‘Control’ Category

We Missed It a Few Months Ago

On the front page of the The ‘Money & Invest­ing’ sec­tion of today’s edi­tion of The Wall Street Jour­nal, there is an arti­cle enti­tled, At SEC a Scholar Who Saw It Com­ing.

The arti­cle is about Henry Hu, who man­ages the newly-​formed Risk, Strat­egy and Finan­cial Inno­va­tion divi­sion at the SEC.

Though he sounds like a good guy, we don’t know much about Mr. Hu, but that’s not why we’re writ­ing. It also men­tions that in Novem­ber, Mr. Wu hired Richard Book­staber to lead staff train­ing and data analy­sis, and that is a good thing. (The print ver­sion incor­rectly iden­ti­fies him as David Bookstaber.)

If you haven’t heard of Mr. Book­staber, he has much knowl­edge and much expe­ri­ence work­ing at large trad­ing firms and hedge funds. In fact, he takes “par­tial credit” for a few of the past crises, includ­ing the Crash of 1987.

Mr. Book­staber is also the author of the 2007 book, A Demon of Our Own Design, which dis­cusses those crises, his roles in them, as well as his approach to risk (and uncer­tainty) management. We highly rec­om­mend the book to any­one in the finan­cial ser­vices indus­try and within par­tic­u­lar roles in other indus­tries, too. For exam­ple, we recently rec­om­mended it to the chief of secu­rity at a large, U.S. based, multi­na­tional that oper­ates fac­to­ries and plants through­out the world.

In the book, Mr. Book­staber makes the excel­lent point that overly-​rigid or overly-​complex risk mon­i­tor­ing and safety sys­tems can actu­ally increase the prob­a­bil­ity of fail­ure and the loss given fail­ure and dis­cusses it both within and out­side of finan­cial ser­vices. (Recently, we made sim­i­lar points in our analy­sis of intel­li­gence fail­ures and bad infor­ma­tion sys­tem design.)

Besides read­ing the book, we also encour­age our read­ers to visit Mr. Bookstaber’s blog, espe­cially to read his tes­ti­mony before Con­gress – the links in the right-​hand col­umn). It is well-​written and not overly-​technical.

Regard­ing risk and uncer­tainty man­age­ment, Mr. Book­staber makes points sim­i­lar to ours, with the main inter­sec­tion being that not every cri­sis is pre­dictable, but thought­ful­ness and con­tin­gency analy­sis goes a long way to mit­i­gat­ing crises. In fact, prepar­ing (rather) gen­eral responses to pos­si­ble, spe­cific crises can pre­pare one for com­pletely unknown ones, too. (See our essay on uncer­tainty man­age­ment and almost any of our posts cat­e­go­rized as uncer­tainty or risk. By the way, we really like our post with the tongue-​in-​cheek title, The Role for Sur­vival­ists and Depres­sives in Uncer­tainty Man­age­ment, because we think that per­son­al­ity traits like skep­ti­cism and pes­simism are under-​weighted and under-​valued in most risk man­age­ment hir­ing process.)

The best that we can tell, we tend to place more empha­sis on stress-​testing and sce­nario analy­sis than he does, but that’s because we think that imag­i­na­tion, like skep­ti­cism, is under-​estimated, too.

One topic where we do dis­agree is his insis­tence that every­one (that mat­ters) under­stands the lim­i­ta­tions of the use of nor­mal dis­tri­b­u­tions in risk mea­sures like VaR (Value at Risk). To explain, 2e’ll try to be con­cise but thor­ough but will err on the side of brevity.

It is well-​known – though not wholly-​agreed-​upon – that assum­ing nor­mal­ity (or log-​normality) mis-​specifies mod­els of returns, and we think that many ‘quants’ do know that, but they use those assump­tions nonethe­less, and that’s for a few reasons:

1. There is no other choice, or no other tractable choice.
2. Depend­ing upon the con­text, it may not mat­ter much.
3. Ease of cal­cu­la­tion and effort. (This is dif­fer­ent than (1).)
4. As a way to reduce mea­sures of risk characteristics.
5. Ease of com­mu­ni­ca­tion to others.

