We occasionally get comments (from folks that don’t know us very well) that our consulting practices seem broad and unrelated. Their (unsolicited) advice is usually that we should “focus.”

In those situations, our verbal response is simply, “thanks.” However, it is quite possible to be an expert in more than one field, especially if those fields are (1) related at a more basic level and (2) support each other.

More importantly, for knowledge workers, cross-field expertise applied to substantial and/or pernicious problems is where value is created for organizations and society. In our case, we can cite three easy examples of such cross-field expertise.

1. Integration of Managerial Control & Risk Management

As we explain on our Control & Risk Management page and our Industrial Control & Risk Management page (and in a multitude of posts) managerial control involves developing mechanisms, including incentive schemes and information systems that ensure that the organization’s goal is obtained. As such, in decentralized environments, managerial control involves (consistently) influencing the decisions of subordinates in incentive-compatible or goal-congruent ways through either incentive schemes, including performance measures; information systems; or other “control” mechanisms. (Note: the consistency of decisions defines the actual strategy that is implemented or pursued–not the stated or “talking-point” strategy–so control mechanisms must work as designed with no “uninteded” consequences.

Those sequences of decisions, however, are not made in vacuums, but instead are made in uncertain environments. Therefore, it is necessary to consider and combine uncertainty management–commonly known as risk management–and managerial control. That integrated approach allows senior managers to predict the possible harmful outcomes of decisions and the likelihoods of such outcomes. (It also permits them to find “natural” hedges that may exist within a diverse organization.)

It is easy to argue–and we have–that much of the recent financial crisis was due to the lack of stewardship, including the lack of controls, which often started with boards and worked downward to traders and risk managers. (How can one control a subordinate’s opportunistic, and potentially harmful behavior, if one doesn’t understand the trades or derivatives?)

So, how one could properly protect an organization from harm without the complete integration of managerial control and risk management is beyond us. Presumably, one must then count on good luck, which doesn’t seem to be the most robust strategy, and as in 2008, seemed to fail.

2. Web Applications & Public Relations

Between the two principals at Spero Consulting, we have expertise in (among other things) web applications, some design skills (and style), and substantial expertise and experience in corporate public relations.

That cross-expertise and (very) close working relationship, allow us to quickly develop and publish content for client web sites.

Whether an engagement involves incentives or public relations, at the heart of the issue is understanding and predicting human behavior and influencing individuals to help achieve your goals. That constant focus on the replies and responses of others to your statements or actions, allows us to develop both interesting and search-engine optimized content. That’s why we refer to our approach as “Grownup Web Design™.”  That’s also why employ what we refer to as “Out-of-site, out-of-mind” strategies and tactics, including many subtle tips and actions that optimize a firm’s web marketing by improving the odds of attracting prospects and converting them into clients or customers.

3. MIS, Web Apps, Control & Decision-making

The impetus for this afternoon’s post was an e-mail forwarded from a good friend, who unlike the folks mentioned in the first sentence, does know us well. It was the “Management Tip of the Day” sent by Harvard Business Review. The tip involved the new notion/word, “bitsmith,” and referred to an earlier (April) HBR blog post, Do Your Knowledge Workers Have a “Bitsmith”? Per John Sviolka, “Bitsmiths are people who have deep knowledge of both the work content and the tools used to support the work. In other words, they are almost as expert in derivatives or computer design as they are in computer-programming languages.”

We briefly explain our approach to information system design on our MIS page. Our decision support systems are surprisingly easy to build–thus making them affordable–and are far more flexible and adaptable than traditional, large-scale, poorly-fitting, rigid, megalithic (and monolithic) systems. (Those systems are useful and necessary databases that serve useful, record-keeping purposes, but they rarely serve as effective decision-support or information systems. In fact, every customized EXCEL spreadsheet that is routinely used reporting purposes is an indictment against those standardized, ill-fitting behemoths.

Our flexible systems are what knowledge workers want and need to maximize the firm’s value (while simultaneously maximizing their own value and human capital) and to communicate with each other than their superiors. Flexible, adaptable, but secure and industrial strength: what’s not to like?

We ask: why continue to use clunky e-mail messages, with silly, self-defeating retention policies that toss-out institutional knowledge like worthless garbage, as your firm’s main decision support system? (We’re not keen on PDF attachments, either.) And, yes, unless yours is an exceptional company, your e-mail system is–usually implicitly–your firm’s most used information system for all important strategic decisions.

Those are three examples where cross-field expertise is extremely valuable, and three areas where we can transform your firm through the combination of subject-matter expertise, careful analysis, empathy, and knowledge of the tools-of-trade.

P.S. Thanks, Curtis.

Recently, much has been written about “Wall Street” bonuses. Almost all of those articles mention the same two things: (1) populist and government sentiment against the bonuses, and (2) the composition of the bonuses towards long-term, restricted stock and away from cash. At least some of the drive towards a more stock-heavy composition seems to be management’s attempt to appease the government and the public. In this post, we argue that such moves are needlessly costly, which means inefficient and larger than need be.¹

In a previous post, Government Whining and Bailout Fees, we discussed the outrage and mentioned that citizens have a right to be angry–at the government. In this post, we analyze the reported composition of many of bonuses. In particular, we think the insistence on long-term, restricted stock grants is inefficient for several reasons that we discuss below.

However, before continuing, it is worth re-mentioning that much of the controversy could be eliminated by eliminating proprietary trading at insured institutions. As we have repeatedly written, we have nothing against proprietary trading or traders, but see no reason why we or other tax-payers should subsidize trading losses. Note, too, that there are other good reasons to eliminate such activities at insured institutions, including the fact that they diverts managerial attention away from (boring and mundane) everyday activities of running commercial banks. We know that at the margin, there’s not much of a difference between a bank’s treasury (asset-liability) management and certain kinds of prop trading, but we’d prefer that regulators keep a narrower focus. Finally, to get, in a single edition of The Wall Street Journal, Thomas Frank, Jonathan Macey, and James B. Stewart to agree with us is mind-boggling. It indicates the abject perversity of the status quo.

Now, having said that, we hope that everyone receiving the much-discussed bonuses get maximum enjoyment and satisfaction from them. We certainly don’t blame anyone for trying to maximum his or her compensation in an attempt to maximize their satisfaction, their family’s satisfaction and well-being, and their contribution to the less fortunate. The problem is that there are likely cheaper ways to provide the same level of satisfaction and reward.

Aside: note that for the remainder of this post, we’ll use the word “expected,” as in “expected compensation,” in a very loose, non-mathematical way. That’s because we are rather pedantic and like to emphasize the difference between uncertainty and risk. Like others, we define risk as measurable uncertainty, and that means that risk is a special type of uncertainty or unknowing can be (appropriately) described as a probability distribution. Not all probability distributions have means or expected values, and that seems to be the case in financial markets. So, trying to calculate one’s expected bonus as a function of market performance might not be technically feasible if the distribution of returns is unknown or its moments don’t exist.²

So what’s wrong with bonuses in the form of long-term, restricted stock?

Well, they are long-term so they defer consumption, they are restricted so they’re are expensive to convert into consumption, and they in sotck so they are risky (uncertain) because they are only very weakly tied to an individual’s performance.

Delayed Gratification:

Are there good reasons for long-term compensation schemes? Yes, there are.

When employees take actions or make decisions that have long-term implications, then signals from multiple periods can be used to infer whether the employee behaved appropriately–back when the the decision was made.

Generally, the use of multiple signals improves the precision of the inference, and that means that less risk is imposed on the employee.³ For risk-averse employees, that means a lower risk premium is required to ensure his or her participation, which means a smaller expected bonus is required.⁴ So, the key to rewarding long-term performance is classifying current period results into the time periods when decisions were made so that one can make better inferences about the decisions made in a prior period. It’s not as easy as it sound, but it is possible to do.

So, yes, most traders that make long-term bets should be rewarded on long-term performance, and features like claw backs should be used, but in the specific way that we wrote about in Clawbacks: the Good, the Bad, and the Ugly and Incentives at UBS and in General.

However, requiring someone to wait five years to receive stock in a mega-corporation is not the same thing. That’s because:

1. Five years is arbitrary, and  may have little to do with the length of the employee’s investment decision. Moreover, it is a long-time to wait for a pay-off.
2. If we’ve learned nothing else during the past few years, we have learned that, in general, share prices are very volatile, which means that employees who must wait five years for their reward must bear a substantial amount of risk.
3. Other than possibly a few senior executives, no single employee has very much anticipated or expected influence on share price in five years. Ex post they may have, but not ex ante.

So, it seems reasonable to conclude that impatient, risk-averse employees would substantially discount the expected value of such stock grants.⁵  That means that all things equal, it means that if they can, employees will demand larger bonus grants to compensate for the delayed gratification and the risk.

Restrictive:

We imagine that the only people who prefer that bonuses be in the form of restricted stock are folks who aren’t getting them and the envious types: please see The Children who Have Eaten their Cake…

Usually, there are ways to borrow against such grants and/or hedge the value of such grants, but not all firms permit such actions. Moreover, they’re not cheap and they can be time-consuming.

That means that employees will bear costs of converting the awards to nearer-term consumption and, if possible, will demand larger bonuses to cover those costs.

Risky and Uninformative:

For some reason,many folks (and politicians) believe that when employees own shares, including restricted stock, incentives are somehow magically aligned–kind of like Lucky Charms.

However, except for possibly a small handful of very senior managers, that’s very silly. Consider that Bank of America has nearly 300,000 employees, CitiGroup has about the same, and even smaller firms like Goldman Sachs have more than 30,000. So, the effect of any single employee is usually very small. (Moreover, the predicted effect is usually very small. In fact, when it is large, it is often due to the firm’s franchise and reputation and not that particular person’s actions.)

Do note that attempting to link the effects of a particular action, decision, investment or trade to share price today or any point in the future is extremely difficult. (Maybe not in finance class, but it is in real life.)

Just as importantly, and as we mentioned above, even if it can be done (in expectation) the firm’s stock price is a particularly noisy measure of a particularly person’s performance. So, it’s quite possible to conclude that employees will ignore the implication of their decision of share prices, which is completely rational, and do what’s best for themselves. That very much reminds us of that quote of Huckleberry Finn that we always used when we taught: “Well, then, says I, what’s the use you learning to do right when it’s troublesome to do right and ain’t no trouble to do wrong, and the wages is just the same?”

For more on this general topic, we refer interested readers to our essay in the Fallacies section of the web site: One Performance Measure to Rule Them All.

For more on this topic as it pertains to trading, we encourage visitors to read the last half of the above-mentioned, The Children who Have Eaten their Cake…

In sum, we argue that (1) the long-term nature that delays consumption, (2) the restricted nature that is costly to bypass, and (3) risky nature further reduces the value (think in terms of expected utility or certainty equivalent) make such bonuses worth substantially less than their face value. If employees have any bargaining or negotiating power, firms will have to increase the stated value of the bonuses to satisfy them.

Those extra costs would be worth bearing if they aligned incentives, but unless you, dear reader, believes in magic, there is no reason to believe that any future actions by those employees will be cooperative in nature.

So, it seems that long-term, restricted stock awards are inefficient ways to motivate employees.

We’ll likely proofread this post and edit it in the near future.

P.S. Our New Year’s resolution is to write more about financial matters, the industry and the crisis than we did during last half of 2009. Last fall’s drought occurred for a variety of good reasons, but two related ones are worth mentioning: (1) while many of our posts tend to be long, we hate being repetitive, and in our mind there was little new to say, and (2) with little new to say, we found many of the events and proceeding to be quite boring. For writing blog posts, “boring” means too many references to old material–like above–but we’ll try to write more in 2010.

Copyright © 2010 Spero Consulting

Footnotes:

Related posts:

• Clawbacks: the Good, the Bad, and the Ugly
• One Measure to Rule Them All
• Your Government (not) at Work
• Out of Their Elements
• Patience Please! They Just Need More Time!

That’s what we wrote about last week where we blamed failures on overly-centralized and overly-rigid information systems:

1. Sad but True: Intelligence Failures & Bad Information Systems
2. Human Error (versus Systemic Failure)
3. Intelligence Failures and Bad Information System Design

As he wrote:

The problem is often not the intelligence we collect, but assessing its implications.

In other words, the data were there, but no one noticed, or someone did notice, they either: (1) didn’t bother to mention it or (2) mentioned it and no one listened. That’s the problem with overly-rigid and overly-centralized information systems.

In many organizations, there’s a vital use for large, centralized, rigid systems, but that use involves record-keeping of easily-understood transactions and events and not the storage of assessments and interpretations–like whether someone might be a terrorist.

In that regard, maybe a good heuristic for intelligence system designers (and all designers) is: if a field or record requires many assumptions to interpret, its placement in a large-scale system may be sub-optimal (and data and information should be retained and analyzed at a local level). We’ll write more about that on another day, but it is the conformance process that doesn’t separate the “wheat from the chaff” so-to-speak. In other words, the (false) demand for uniformity and standardization strips away the signal as well as the noise. For example, seethe discussion about “Rreasonable suspicion” in Human Error (versus Systemic Failure).

That’s similar to what he wrote:

Each intelligence agency should be able to place its analysis of data into a competitive marketplace of classified ideas—this will help determine which is the superior product.

That’s why we recommend a decentralized approach, where agencies need not conform to a uniform, centralized outlook (or set of assumptions). So we ask: why can’t the secure, encrypted national-security intranet be more (a little more) like the internet and the blogosphere?

Related posts:

• Two Americas
• Commodity Speculation
• TARP? Garp? Is There a Difference?
• Memorial Day, 2009
• Pet Peeve: the Emotionless Jesus

“Those who do not learn from history are doomed to repeat it.”

—George Santayana

Preface: on Monday, we wrote Human Error (versus Systemic Failure), which supplemented our longer post from Sunday: Intelligence Failures and Bad Information System Design. Much of that ‘Human Error’ post was devoted to mentioning that within organizations, most failures, including human failures, are systemic failures. You can’t blame it on your subordinates!

In the Sunday post, we hypothesized and speculated that bad information system design could be the cause of the recent intelligence failures. We based those suppositions on our knowledge of information systems, common design flaws, and the dysfunctional nature of the federal bureaucracy but with no real or specific knowledge of the circumstances. We don’t work for the government, and we’re too lazy and too busy to investigate on our own, but we figured our hunches were correct (and were willing to stake our meager reputation on them).

So, in the Monday post, we used L. Gordon Crovitz’s column, Intelligence Is a Terrible Thing to Waste, which appeared in that day’s edition of The Wall Street Journal, to provide some anecdotal evidence to support our conjectures of the overly-centralized and overly-rigid nature of the systems.

We closed Monday’s post with: “Sad,  but true.”

Unfortunately, an article in Friday’s edition of The Wall Street Journal, Years of Spotty Data-Sharing on Suspects, provides additional evidence to support much of the criticism that we levied on Sunday (based upon our speculation).

We write “unfortunately,” because this is one of those cases where we hate to be right, but read it (the article) and weep. Here are several items mentioned in the article and our comments.

President Obama ordered agencies to bolster information technology.

• It’s unlikely that the failures are about technology or inadequate budgets. Note, using open-source web apps, our database-driven site and e-mail costs less than $150 per year to operate. It is a state-of-the-art publishing system that could be easily used by departments and agencies to post (and categorize) qualitative information and leads. Those categories could include substantiated versus unsubstantiated claims.
• More likely it’s about system design. We’re not under-estimating the volume of data for some agencies, but we are questioning the need to centralize its storage and management. More on this below.

A previous integration attempt, appropriately called the Information Integration Program, failed.

• Is anyone surprised by that result?
• We suspect it is overly-rigid and centralized.
• We also suspect that if such an integration attempt were to ever succeed, it would be immediately obsolete–most likely because some such agency upgraded one of its databases, and it is no longer integrable.

Supposedly, another integration attempt won’t be complete for two years.

• Remember: the last attempt failed. So, why believe the two-year deadline?
• It likely involves many industrious and very hard-working consultants spinning around on the little hamster wheels and sweating profusely, but with no real chance of success. It would be a Greek Tragedy if it weren’t an American one.
• There are needs for large systems, but we suspect far fewer than presumed.
• The issue isn’t how to accumulate all information and data, it is how to access information as efficiently as possible. So, why should a middleman aggregate it when individual agencies could publish it and searchers (with proper clearance) could immediately find it.

Emphasis on connecting e-mail systems

• Please see our post, Inexpensive but Valuable Web-​based MIS, especially the section, ‘E-​mail as the Central Nervous System.’ No need to repeat the argument here, but e-mail is an inefficient management information system. Better and inexpensive substitutes exist.
• Communication should be about be about publishing facts, speculations, and opinions, and letting others search those posts or reports (and/or receive feeds of future ones).
• E-mail is archaic for these purposes. We ask, dear reader: do you know any one of our several e-mail addresses? Unless or are a friend or acquaintance, no, you don’t. Yet you can read our current and past speculations and be automatically informed of future ones.
• Why shouldn’t intelligence analysts, within their own communities, have the same capacities that you, dear reader, have throughout the worldwide community that is the web? Provided you live in a free, uncensored society, you have the capability at little or no cost. You can search for items of interest and read and evaluate them based upon your knowledge and perspective. You can think we’re a fool or not, but you can make that assessment yourself for your particular problem or need. Why shouldn’t analysts be able to do the same on their intranet?

