_= Society
(Volume 44, Number 3)
There is No Substitute for Profit and Loss
Jeffrey Friedman
s [read Howard Husock’s brilliant essay, 1
A= 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 ofall, “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, atleast 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”—exceptin 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, t00,
should be quantitatively measurable. Then begins a
wild goose chase for proxies of the very thing that, by
their nature, nonprofits cannot make: profits.
48 SOCIETY* + MARCH/APRIL 2007
‘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 frst. Economic theory tells us thatthe 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 thesymposium: the politics, of philanthropy,
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 altemative 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 ofthe 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-profit.
‘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 later 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:
1. Publie-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 tothe nonprofits the illu-
sion of success, even though what the nonprofits are
supposed to be producing—the actual adoption (not
{ust the proposal and discussion) of good policies, or
the actual repeal or ejection of bad policies—never
seems to materialize.
2. 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
3. ‘The herd mentality. Donors are often prey to the
notion thatthe legion of other donors who enable
‘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-
pet—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
‘THERE IS NO SUBSTITUTE FOR PROFIT AND LOSS 49symposium: the politics, of phillanahnopy:
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.
Ifnot 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—if 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 firms 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
hhas the underrated advantage of leaving room for the
inscrutability of whatever combination of factors may,
ina given instance, end up serving investors well—by
serving consumers well.
‘The cliché 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
50 SOCIETY® + MARCH/APRIL 2007
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 oft is that
nobody—even the successful entrepreneurs or inves-
tors—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 putt 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 makesSymposium: the politics of philiamtlnopy:
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
‘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, itis true, may fail to
solve any problem except that of raising funds. Unlike
failed commercial firms, such nonprofits may continue
toimpress their donors because of the flawed heuristics
for success thatthe latter employ. But these only-appar-
ently-suecessful 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
cone 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-
Jems. 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 isa widespread belief in it.I take Husock
tobe saying that there is such a belief, and that the belief
has much going for it. My view is the opposite. What
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
widely accepted doctrine. Itis 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. Itis 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-
Jems they perceive as being important. The democratic
ethos thus encourages a pluralism of theories about
‘THERE IS NO SUBSTITUTE FOR PROFIT AND LOSS 51how to solve problems, and a pluralism of nonprofits
to embody those theories. I am not saying that “the
‘common man” is inherently a better theoret
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 right solution to a problem
if itis 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.
1 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.” Ido 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 Lam 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 1
understand to be Husock’s answer: that government
service is less “likely to attract committed employees
52 SOCIETY® + MARCH/APRIL 2007
and volunteers” than nationwide nonprofits. }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. Exposés 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
‘egulation—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 thatresistance to one goes with resistance
tothe 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,
think, accounts for the ridicule that proposals for “a
thousand points of light” receive from the best and thesymposium: the politics: of philandhnopy
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 ofthe 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 Westem, 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 wall 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, atleast, 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
have tried to suggest here—an argument for a piural-
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. Tis isn't to say thatthe nonprofit
sector shouldn’tbe defended. But I think the defense must
be epistemically minimalist if it is to be consistent with a
like defense of capitalism—and with Husock’sidentifica-
tion of the main problem plaguing human endeavor in
all fields: the problem of knowing what works.
‘Jeffrey Friedman has taught political theory and social
ence methodology at Barnard, Dartmouth, Harvard, and
Yale. He is the Max Weber Senior Fellow of the Insitute for
the Advancement of the Social Sciences, Boston University,
and the editor of Critical Review: An Interdisciplinary Jour-
nal of Politics and Society.
‘THERE IS NO SUBSTITUTE FOR PROFIT AND LOSS 53,