We are very sym­pa­thetic to the first two rea­sons, and being some­what lazy, we are also sym­pa­thetic to the third. However, the fourth rea­son hints at cyn­i­cism and greed and, depend­ing upon who is using the mea­sure, it can be very destruc­tive. Also, if such assump­tions are used for oppor­tunis­tic rea­sons, that can indi­cate the tra­di­tional weak­ness of risk man­age­ment vis-​a-​vis revenue-​generating departments.

The fifth rea­son hints that maybe – just maybe – not every­one under­stands the cal­cu­la­tions and assump­tions and their flaws.

We have dealt with very high-​level man­agers at very large firms who are quite igno­rant of the basic char­ac­ter­is­tics of nor­mal dis­tri­b­u­tions. To their credit, a few were quite will­ing to admit as much. (They are the least harm­ful of the bunch.) But given those expe­ri­ences, it is dif­fi­cult to believe that most board direc­tors under­stand the arith­metic; so, it is dif­fi­cult to accept that all senior man­agers (at such firms) under­stand the cal­cu­la­tions; so, it is dif­fi­cult to believe that all other man­agers, traders, sales­men, and investors are knowl­edge­able and well-​informed. (And, boy, could we tell you sto­ries!) The fact that, as Mr. Book­staber points out in his tes­ti­mony, such top­ics appear in text­books is a non sequitur.

When one com­bines cyn­i­cism with mis­com­mu­ni­ca­tion – whether pur­pose­ful or not – there’s a good chance that the orga­ni­za­tion is bear­ing more uncer­tainty and risk that it imag­ines or mea­sures, and that’s not good. So, that fact that “every­one knows” some­thing – even if it that some­thing is true – doesn’t mean that it’s not abused. For exam­ple, pick any vice that every “knows” is wrong but folks do it any­way. The abuse of ille­gal drugs and obe­sity are two anal­o­gous exam­ples. (Oh, by the way, gov­ern­ment reg­u­la­tion doesn’t seem to help much there, either.)

Finally – almost – these last two issues hint at incen­tive prob­lems – both moral haz­ard and adverse selec­tion – that exist within firms, and we’ve writ­ten exten­sively about that, too, e.g., Incen­tives and the Finan­cial Cri­sis and many more.

In sum, while we have never met Mr. Book­staber and likely never will, we are encour­aged to see the SEC hire such a knowl­edge­able and wise per­son. We wish him the best in his new role. (We only wish that we would have done so a few months earlier.)

The Out­rage Makes Them Larger

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 coöper­a­tive 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

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Foot­notes:

Given the past two days’ front page head­lines in the The Wall Street Jour­nal, it seems that banks are doing a lot of brac­ing. Monday’s head­line announced that Banks Brace for Bonus Fury, and today’s head­line announces that Banks Brace for Bailout Fee.

The first arti­cle notes of com­plaints by the pub­lic and gov­ern­ment offi­cials about bonuses paid for 2009 ‘results.’ The sec­ond arti­cle describes a likely attempt by fed­eral offi­cials to, in some sense, mon­e­tize those com­plaints by levy­ing new fees onto banks. (Soon, we’ll soon pub­lish a related post regard­ing the inef­fi­ciency of many of the bonus plans.)

There is some­thing dis­turb­ing about large bonuses at sev­eral, if not all, of the firms that are fre­quently men­tioned in the press. That’s because firms like B of A (and its sub­sidiary Mer­rill Lynch) and many oth­ers did not gen­er­ate last year’s gains and prof­its on their own. They could not have gen­er­ated those prof­its on their own. So, regard­less of their repay­ment of the TARP funds, it doesn’t seem that all those prof­its should be theirs to use or dis­trib­ute in what­ever man­ner that they choose.

Thus, the pub­lic has a right to com­plain about the pay­ment of the sub­si­dized bonuses, but don’t blame the employ­ees at the firms; instead, blame the gov­ern­ment for not hav­ing thought through the impli­ca­tions of its guar­an­tees and promises when it made the invest­ments. It was another case of very short-​term think­ing by our elected and appointed officials.

To be sure, it is highly likely that many dili­gent and earnest work­ers per­formed well and earned their bonuses, but for many others, profits were rec­og­nized only because the fed­eral government’s guar­an­tee kept many of their firm viable and/​or credit-​worthy.