National Intelligence Library permits searches of finished reports

• That’s good, but it’s not enough.
• How much subjective and unsubstantiated and unverified data are eliminated from those finished reports? Again, that’s the stuff of new leads and threat identifications.
• How long does it take for such reports to be “finished” and available for general consumption?
• If agencies or work groups had their own (secure, intranet) publishing platforms, why bother consolidating? Let potential users, with the right clearances, surf. Another way to ask: why bother consolidating when the consolidator cannot necessarily anticipate the needs of users? Also, each blog on the web has its own system of permissions for access to private and password-protected information. Has anyone investigated whether a central clearinghouse is more efficient than maintaining access to data at local levels.  We don’t have many subscribers, but we know when we have new ones, and can grant various levels of permissions to them.

Problems searching unprocessed information, especially clearances

• See Sunday or Monday’s post.
• Regarding who has access to which databases, security clearances are a major issue for a variety of good reasons, but distinctions should be made between data about citizens and foreigners, and there is no reason to endow foreigners with our rights; so, information about foreigners should be more easily accessed.

Security clearances

• Obviously necessary, clearly a constraint. In fact, by definition, they are constraints on sharing.
• We don’t have an answer to this issue, but we do have questions: Is clearance a status-symbol? Should lower level investigators and analysts have greater access? What are the costs and benefits of greater access? How could leaks compromise various investigations? Obviously, records of visits, queries, etc, can be kept (just like we have at our site and most other web publishers have).

Terrorist Identities Datamart Environment

• We ask: who, other than a government (or corporate) bureaucrat (or parasitic consultant), could like that name? Seriously? Is it that crucial to create a word from the acronym?
• Does the mangling of English imply anything about the construction of the system? We wonder.
• It’s clearly a centralized system, and based upon the Crovitz column we mentioned above, it seems very difficult to get on the list. We suspect it is harder to get off of the list.

What would we do?

For certain standardized monitoring and detection systems, there is a clear need for large databases. These are similar to record-keeping systems for transactions and events, i.e., not much different than, say, keeping track of checking account transactions or purchases and returns at WalMart. In a world-wide endeavor like terrorist detection and monitoring, such systems need to be search-able web applications (on a private intranet). That very much reduces the need for consolidation into one ginormous database.

In fact, the web is nothing if not one, large, searchable database (made of millions of small ones). However, the consolidation and aggregation is inherent and organic, rather than commanded or centrally-planned. In fact, modern sites are database-driven, and a visit to a page is the call to an (actual) database. Every time a Google search is performed, the web surfer is running a query, and has access to some sites but not other, password-protected ones.

Moreover, the search engines have developed algorithms to present the results in particular ways, and they are incredibly good at it. (At least on those searches where we rank high.) That is where time and effort should be devoted–not in attempting to physically consolidate disparate databases.

In that respect, let the disparities grow so that each agency can best serve its own mission, yet produce and publish intranet-accessible reports and notes.

We’d imagine that many of investigations are ad hoc and involve a bit of serendipity. We would imagine that with slightly different missions, the agencies have slightly different data and information requirements and emphases and traditions and cultures. So, why try to centrally consolidate (and therefore homogenize) the unique systems that may have evolved for specific and good reasons.

However, small, idiosyncratic systems that comprise a security intranet,  can be index-able and search-able–just like the web.

So, we say harness the power of existing web applications and technology to protect our nation. Allow investigators and analysts be entrepreneurial publishers of their idiosyncratic views, facts, and suppositions. (All private and all secure on an intranet.)

Let investigators and analysts publish their reports and speculations for themselves and other agencies, join forums, and converse with their colleagues–even anonymously. (We reiterate: all published securely and privately on a huge intranet, of course.) Let them use their intellects and training to behave entrepreneurially, not bureaucratically.)

Use central resources to develop search algorithms and security clearance/permissions applications that operate seamlessly in a secure environment. Integrate intelligently, not by consolidation, by query. User management and permissions are immensely important, but millions of sites have solved such problems. With a bit of guidance and in time, we think the government can, too.

Information: it’s like the economy (and wealth) stupid. Try to centralize it, and you’ll kill it and destroy the incentives to produce more. In that respect, see The Wall Street Journal’s Review & Outlook, ‘A Failure to Connect the Dots’, for more corroborating evidence and perspective.

We’ll likely edit this post in the morning. (We did, and will likely do so again.)

Related posts:

• John Bolton is Right
• Idle Speculation about Spam and Terrorists
• Information System Design
• Human Error (versus Systemic Failure)
• A Nationwide Dangling Feedback Loop

After intermittently pondering the attempted Christmas Day bombing of Northwest Flight 253, yesterday we published Intelligence Failures and Bad Information System Design.

Per its title, we speculated that bad information system design could have been the cause of the failure. In particular, if the system is overly-centralized and overly-rigid intelligence failures can occur. (It’s a long post, but we think that it is well worth reading.)

Shortly after publishing it last night, we saw today’s (Jan 4) opinion column by The Wall Street Journal’s L. Gordon Crovitz. His column is entitled Intelligence Is a Terrible Thing to Waste.

In it, he quotes the head of the FBI’s Terrorist Screening Center, Timothy Healy, and Mr. Healy’s explanation of ”reasonable suspicion,” which is what it takes to get on a “list.”

“Reasonable suspicion requires ‘articulable’ facts which, taken together with rational inferences, reasonably warrant a determination that an individual is known or suspected to be or has been engaged in conduct constituting, in preparation for, in aid of, or related to, terrorism and terrorist activities, and is based on the totality of the circumstances. Mere guesses or inarticulate ‘hunches’ are not enough to constitute reasonable suspicion.”

Mr. Crovitz then goes on to explain that if Mr. Healy’s explanation sounds like legalese that’s because it is and that it is silly and dangerous (our words) to treat potential foreign terrorists and enemy combatants as domestic criminals.

That’s very similar to we wrote yesterday:

…In particular, we could imagine that unverified and unsubstantiated reports are among the least generally-accessible data–until they are verified, reviewed or accepted by the bureaucracy, regardless of whether that involves a single agency or an over-seeing umbrella group.

BUT those unsubstantiated reports are the ones that are most likely to provide information about new terrorists like Abdulmutallab, (and that is the problem with treating foreigners who are threats to our national security as criminals rather than enemy combatants.) If our hunch is correct, then one should expect future “intelligence failures” to arise in similar situations.

Moreover, if our hunch is correct, then a centralized, database administrator’s (rather arbitrary) rules–or worse, some lawyer’s rules–substitute for the individual knowledge and discretion of various field agents and supervisors.³ As such, fields agents may not have the opportunity to synthesize the information until it is too late. (It’s a case of the perfect being the enemy of the good.)

By the way, Mr. Crovitz concludes with:

We have a choice. We can limit how information is used or we can allow smart use of information to prevent attacks. If we continue to choose to limit how information can be used in our defense, we shouldn’t be surprised when our defenses fail.

In that closing paragraph, he succinctly states the problem that we more precisely explain (in terms of information system design) and our recommendation to make security-related information systems more like the internet and blogosphere.

When Human Errors Are Systemic Errors

Please note our footnote (#3) in the third paragraph of the above excerpt from yesterday’s post. It reads: In this post, we won’t provide any support for the following statement , but, like errors in banking and the financial services (and almost everything else), we prefer errors to be idiosyncratic rather than systemic. (See Systemic Risk Regulation and Irony and especially Idiosyncratic and Concentration Risk, Again for our perspective in those areas.)

We noticed an article in today’s Pittsburgh Post-Gazette, Bomb attempt blamed on human error that describes Deputy national security adviser John Brennan’s explanation for the security failure.¹ To paraphrase, he said it was human error.

Blaming something on “human error” makes it seem like an individual, rather than the system, failed–like the sole checkpoint operator arrived late because he was hung-over from a Christmas party. However, unless some device or dog fails, all errors are human errors. In fact, one could argue that device and canine errors are human errors, too, because the planner or designer did not have the foresight to anticipate and mitigate those errors or failures.

So, one–that would be us–could argue that fixing the blame on human error isn’t very descriptive or useful. If at some level, all such errors are human errors, then we haven’t been told much or learned much. We don’t know if those “human errors” are truly idiosyncratic or systemic. Did a poorly-designed system induce higher levels (or probabilities) of human errors (than what could have been)? We don’t know.

When it seems reasonable to assume that near-perfect detection is demanded, we wonder why the system designer or administrator would permit truly idiosyncratic errors, and we wonder if contingencies have been developed in case of failures.

We’re not calling for over-complicated solutions, just a little foresight. In that sense, it’s not different than planning for the failure-related activities in manufacturing or any other field of endeavor. Such planning should occur ex ante, rather than ex post, but does it?²

So, unless there was egregious, criminal, or treasonous behavior by a member of one of our security forces, blaming human error doesn’t answer the question of what went wrong, and does little-to-nothing to prevent such problems in the future. Moreover, it validates what we wrote yesterday (immediately below the excerpts shown above):

Unfortunately, that problem is exacerbated once those rules and policies are set. Later administrators may be unwilling to “rock the boat” and initiate worthwhile changes because there is a chance of being blamed for subsequent failures but little chance of being rewarded for success. (Those accolades would most likely go to the “eagle-eyed” agent who noticed something was wrong.) By the way, as we often argue, it is difficult to categorize such a choice–not to act–as irresponsible behavior, especially when it is induced by poorly-designed policies and a lack of managerial discipline. That’s why it is a bureaucracy, after all.

So, rigid policies self-perpetuate and information, hunches, and rumors are not passed along.

Sad, but true.

Related posts:

• John Bolton is Right
• Systemic Risk Regulation and Irony
• Sad but True: Intelligence Failures & Bad Information Systems
• What ‘Miranda’ Rights?
• The Cure is Worse than the Disease

In this rather long post we speculate about a possible underlying cause of the “intelligence failure” involving Umar Farouk Abdulmutallab, the Nigerian accused of trying to blow-up Northwest Flight 253 on Christmas Day. Of interest is how he was cleared to fly despite his father notifying U.S. authorities of his–the son’s–extremism and potential for terrorism.

Note that we have absolutely no private information regarding either the incident or government information systems; so, we speculate based upon our knowledge of other large, bureaucratic organizations with rigid, poorly-designed systems.

We realize that incentive problems–which result in the unwillingness of agencies and individuals to share data and information across jurisdictions–and our freedoms and rights constrain the effectiveness of investigative efforts, but for the most part, we’ll ignore those issues to focus on information systems.

Common MIS Issues & Problems

A few weeks ago we wrote Inexpensive but Valuable Web-based MIS. Besides describing those beneficial systems, we mentioned that many so-called “management information systems” are, in fact, merely data-processing and record-keeping systems (for transactions and events).

Such systems rarely provide information–decision-altering content–for the types of strategic decisions made by senior managers, and unfortunately, they may not be well-designed to provide useful tactical information, either. That’s the case if the systems:

1. Produce useless standardized output (reports);
2. Are difficult to fully access or query; or
3. Don’t adapt quickly or well to changes in the environment, operations or institutional knowledge.

In Umar Farouk Abdulmutallab’s case, we suspect that it is the inherent rigidity of the database application and/or the rigidity of the designers’ thought processes that are to blame. (Note that for new information systems, useless standardized reports result when systems designers don’t ask users the correct questions or do ask the right questions, but don’t really understand the replies. See Details Are Not Information for more on this topic. One of our MIS friends often remarks that her key function is to serve as a translator between system users and system developers, and that role is critical but too often ignored. For older systems, irrelevance and obsolescence usually result when the system isn’t easy to change.)

What Went Wrong on Christmas?

When bad things happen, i.e., when someone like Umar Farouk Abdulmutallab squeezes through the detection sieve, it is possible that nothing failed. One must consider that the detection system–the net, the filter, the web–may not have designed to catch everything and that the designer or owner considered a certain level of error or misclassification to be acceptable.  The designer may have concluded that a perfect, error-free system is too expensive to develop and maintain.¹

However, the failure in the Abdulmutallab case was so egregious that it seems far more likely that either the detection system was either incompetently designed or administered.

Now, it is quite possible that a government sentry or sentinel fell asleep or neglected his or her responsibility. In that case, it is both a human error–because a person failed–but also a systemic error because there was no redundancy or backup mitigate such error. However, rather than criticize government employees involved with the nation’s security, we’ll assume that they are earnest, capable, and hard-working as we believe that is true.

In that case, it must be that despite their best efforts, the detection system failed, and one reason for the failure could be the improper design of the government’s information system.

One obvious weakness in the terrorist detection system–and it is by design–is the government’s unwillingness to use conditional probabilities to assess the likelihood that someone is a terrorist, especially if the person is a foreigner and is not protected by our Constitution and Bill of Rights. As we wrote in The Absurdity of Hassling Grandma but not Nidal Hasan, we do blame the government (and President Obama) for maintaining policies and procedures that ignore information, i.e., prior and posterior (conditional) probabilities that someone fits the well-defined profile of a terrorist.

However, other than criticizing his unwillingness to “profile,” we don’t blame President Obama for the failure on Christmas, and we think that it is silly for others to blame him.

We do think that his preferences and mindset for large, centralized, mechanisms–e.g., nationalized health-care, bail-outs, etc–are similar to the problem we discuss below, but in all likelihood, the system predates his tenure.²

So, despite the system handicapped by the unwillingness to profile, if the intelligence failure was not President Obama’s fault (and not former President Bush’s fault) and it is not the fault of those manning the systems, than who or what is to blame?  We suggest that the reader consider a poorly-designed, overly-rigid database/information system.

Too Rigid

By definition, in an overly-rigid information system, both the input and output functions may be less flexible and user-friendly than required. Given the federal government’s penchant for large, centralized, standardized solutions, it is easy for us to believe that such an information system (or systems) has (have) been employed in the war against terrorism and that such systems increase the likelihood of “intelligence failures” and terrorists evading detection.

Rigid Input: Round Holes, Square Pegs and Worse

Consider the idiom of “putting a square peg in a round hole.” For databases that means that certain facts that should be recorded may not be easily categorized into available fields because proper, descriptive fields do not exist (and cannot be easily added). For example, consider census or EEOC forms where there is no appropriate box to check: where it is required to select a single “nationality” or “race” when you are 1/16 of this and 1/8 of that, et. al.

If such metaphorical “square pegs” could consistently be jammed into “round holes,” there would not be an issue because users would likely have developed heuristics (rules-of-thumb) to create well-formed substitutions and work-arounds. In all likelihood, those rules or mappings would not be formalized in any official manual or documentation, but they would be well-known and transmitted during both formal and informal training sessions.

Unfortunately, real-life is often not so simple, because the so-called “square pegs” may not be of, say, uniform size, color, and shape.

In fact, other than certain fields like names and addresses, we suspect that many of the facts that should be recorded can’t be easily or succinctly described in a word or two–that they are more nuanced and qualitative and graduated and require lengthier, usually subjective descriptions. Actually, they may not be very different than blog posts, and we would hope that writers and recorders of those posts would have the flexibility to create new fields and categories on-the-fly–like we do every time we add a new tag or category.

Unfortunately, we suspect that leads to many “coding” errors and inconsistencies and extremely long descriptions of fields (to prevent such “errors”.) We also suspect that it leads to too much oversight; many layers of approval by superiors (and therefore much editing and changing); and overly-restrictive input policies, e.g., “he doesn’t have the permission or authority to write that.”

Moreover, we also suspect that these problems are exacerbated when investigators and field agents aren’t involved in the information system design process.

Rigid Output

Other problems with rigid, poorly-designed systems include (1) not providing useful, standardized output or (2) not having the capacity for users to easily search and access stored data for ad hoc queries.

Note again that we have no knowledge of actual, routine TSA, FBI, CIA, and Homeland Security reports, and if we did, we probably couldn’t write anything.

1. Too Centralized and Uniform

That being said, we could imagine that there are different levels of security clearance, and that access to the data could be overly-restricted based upon those clearances. In particular, we could imagine that unverified and unsubstantiated reports are among the least generally-accessible data–until they are verified, reviewed or accepted by the bureaucracy, regardless of whether that involves a single agency or an over-seeing umbrella group.

BUT those unsubstantiated reports are the ones that are most likely to provide information about new terrorists like Abdulmutallab, (and that is the problem with treating foreigners who are threats to our national security as criminals rather than enemy combatants.) If our hunch is correct, then one should expect future “intelligence failures” to arise in similar situations.

Moreover, if our hunch is correct, then a centralized, database administrator’s (rather arbitrary) rules–or worse, some lawyer’s rules–substitute for the individual knowledge and discretion of various field agents and supervisors.³ As such, fields agents may not have the opportunity to synthesize the information until it is too late. (It’s a case of the perfect being the enemy of the good.)

Unfortunately, that problem is exacerbated once those rules and policies are set. Later administrators may be unwilling to “rock the boat” and initiate worthwhile changes because there is a chance of being blamed for subsequent failures but little chance of being rewarded for success. (Those accolades would most likely go to the “eagle-eyed” agent who noticed something was wrong.) By the way, as we often argue, it is difficult to categorize such a choice–not to act–as irresponsible behavior, especially when it is induced by poorly-designed policies and a lack of managerial discipline. That’s why it is a bureaucracy, after all.

So, rigid policies self-perpetuate and information, hunches, and rumors are not passed along.

2. Searchable? We Doubt It.

As we have repeatedly mentioned, much of this post is mere speculation. A few of our conjectures are projections based upon our own experiences. Given that, we could imagine that investigators, analysts, and agents cannot query or search the entire database (if it exists in one place).

