The Fable Of Market Meritocracy

Markets don't reward smart people, nor should they.

It's a good thing that French President Nicolas Sarkozy is brimming with amour propre because he certainly did not earn any amour from the business elite gathered in Davos last month. In a bombastic riposte--delivered, no doubt, in one of his fabulously expensive designer suits-- he proclaimed that the recent financial meltdown had demonstrated that letting markets decide executive compensation was "morally indefensible." "There are remuneration packages that will no longer be tolerated because they bear no relationship to merit," he said.

But here's some news for Mr. Sarkozy: Markets don't reward merit; they reward value--two very different things. If Mr. Sarkozy does not appreciate the difference, it's not his fault actually. Most advocates of markets have failed to fully make this distinction, perpetuating a cult of market meritocracy--something that has hindered, not helped, the cause of free markets.

With the notable exception of Nobel laureate F.A. Hayek, market theoreticians have to a large extent employed the equivalent of the Great Man theory of history to explain what makes markets tick. According to this theory, the course of history is shaped not by the convergence of multiple, unpredictable events but by the intervention of great men. Likewise, in the conventional thinking about markets, economic progress depends not on the labors of infinite economic actors but on the select few, the brainiacs, who rise to the top and generate innovations from which ordinary mortals benefit through a kind of trickle-down effect.

English sociologist Michael Young noted in his influential 1958 fable, The Rise of the Meritocracy: "Civilization does not depend on the stolid mass, the homme moyen sensuel, but upon the creative minority, the innovator ... the brilliant few … the restless elite who have made mutation a social as well as a biological fact." Less elegantly, Ayn Rand evinced a "pyramid of ability" in capitalism under which "the man at the top contributes the most to all those below him." What's more, this Nietzsche of capitalism opined: "Man at the bottom who, left to himself, would starve in his hopeless ineptitude, contributes nothing to those above him, but receives the bonus of their brain."

What's good about markets in this line of thinking is that they identify the incandescent geniuses among us and catapult them to the top where their innate brilliance is harnessed to improve the lot of mankind. At once, then, markets yield economic progress and what Rand (and others) regard as justice--the biggest rewards to the best.

The only problem with this neat little formulation is that it is wrong at every level. For starters, the idea that value creation is a one-way street from the top to the bottom is not just offensive, but it ignores the principle of comparative advantage, a key breakthrough in market theory. Put simply, this principle holds that everyone benefits by exchanging goods and services with everyone else, regardless of anyone's inherent capabilities. It's in the interest of even the most annoying "all-rounder" (as we say in India), who is better than me at everything, to specialize in those tasks in which our gap is the biggest and trade with me for those in which our gap is smaller. Under the elaborate division of labor that ensues, both the less-endowed and the better-endowed contribute to each others well being.

But is it the case that this division of labor necessarily directs the biggest rewards to the most gifted by putting them at the highest end of the value chain? No.

The beauty of the market, Hayek brilliantly pointed out, is that they allow people to use knowledge of their particular circumstances to generate something valuable for others. And circumstances, he emphasized, are a matter of chance--not of gift. Furthermore, since no two people's circumstances are ever identical, every producer potentially has something--some information, some skill or some resource--that no one else does, giving him a unique market edge. "[T]he shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others," noted Hayek.

In a functioning market, Hayek insisted, financial compensation depends not on someone's innate gifts or moral character. Nor even on the originality or technological brilliance of their products. Nor, for that matter, on the effort that goes into producing them. The sole and only issue is a product's value to others. Compare an innovation as incredibly mundane as a new plastic lid for paint cans with a whiz-bang, new computer chip. The painter could become just as rich as the computer whiz so long as the savings from spills that the lid offers are as great as the productivity gains from the chip. It matters not a whit that the lid maker is a drunk, wife-beating, out-of-work painter who stumbled upon this idea through pure serendipity when he tripped over a can of paint. Or that the computer whiz is a morally stellar Ph.D. who spent years perfecting his chip.

The idea that there is no god (or some secular version of him) meting out cosmic justice through the market's invisible hand is unsettling, even to market advocates, but it shouldn't be. It opens up the possibility of a defense of markets that is, as it were, more marketable.

Few would dispute that markets are fairer than the aristocratic order they replaced where privilege was a birthright, not something to be earned. But the view that the super-gifted or the super-smart deserve the biggest rewards doesn't seem a whole lot fairer given that these traits are arguably inherited, too. This conception, in fact, forces those who are less successful to internalize their failure--accept their second-class status as preordained--breeding alienation and resentment. Hard work or some quality of character would offer a more palatable basis for building a case for markets, except that all the lowlifes who routinely make it rich in markets offer too much evidence to the contrary.

Hayek's understanding of markets overcomes these problems by, first and foremost, democraticizing the concept of merit. If anything in your possession, no matter how trivial--some local knowledge, some quirky interest--can potentially be turned into something useful for others, then there is not any one formula for market success; there are a potentially infinite number. This means that success is possible for a far wider range of people in a market, making market societies inherently less hierarchical than more closed ones.

Take, for instance, India in its preliberalization days. Economic opportunities were exceedingly limited in its regulated and centrally planned economy. The most sought-after professions were engineering, medicine, accounting and--hang on to your fountain pens!--civil service, because they offered a path to secure jobs in government-approved sectors. Competition for professional colleges was fierce. The lucky few who made it into elite institutions such as the Indian Institute of Technology for engineering were regarded almost as a special breed. Even now, the unabashed elite-worshipping that IIT graduates command in India would make Zeus blush.

But free markets change all this. They close the talent-gap by allowing people to ferret out and market whatever they've got--even, regrettably, Paris Hilton. In America, for instance, there are opportunities galore for funny people--standup comedy, late-night talk shows, etc.--who may have no head for math or science. Their sense of humor is a prized commodity, a gateway to riches and fame, instead of social ridicule as it would have been in the India of yore.

But markets don't just expand and democratize the concept of merit; they render it moot. No longer does it matter what great qualities reside in you. What matters is if you can make them work for others. The concept of merit is replaced by that of value. Merit is intrinsic, concentrated and atomistic; value is relational, decentralized and social.

The need for embedding this Hayekian understanding of markets in the public consciousness cannot be overstated. And the first step in doing so might be purging the word "merit" from the vocabulary of markets and replacing it with value. This would make it much easier to explain how no functioning industry, absent access to taxpayers' pockets, can afford forever to pay its executives obscene salaries beyond the value they are generating. At once, then, it would be possible to oppose both the recent government bailouts and government regulations such as Sarkozy-style caps on executive salaries.

More importantly, it would become possible to counter the popular perception--the source of so much hostility against markets--that there is some body of super-elites, masters of the universe, who can sit in their plush offices on Wall Street and Silicon Valley and reign supreme through their sheer brain power. If value, not brain power, is the engine that drives markets, then the market's inherent nature militates against elite control.

Markets are a fundamentally antielitist social force. If this is not generally recognized, it is not so much because of what the enemies of markets say to attack them--but what their friends have said to defend them. To rescue markets, then, one has to rescue them from their friends first. Mr. Sarkozy is not the main problem here.

Shikha Dalmia is a senior analyst at Reason Foundation and a writes a biweekly column for Forbes.