It wasn’t the pre­ferred stock invest­ment that kept the firms alive when their counter-​parties and oth­ers had lost faith nor the sub­se­quent increase of some silly cap­i­tal ratio. You seen cap­i­tals ratio et. al., are non sequiturs dur­ing a liq­uid­ity cri­sis. If the firm doesn’t have cash and can’t raise it because no one will buy its hold­ings or invest in it, its can’t sell the cap­i­tal ratio or use it for collateral.

It was the government’s guar­an­tee to each firm that was deemed “too big to fail” that saved it one of them and allowed their trad­ing part­ners to prosper.

Those guar­an­tees made the gov­ern­ment the de facto resid­ual claimant despite its small, for­mal own­er­ship stake (in pre­ferred stock for the most part).¹

The prob­lem is that the gov­ern­ment didn’t do a very good job of nego­ti­at­ing the terms of those guarantees.

At the time of the TARP invest­ments and promises, our pub­lic ser­vants pan­icked. They didn’t take the time to demand covenants and restric­tions on the future use of funds nor did they charge an ade­quate fee for sav­ing the insti­tu­tions.² As we wrote at the time, we thought the fees should include many rolling heads and the elim­i­na­tion of much com­mon equity.

Given that, it’s a lit­tle bit ironic and quite a bit silly for gov­ern­ment offi­cials to com­plain about cur­rent com­pen­sa­tion lev­els and 2009 bonuses. If the gov­ern­ment wanted to do some­thing about bonuses it should have restricted them when it injected the cash and guar­an­teed the firms’ sur­vival.³ It shouldn’t whine now or attempt to apply retroac­tive fees although charg­ing sub­stan­tial fees for the con­tin­ued sub­si­diza­tion is okay with us.

A long aside: at first glance, reg­u­lar read­ers may regard our opin­ion as incon­sis­tent with our sup­port last sum­mer for Andrew Hall in his dis­pute with Citigroup, but it’s not. See Prop Trad­ing and Pay at Banks.

Our points then were:

1. The gov­ern­ment and reg­u­la­tors had no author­ity to abro­gate con­tracts, includ­ing pay con­tracts. So, Citi should give him his due.
2. Bank­ruptcy does pro­vide the oppor­tu­nity to rene­go­ti­ate con­tracts, but the gov­ern­ment wouldn’t let events run their course. Arbi­trar­ily abro­gat­ing (or dishonoring) contracts is uncon­sti­tu­tional. More impor­tantly, main­tain­ing the dis­ci­pline to uphold seem­ingly unpop­u­lar con­tracts is cen­tral to main­tain­ing the Rule of Law. It dis­tin­guishes the U.S. from many other nations, and that col­lec­tive self-​restraint makes this a great (and gen­er­ally pre­dictable) nation.
3. Mr. Hall and all other pro­pri­etary traders should find new, unreg­u­lated places of employ­ment, where they can reap the rewards of their com­bined clev­er­ness and efforts but also bear the risks of fail­ure. (It seems to have worked-​out well for him, and we sus­pect would work out bet­ter for most traders.) See our post Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions.

We pre­sume that Mr. Hall and Phi­bro would have made those gains with or with­out Citi; so, the gov­ern­ment sav­ing Cit­i­group had lit­tle effect on his trad­ing strate­gies. (Who knows? His gains may have been larger with­out Citi and with more capital.)

Why do we whine about about our pub­lic ser­vants whin­ing and try­ing to impose fees? Well for two rea­sons: (1) it’s annoy­ing to her them com­plain about com­pletely pre­dictable behav­ior that they induced and (2) the cur­rent sit­u­a­tion is no dif­fer­ent than the sit­u­a­tions that the gov­ern­ment cre­ated at Fan­nie and Fred­die when those two thin­gies were pay­ing large bonuses for “per­for­mance” that was wholly-​subsidized by the gov­ern­ment. That cre­ated and/​or exac­er­bated moral haz­ard prob­lems then and will now, too.

In con­clu­sion, note that we’re not resent­ful or envi­ous of any­one get­ting a large bonus, and we hope that folks enjoy them, but we do blame the bureau­crats at the Trea­sury and the Fed for not con­sid­er­ing this out­come in the fall of 2008 and early 2009. Fur­ther­more, we don’t see the pro­posed appli­ca­tion of an arbi­trary, ex post tax as any­thing other than vin­dic­tive­ness or the appease­ment of the pop­ulist mob. Either motive should be beneath our fed­eral officials.