Most likely, they receive exported subsets of the data, and those subset do not arrive immediately upon request. (The decision to grant the request is probably made by a database manager or administrator and may require detailed specifications and possibly multiple approvals–a whole process. Again, that’s why it is a bureaucracy.)

Now, we’re not sure of the benefits of such a bureaucracy and suspect that such processes continue to exist because “that’s how we’ve always done it,” which could be translated as “we don’t know any better.”

Regardless, there are costs to such procedures. Besides the possible lack of timeliness, there is a reduced opportunity of discovering anything–patterns, what not–accidentally or serendipitously. When a subset or export is requested and justified it must be completely specified; so, the requester needs to know exactly what he or she plans to investigate before completing a request and there is little chance of expanding or redirecting the investigation without re-submitting requests for additional fields.

In addition, if the entire database is not fully-searchable, then investigators are less likely to find matches and patterns across fields. Recall our criticism above: with rigid input fields, and varying “square pegs,” agents in different locations and departments may input similar facts in different fields. If some of those fields are not available and searchable, then investigators will get fewer hits and matches and that will reduce the chance of making connections and discoveries.

Our Recommendation

So. the diligent reader, who has made it to this point, may ask: if your hypotheses and speculations are correct, then what’s your solution? (Alternatively, they may note that the sellers of hammers tend to see a lot of nails.)

We reply with a rhetorical question: why can’t such systems or conglomerations of systems be more like the web and blogosphere? By that we mean why can’t they be unfettered, completely-searchable, accept responsible comments and questions, and even permit writers with varying degrees of credibility to post entries. (If the government already has such a system, then kudos to it.)

Why not decentralize the process and empower security investigators, analysts, and agents to use their idiosyncratic beliefs, opinions, information, experiences, positions, and knowledge to identify problems and to adapt the database as threats and knowledge change?⁴

We imagine a mini-version of the internet (with the ability to search the entire internet, too), where individual agencies publish blogs and news reports for themselves and other agencies. (Geez, they could even sign-up for each others’ feeds.

Of course, such a system would need to be at least as secure as on-line banking, but more private, but all such systems must be.

Note, also, that nothing precludes the running or harvesting of routine reports from such sites. That’s what search engines and their bots and a host of sites already do. They standardize the output of many disparate systems. In fact, our recommendation does not require any new or advanced technology–just the application of existing platforms that are freely and readily available to anyone with a few bucks and an internet connection.

Granted, it’s on a much larger scale than our blog, but it need not be expensive.⁵ Moreover, we suspect that access to existing systems could be incorporated easier via web apps than through custom programming forays that attempt to merge or consolidate existing databases.  For example, every Google query searches millions of MySQL and MSSQL databases all with slightly different structures and fields.

Maybe we’re wrong, maybe we’re right. However, even if our diagnosis is correct, we doubt that the government would act on our recommendation. It would most likely try a centralized “fix” of the identified problems or would try a pilot-program that (due to its limited nature) would be destined to fail. In that case, hoping for continued good luck might be the most reasonable and viable strategy.

In closing, note that we are not disparaging the efforts of our fellow citizens or the nation’s allies in their defense of our country and way of life. Instead, if our speculations are correct (or nearly so) we are recommending a change in strategy and tactics so that their earnest effort yields more productive results.

As usual with long posts, we’ll likely make corrections and edits that clarify our prose during the next few days.

Copyright © 2010 Spero Consulting.

Footnotes:

Related posts:

• John Bolton is Right
• Information System Design
• Idle Speculation about Spam and Terrorists
• Human Error (versus Systemic Failure)
• Sad but True: Intelligence Failures & Bad Information Systems

The children are all snug in their beds with visions of Wii’s dancing in their heads, and after four weeks, we finally have the chance to finish a post that we started on Thanksgiving Day, when we read a very silly column by George Will.

His column was entitled, “No gifts, please.” In it he discusses (and approves of) a pamphlet called Scroogenomics: Why You Shouldn’t Buy Presents for the Holidays by Joel Waldfogel. Based upon both Mr. Will’s column and the book’s title, it seems that Mr. Waldfogel believes that buying Christmas gifts destroys value, i.e., the collective satisfaction in the economy (and perhaps the world) would be greater if Christmas gift-givers spent the money on themselves instead of on loved ones and others.

Before criticizing that conclusion, we do want to mention a few caveats:

1. We’re not sure if Mr. Will wrote the column in a tongue-in-cheek manner, but there is no indication that he is anything but serious, and the column was published on Thanksgiving, not April Fool’s Day.¹ Also, we do realize that he is constrained to only a certain number of words per column, and that relatively low number may make complete and clear communication difficult. Or, maybe a dim editor unknowingly hacked the wit out of the column.
2. We didn’t and don’t have the time or interest to locate, buy, and read Mr. Waldfogel’s book, so it may be more nuanced and sophisticated than Mr. Will understands it or cares to explain it. If that’s the case, then we apologize to Mr. Waldfogel for grouping him with Mr. Will.
3. Similarly, Mr. Waldfogel may have written the book in either a tongue-cheek-manner or–using rhetoric and exaggeration–in an instructive way to educate his students. If that’s the case then, again, we are sorry for criticizing him, and we note that Mr. Will did him no favor by publicizing his work in such a poor manner.

That being said, using common sense and a little knowledge of economics, there are at least four ways to negate their conclusions:

1. Revealed preference of gift-giving actions..
2. The preferences, including the risk preferences, of gift givers and receivers and what that means for collective satisfaction.
3. The existence of uncertainty as it relates to the level of enjoyment.
4. Whether one truly knows ones own tastes and how they will change through time and if others know better.

The first three can be discussed within the context of standard microeconomics and utility theory, while the fourth one involves the violation of one of the most common and basic assumptions in economics.

Revealed Preference

This is the simplest argument to follow. Revealed preferences means that  actions speak louder than words–i.e.,  what people do is what matters–not what they say.

The fact that rational folks voluntarily buy presents for others means that they have concluded it is the best use of their money (or credit). Otherwise, one must assume that those being studied are irrational and/or that factors other than their own consumption affect their well-being or satisfaction. Both are easy to believe, but once an economist assumes irrationality it becomes very difficult to draw any conclusions.

In fact, if they are irrational, telling them so isn’t likely to have much of an effect on them or their behavior.

For example, if folks are irrational, then what can Mr. Waldfogel say? “Many people can’t think clearly and waste money.” We have no doubt that it is true, but that’s not very insightful or new. In that case, they don’t just waste money at Christmas but during every other season. (Perhaps they waste less at Christmas than they otherwise would (without the emphasis on peace, love, and joy and shopping for others).

Now it is possible that Mr. Waldfogel has a game theoretic model–similar to, say, the Prisoner’s Dilemma–in mind, where some “bad” equilibrium of gift-giving obtains by everyone behaving rationally. But, for a variety of reasons, every Christmas people stop buying presents for other folks. So, unlike a textbook problem that involves incarceration or commitment, it seems that real people can and walk away in the middle of the “game” if they want.

Thus, when he states that value is destroyed, given the fact that folks continue to do it, it may simply be the fact that Mr. Waldfogel may have mis-measured the overall satisfaction folks get from giving and receiving.

Risk Preferences

Presumably, to conclude that value is destroyed by Christmas gift giving–and to assign a dollar amount to it–some measure of satisfaction, like utility, must have been assumed–at least implicitly. Moreover, that measure, e.g., utility function, must be invertible (from satisfaction to dollars) .

Again, without reading the book, there seem to be a number of ways to defeat the assertion that value is destroyed. Here are a few.

First, collective satisfaction can be aggregated and weighed any arbitrary number of ways. For every setting that shows value is destroyed, one can weigh the satisfaction of recipients in such a way that valued is created.

Secondly, obviously individuals may have different preferences for different goods and services, and they may have different preferences for the same good or service at different levels of (their own) wealth and consumption. Most economic models keep things simple and assume that individuals have relatively constant preferences, i.e., that they are either risk-neutral, risk-loving, or risk-averse for the entire range of consumption.

For a simple world where there is only one good, economists generally assume that satisfaction increases (or at least doesn’t decrease) as more of that good is consumed. So, in a “single period,”

• Risk-neutral means that preferences are linear with respect to the good. That means that regardless of the number of units consumed, each additional unit brings the same level of satisfaction, i.e., the 31st hamburger is as satisfying as the first.
• Risk-loving means that preferences are convex with respect to the good, i.e, the more units consumed, the greater the marginal satisfaction. It is very rare to see such behavior. It means that in a world consisting only of hamburgers, eating the 31st burger brings more satisfaction than eating any previous one, including the first one.
• Risk-averse means that preferences are concave with respect to the good, i.e., the more units consumed, the lesser the marginal satisfaction, i.e., the 31st hamburger eaten is the least satisfying–although still positively satisfying.

Now it is possible in multi-period, over-lapping generation models, for folks to get satisfaction from both consuming and giving–by following the Golden Rule of giving this period in exchange for receiving in the future, but that’s not what Christmas is about. The young don’t give presents to the old in hopes of getting presents when they are old.

Without presenting anything close to a formal model, consider a case where everyone is risk-averse. If they have the same utility function, then wealthy individuals forsake less satisfaction (from, say, the 31st hamburger) by giving or donating to less wealthy folks who gain by receiving such benefits. (Remember with similarly-preferenced, risk–averse agents, wealthy folks give up less (marginal) satisfaction or utility than poorer gain. Draw an increasing, concave function, like a square-root function to convince yourself that satisfaction increases with consumption but at a decreasing rate.))

The last time that we checked, there were not a lot of models that incorporated donations and giving, but even if the net spenders lose some satisfaction by consuming less due to their gifts–let’s say they are compelled to consume less or donate–then those acts do not destroy value if the recipients are particularly grateful and derive more satisfaction from the gift than to givers lose by not behaving selfishly.

Of course, Mr. Will and Mr. Waldfogel may be surprised that individuals enjoy giving of themselves and their resources–whether to family, friends, or strangers. The fact that such acts are outside of many economic models, doesn’t make such people irrational, it makes them kind and generous.

Moreover, if economists have a difficult time modeling such behavior, that’s not a short-coming of generous individuals, it is a short-coming of economics (and note that we are extremely sympathetic to the difficulty of modeling such social phenomena).

Now, parsimonious readers may disagree with our conclusion that net satisfaction is higher because of Christmas gift-giving and exchanging because they may argue that the giver may not know what the recipient wants. We’ll rebut that position with two related, but separate points: (1) in uncertain environments, you don’t always get what you want or pay for, and (2) in real-life, you don’t always know what you want–i.e., what makes you happy or what’s best for you.

The Presence of Uncertainty

Who knows? It may simply be the case that no one cares enough about Mr. Will to have given him a present that he wanted, and that may have caused his Scrooge-like column, or maybe he was told one too many times that “you’ll shoot your eye out.”

That scene from A Christmas Story of the ricocheting BB breaking the Ralphie’s glasses perfectly illustrates that in real life, random, uncontrollable events affect the enjoyment of any every good and service consumed.

So, when combined with bad luck, getting exactly what you want can be disastrous, and far worse than getting a safer, less-desirable version of the good or service or a substitute. For example, think of the teenage boy who would prefer a sports car to a large sedan, but is far more likely to harm himself and/or others in a new Corvette as compared to a new Suburban.

So, before one can conclude the net value is destroyed, one must be able to aggregate the actual satisfaction received rather than the expected satisfaction when the gift is received. In other words, it is important to know the range of outcomes and their probabilities–when they are knowable–to measure how things worked out.

More precisely, for risk-averse individuals, it’s not just the mean that matters, but the distribution matters, too, and others may understand (or have better information about) that distribution than the recipient. That means that their gifts may be more appropriate, and have a higher conditional expected value.

Does that mean that others always give better presents than items purchased by ones self? Of course not, but it means that in some cases, the difference might be smaller than supposed or negative.

Know Thyself, or Not

We’ll readily admit that our three counter-arguments are not very precise. However, each implicitly assumes that (at least) the recipients, know what’s best for themselves.²

As we mentioned above, with uncertainty (and different priors and signals, which generate different posteriors) it is possible that givers may have better knowledge of the environment, i.e., the distribution of (possible) outcomes, and, therefore, they may be able to select the most appropriate gift for the recipient.

In this section, however, we have something a bit different in mind. It is possible that on certain dimensions, others know you better than you know yourself. Thus, they may be able to select more appropriate (useful, valued, appreciated) gifts than the recipient could have selected for him or herself.

We suspect that like us, most readers didn’t always get what they asked for, but on some of those occasions ended up liking the substitute better than the original. We also suspect that sensible readers will agree that until a certain age, parents definitely know better than their children what will maximize the child’s expected, discounted, satisfaction.

The question is: at what age does that change? Is it when a twelve-year-old wants a Wii, or is into adulthood, when the child wishes to marry. (In some cultures, with arranged marriages, it is at least that age.)

In most mathematical models of preferences, individuals know their own preferences. Otherwise, it is difficult to sole the individuals maximization problem, i.e., what does one maximize or optimized?

In real-life that isn’t always true. Moreover, preferences do change. Do you, dear reader, eat the exact same foods that you did as an infant; as a high-metabolism teenager; as a college student? While some folks are surprisingly consistent, most aren’t, and a favorite restaurant one day is no longer visited the next.

So, if one is willing to admit that one doesn’t always know what one will like in the future and one cannot completely specify how to order likes and dislikes (preferences) today, is it that much of a stretch to imagine that others may know certain aspects of your preferences (and behavior) better than you, yourself, especially how those preferences may evolve through time? We don’t think so.

Thus, is it that difficult to believe that the net result of informed gift-giving increases collective happiness despite the fact that many inappropriate gifts are received (and regifted)?

Merry Christmas!

Now we mention our objections to Mr. Will’s silly column in the spirit of true Christian gift-giving, especially as we belatedly publish it on this Christmas morning.

There’s another small book–very thin and short–that both Mr. Will and Mr. Waldfogel may wish to read. It takes an hour or two for most adults to complete, or a few hours more if read to a child (presuming that the men like and/or have children or grandchildren). It’s called A Christmas Carol by Charles Dickens. Our readers may have heard of it, and it is available free on-line at many sites.

We strongly encourage all our readers to read it every year so that they don’t end up like old Marley, er, we mean Will.

God Bless us all, and we wish you a Merry Christmas and a Happy New Year.

–Andy, Jill and the gang

P.S. It’s late and there are probably several typos. We will correct them tomorrow.

Related posts:

• Move on Mr. Letterman
• Agility, Grace, Roethlisberger and Bush
• Our Christmas Wish
• Reason and Science
• When Did They Stop Being Funny?

In the paper edition, the article appeared under the “Small Business’ banner, and it now resides under a similarly-labeled section of the web site; however, it applies equally well to businesses of all sizes.

We must admit, though, that the topic is especially poignant for small businesses because the decision-maker and the implementer (executioner) are often one-and-the-same person, and the customer may be a friend or acquaintance. There’s no, “my boss told me that I have to do it” excuse when you are the boss. Note, however, that many seemingly-independent, entrepreneurial men still use their wives as reasons why something can’t be bought or sold at a given price. We would never admit to such behavior, unless our Chairman, Jill, permits us.

The main point of the article is that despite generally tough economic times, a few small businesses are finding that it is not worthwhile to deal with certain clients because those clients disproportionately consume time and resources given the revenue that they generate.

Discipline! Discipline!

Though we sound like Colonel Hathi from The Jungle Book, there are a couple of obvious ways to minimize the probability of enabling such problems:

1. Don’t appear too desperate or too needy for the business. (In that sense, it is a lot like dating.)
2. Evaluate the client, and have a sliding scale of prices ranging from lower prices for easy clients to higher prices for pains-in-the-butt or annoying ones, and stick to it.

Admittedly, such tactics may not be feasible with all products and services. They generally work better for services than products, and for customized services, rather than uniform or generic ones, and for short-term projects rather than long-term ones. However, unless there is a substantial benefit that can be derived from either existing or prospective clients because of the relationship with a tiresome one, the tiresome one should pay for the irritation, aggravation, discomfort, and effort that they cause. (We’ll qualify this a bit below.)

If such customers are not willing to pay, then the supplier or vendor is, in fact, subsidizing the opportunistic behavior. Moreover, if the supplier is not willing to sever the relationship (or take actions that will change the other party’s behavior and profitability), then we humbly recommend that they not complain to everyone around them (thereby making their employees’ and families’ lives more miserable than need be).

That may seem a bit harsh, but it is consistent with our response when someone complains about a spouse: divorce them, kill them, or shut-up. Revealed preference says that despite the complaints, if the vendor is unwilling to sever the relationship, then he or she must find the arrangement to be acceptable. Sometimes it is necessary to do unpleasant things–not immoral, unethical, or illegal, just unpleasant ones–to get what one wants out of life.

So, be a good stoic, and live with it in silence (or turn it into a blog post).

We prefer to maintain pricing discipline because at the margin, one’s willingness to lower the price or fee is often viewed as a sign of weakness. So, clients who make that inference then often request more time and/or resources. That means that a sign of weakness harms both revenue and resource-usage, especially for services that are provided over time. (Note that this problem can be mitigated somewhat by offering a lower-quality or less-robust substitute whenever someone wants a lower price, i.e., “we’ll lower the price, but you’re not getting…”)

By the way, another option is to write very, very detailed contracts, but those preparation costs only add to the resource consumed by such customers, and covering those incremental, transaction-related costs increase the necessary price to make the transaction “worthwhile.” (You can see why many folks open franchises where such development and preparation costs can be shared nationally or even globally.)

