can be dismissed. Given my experience in business, it appears decision-makers often behave in irrational ways or ways that reduce Quality. The popular thinking amongst business leaders seems to be increasingly short-term in nature. Ammous even makes the point himself, claiming that “by destroying the ability of individuals to save for the future, fiat money takes away the incentive to delay gratification, reduces the creation of capital, and undermines the basic starting point of economic development and civilization.”
Both schools of thought have a point. We should certainly be skeptical of economic manipulation, as the Austrians insist, but Quality decision making requires delaying gratification. Delayed gratification might be the natural consequence of the process of civilization in a real economy, but in an abstract economy, which shortens the time preferences of decision-makers, it is not a naturally occurring phenomenon. I believe behavioral economists are measuring genuine long-term irrationality that is the result of operating in an abstract economy. Ultimately, the final solution to this irrationality is to remove the influences on the economy that make it abstract and resume the forward progress of civilization, which makes Quality the status quo. In the meantime, I think it is prudent to recognize the existence and importance of the abstract economy, acknowledge that it is making us irrational in the long-term, and implement tools that facilitate delayed gratification, so as to mimic the real economy to the best of our ability. For decision-makers within organizations, the best of these tools is the organizational quality system.
Quality Systems
In a real economy, business incentives would be aligned with Quality, but in an abstract economy, the incentive structures are distorted, so as not to encourage and reward decision-makers who prioritize long-term prosperity. In the absence of natural incentives, organizations have managed to improve delayed gratification through the implementation of quality systems, whether they call it that or not. They are occasionally mandated by government agencies, such as in the medical device industry, but often they are the result of market expectations. A quality system is simply a method for standardizing business practices, managing change, and collecting data, so as to provide decision-makers with the necessary information to make rational decisions for their organization in the long-term, despite the incentives to be irrational. Ammous makes the point that, “religious, civic, and social norms all encourage people to moderate their immediate impulses in exchange for the long-term benefits of living in a society, cooperating with others, and enjoying the benefits of the division of labor and specialization.” Similarly, organizations moderate their immediate impulses by implementing a network of processes and a system of checks and balances for decision making. This network is often referred to as a quality system, and it allows the organization to maximize productivity by taking full advantage of the division of labor and specialization cross-departmentally and throughout their supply chains.
The process of civilization relies of the elevation of decision-makers who have a greater than average base instinct for delayed gratification. Over time, the distorted incentive structures of the abstract economy have led to the elevation of decision-makers with shorter time preferences, but even for those with longer time preferences, the disorientation of the abstract economy is real. It is not always clear if the decisions they are making will increase the capital of the business (i.e., Quality decisions), or they are simply destroying capital at a lower rate than would otherwise occur from inflation.
Organizations, or businesses, are complex, and the existence of the abstract economy makes them even more complex. In his The Road to Serfdom, F.A. Hayek, another famous Austrian economist, discusses the nature of a “complex society,” saying that it “must take account of facts no individual can completely survey” and that if we are to “maintain our present complex civilization,” that individuals must “do things which [they do] not comprehend the necessity.” If this is true about a society, it is true about an organization as well. The process of civilization has been the result of sufficiently delaying gratification through means that no individual can completely understand. Properly implemented quality systems create a network of processes within an organization, of which the execution can be trusted to improve profitability over the long-term, without being completely understood by all individuals.
The requirement to adhere to a quality system is often thought of as an obstacle to the maximization of productivity and profitability and so decision-makers are constantly at odds with their proper implementation. Metrics like cost-of-quality (COQ) are emblematic of this type of thinking, where the organization’s leaders focus on how expensive it is to ensure product quality, rather than the opportunity cost of not doing so. This causes a problem because decision-makers typically have the authority to subvert, deviate from, or manipulate the quality system. This authority and outsized influence are why it is paramount for decision-makers to understand the macroeconomic environment that businesses are subject to in today’s society, the problem it creates for Quality, and the role that quality systems play in helping to solve this problem. This is true regardless of their ability to properly attend to and understand each individual economic decision in their complex organization.