Finally, note that we’ve com­plained about sim­i­lar gov­ern­ment actions in the past. For exam­ple, see The Chil­dren who Have Eaten their Cake… and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary and Dan­ger­ous.

We really like Ambas­sador John Bolton’s opin­ion col­umn, Let’s Take Bureau­cracy Out of Intel­li­gence, which appears in today’s edi­tion of The Wall Street Jour­nal, and we like it for the usual rea­son: his iden­ti­fi­ca­tion of the cause of government’s recent intel­li­gence fail­ure and rec­om­men­da­tions are sim­i­lar to ours.

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?

“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.)

Is There a Dif­fer­ence? Sometimes.

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.

Mak­ing Infor­ma­tion Tech­nol­ogy Work for You…Finally

We’re not sure if our vague title is a good one because regard­less of the for­mal­ity of their other “infor­ma­tion” sys­tems, every firm and orga­ni­za­tion already has at least one rel­a­tively inex­pen­sive, web-​based, man­age­ment infor­ma­tion sys­tem (MIS). That sys­tem is e-​mail, includ­ing the mes­sages and the myr­iad of hideous, incon­ve­nient, and awk­ward Word, Excel, and pdf doc­u­ments that are so often attached to said messages.

The low cost of e-​mail-​as-​information-​system isn’t the issue. At issue, is whether greater ben­e­fits can be real­ized by using more appro­pri­ate web appli­ca­tions that can be imple­mented at very low mar­ginal cost: both finan­cial and human-​effort-​related costs. The systems/​applications are cheap and easy-​to-​learn.

E-​mail as the Cen­tral Ner­vous System

It’s our con­tention that most man­agers, includ­ing “IT” man­agers, don’t rec­og­nize e-​mail for what it is.

It is the metaphor­i­cal cen­tral ner­vous sys­tem of their firms and orga­ni­za­tions. (We have in mind the somatic ner­vous sys­tem, whereas trans­ac­tion pro­cess­ing and data-​processing, in gen­eral, remind us of the auto­nomic ner­vous sys­tem.)

With­out that recog­ni­tion of e-mail’s cru­cial role, there is no rea­son to search for a sub­sti­tute that is supe­rior at cer­tain infor­ma­tion pro­cess­ing, trans­mis­sion, reten­tion, and retrieval func­tions. (Oh well, we guess we’ll con­sider it our lit­tle secret, share it with that hand­ful of peo­ple who read blogs on the inter­net, and con­tinue to profit from that realization.)

We ask: if senior man­agers both in and out of “IT” did rec­og­nize the true use of their firms’ e-​mail sys­tems, how would they jus­tify silly, fear-​of-​litigation-​based, 60-​day e-​mail “reten­tion” poli­cies? We don’t think that they would. In which case, they might stop toss­ing the prover­bial baby with the bathwater.

By that we mean senior man­agers under-​estimate or com­pletely ignore the long-​term ben­e­fits of reten­tion because (1) the seem­ingly pri­vate, per­son­al­ized nature of mail, (2) the form of those mes­sages obscures their infor­ma­tional con­tent, or (3) they may con­clude that the attach­ments are saved; so, what’s to lose.

We argue that vol­umes of qual­i­ta­tive infor­ma­tion, includ­ing valu­able insti­tu­tional details and his­to­ries and assump­tions, are lost when mes­sages are deleted or when Word doc­u­ments are deleted or purged when an employee quits, is fired or is trans­ferred or when oxymoronically-​named “reten­tion” poli­cies are ruth­lessly applied to mes­sages on a mail server.

No, we don’t think that would hap­pen if those mes­sages were viewed for what they are: an inel­e­gant, qual­i­ta­tive infor­ma­tion sys­tem and data­base, rather than mere correspondence.