Two Costs to Consider

Before firing a customer who is thought to be ”unprofitable” be sure to consider a few factors to determine if the customer is truly unworthy.

Clearly the choice of firing or retaining a customer is a decision, or the selection (and implementation) of one possible alternative from several available alternatives. (Note that “do nothing” is often an available course of action.) So, rather than be concerned with the reporting of financial results,  or accounting, per se, we are interested in the costs and benefits that vary across alternatives, the relevant costs and benefits.

In particular, we are interested in

1. Expected Relevant  Benefits and Costs
2. Expected Opportunity Costs

Note that these costs may vary through time as circumstances and capacity utilization change. Technically, opportunity costs, which we’ll define below, can be categorized as relevant costs, but we think that they are worthy of their own place on the list.

1. Expected Relevant Costs (& Benefits)

In a decision, which involves the selection of one possible course of actions from several available options, the relevant costs of an alternative, like firing a customer, are the resources sacrificed by selecting and implementing that course of action. Relevant revenue (and/or benefits) is(are) the resources received by taking that course of action.

Generally, one thinks of such costs and benefits as being measured financially and reported in terms of dollars or some other currency, but they need not be. That’s true for small businesses where many sacrifices, including, say, staying awake an extra hour to work on a project, are difficult to measure financially.¹

For items that can be measured financially, the difference between relevant revenues and relevant costs is the contribution, and the contribution of an alternative can be very, very different than its reported profit. That’s because: (1) certain relevant items may not appear on an income statement the shows reported revenue and expenses and (2) certain reported revenue and expenses that do appear on an income statement may be irrelevant for the decision at hand.

So the total net benefit of an alternative is some measure of the difference between relevant revenues (and other non-financial benefits) and the relevant costs (and other non-financial sacrifices). We are ignoring the problem of combining dollar-denominated revenues and costs with non-financial and psychic benefits and costs since it is very subjective and goes far beyond the scope of this already-long essay. We would have to introduce a long recitation about utility functions and expected utility.)

Prospective, not Historical

Note that these costs are incurred prospectively–i.e., in the future, not in the past, and that means that they are uncertain or imprecisely known. That’s why we titled this section “Expected Relevant Costs:” to indicate that randomness. However for simplicity we’ll immediately drop the uncertain aspect and assume that we can precisely measure such resource sacrifices.²

Despite our various caveats and qualifications, we’ll try to be clear:  by “relevant” we mean the real incremental costs that are incurred by making a decision. For example, if the decision is deliver a good or perform a service,  then costs of rent, computers, software, and most non-manufacturing-related utilities usually don’t change whether an additional customer is served or not. Paper and ink or toner costs might change–if there is a lot of printing involved. Monthly health-care premiums won’t unless more employees are added and retained. Transportation costs will but only if more travel or transportation is required.

Arbitrariness of Reported Costs

By “relevant” we don’t mean necessarily mean the reported or accounting costs that are assigned or allocated to a customer or project on some arbitrary basis.  An accounting system, regardless of its cost, serves many purposes, e.g., to satisfy the IRS, for performance measurement, etc. When there are jointly-used resources and/or resources that last more than one accounting period, then all accounting systems require many, many assumptions and conventions. Those assumptions and conventions permit simplifications so that addition, subtraction, multiplication and division can be used to determine reported costs, but such accounting systems are very particular models (or abstractions or distortions) of history–of the reality that has happened, and do not consider (much) of the future.

Irrelevant Costs

For example, by definition, the allocation of fixed and/or sunk costs, e.g., depreciation, of shared resources is arbitrary. For long-lived assets, the allocation of its cost across time is arbitrary. For shared resources, the allocation across objects is arbitrary. That means that the reported cost depends upon the accounting methods applied and is an artifact of simple arithmetic calculations and not a reflection of behavior. (They’re fixed for Pete’s sake.)

So, while purchase costs of such shared resources can often be measured with high degrees of precision, there is no notion of accuracy when allocated to particular customers or products. There are generally an infinite number of reasonable and justifiable ways to make such assignments.

There are good reasons–behavior, tax, rhetorical–for selecting one allocation method over another, but none provides more or less information. Different methods may provide greater or fewer details and may provide different assignments across objects–different reported costs. That may or may not be useful for those non-informative purposes, e.g., minimizing taxes, but by its very nature, the arbitrariness of the method makes it uninformative. In other words, unless there is only one customer (in one accounting cycle), then shared-and-fixed costs can be assigned to customers in a variety of reasonable and appropriate ways, and one method isn’t better than another unless it helps attain a goal. Moreover, some allocation methods may make  a customer appear to be “profitable” or not–despite the fact that there would be no change in resource consumption if the customer is dropped or kept.

In the previous paragraph, we covered the equivalent of five or six sessions of a good managerial accounting course–like the kind we used to teach. The lesson for small businesses–and for all for that matter–is simple. Don’t try to be too sophisticated and believe that the output of your accounting system, the reported costs accumulated from past transactions or event, describe reality for any particular decision (set of alternatives). If there are shared resources–shared across objects or time–then there is no notion of true profitability.

That means that one shouldn’t imagine that there is some type of hidden accounting magic that permits vast simplification via various assumptions and conventions, yet somehow cancels out in just the right way to accurately inform, regardless of the decision. Now, if that sentence doesn’t make sense to the dear reader, and he or she is in charge of such decisions, then the reader should consider getting help because it is a very important notion.

Your accounting system output may be useful to help determine relevant costs of a decision, but when shared resources have fixed costs, know that your system is one of many equally-valid and simplified representations of reality–analogous to Picasso’s cubism or a two-dimensional cartoon animation of yesterday’s commute or the size and color variety of the pixels of a digital photo. With different assumptions, the reported costs of various objects will change; otherwise, the different assumptions would really be different. However, note that the underlying reality doesn’t change.

Costs reported in accounting systems can help identify some categories of relevant costs, but accounting systems capture only past transactions and don’t capture future sacrifices (and how those sacrifices change among alternative (future) courses of action). In addition, cost reports ignore opportunity costs, or benefits foregone by taking one action that precludes taking another, mutually-exclusive one. (But, we won’t ignore, them: see below.)

The consideration or inclusion of irrelevant costs–particularly the poorly-reasoned desire–to recover or recoup the allocated expenses related to fixed or sunk shared resources often leads to disaster, e.g., downward death spirals of demand. In such cases, the elimination of one “unprofitable” customer creates additional unprofitable ones in the future because they the costs may be much more rigid than perceived or reported.

Be sure that reported costs behave the way that you think they do–and are, in fact, relevant–before eliminating seemingly unprofitable clients.

2. Expected Opportunity Costs

In a decision, the opportunity cost of the selected course of action, is the benefit forsaken by not taking the next best alternative. It is non-negative, and if there is nothing better to do, it might be zero.

Unlike in our discussion of relevant costs, we’ll keep the modifier “expected,” because the next best alternative may involve attempting to gain business and revenue from new customers, and the outcomes of such activities are usually uncertain.

Technically, and non-financially, there is an opportunity cost to any course of action, and through time, as constraints vary, the next best thing to do changes frequently. (Often, however, that sacrifice has zero monetary value.)

Perhaps the reader visits this site from their office but never visits it from home. Why? As much as it hurts to admit it, perhaps the reader has estimated–possibly erroneously–that there may be more valuable or enjoyable actions to take at home than reading our opinions and expositions. That might not be for certain, but there may be a high enough likelihood and high enough pay-off to justify ignoring us in the evening.

Aside: given the various constraints that come and go through time, those readers with a bit of mathematical aptitude should be able to imagine the difficulty of modeling and quantifying these various opportunities…a seemingly infinite horizon, multiple decisions that affect resources and opportunities, the option to quit… ad infinitum. It gets ugly very quickly.

Expected to Operate at Capacity

So, if a business plans to operate at capacity and that capacity cannot be changed, then the expected opportunity cost of accepting a new customer is the financial contribution (and other benefits) associated with the next best alternative, i.e., the lost financial contribution(s) and benefits associated with getting rid of the customer(s) to free-up sufficient capacity to serve the marginal customer.³

Expected to Operating below Capacity

If a business plans to operate below capacity, then the expected opportunity cost is what the firm is likely to forsake by not pursing other customers. That requires the assessment of the likelihood of gaining new customers and the “distribution” of contributions from those new customers. For our mathematical and argumentative readers, note that we are using “expected” and “distribution” very loosely. Moreover, depending upon one’s risk preferences, the expected opportunity cost may be of little interest. (Strictly, the expected opportunity cost is interesting only to risk-neutral decision-makers.)

So, when deciding to drop a customer, the decision-maker should compare the financial contribution of that customer (and any other non-financial benefits) to his or her assessment of the probable and (the appropriately-weighted) improbable benefits of finding new customers during the time period of interest.

If there is a strong chance of gaining new, profitable business elsewhere, then drop the client and start your marketing drive. Part of that calculation should include the less-obvious, indirect benefits of each alternative. We refer to them as ancillary concerns, although their magnitude could be quite large.

Ancillary Concerns:

Side Benefits of Difficult Customers

1. Reputational Effects on Existing or Potential Customers
2. Learning and Experimental Learning

1.Reputational Effects on Existing or Potential Clients

Consider how severing the relationship with one customer may affect others. Is the client particularly prestigious or well-connected so that an association with them generates additional side business or benefits? Will severing the relationship harm that business or the prospect of gaining new clients? Or will it be easier to maintain higher prices with existing clients if they know of your pricing discipline and examples of dropped customers?

No action is taken in isolation; however, not every action generates observable or measurable implications. So, specify the various indirect outcomes of firing a customer and estimate the short- and long-term contributions and net benefits of such actions.

2. Learning

Note that there is an indirect advantage to dealing with and maintaining difficult customers. They provide valuable information about how to communicate with other, existing customers; how to market to prospects; and how to protect one’s time, sanity, and organization. They teach what to promise and what not to promise.

Similar to the notion that nothing is foolproof because fools are so ingenious, difficult clients expose the weaknesses in standard operating procedures and business methods and practices.

So, there is an informational value to the association, which may be maximized if the supplier behaves opportunistically, too. By that we mean experiment with actions and reactions to see how the difficult customer responds. Slow delivery, slow the return of telephone calls and e-mail messages, mention additional service charges for anything not specified by the contract, and consider the response.

We don’t recommend such tactics to be vindictive or vengeful, or passive-aggressive, or any other anti-social reason. We recommend it simply to discover new ways to use the relationship advantageously. If there is no financial advantage, then seek other advantages, and experimenting with a real, live (though unprofitable) client is one way to get valuable feedback that may help manage the expectations and relationships (and therefore the profitability) of other customers.

Alternatively, it may be the case that such customers are much more pliable than previously thought and that they are (or were) simply better negotiators.

In addition, the predicaments they cause that must be solved and those solutions may provide valuable technical know-how that can be applied elsewhere (or sold for profit).

We’ll likely add or edit this post in the near, future. If you would like to know more, please contact us.

Copyright © 2009 Spero Consulting.

Footnotes:

Related posts:

• Seinfeld, a Youthful 54
• Clawbacks: the Good, the Bad, and the Ugly
• Three Strikes and You’re Out…
• A Very Exciting Day for Us
• The Volcker Rule: Obama’s Right…

Penny-wisdom and Pound-foolishness

A few weeks ago, we had a conversation with the CEO of a mid-sized organization who asked, “Why would I ever want my divisions to compete with one and other?”

It was posed as a rhetorical question, but when we finished the “short version” of our answer–about 30 minutes later–we were sure that he understood that, indeed, there are times when intra-organizational competition is a good idea–by good we mean value- or wealth- or welfare-maximizing. (Obviously, it’s not all of the time, but there are times, and that’s part of what this post is about.)

Like transfer pricing, such competition can–actually should–lead to disagreement and conflicts within the organization (and in many cases duplication of effort and a seeming waste of resourse), but such policies may still be optimal when they create cost-effective disciplining and control mechanisms. In other words, incurring marginally higher costs is beneficial if the costly activities generate greater marginal revenue or greater savings elsewhere.

What’s It Have to Do with the DoD?

Former Secretary of the Navy John Lehman had a very interesting essay in the July 18th edition of The Wall Street Journal: Wasteful Defense Spending Is a Clear and Present Danger. In the essay, he complained about cost overruns and the current, disgraceful state of the bloated Department of Defense bureaucracy. (But the government will manage health care efficiently, won’t it? Yeah, right.)

Based upon our reading of his essay, we think that the former secretary missed the main cause of the inefficiencies and escalated spending that he criticizes.¹ Mr.Lehman mentioned a few problems and many symptoms but not the root cause of the exorbitant costs, which result from misguided and incompetent attempts at cost savings. Yes, the cost overruns result from poorly-conceived attempts at cost savings, especially what we see as the over-centralization of procurement. (Why, it is almost like one of those unintended consequences thingies that seems to surprise our elected officials every once and awhile, and that one occasionally hears about in the news.)

We’ll explain our reasoning below–this a very long post–but first we want to mention an aside related to fixed, sunk, and marginal costs, and that’s–what should be–the well-known distinction between average total costs and marginal costs. The distinction is quite well-understood–or should be by anyone whose taken an introductory microeconomics course and/or understands division at a fourth-grade level–but many folks, especially our public servants, still seem to get it wrong.

A Long Aside

Many, if not most, new defense programs–e.g., new types of fighters, bombers, ships–involve huge, upfront design costs that are fixed with respect to the number of units produced. Moreover, besides being fixed with respect to volume, they also sunk or already incurred by the time that production begins.

Now, for the moment we’re ignoring the production change orders that Mr. Lehman noted are problematic. However, excluding those ad hoc demands for change, once the design is finalized, actual manufacturing costs per unit tend to be set and are often a surprisingly small percentage of total costs.²

So, once the design is set, the marginal cost of each additional unit is relatively small.³ However, marginal production costs will depend upon on the quantities ordered and the timeliness of the order (so that production can be planned efficiently). One can think of this in terms of classic labor/capital cost-volume-profit analysis.

As we understand it, the marginal costs–if known by anyone in the Pentagon or the government–are rarely, if ever, divulged. If any per-unit cost is reported, it is usually a guess at the total average cost, which is the sum of the actual marginal cost and the average fixed cost (plus the permitted per-unit profit). The average fixed cost is simply total fixed costs divided by the number of units produced.

So, as planned output is cut and then possibly further reduced (due to, say, high average reported costs per unit) the average fixed cost and, therefore, the total cost per unit increases (at an increasing rate) with little true overall cost savings. We see that as the danger of not learning about fractions and division in the fourth grade, i.e., when the denominator decreases, the absolute value of the fraction increases.

Note: in competitive or semi-competitive markets, when a firm attempts to set prices based upon average total costs–and the firm is not the most efficient producer or doesn’t differentiate its products in a sufficiently appealing way–it may enable a downward (death) spiral of its own demand that eventually bankrupts it. (Anyone heard of GM?) That is, whenever the firm increases prices to “recover costs” fewer units are sold, and a smaller portion of fixed costs are covered by sales; so, average costs increase. Repeating the initial justification that the sales price must be high enough to cover fully-reported unit costs, the firm raises prices, even fewer units are demanded, average cost(s) increase, and the cycle repeats, ad infinitum or, more precisely, ad nauseum until it dies or is bailed-out.

We think that the above aside explains some of the higher unit costs and inflation that Mr. Lehman mentions, i.e., the application of a flawed heuristic or rule-of-thumb. However, we think that the main causes of the increase in costs and losses in efficiency result are more structural and relate to: (1) the relatively recent demand for increased centralization of procurement and (2) the coincident desire for (erstwhile) standardization within the Department of Defense.

When Standardization Isn’t Cheaper

We’ll address this second cause first because we think that the goal of platform and asset standardization is a component of and informs upon the larger costs associated with the over-centralization of procurement, but before continuing, it’s important to note that we’re being highly speculative in our conjectures and hypotheses, but that’s our nature and a large part of–what we see as–our ever-growing charm.

One would expect an economic–meaning an efficient–procurement program involving many assets and goods across many users would include both custom and standarized designs. By definition, a program that is biased either way–too little or too much standardization–would lead to higher costs for a given level of performance and/or worse performance for a given level of cost than could otherwise be obtained.

Two Ways to Standardize Designs

When attempting to design common or standardized products to suit a variety of users, we think there are two mian and opposing philosophies, which we’ll refer to as (1) the intersection approach and (2) the union approach.

1. Intersection approach makes the item as simple as possible by providing only the shared functionalities among a set of potential customers and uses, like, say, a double-edged knife–one serrated and one not for everyone who wants both capabilities. This is approach is most likely to generate design and production saving–at the expense of reduced functionality.
2. Union approach attempts to design the item to be all things to all users–kind of like a Swiss Army knife–that incorporates all of the various desired characteristics that various users may have been demanded.⁴ This approach is likely to have much higher design and manufacturing costs but produce more usefulness. However, it may also cause certain users to incur higher filed (usage) costs.

Both the intersection and the union approaches involve making trade-offs during the design stage. Obviously, those trade-offs involve both costs and functionality in the various fields of use. We’ll categorize the costs, including the opportunity costs, into five categories although we do understand that there are other equally valid ways to classify them, e.g., design, production, usage.

Five Costs Associated with Standardized Designs

There are many potential costs associated with uneconomical standardization:: (1) the increased time, effort, and cost of design (when, for example, contractors use the union approach an attempt to cram every service’s unique specifications into a single, finished product); (2) the increased care and cost of producing to tighter tolerances that is often required when products become more complex and complicated (sometimes more than they should be); (3) the costs of special requests and production changes because the compromised near-final product meets no single consumer’s unique needs; (4) compromised operation and higher overall operating costs because the final product may be more or less than required, especially when only specific, limited –but distinct–functionality is demanded; and (5) higher failure costs–both repair costs and failure-related costs. These costs need not be financial. The failure of equipment in battle can lead to loss of life and tactical or strategic defeat; so, we’d rather each service use safer rather than sorry designs.

1. Lengthy & Expensive Design Processes

Because the process involves at least one more step, determing common requests under the intersection approach would lead to more lengthy design times and more expensive processes than if each service acted and purchased in a completely autonomous manner.

However, these cost differentials would be substantially greater under the union approach. As more and varied (and possibly conflicting) specifications are demanded under the union approach, more design effort, time and cost are incurred. That is especially true if the desired specifications conflict with each other. For example, if the asset or good is supposed to be both light and strong–like a durable notebook computer or an easy-to-carry M4 carbine that is light but has a sufficiently thick and heavy barrel to withstand the intense heat of rapid and repeated fire. Obviously, that’s true within one service, but the issue is exacerbated–perhaps accelerated is a better word–when additional, conflicting specifications are demanded across users.

Under the union approach, not only are initial designs of more complex products more expensive to complete, but due to the inherent complexity and inter-relationships, revisions are, too. Unless there is complete modularity–like swapping out a computer’s SATA hard drive or a USB mouse or VGA monitor–revisions must consider those inter-relationships and effects on the other desired properties and functionalities as design characteristics are changed.⁵

Mr. Lehman notes that “there has been a loss of discipline and control over equipment requirements and a surge in gold-plating in all Pentagon programs.” We view this as an implication of the “union” approach of attempting to be all things to all armed services. With many conflicting requirements, the “gold-plating” occurs because it is often necessary to use state-of-the-art designs, materials, and production processes (to produce assets with many conflicting design requirements).

In sum, and very generally, one can think of (1) the time to complete a design and (2) the cost of both the design process and production to be increasing and convex functions of the number and stringency of different performance attributes and functionalities. Changes in technology would shift and rotate those relationships, but that’s a story for another day.)

2. Increased Care & Costs of Production

Under the union approach, for a given level of  technology, satisfying multiple and conflicting requirements generally requires the producer to incur higher failure “prevention” costs, which are the upfront costs of increasing the probability of conforming output, and higher process monitoring costs, i.e., more careful and supervised production. Technological innovation, by upwardly shifting performance attributes and production functions, can mitigate these costs; however, per our point in (1) above, often the complexity of design does not permit such easy, implication-free substitutions.

It seems that much of the layered bureaucracy within defense contractors and the Department of Defense involves recording and certifying and auditing many of these quality-related process variables. Ironically, it is often in the name of increasing efficiencies and cost management. What a joke!

3. Costs of Special Requests & Design Modifications

Under either approach, when designing a “standardized product,” there seems to be a reasonable chance that no one will be completely satisfied with the final design trade-offs. Under the intersection approach, that’s because each user may be denied a unique and important functionality, whereas under the union approach, it is not necessarily feasible to produce a union of all demanded characteristic, or the inclusion of all demanded functionalities may require some users to bear higher costs than they otherwise would have done so.⁶ As such, the final design may be a proverbial jack-of-all-trades, but master of none.

So, one can easily imagine ad hoc demands for changed specifications during or immediately prior to the start of production runs for particularly branches of the service. For example, when a standard item’s paint is changed from Army green to Air Force blue,  one can imagine the Air Force other changes to the item, and those requests increase production time and costs. Thus, the promised savings from standardized design and production are likely to be reduced if not eliminated.

We suspect that given the different services and the real differences in their needs, there is far less realized standardization than promised or initially hoped for under a “joint” or union approach. So rather than separate, duplicate, upfront designs, there are last-minute, duplicate, ad hoc designs. We’d argue that such ad hoc changes and designs are more expensive than planned ones.

In fact, Mr. Lehman mentions something about 75 change orders per week for (some set or subset) of defense contracts. We’re not sure what that number should be compared against or what historical levels were, but we’d hypothesize that many of those requests are adaptations of a supposedly standardized, joint design to the different demands of the Army, Navy, Marines, etc.

4. Compromised Use & Higher Operating Costs

Under the intersection approach, this compromised use would include the cumulative opportunity costs of each user not having the functionality that they desire (and need). Unfortunately, this is one area where the non-financial costs of compromised usage can be enormous. They include the tragic loss of sons and daughters, mothers and fathers, and brothers and sisters. They may also include the loss of tactical goals (battles) and strategic opbjectives (wars).

Those same costs can arise under the union approach, too. That design approach can create (the metaphorical) “too much baggage.” By providing functionality for one particular user in a shared design, it is possible to reduce it for another by overburdening them. For example, making something, say, rugged for one group may make it too heavy for another or making it light for one may make it too fragile for another.

Think of a firm that provides each employee with a nearly-indestructible, ruggedized, $4,000 laptops, with say, a 13-inch screen. Many employees would be better-served with desktop, a cheaper notebook, a tablet, a very cheap netbook, a handheld device, or simply a dumb cell phone. For example, we’d imagine that there are pilots in the military who are assigned planes that can’t fly slow enough to optimally perform their missions, and we’re sure that someone with military experience could provide more examples.

5. Higher Failure & Repair Costs

Related to compromized usage and higher operating costs are higher failure-related costs, including–but not limited–to repair costs.

All things equal, the Swiss Army approach of more complexity and more parts would generally lead to higher external (field) failure rates and higher repair and replacement costs. This is especially problematic when failure or one, otherwise extraneous or unnecessary component, prevents operation of the unit as a whole.

Often these higher costs induce those responsible for the asset to use it less than it should or could be used, e.g., think of the beautiful and expensive “good” china and crystal that sits in the cabinet rather than on the table when there are no guests.⁷

As with compromised functionality, besides the incurrence of higher financial costs, the occurrence of increased external failures and breakdowns (and possibly lengthy repair processes and durations) leaves the nation less prepared to defend itself and, most importantly, may expose our soldiers, sailors, and marines to unnecessary and lethal dangers.

Given these five potential cost categories, one should question whether the development of “joint” programs is either efficient or effective. We doubt it. In our mind, a proper accounting would show few cost savings, many delays, and many opportunities for errors, mistakes, and failures.

Under either approach, in our mind, unnecessary standardization is a symptom of the bigger problem: an uneconomical centralization.

The Failure of Centralized Procurement

Admittedly, it is difficult to compare the cost and waste of the current, rather centralized system with the costs (and benefits) under a more decentralized procurement structure because there is only one Pentagon, and we can’t observe the performance under the alternative structure. However, we argue that beyond too much standardization, too much centralization can lead to higher costs, reduced efficiency, and reduced effectiveness and performance in the field, and that is the current state of defense procurement in the USA.

Secretary Lehman–and others–provide evidence that the current, rather-centralized, process is broken. In our mind, no stronger evidence exists than the recently signed law that will add 20,000 more bureaucrats to “reform” defense acquisitions. Unfortunately, that will likely lead to an even more centralized structure.⁸ That mentality is very much like what we see with health care, where the failure of the Medicaid and Medicare to control costs has led to the call from some parties for more centralized resource allocation.

How to Think about the Problem

At the bottom of Our Control Framework page, we list the possible benefits and costs of decentralization–i.e., delegation and autonomy–versus a more centralized structure.

The costs associated with autonomy relate to (1) selfishness and (2) ignorance, and include those associated with the duplication of effort. Such duplication can occur because one subordinate doesn’t know that another is performing the same activity (ignorance) or because one of the parties wants to “do it my way” (selfishness).

While such duplication may seem bad on the surface, eliminating it and the associated costs need not be optimal–in either the short-term or the long-term. That’s because eliminating the costs of decentralization usually destroys the associated benefits, too, and those benefits may be greater than the costs. Thus, the desire to eliminate government waste may be very myopic behavior and is not much different than firms that attempt to maximize profits on a quarter-for-quarter basis rather than their long-term value.⁹ Such “waste” may be a byproduct of the most efficient structure, but one wouldn’t know that if their response were nothing more than a thoughtless, knee-reaction to eliminate it.

We suspect that the demand for more centralized structures within the Defense Department arose from such reactions–reported incidents that showed such duplication and perceived “waste.” For example, someone may have observed that the Army was separately doing the same thing as the Navy was doing, and rhetorically asked, “why can’t we combine them?” and thus, operations were “stream-lined” before the rhetorical question could be intelligently answered.

Given that there is not a goal of profit-maximization at the Defense Department, we’d hope that its goal involves maximizing the nation’s defense capabilities–something like keeping our country and its citizens safe subject to various uncontrollable environmental and budgetary constraints. That’s a much more nebulous goal than mere profit maximization, and it makes studying (and managing) governments (and other types of not-for-profit organizations) more challenging than analyzing and managing firms. Regardless, one can still manage thoughtfully if one chooses, but our point is that the knee-jerk reactions of Congressmen and bureaucrats to consolidate programs and centrally administer them is no different than other myopic, inefficient, cost-minimizing behavior. In other words, trying to minimize a subset of costs need not maximize value, efficiency, effectiveness nor even minimize total costs. We think it requires a particularly high degree of (self) discipline to incur these costs because they related to others‘ behavior. (See our essays, Common Managerial Mistakes in Decentralized Organizations and Strategic Consistency and Managerial Discipline for more on this topic.)

Again, per the marginal benefits of decentralization that are listed on the bottom of Our Control Framework page, it is easy to believe that:

1. Subordinates (on land, in the sea, and in the air) are better informed…

… about the circumstances and environments that they face or may face and about their own needs. Thus, they are better able to precisely specify the assets, goods, and materials that they need to accomplish their specific missions.

2. Subordinates have more expertise and knowledge…

…to procure what they need to adapt their capabilities to their current and prospective environments, including likely foes and locations. They have more expertise about how they fight and train and use the assets under consideration (and what would be optimal configurations of those assets).¹⁰

3. Subordinates can respond quicker and decide faster…

…than (a monolithic) centralized authorityor authorities like the um, er, the Pentagon and the DoD and the Congressional bureaucracy. The ingenuity and creativity that Americans so love, especially in their armed forces, is crushed by such processes. Thus, one sees it in the change orders and field (and battlefield) adaptations because they were given compromised assets and equipment–rather than specialized equipment. Why not permit (or induce) them to be ingenuous in the design phase to meet their particular needs–especially when their lives are at stake?

The elongated design times would likely be substantially reduced if the branches of the service were given more autonomy to purchase to their specific needs. It would take less time to accumulate demands and consider the trade-offs, and the compromise on those demands (across the services) would be eliminated. That could permit shorter asset life cycles and the earlier implementation of enhanced functionalities and technologies of later generation platforms.

4. Subordinates may be better motivated…

and may better understand the relationship of their actions to their organization’s goals and environment. Per Mr. Lehman’s essay, “there has been an obliteration of clear lines of authority for managing procurement programs.” In other words, your service’s piece is small, it’s not in your budget, the joint-platform has to be completed and won’t be discarded, and you can always try to change it later when they’re producing your units. So why bother fussing with controling the design time or costs? What can one person do anyway, and who can blame them freeloading?¹¹

Can the reader imagine a bureacrat stepping up and taking responsibility for a project and its success? (TARP anyone?)

The branches of the service would also be better motivated to procure efficiently if they (a) faced stronger, inter-service competition for procurement budget dollars and (b) perhaps some types of deadlines, and that competition would control costs and the gold-plating Mr. Lehman mentions. The former, (a), is consistent with our observation that not all intra-organizational competition is bad, and (admittedly) the latter, (b), is something that we need to think more about. (In many ways, these elongated, decentralized design processes remind us of the eight-year-old hole in the ground in Lower Manhattan. Following a WSJ editorial on July 21, we wrote about it in The Right Comparison and the related Corporate Projects and D-Day.)

5. Information system costs may be lower…

…as less data collection and aggregation is necessary.

We realize that we’re being unrealistic in hoping that in the future, engineers at contractors may be permitted to account for their time in greater than six minute increments.¹² Such policies are stupid (self-defeating), demoralizing, and dehumanizing, but we doubt that such regulations will be relaxed. However, in the context of this essay, less centralized data collection and aggregation means fewer parasitic bureaucrats who are aggregating already aggregated reports for no other purpose than to aggregate and bureaucratize. For that reason, alone, citizens should prefer a more decentralized approach to procurement.

The realization of many of these benefits would individually (and collectively) reduce the five costs of excess standardization that we mentioned above; however, they are broader and involve more than just standardization of particular assets and goods, i.e., the joint platforms as they involve overall costs savings and improved efficiency and effectiveness.

We’re not understating the difficulty of solving such a crucial, yet amorphous, problem, especially given the number competing and conflicting claimants–both within and outside of the government. We are simply arguing that centralization of resource allocation need not be optimal, and at the present time it is likely sub-optimal within the Department of Defense.

Finally, we see no reason to believe that the centralization of health care procurement will be any more effective than the failed centralization of defense procurement (and already failed healthcare programs). In neither case, should one expect that additional centralization will compensate for the wastes associated with excess centralization.

P.S. We’ll likely edit this in the near future to eliminate typos and add skipped words and improve the sentence structure of certain paragraphs.

Copyright © 2009 Spero Consulting.

Footnotes:

Related posts:

• Healthcare Going to the Dogs?
• Squalor and Health-care
• Common Managerial Mistakes in Decentralized Organizations
• Wow! What Insights!
• Danica Kournikova?

Why do we write that it is “excellent” the dear reader may ask?

Well, for the obvious (and self-serving) reason that we have been writing the same critiques on these pages for much of the past year or so.

Mr. Blinder identifies several problems that created the potential for the crisis and its subsequent realization.¹ We will categorize the problems that he identifies as:

1. Wrong legal form/organization structure for some firms,
2. Incompetent boards, and
3. Lax controls and poorly-designed incentives.

He treats them in a different order than we list them; we’re going from top-to-bottom, which is consistent with Our Control Framework. Clearly, the three categories are related. For example, see our popular post, SOX’s Roles in the Financial Crisis of ‘08, which hits on all three topics, and criticizes government regulation to boot. In our mind, they all provide evidence of the fallen nature of man. (We’re not complaining about that nature. We accept it in ourself and, to a lesser extent, in others. We’re only trying to profit from it.)

Wrong Legal Form/Organization Structure

We wrote about this on September 26, 2008, when we asked Will Investment Banks Go the Way of the Dinosaur? In that post we speculated that partnerships may make a comeback because “They provide control mechanisms and levels of oversight and scrutiny that seem difficult to duplicate in public corporations.”

Mr. Blinder made explicit what was implicit in our post: the difference between one’s level of risk-taking when managing OPM (Other People’s Money) versus what he refers to as MOM (My Own Money), or one’s own money.² Those facing unlimited personal losses tend to be more conservative than those with limited losses.

In January, in a critique of The Wall Street Journal‘s editorial board,  What Did They Expect?, we wrote, “We also disagree with their [the editorial board's] assessment that “compensation levels are a business judgment made under the pressure of competition.” That might be true if the firms were partnerships or otherwise privately-owned, there was no agency costs, and there was no self-dealing, i.e., the firms were run by independent and knowledgeable boards.”

But with D & O (directors’ and officers’) insurance, the limited downside of losses severely decompresses that so-called “pressure of competition” for boards. Moreover, shareholders of bank holding companies (and other corporations, too) implicitly permitted managers to take greater risks. In fact, Mr. Blinder seems unwilling to blame shareholders when almost every stockholder was quite capable of selling their stakes. So, we have no sympathy for folks who wanted the opportunity for large gains without bearing potential liabilities if the firm.³

Incompetent Boards

While “Incompetent Boards,” may seem a bit harsh to some, we think that it is milder than many alternative and equally fair characterizations, and there is no shortage of evidence. See Directors Are Faulted at Home Loan Banks for example.

Regular readers will note that we often ask whether a party is ignorant or cynical, and in this case we’d prefer to believe that many directors were unqualified to understand the uncertainties and risks associated with investing and trading, particularly with derivatives and other structured products. In some way, that seems more “decent” and ethical than the alternative: the cynical and devious behavior of understanding the potential for loss but ignoring it due to one’s own limited liability.⁴

For example, with the recent changes in the composition its board, Citicorp has as much as admitted the lack of requisite expertise of its past board. We’ve written about these topics in the past, particularly in: The Failure of Boards to Direct, The Seventy-Year-Old Teenager, When the Going Gets Tough…Quit, and Idiosyncratic and Concentration Risk, Again. (Update: within hours of publishing this post, B of A announced that one of its directors was resigning: see BofA Says Sloan Quits Board Seat. There was much speculation that it was due to government pressure.)

Those (generally weak and) incompetent boards permitted senior managers to maintain the lax controls and poorly-designed incentives about which we have often written, and here is a summary.

Lax Controls and Poorly-designed Incentives

As Mr. Blinder notes, poorly-designed incentives–primarily via compensation schemes–led to ex post “excessive” risk-taking. We write ex post as in 20-20 hindsight as in “there are massive losses, so someone must have done something wrong,” but, in fact, we’re note using that logic. Instead, we note that there was no shortage of individuals warning about the risk and uncertainties ex ante.

Unfortunately, many such folks were dismissed either figuratively or literally by senior managements. (It’s analogous to the SEC’s treatment of Harry Markopolos. See Cassandra, the SEC and Mr. Madoff.) Moreover, it is consistent with the perspective that risk managers generate no revenue and are costs to be minimized (and often voices to be ignored).

So, yes, traders (and their managers) took gambles because they bore (or thought they bore) limited downside risk but instead focused on the potential for substantial (enormous) compensation rewards, but lax controls and ignorance are bigger issues than just poorly-designed compensation schemes because said traders were allowed to take those gambles with OPM.

That lack of control has many facets, but can be summarized in terms of as greed, ignorance, and insecurity. Notice that, of course, those emotions/human conditions are always present, but precisely the job of senior managers (and boards and owners) to design schemes and mechanisms that take those as given and mitigate them–rather than exacerbate them–while the organization attempts to achieve its objective. (We’ll have more to say about that below.)

Ignorance, and its relative, insecurity, were crucial to the control failures. Few folks are willing to admit that something is immeasurable or nearly impossible to quantify because that can be turned-around and used against them as a personal short-coming:, e.g., “that’s just because he doesn’t know enough.” So, personal insecurity and incentives often induce employees to “take the easy way out” and endorse or embrace a simplistic and inapplicable valuation or risk model.

For example, in early November, we wrote The Understatement of the Year! in response to an article in The Wall Street Journal entitled, Behind AIG’s Fall, Risk Models Failed to Pass Real-World Test. While the entire post is relevant to this discussion, we particularly like this extended excerpt:

The problem, dear reader, is that few senior managers (and almost no board members) understand the valuation and risk models used for securitizations, and many of the traders, consultants, and analysts who wield such tools often suffer from, what one may call, “framing” issues; we don’t mean that aspect of home construction despite its recent relevance.

We mean that if one’s only tool is a hammer, then lots of things look like nails.  The metaphoric hammer may be an intangible Visual Basic or “C” programming algorithm, but the point remains the same; it’s just harder for senior management to see what one is pounding in their cubicle, office, or trading-floor seat.

To be sure, if anyone within most of the larger firms would have complained of the systematic risk—and how everything could go bad all at once—and the inapplicability of the standard models, which generally don’t permit such events, then that person most certainly would have been told that they don’t know what they’re talking about.  Possibly, that they are unsophisticated or too negative.

Earlier this week in Uncertainty: In God We Trust, we noted “Too many senior managers neglected their responsibilities and permitted the substitution of calculations for thoughts.” That as been a pet peeve of ours for quite some time and is the antithesis of our motto: thought before calculation. See The Difference Between Risk and Uncertainty for a relatively short exposition of the issues.

Those dysfunctional behaviors were not necessarily malicious or anti-social by intent, but does that matter, especially since thoughtful design of control mechanisms could have inhibited them? See Principles Lost and More, in which we contrast Saint Thomas More’s actions in the 16th century with the more recent actions of many less holy individuals prior to and during the Financial Crisis; there’s a reason he’s a Saint and we’re not.

We’ve written much, much more on this topic, but as we noted in The Problem of Induction, we’re not underestimating the difficulty of the problems faced by traders, structurers, and risk managers. In fact, if anything, we’re overly conservative by stating that not all uncertainties and losses can be quantified and the problems are much more difficult than some suppose and/or communicate.

What To Do?

Unfortunately, Mr. Blinder notices that there has been little-to-no structural change in corporate governance. He attributes the differences in markets–the illiquidity or lack of trading–to fear, rather than to newly designed or revised controls, and that seems about right to us. As we noted last month in Learning the Difference Between Risk and Uncertainty, or not, job descriptions and hiring requirements for many trading and risk management positions don’t seem to have changed; so, it doesn’t seem the firms have “re-engineered” or redesigned their operations or controls.

In October, we wrote a tongue-in-cheek post about The Role for Survivalists and Depressives in Uncertainty Management, but in all seriousness, hiring such personalities and listening to them is one way to compensate for flawed risk models.

To be fair, we have read about a few firms, like UBS, that have changed their compensation schemes to include features like clawbacks. See Clawbacks: the Good, the Bad, and the Ugly and Incentives at UBS and in General. However, it is not clear whether such changes have been thoughtfully managed. As we mentioned in Business Schools, Incentives, Uncertainty, and the Financial Crisis, it seems that little has been done because: (1) such incentive problems are very challenging to solve, and (2) universities don’t do a particularly good job of training business students to solve them. (Of course, for the right fee, we would be glad to help.)

So what to do?

Mr. Blinder calls for change, but doesn’t exactly explain how or what.

We’ve made several recommendations in past, including this post from early October: Eliminate Proprietary Trading at Insured Institutions. Everything in it–and there’s a lot–holds up well, and we’ve not heard a compelling argument against such a ban. As we wrote back then:

We’re completely for the free-market—more so than most bank managers—but until such institutions forsake their government insurance, we’ll insist that they have an obligation to the citizenry—through the government—to behave in a responsible, low risk manner.  If that generates lower returns for them on average, then so be it.  That’s the nature of the risk-return spectrum and their legal and fiduciary responsibilities…

We think that such a ban is feasible and would substantially mitigate many of the risks that those banks by eliminating the (socially) undesirable behavior.

Now, that (maximum) risk-seeking behavior is not universally undesirable, but it is within subsidized institutions. We’re all for permitting “prop” structurers and traders to operate in unregulated partnerships and hedge funds, and wish such organizations the best of luck.

P.S. Although this post is rife with links, we’ve written much, much more about the topics of risk management, incentives, and the crisis. Feel free to peruse the archives, and let us know if we’re wrong about anything–other than a few predictions.

P.P.S. As posted, this is rather long, and we’ll likely revise it in the near future as we discover typos, etc.

Related posts:

• Do Business Schools Provide Education?
• Financial Projection in a Crisis
• So Far, So Good, Mr. Obama
• Taking the TA out of TARP
• $37 Billion Loss & Concentration Risk

We don’t answer that question here, but shouldn’t one be required to master something?

It Was a Matter of Time

Since early October, we’ve wondered when we’d see the first editorial criticizing MBAs and business schools for their role in the ongoing financial crisis.¹ In our mind, much of the blame should be shared between business types, i.e., MBAs, and so-called “quants,” with the majority of the blame placed on senior managers who permitted lax controls and misaligned incentives to exist.

We didn’t write about it when the thought originally occurred to us nor during the intervening six months-or-so, but we’ve been tempted to write on any number of occasions.

Two events occurred last week that motivated us to write today. First, our excellent, former TA, Bridget Ardoyno, wrote to us that she has been blogging at http://econmom.blogspot.com, and that reminded us of teaching MBAs (but in a good way).

The Main Shortcoming

The other event was the appearance of an excellent opinion column, How Business Schools Have Failed Business, in last Friday’s edition of The Wall Street Journal. The column, by Michael Jacobs, lists three main failings of business schools with respect to the teaching and the crisis, but in fact, his three are all examples of the lack of the quality instruction regarding control and incentives.² Basically, incentive issues are a type of control problem that arise in decentralized organization, where subordinates are permitted a degree of autonomy to act as they see fit.

The Root Causes

There is much to like about Mr. Jacobs’s criticism of business schools. However, while we realize that editorial space is limited, he ignores the two main causes of the problems that he identifies: (1) poorly-prepared students, and (2) an over-emphasis on entertainment and teaching ratings that motivates instructors to offer simplistic lessons at the expense of substantive learning. The first is related to the pathetic undergraduate educations most folks receive and the second is, well, an example of an incentive problem. (We’ll get back to both of these below.)

Incentive Problems Are Easy to Identify, but Difficult to Solve

Incentives problems are as natural and as old as recorded history: everybody wants what they want. In the Old Testament, were Adam and Eve anything if not incentive problems? Cain? We could go, but there’s no reason. All of the individuals were free to act in a decentralized setting, and failed to live up to their responsibilities.

In the New Testament, Jesus discusses incentive problems on any number of occasions. Two of our favorites: (1) the parable of the faithful and unfaithful servants (Luke 12:41 – 48) and (2) the parable of the good shepherd, (John 10:11 – 13). All consider the fallen nature of man and his (completely natural) selfish behavior.

That being said, there is not a more complex topic to address in business schools–or any type of school, for that matter–than incentives. That’s because the topic involves social (or multi-party) situations where one needs to be able to predict how another party will respond autonomously and freely to control mechanisms like compensation schemes.

Many of our readers already know that decisions can be categorized as games against nature–single-person decision-theory–and games against others, i.e., game theory. Generally–though not precisely–one can think of the investigations in the natural sciences as examples of single-person decisions and investigations in the social sciences as examples of multi-person decisions, e.g., how does one respond to a survey so how should the researcher interpret that response?

Incentive or agency problems–and information economics problems in general–can often be modeled mathematically using game theory or similar methods. In many of these problems of interest to business students, one decision-maker–say, the superior or principal–is attempting to maximize his own expected satisfaction or profits while ensuring that (1) the other person–the subordinate or agent–is willing to participate with him (in the social setting like a firm or organization) and (2) with full knowledge that the subordinate or agent will do what’s best for himself.

Those two conditions–participation and incentive-compatibility–constrain the principal’s ability to maximize his own expected satisfaction, and the latter problem is especially vexing to solve because it means that one of principal’s constraints is the other person’s optimization problem. How do you do what’s best for yourself while realizing that the other person is also behaving opportunistically (by doing what’s best for himself)?

Objectively modeling these issues as mathematical problems tends to require a rather high level of sophistication, and solving the resultant problem–or even knowing when a mathematical solution exists–requires an even greater understanding of advanced calculus, optimization, real analysis, and other mathetical theories and techniques.³

Very few MBA students are prepared to tackle those topics (and their applications) at that level of understanding.

Our Root Causes, Again

A larger set of students can handle simplified illustrations and examples of problems that tend to be more numerical in nature. Often, when taught in conjunction with a math software program, they can gain a keen understanding of the subtle issues that arise in the study of incentives, e.g., paying more for more output isn’t necessarily optimal nor incentive-compatible.⁴

Unfortunately, the root causes that we identified above–ignorance and selfishness/greed–make it difficult for most instructors to offer and successfully teach such a course to MBA students.

We’ll emphasize the students’ ignorance and not the instructors’; instead, we’ll focus on their selfishness.

Most MBA students are poorly prepared to think clearly, abstractly, and quantitatively, and that makes it a challenge to teach them either (1) quantitative subjects or (2) topics that can be effectively modeled, illustrated, or explained in a quantitative manner.

Incentive problems fall into the latter category. (What we’d call) simple mathematical or numerical models provide (by definition) abstract illustrations of particular phenomena and behaviors. They’re rarely solutions to real world problems.

Most MBA students are not sophisticated enough to handle that distinction; they want recipes, not thought processes, and recipes are easier to teach and grade. It’s not because the students are stupid, but it often is because they were poorly-trained as undergraduates and in require, core classes. Per Mr. Jacobs’s essay, there’s generally not much evidence of profs teaching compensation-related recipes in business schools because of the lack of relevant incentive-related courses.  Thatt’s evidence of absence (of the courses), rather than an absence of evidence.

There’s much more evidence of that behavior in finance classes, where students want recipes for valuation. They’ll take abstract models, with either unrealistic assumptions or very, very specialized assumptions and unwittingly (and unknowingly) treat them as very practical  and precise methods that calculate the one true value of the thing.

Unfortunately, they’re often encouraged to do so by their professors because it’s much easier to teach numerical–though irrelevant or mis-specified–recipes than it is to teach (and grade) thought processes.

In fact, that tendency to dumb-down teaching even extends to some faculty members’ research agendas. During our academic career, we attended any number of seminars where we heard the presenter justify his or her overly-simplistic and vacuous model by arguing that “we want to be able to explain it to MBA students.”

Imagine if medical research were conducted in the same manner? Or any serious field of inquiry for that matter?

From our perspective, it’s completely ass-backwards (and, in fact, its presence goes partially to explain why we’re in the private sector, today).

In an ideal words, the pedagogical emphasis would be on educating the students by attempting to pull-them-up to a level that they had not anticipated nor even known existed, and not presenting dumb-downed “research” papers for entertainment or pretense, but, hey, the latter alternative is easy, and one can generally garner higher teaching ratings by not challenging the students, especially if that perspective and technique is pervasive within the school. (We knew any number of faculty members at very expensive and seemingly prestigious institutions who would provide “sample” or “practice” exams before test dates–the actual exams would have slightly-changed numbers; who would schedule frequent guest speakers because “the students like it (and we don’t have to prepare);” and would show videos of factories or whatever once per week because, again, ”the students like it (and we don’t have to prepare).” (Geez, it’s almost enough to make one cynical.)

Anyway, that combination of poor preparation of most students and the misaligned incentives of b-school professors make true learning about these thorny and difficult (social) problems, which all firms and organizations face, nearly impossible to achieve.

Why It’s Difficult to Teach about Incentives Issues

It’s not just the mathematical nature of the most compelling models of incentives that makes teaching difficult. It’s also because the problems are not particularly robust. By that we mean, illustrations and examples must be carefully (and empathetically) constructed, or they’re either (1) extremely stupid and un-insightful, or (2) extremely specialized, detailed, and so qualified (by assumptions) that they need a very high degree of mathematical understanding to comprehend and solve (and they end-up saying very little, anyway).

The fertile middle ground requires instructors and students to possess a rather high level of economic reasoning and strong math skills. We’ll avoid criticizing instructors, here, but unfortunately, many MBA programs have de-emphasized, eliminated, or consolidated microeconomics courses, and those courses are (or were) the best place to develop the requisite level of economic reasoning. In those courses and well-designed incentives courses, there is no substitute for a lot of hard work.

By the way, we unsuccessfully tried to establish just such a Control & Incentives course at our last academic employer, but there were no required econ courses and only a few very motivated, very curious, or previously-trained students would enroll in the elective. (Too much work!) As a public service, we’ll attempt to put that course material on-line in the near future.

But Difficulty Is Really No Excuse

It’s up to trustees and deans to ensure that schools and professors educate MBAs, rather than attempt to be “popular.” That’s true at both the individual level and the sum of the individual levels, i.e., the school level, where administration’s allow themselves to be subjected to the whims of Business Week writers and survey respondents. As a faculty member, we won our share of teaching awards while trying to do the right thing; so, there’s no sour grapes here, and we know that it can be done; however, we suspect that the short-term emphasis will not change. There’s too much inertia and very little confidence.

From our selfish perspective, it’s not as bad as it seems because that general failure to learn and teach presents many opportunities for consultants who understand both incentives and risk–people like ourselves. (We’ve written extensively about both issues, especially as they pertain to the current financial crisis. Please search the archives if you’re interested. Our Illustrations discuss many of these issues, too.)

Are you sure that your firm or organization isn’t about to do something stupid with incentive pay or clawbacks or whatever?

We’ll likely continue to revise and edit this post in the near future. (It’s long and there’s probably a few typos, but then TQM is rarely optimal.)

Copyright © 2009 Spero Consulting.

Footnotes:

Related posts:

• Do Business Schools Provide Education?
• The Children Who Have Eaten Their Cake…
• Volatility and Losses: No End in Sight
• Incentives and the Financial Crisis
• Uncertainty and Risk Management

Suffocating Regulations and Bureaucracy

Is there any other kind? Well, yes. As we see it, regulation is either suffocating or ineffective, and the former often has a crushing feel about it. Like modern digital television sets, government regulators seem to have no “fine-tuning” dial; it’s generally one extreme or the other: either there’s “NO EXCEPTIONS” or “it’s all good, do what you want.”

Victoria Toensing discusses that overbearing weight of the government in Welcome, Businessmen, to Government Oversight in which she highlights, among other indignities, the silliness of government offices unable to accept small gifts like cherry pies.  Our guess is that she has spent most of her life in public service and doesn’t appreciate how similarly bureaucratic large corporations can be, but that’s besides the point because much–although not all–of that corporate bureaucracy is induced by government regulation.

We’ve discussed both negative aspects of regulation in numerous posts although we tend to highlight ineffectiveness because it has been very obvious in the current financial crisis and the mortgage debacle that preceded (and which continues to coincide with) it.  For example, on Saturday we wrote The Cure is Worse than the Disease, which criticizes Mr. Geithner’s proposed financial system regulations.¹ We fear the suffocation to come.

Generally, we favor decentralized government and much prefer decentralized working environments, i.e, light regulation with the policing authority’s option to crush, i.e., heavily penalize for indiscretions. We take that from the Bible and the Parable of the Good (and Bad) Servants, which covers both moral hazard and ignorance, and that’s why we’re strong proponents of nationalizing the weakest of the large banks. (Not because we think the government will manage them better but because we think shareholders and current managements have forsaken the right to control those assets.)

Suffocating regulations and bureaucracy usually provide no benefit to society and are inhumane and demeaning. If “effective,” they usually end up killing the thing they are trying to protect.  (Nationalized health-care anyone?) In short, that’s why we’re against Mr. Geithner’s plan.

Transparency Anyone?

The other column worth mentioning is L. Gordon Crovitz’s Transparency Is More Powerful Than Regulation in which he focuses his attention on a substitute for extensive regulatory oversight: more reporting transparency. For support of his position, he mentions former Supreme Court Justice Louis Brandeis’s point that “sunlight is the best disinfectant,” which we often cite, but is irrelevant here.

While we tend to agree with many of his points, we think, that in the end, Mr. Crovitz draws the wrong conclusions because (1) in general, in social settings more transparency isn’t necessarily better (doesn’t necessarily improve social welfare and can decrease it), and (2) in the special case of  securitizations of pooled assets, additional transparency won’t solve the problem of flawed pricing models because the models’ owners have lost confidence in them.

Is More Information Always Better?

It depends. In single person games–i.e., natural science experiments and games against nature, more information is better.  Roughly, that means it leads to higher expected satisfaction for the participant.² Clearly, record-keeping is necessary for several reasons, but often those records don’t necessarily provide marginal benefit for decision-makers in all decisions, i.e., the records might not  identify additional relevant or differential costs or benefits among the possible alternatives for the decision. Alternatively, because they are not perfectly rational, decision-makers may not be able to categorize and synthesize or relate the new information that is present, or they might misuse it.

In a seeming contradiction to that view, last week, in Separating the Mortgage Debacle from the Liquidity Crisis, we agreed with Hernando de Soto’s recommendation that  more details about contingent claims and securitization contracts should be made public, and Mr. Crovitz explains how this is technically feasible through the XBRL initiative.

As we see it, such details are informative about certain aspects of the contracts, but not what Mr. Crovitz thinks. For example, it might help creditors better understand particularly low outcomes associated with certain securities; so, we think that the details are worth reporting, BUT the additional details may not help with pricing claims on the pooled assets. Thus, we don’t see how transparency will induce liquidity. In fact, markets often fail because there is “too much” transparency to sustain transactions, i.e., no one wants the clearly-identifiable crap–the lemons.

As we’ve written in the past, one of the problems with these pricing models for pooled assets is that their owners have lost confidence in them. They’ve lost confidence because they view the models as no longer applicable, and they view them as no longer applicable because they have failed empirically.

They failed because they did not capture the relationships and inter-relations among the assets, particularly among residential mortgages. (In other words, the traders and analysts vastly under-estimated the joint dependencies among cash flows and collateral values, which those folks may express as having a poor estimate of the correlations, but which is likely more complicated and far less calculable than that.) We’ve written about that on several occasions, including here: Trading, Incentives, Organizational Structure and Risk Management, where we explain it as a contagion. (We also discuss it in Well, This Is a Fine Mess You’ve Gotten Us into…. along with other still pertinent issues.)

The problem is that there are few mathematically tractable ways to specify how these assets are related; so, solvable–but nondescriptive and misspecified–methods were employed. In stable times and with a bit of good luck, that misspecification didn’t seem to matter.  Unfortunately, luck changed, and did and it does now.

So, we don’t see how transparency will induce trading, but that doesn’t mean that trading cannot occur.  (Mr. Crovitz has a good solution, but to a different problem, i.e., Mr. de Soto’s problem.)

Our Solution

Since September we’ve recommended changes in tax policies–via mortgage investment tax credits or immediate write-offs of purchase prices–as a way to induce trade and create liquidity in these security markets. Providing a 30-40% cushion in the purchase price, will induce trading even if buyers aren’t completely confident of their calculations. Imagine if the same tax incentives were available to new car buyers? (See “The Good Cop” section of Poor Mr. Geithner: No Forest, No Trees, Just Lost for a recent overview of our plan.)

What Does This Have to Do with MIS?

The same types of system that XBRL is based upon are available very cheaply for internal decision-makers.  We’re designing and implementing similar robust, tagged systems for our clients.  They are easily searchable systems–both informally (ad hoc) and formally (routine reports); they’re easy to update and edit; they’re secure; and they’re relatively inexpensive. The benefits of technology can now be realized by any size firm or organization. Contact us for more information.

As always, we might update this post after we re-read it.

Copyright © 2009 Spero Consulting.

Footnotes:

Related posts:

• Wisdom in the Stock Market Crowd? Really?
• The Banks' Mark-to-market Gains on Debt
• International Accounting Standards Will Save Us!
• More Silliness on Valuation and Government Purchases
• Influenza Pandemic Stress Test, Part II

As we read it, Vedder and Denhart complain that collegiate athletics are not coddled or treated well enough and that they should consider unionizing and bargaining for greater benefits.  You know, benefits other than the free, if generally under-utilized tuition and education; free room-and-board; free travel; free use of state-of-the-art facilities; free health-care; and the adulation.

Now before continuing, it’s worth noting that we’re rarely confused with apologists for the NCAA or fanatical college presidents or alumni. Our PhD is from a small, rigorous university, and our first academic position was at a similar school.  Subsequently, we spent a few years at a large, state institution that over-emphasized sports. (No, it wasn’t prison, but there was no shortage of back-stabbers, shanks or prison bee-atches.)

While at the state school, we saw what we had missed in our prior Division III environs: the over-emphasis on sports.  (Now, our Alma mater seems to be overly-fixated on its incredibly shrinking endowment. Perhaps if they had focused more on sports, they would have done less damage to themselves.) While we write that parenthetically and as a joke, we’re quite serious about the converse.

At the state school, we realized that if in the administration’s judgement, the most important areas to focus their attentions were sports and sport facilities, which really are inessential to the true purpose of higher education, then working on those tasks were, in fact, the very best places to focus their attention. In other words, given their poor judgments would you really want them to focus on educating the youth? Or in still other words, thank God for decentralized institutions that basically run themselves.

There are any number of criticisms to levy against Vedder (and his sidekick), and we’ll mention as many as we can–until the Pitt game starts.

First, Mr. Vedder should put his money where is mouth (or keyboard) is. Per his allusion to minor league baseball, he should create minor league basketball and football leagues and pay the young athletes at least the “living” wage that he proposes.

However, if that is infeasible, then focus on implementable, realistic recommendations.

Secondly, he writes as if the athletes have no choices in the matter or responsibilities for their own actions and decisions.  Yes, we’re sure that playing major college athletics requires a HUGE time commitment, BUT it’s fun, AND in almost every case, the players like to play sports; so, they do get satisfaction from the experience.

Moreover, millions and millions of students have attended college and graduate school while working full-time. Many of those individuals have enrolled in school full-time while also working full-time.  While not everyone is successful, somehow many of those individuals found a way to complete their studies without the assistance from team tutors and counselors.

In the end, despite the time commitments and with the assistance, the student-athletes are still responsible for themselves, and IF their academic performance is worst than other students, it’s their performance and their responsibility. There is freewill.

Thirdly, it seems that Mr Vedder is applying the labor theory of value; the athletes–because they play the games–rather than the universities which organize them, should earn the rents.  Here, as counter-intuitive as it seems, the universities are playing the roles of the entrepreneurs, and if they can meet the athletes’ reservation utility–i.e., participation constraint–and incentive compatibility condition, and they do, then why should they overpay? (We mean that there are no shortage of willing athletes and they certainly seem to try their hardest and best, so why should the schools do anything differently, eh Mr. Marx, err, Vedder?)

Finally–it’s almost tip-off–the authors make a fuss about the fact that recent graduates (and non-graduates) make substantially more playing pro sports than they do in college. That’s irrelevant, but it is also true for a host of occupations, whether the training involves the classroom work or apprenticeships in the trades.

As an example, they use Kevin Durant and his pro salary compared to his non-existent one in his single year of college.  It seems highly likely that if he could have played in the pros at the same salary without going to college he would have.  Moreover, it’s highly likely that he considers his unpaid year at Texas as well worth the time and effort given the opportunity that he had to exhibit his talent and skills and his subsequent salary.

As we said, abject silliness.  Shame on The Wall Street Journal for publishing it.

We’ll likely update and edit this post after the game.

Related posts:

• IBM: Incredible Bull Manure?
• Set an Example, Mr. Cohon!
• Going to Copenhagen
• If It Were Only that Easy
• The Supervisory Capital Assessment Program

We saw in yesterday’s (February 4th) edition of The Wall Street Journal that certain legislators, including Barney Frank, want a government agency, possibly the Federal Reserve, to “control” systemic risk in the economy, particularly in the financial markets.

We’ll ignore the fact that this is the same Barney Frank who induced much systemic risk by insisting for many years that Fannie Mae and Freddie Mac make home ownership affordable for those who could not afford a home.  He was then shocked, shocked, and dismayed that a good percentage of those folks couldn’t afford their new homes.  Yes, very surprising, indeed!

Doing more harm than good: Instead, we’re writing because we find it quite ironic that an agency, i.e., a single government regulator or a small group of regulators would be able to “control” and “manage” something like systemic risk without either (1) completely destroying the economy they’re assigned to protect or (2) converting their own idiosyncratic perspectives and preferences into more or new kinds of systemic risk.

Good intentions and the road to hell: The first outcome is actually the worst-case scenario of the second one and isn’t much different than Mr. Frank converting his own idiosyncratic preferences about home ownership into the gigantic mortgage losses incurred by Fannie and Freddie, among others.  One need not be greedy or selfish to be misguided.

By far, the easiest way–and the historically-proven way–to control systemic risk would be to destroy the economy.  That would certainly eliminate variations–the ups and down–because the ups would be gone: kind of like the former Soviet Union or modern-day Cuba.

We’re sure that the destruction would be inadvertent and would be the outcome of well-intentioned efforts, but that wouldn’t lessen the pain.

We ask: which past (and failed) attempt at central planning has not been about “preserving jobs” or “creating jobs” or doing something wonderful for humanity?  We can’t think of any.

The irony of systematizing idiosyncratic risk:  As we mentioned above, our point is that centralizing decision-making in one person or small group of people and permitting them to regulate or govern the economy creates additional systemic risk to the detriment of all.

We have discussed these issues in a number of posts, including Common Sense? Smart Money? Oh, Please! 

We’ve focused on the notion that the idiosyncratic becomes the systemic as portfolios get larger and the decision-making becomes more centralized, and we’ve mentioned it quite often because it is generally ignored by folks.  Such risk is assumed-away in introductory finance models that show benefits of diversification; so, most folks don’t think about it.

We mentioned it when discussing mergers in Bigger Is Not Necessarily Better:

“Each senior decision-maker’s idiosyncratic (and possibly irrational) beliefs and judgments affect a larger and larger share of the economy’s resource decisions, and that can’t be a good thing.  Thus, there is a trade-off of the cost savings (of consolidation) versus the additional risk of such centralized decisions.”

Think of it as the undiversifiable risk due to the fact that the portfolio is chosen by a semi-rational human or small group of humans, each with their own unique and shared flaws and assumptions.  The fact that such an error term does not exist in these financial models does not mean it is absent.  It means that the model is an abstract, stream-lined version of reality that ignores certain factors–oftentimes, important factors.

As we’ve often mentioned, given our conservative nature, we do wish our elected leaders and appointed regulators would take an equivalent of the Hippocratic Oath: beyond all else, “do no harm.”  Unfortunately, as their actions over the past several months have shown, that is asking far too much of them.

So we ask: can’t we all just wear our “WIN” buttons from the seventies? We can change the “I” from ”inflation” to “illiquidity” to “Whip Illiquidity Now!”  It would be silly today as it was when Gerald Ford was President, but it would be far less harmful than having a couple geniuses–like, say, Barney Frank or Henry Paulson–sort through and “solve” our problems.

Related posts:

• The Cure is Worse than the Disease
• The Stock Market and the Stimulus Package
• Human Error (versus Systemic Failure)
• John Bolton is Right
• Forced Mergers? Bigger Is Not Necessarily Better!

As we’ve seen in various news reports, Citigroup has lost about $30,000,000,000 or so in the last five quarters and has received about $45,000,000,000 in TARP funds, and the federal government has guaranteed another $250,000,000,000 or so of its debts.

And yet, and yet, Citigroup’s stock price is about $5, which gives it a market value, according to Google Finance of about $32 billion.  That’s less than 10% of its share price two years ago and about 20% of its share price this time last year.

As a point of comparison, if the federal government gave us $45 billion, we would be worth $45 billion.  (Well, almost $45 billion, but a lot closer to $45 billion than $32 billion.  And, yes, we know there is a difference between the government’s preferred investment and market value of the common shares.)

Hmmm, without bothering to check the tax implications, let’s gross-up the loss of about $30,000,000,000 to the $45 billion.  That means that the government has subsidized all of the recognized losses to date.

So, despite the guarantee of debt, which could be valued the same way that banks estimate values of their insured deposits, and despite the additional deposit insurance coverage, etc., society and the world economy think that Citigroup isn’t worth a whole lot.¹

Diligent, and younger readers with good memories, may recall that as far back as September we separated the mortgage fiasco from the larger, and far more serious, liquidity crisis in confidence.  (Here’s an entry from early October: Even A Perfect Bailout Will Fail.)

We cite Citigroup as prima facie evidence of that distinction.  Based upon equity values–despite the government’s massive injection of funds and its guarantees–we’d say that the mortgage fiasco has informed investors throughout this country and across the world that’s Citi’s management excels at value destruction, and that’s the consensus prospective estimation.  That is, of course, unless investors estimate that recognized losses, which appear on financial statements, are only a fraction of Citigroup’s true losses so far.

This wouldn’t be the first time that Citigroup under-estimated its losses.  As the Journal editorial notes, in October, 2007, Citi officials claimed that it had only “$70 million in indirect exposure to subprime assets.”  Now, how many orders of magnitude is that from the truth?  So whether clueless or duplicitous, “why trust them?” the market seems to be saying.

In this case, it seems hard to argue with that logic.

By the way, the front page headline of today’s paper is “Citigroup Ready to Shrink Itself by a Third.” We wondered–in jest–why the second line didn’t read, “In Small Attempt to Align Assets with Equity Values.”

Like always, we may edit this post in the future, in case our early-morning, frostbitten fingers have erred.

Copyright © 2009 Spero Consulting.

Footnote:

Related posts:

• The Banks' Mark-to-market Gains on Debt
• Citibank? Bad Bank? Good Bank? How About Our Bank?
• Our Middle-class Morality
• Our Second Anniversary
• When the Going Gets Tough…Quit.

We’re neither sympathetic nor antagonistic towards Mr. Thain, who has only been in his position for a year; so, we take no glee in his being shut-out.  Hopefully, he’ll be able to make-do with his $750,000 salary, $15-$20 million signing bonus from late 2007, and his other accumulated wealth from his past executive positions.

What interests us in the article is the mention that Morgan Stanley plans to implement compensation schemes that include “claw back” features.  That means that in the future, the firm could recoup earlier bonuses if, say, a trader later blows up.

Please note that we are writing in generalities and not attempting to construct an optimal contract, but we do see claw-back features as moving in the right direction for both firms and employees.  (We’ve written positively about similar features before.)

At first glance, such clawbacks may seem to impose more risk on employees, but if they’re structured and used properly, they need not; thus, we’d expect them to be wealth-maximizing for the firm and expected-utility maximizing for employees.  That’s if they are constructed intelligently.

We’d hope that Morgan’s scheme is so constructed–to, say, claw back portions of a 2008 bonus because trades or investments made in 2008 subsequently go bad.

We hope that the firm does not attempt to claw back a portion of say, a 2008 bonus because the trader made a money-losing trade in 2009.  We understand the averaging effects of long-term contracts, but believe that such reprimands would likely be perceived as being arbitrary and capricious and subjective and would likely have two effects: (1) before-hand, many traders would leave to join hedge funds or to trade for themselves, and (2) those traders who did stay and win large bonus awards could be expected to become substantially more risk-averse in the future (because both the current period’s bonus and past bonuses were all still at stake).  In general, it doesn’t seem that most trading and investing firms want to induce traders to minimize risk; instead, it is to manage risk intelligently or efficiently.  If the goal were, in fact, to minimize risk, then paying a bonus as a function of profits would be a huge mistake in the first place.  There’s much cheaper ways to induce that behavior.

The Good: Besides claw backs, we’d recommend that firms continue to pay bonuses on earnings even after traders have left the firm–solely to induce them to behave and act in the firm’s long-term interests while they are employed.  It is very tempting to want to punish former employees for leaving or for a variety of real or perceived transgressions, but it is not necessarily the wisest policy nor fiduciarily responsible.

Unfortunately, it seems that UBS may have taken that course.

We’re very grateful that the WSJ article mentions that UBS implemented clawbacks in mid-November because we had previously missed that announcement in the press.

The Bad: In August, we commented on UBS’s plans to use phantom shares in its compensation schemes in Incentives at UBS and in General.  That plan seemed to impose a substantial–we mean excessive–amount of risk on its employees.  W would strongly encourage interested parties to read that post.

From our reading of a few articles more recent articles, especially this London Times article, UBS’s plan seems downright vindicative.  While that may be justified in the cases of former senior executives and while it may be satisfying to stiff employees in bad times, it’s generally not wealth-maximizing; it seems quite sub-optimal.

UBS calls a negative bonus a ”malus.”   Get it?  It substitutes “mal” for “bon” to get the opposite.  Very clever!

The Ugly: According to a Telegraph article, UBS will attempt to claw back previously awarded, but not distributed bonuses, if the bank under-performs, and it could recover up to two-thirds of the cash portion, which would be held in escrow for at least a year.  So imagine that you, Joe Trader, or more precisely Josef Trader, had a particularly good year in 2009, but the firm had completely horrible year in 2010; so, not only do you not get a 2010 bonus, but your 2009 bonus is gone, gone, gone.  How would you feel?  What are the odds that it could occur?  Is it worth taking the chance (bearing the risk) of such personal losses?  If it’s not, you may want to seek employment elsewhere.

The Times article mentions that Share-based bonuses won’t vest for three years and executives will be required to retain 75% of those shares for several more years, and the ”malus” system will apply to shares, too.  As we wrote in August and repeated above, such plans impose substantial risk on employees.  UBS should expect to pay higher compensation on average and expect an exodus of employees.  We’d guess that it would lose many of its best, most confident employees, and many of its most risk-averse, and especially the intersection of the two.  Would you, dear reader, tolerate such a scheme?

By the way, for exiting employees, all bonuses paid on departure will be subject to the “malus” system.  What are the chances that will be manipulated against the employee (as, say, a short-term way to boost current-period profits).

In that regard, we love this quote from the bank that appeared in the Telegraph article: “This should prevent any payments that prove to be inappropriate in the near future.” But, when did preventing any, which we take to mean “all” inappropriate, payments become the goal?

In economic models, profit-maximization in the short-term or wealth-maximization in the long-term do not imply the all costs can be eliminated.  We, and every other economist that we know, teach that there is an economic level of costs that maximizes profits.  Likewise, in decentralized organizations, all dysfunctional behavior cannot be eliminated without also eliminating the benefits of autonomy; it is throwing the proverbial baby out with the bath-water or being penny-wise and pound-foolish.  (See just about anything that we’ve written in our Illustrations and Fallacies sections, especially about extremists in Common Managerial Mistakes in Decentralized Organizations.)

We what find to be especially galling is the fact that intelligently-applied clawbacks are a great idea for both firms and employees, but unfortunately, if (as an early adopter) UBS botches its implementation–which given the information in the press seems highly likely–then other firms will likely be hesitant to use them.  That’s a shame.

If large firms want to eliminate risk, then we encourage to eliminate proprietary trading and operate relatively low-risk, low-margin businesses. That’s what we’ve recommended for government-insured firms in our aptly-titled post Eliminate Proprietary Trading at Insured Institutions.

We’ll likely edit and add to this post in the near future.

Copyright ©2008, Spero Consulting Incorporated.

Related posts:

• Incentives at UBS and in General
• The Children Who Have Eaten Their Cake…
• Ugly Is Not Harmful; It is Just Plain Ugly.
• Inefficient Bonus Schemes
• Tomorrow (Friday) Should Be Interesting

Have their collective managements through the years embraced of any single fad that led to sustainable improvements anywhere?

Now, it is true that many fads–and we are using that word pejoratively–contain useful recommendations and are consistent with effective and efficient management.  However, that’s only if such policies and techniques are thoughtfully applied to one’s particularly organization and situation, and that is a big, bold IF. 

Spending vast amounts of time and energy trying to get apply the inapplicable might be hard and expensive work and might require creativity and ingenuity, but it is almost always worthless, regardless of the satisfaction felt by completing a difficult project.

It’s our view that the thoughtful application of sound business policies and practices precludes the necessity for such fads in the first place.  A different perspective and specialized expertise are benefits that some consultants offer, but the wholesale revamping of only certain functions is usually myopic and often as senseless as fitting square pegs in round holes.  The fact that XYZ worked for firm RST in industry LMN means very little for firm ABC in industry DEF unless there are direct analogues.

Likewise, that fact that RST’s market value increased when it implemented XYZ means very little for firm ABC.  For example, one could ask: how were equity markets and industry indices moving in general during that the time of the implementation?  As we have all read many, many times, correlation is not causation, and correlation based upon a sample of one generally doesn’t mean much, either.

In every functional area–production, finance, sales, human resources–from quality circles and total quality management to supply-chain management and just-in-time inventories to process engineering–even robotics–to activity-based costing to EVA™ to knowledge management et cetera, et cetera, did the car-makers avoid or ignore a single one of them?    (We’ve actually forgotten many older fads or the list could have been longer.  We think that quality circles were after disco, but our memory fails.)

Were any faddish techniques thoughtfully applied?  Was the wheat, so-to-speak, ever separated from the marketing chaff? Did the success of the implementation (of a previous fad) preclude the adoption of a new one?  Were any of the programs true management innovations?

We wonder how much have the “Big Three” spent on large consulting firms that were marketing such fads and implementations during those thirty-five years?  To what benefit, and who measured the benefit?  The consulting company?

Was the downfall of the big three inevitable?  We don’t think so. 

Was the time to collapse lengthened or hastened by the purchase of those fads?  Could anything have been substituted for in place of those fads that could have provided longer, more persistent benefits?  Say, something like thoughtful, disciplined management with a solid understanding of the business of designing, manufacturing, and selling automobiles?

We doubt that one person could possess all of the requisite knowledge to master and directly control all operations and functions of a large auto manufacturer, but that’s not the point.  If senior management does not have the personal knowledge to design, build, and sell cars, then it needs the managerial knowledge and discipline to organize and control activities of those who do.  That’s not to be outsourced through a sequence of fads.

Without managerial knowledge and discipline, what hope–other than good fortune–does a firm, its employees, and its shareholders have to (1) avoid wasteful fads and other missteps in the short-term or (2) survive in the long-term?  This certainly seems to be true for firms with 60% market share in the late 1960s, and 50% market share in 1980, and 35% as recently as fifteen years, ago, and about 20% today.  (Of course, we’re speaking of GM, the big three still had nearly 60% of the domestic market as recently as 2003.)

What hope does a government bailout offer for institutions that have squandered so much?

Does anyone else imagine that Henry Ford is spinning in his grave?

Related posts:

• GM's New Owners
• Patience Please! They Just Need More Time!
• Contact
• Home
• Planes, Trains, and Automobiles and Banks and Farms and States…

There’s an article in the weekend edition of The Wall Street Journal, entitled, It’s a Done Deal: Merrill and BofA.  It is subtitled, “At Thundering Herd’s Last Meeting, Thain Presides Over Sadness and Anger.”

In previous posts we’ve already commented on a variety of related topics, including our dislike of mega-mergers, which concentrate idiosyncratic decision-making and exacerbate moral hazard issues. (For merger-related issues, see: Forced Mergers? Bigger Is Not Necessarily Better!, Bigger Is Not Necessarily Better or Idiosyncratic and Concentration Risk, Again.)  We don’t think that regulation or regulators provide much oversight or control.

Per the subtitle of the article, it seems that much of the anger was directed at the board (which does make sense since it was a board meeting) and we’ve commented about failed boards in other posts, too; see The Failure of Boards to Direct and When the Going Gets Tough…Quit for example.

So, in this post, we’re restricting our comments to a single, short paragraph from the article related more towards a human resource issue.

It seems that Winthrop Smith Jr., the son of one of the founding partners of Merrill Lynch, Pierce, Fenner & Smith spoke at the meeting.  (In fact, he may have been both sad and angry.)  As the reporters note, “Referring to the exodus of longtime executives at Merrill when Mr. O’Neal took over, Mr. Smith said, ‘shame on members of the board for never asking any of us who loved this firm’ why they were leaving.”

In our youth, we were part of a similar exodus; there were six junior colleagues, and five left the organization within months of each other.  (The other one did, too, but at a later date.)  As is always the case, an idiosyncratic or personal reason could be attributed to each person’s decision to leave: A left for family, B wanted to move to a warmer location, C didn’t like the office decor, etc., etc.

If the reasons were purely idiosyncratic, then the organization’s management would be blameless of poor employee relations.  It is even possible that in hindsight, someone within the organization to try to take credit for getting ridding of the deadwood–whether justified or not.  (Those things are very easy to take credit for in retrospect and when the people are gone: “they couldn’t cut it” or other such comments.)

If the organization were truly blameless, then the departures could neither been foreseen nor attributed to any central deficiency or weakness or dysfunctional personality within the organization.

However, a thoughtful, self-critical leader should be willing to ask: ”we’re sure that everyone has their own reason(s), but what are the odds of such an exodus without a centralized or systematic component?”  Per Mr. Smith, shouldn’t someone ask: “why are they all leaving?”  One shouldn’t expect answers from exit interviews as folks who are leaving have little reason to give more than pleasantries at an exit interview, and those who do complain are often dismissed as “someone with an ax to grind” so their feedback is never seriously considered disseminated.

In all likelihood, the probability that there was/is no systematic component is quite small.  We have no inside knowledge of whether the Merrill board investigated their exodus or not.  If not, we certainly empathize with Mr. Smith as it would then seem to be a case of either benign or purposeful neglect.

Of course, the presence or absence of a systematic component doesn’t explain whether the exodus was justified or not (from management’s perspective).  That is a separate issue which will depend upon whether the observed consequences were intended or not.

We talk about similar issues in a few of our essays–particularly, Common Managerial Mistakes in Decentralized Organization and the last part of Strategic Consistency and Managerial Discipline–and several posts, including Insidious Insecurity.

We’ll likely update the post when time permits.

Related posts:

• International Accounting Standards Will Save Us!
• The Absurdity of Hassling Grandma but not Nidal Hasan
• Have a Good Memorial Day!
• Clever, but not Devious.
• Justice and Untethered Ferry Rides

The weekend edition of The Wall Street Journal has a front page interview with Robert Rubin: Rubin, Under Fire, Defends His Role at Citi.

We’ve criticized Citi’s board in the (recent) past, and we’re still particularly fixated on the fact that few directors had financial industry experience.  That seems neither wise nor even prudent for a financial institution with over $3,000,000,000,000 of assets.  (That’s $3 trillion, but we like to write it out for effect, because it seems like a lot of money.)

As the article mentions, Mr. Rubin was “the only board member with experience as a trader or risk manager.”

Since 1999, Mr. Rubin has made about $119 million from Citigroup while having no operating responsibilities.  We have absolutely no problem with that, and, in fact, are looking for similar “work” ourselves.  (Interested parties may use our contact form.)

Where we do have a problem is his insistence that none of Citi’s problems is his responsibility.  As the inside headline reads: “Rubin Blames Citigroup’s Woes on the Broader Financial Crisis.” He almost seems to imply that Citigroup is a hapless, unwitting victim of something bigger than itself–something it couldn’t be expected to consider, manage, of fathom: “Nobody was prepared for this…”

In that case, exactly what type of stewardship, guidance, and profundities did he provide?

Suppose it is true that Citi and its board were faultless.  Shouldn’t they have been able to consider how they might be damaged by a general downturn or a financial crisis that was no fault of its (their) own.  Thus, our little proof-by-contradiction shows the silliness of the argument.

Moreover, we doubt that even the gullible buys the story that Citi was simple a victim of exogenous factors, which were unpredictable and beyond its control.

There is a crisis of confidence, but that crisis erupted and survives because markets and investors realized the large financial institutions, including Citigroup, were far less competent investing and trading than they previously believed, i.e., that in retrospect, previous reported profits were unreal and unsustainable.

Citigroup’s share price of $8.29, which is about double where it was last weekend, has lost about 85% of its value in two years.  (In the first three years of the Great Depression–1929 – 1932–the Dow Jones Industrial Average lost the same percentage without a backstop by government.)  That is an indictment against Citigroup’s way of doing business far beyond the general condemnation of the financial services industry in general and with all of the subsidies provided by tax payers through the various recent government guarantees and bailout measures.

Clearly, investors find fault with Citi’s strategic and operating decisions.  So, if Mr. Rubin wasn’t making operating decisions, what type was he making?  If they weren’t strategic, what remains?  As other critics note, Mr. Rubin is “trying to have it both ways.”

Of course, his posturing is silly, as it was he, himself, who pushed senior management to bear more risk in 2004 – 2005.  If that’s not a strategic, board-level, decision, what is?  From our reading, it seems that he may now be trying to blame a consultant for suggesting the board instruct managers to take additional risk.

He also blames senior management for not executing the strategic plans properly and risk management for, well, weak risk management.

“I wouldn’t run a financial institution based upon someone’s view about what markets would do.”

Of course, as the article explains that is exactly what he did in 2004 – 2005.  (We wouldn’t doubt that he did it at other times, too, but don’t have the time or energy to search for quotes or stories.)  Well, he didn’t do it based upon someone else’s view; instead, Citi’s strategy seemed to be based upon his own views.  (We could well imagine boardroom discussions where inexperienced directors immediately defer to the former Treasury Secretary and Goldman Sachs Co-Chair.

Now, Mr. Rubin should know that developing and acknowledging such a world-view is exactly how financial institutions are run, whether that view is explicitly stated or not.  (If it is not explicit, then not providing such a view and or considering its implications seems negligent at worst and immature at best, ergo, our title.)  What else could strategic and operating plans be based upon?  How else could risks be measured, uncertainties be considered, and contingencies be planned? Or are those considerations too much like work?  If so, it is not difficult to see why Citi is where it is at this November, and that is completely consistent with both a specific and the more general crisis in confidence.

As we see it, Mr. Rubin is seventy-years-old.  He should grow-up and accept the responsibilities that come with his position and rewards, and stop behaving like a petulant teenager.

Related posts:

• Nobody Cares*
• The Harvard-Yale-CALPERS Cycling Club
• Rough God Goes Riding
• Text Messages and The Music Man
• Mininum Wage of Zero ($0)

We’re rather diligent–but not obsessed– about keeping up with financial new.¹  We’ve heard many financial firms announce lay-offs and have read how at a few, like Goldman, senior managers have decided to forgo bonuses.

As we recall, most banks have announced withdrawals from subprime mortgage origination and loans, which seems like a wise move, but given the magnitude of their errors and mistakes, we’re very surprised that we haven’t read more about banks taking dramatic and drastic actions to limit risks and exposures.

We don’t mean hoarding cash and the knee-jerk reactions not to lend.  We’re thinking more about their investing, trading, and structuring operations.

Maybe the banks are eliminating desks and floors, but they just aren’t talking about it, or maybe they have mentioned it, but we’ve missed it.

We’d certainly encourage financial firms to change their ways.  In fact, while we’re close to Libertarian on many economic issues, we wrote on October 11, to Eliminate Proprietary Trading at Insured Institutions as a way to mitigate moral hazard and protect tax-payer interests. (Once they’re insured, it is no longer a free market, and there should be quid pro quo, not just subsidization.)

On September 24, in our post Could a “Bailout” Prolong the Financial Crisis?, we wrote:

So, if the government’s purchase of these thingies is approved, we would expect to see a continuation of the panicky behavior until the securities are actually transferred to the government because it is unlikely that anyone will know who has the worse ones so (means that) all remain suspect. (Also note that the most panicky firms might be ones who are projecting their portfolios onto others, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity market performance, particularly among financial firms, supports our September 24th prediction above, i.e., the continuation of panicky behavior until actual transfers occur.  We discussed related issues on October 7, in Even A Perfect Bailout Will Fail.

Or maybe they’re just taking a wait-and-see approach. That’s what we predicted in early October when we described the very high probability of failure of TARP.

Today’s Wall Street Journal reports that Citi Weighs Its Options, Including Firm’s Sale, and we wonder if it will survive the weekend.

As we argued in Bigger Is Not Necessarily Better way back in September, we see no reason to encourage mega-mergers and we based that argument on both moral hazard and systematization of idiosyncratic risk considerations.

So, as we argued in around October 10, we believe that It’s Time! to nationalize the worst offenders leaving no shareholders, except non-executive employees, with any ownership interests.  We reiterated much of the same argument in a very long post from Wednesday: OMG, Mr. Paulson Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we taxpayers will be on the hook for Citi, anyways, so why not eliminate the middleman and provide any upside benefit to the true residual claimants?

In two recent posts, The Failure of Boards to Direct and When the Going Gets Tough…Quit, we’ve criticized the composition of Citigroup’s board because of their general lack of financial industry experience.  (We’re sorry, but that seems unconscionable to us.)

We won’t repeat all of our arguments for nationalization, but the expropriation of Citigroup would certainly motivate other banks to act quickly and largely to mitigate risks and stabilize cash flows.  (It would likely stop insurance companies and others from buying small banks or S&Ls in their beggarly attempts to become bank holding companies.)

By the way, for new readers, we’re not just for the nationalization of a few banks, we actually have a private solution for the mortgage crisis that involves providing the right tax incentives–like investment tax credits–to individuals, firms, and fund managers.  (Read about it here:  A Better Solution (than a government takeover).)

That solution to the mortgage crisis stills leaves the larger liquidity or confidence crisis for banks.  That has arisen because the mortgage crisis has informed us (and others) that despite their pseudo-sophistication and the veneer of objectivity and science (almost), there is a very good chance that they don’t understand their environment or have reliable ways to value many of their products–despite their massive investments and activities for those purposes.  In terms of an adverse selection problem, they’ve reveal themselves to be low types.  (See last week’s Global Warming and the Mortgage Crisis for a discussion on that topic.)

So, as a nation, we should want (and attempt to motivate) the banks to act quickly and decisively (and with their private information) to get their accounts in order.

The benefits of TARP don’t seem to have provided the correct motivation to the banking firms to act to maintain their own liquidity and capital positions.  We’d argue that this is an incentive problem and that if the benefit of the TARP “carrots” have been insufficient motivate socially-optimal behavior. So, perhaps a “stick,” like the threat of expropriation, induce clean-up.  Moreover, it is seems that Citi will be ours anyway, so, why not give it a try on taxpayers’ terms rather than taxpayers’ backs?

Related posts:

• Citibank? Bad Bank? Good Bank? How About Our Bank?
• Bill's and Bill's*
• What ‘Miranda’ Rights?
• Prop Trading and Pay at Banks
• The Seventy-Year-Old Teenager