Of course, almost all orga­ni­za­tions – par­tic­u­larly large, multi-​locational ones – have other sys­tems that col­lect and trans­mit enor­mous sets of data over the inter­net. Some­times those sys­tems trans­mit infor­ma­tion, too, but trans­mis­sion of valu­able infor­ma­tion is prob­a­bly a much smaller activ­ity than most assume). In that sense, we would dis­agree with those who argue that mod­ern times present some dan­ger of infor­ma­tion over­load, because there is rarely infor­ma­tion overload, but with­out a bit of expe­ri­ence and a clear thought-​process and a bit of self-​confidence, it is quite easy to become over­whelmed with irrel­e­vant data, (or so we’re told). That “over­load” that some folks face is sim­i­lar the old adage about “not see­ing the for­est because of the trees.” With respect to irrel­e­vant data, it’s more of an issue of not being able to see the beau­ti­ful maple for­est because of all the weed sumac trees.

To be clear, there’s a time and place for and value to data pro­cess­ing, but too often folks – who should know bet­ter – con­flate data pro­cess­ing sys­tems and infor­ma­tion sys­tems. In fact, most firms don’t refer to data pro­cess­ing as “data pro­cess­ing” any­more – many call it “infor­ma­tion tech­nol­ogy” or “IT” or some such thing. Our point is that not all data and records are informative. In fact, we would argue that most records in such mis­named “infor­ma­tion sys­tems” are irrel­e­vant for the typ­i­cal and impor­tant oper­at­ing and invest­ment deci­sions that mid­dle– and senior man­agers make. (In our expe­ri­ence, that infor­ma­tion comes from e-​mails and attach­ments and not through either silly, eso­teric dash­boards or the mass of details recorded via mil­lions of transactions.)

Again, data-​processing is valu­able for a vari­ety of pur­poses, pri­mar­ily record-​keeping and book-​keeping pur­poses, but “pro­cess­ing” data doesn’t nec­es­sar­ily con­vert it to infor­ma­tion – if it is never con­sid­ered as a fac­tor in a deci­sion. (One our pet peeves involves that fact that few sys­tems design­ers begin their projects by ask­ing: what deci­sions do you make and what deci­sions could you make (or make bet­ter) with more refined information?”

We men­tion data pro­cess­ing because we think that if a man­ager can’t dis­tin­guish between data-​processing pro­ce­dures from infor­ma­tion sets and sys­tems, then it likely that such a per­son may also ignore the impor­tance of e-​mail as the cen­tral infor­ma­tion sys­tem because the con­tent of those mes­sages aren’t viewed for what they are: fields and records in a large, unwieldy, and self-​deleting data­base. (Self-​deleting where such reten­tion poli­cies exist.)

We are very inter­ested in help­ing firms and orga­ni­za­tions make opti­mal deci­sions with the “opti­mal amount” of rel­e­vant infor­ma­tion, and we’re espe­cially inter­ested in devel­op­ing con­trol sys­tems that sys­tem­atize, facil­i­tate, and moti­vate such decision-​making by sub­or­di­nates. (FYI: in our mind, infor­ma­tion sys­tems are a type of con­trol sys­tem. When they are well-​designed, they help orga­ni­za­tions accom­plish their goals; so, they meet our def­i­n­i­tion of con­trol. Also, note that we put “opti­mal amount” in scare quotes because that deter­mi­na­tion of opti­mal, in and of itself, is a very sub­tle issue that has strate­gic, tac­ti­cal, and oft-​ignored behav­ioral impli­ca­tions.) The cru­cial man­age­ment issue is: when given the organization’s goals and strate­gies and resources and con­straints, what sys­tems – includ­ing infor­ma­tion sys­tems, and mech­a­nisms are avail­able to effi­ciently and con­sis­tently imple­ment those plans to max­i­mize the organization’s long-​term value. Unfor­tu­nately, the MIS por­tion of that prob­lem is often del­e­gated and not prop­erly con­sid­ered, e.g., “I don’t know much about com­put­ers. That’s an IT issue.”

It is also unfor­tu­nate that because e-​mail serves other pur­poses like com­mu­ni­ca­tion to assist with imple­men­ta­tion and coör­di­na­tion of plans, etc., and because it is the default and de facto key man­age­ment infor­ma­tion sys­tem, we con­tend that lit­tle con­sid­er­a­tion is given by any type of man­ager to find­ing “bet­ter” replace­ments for e-mail’s infor­ma­tion trans­mis­sion role, includ­ing the easy stor­age and retrieval of all of the insti­tu­tional knowl­edge and details found in mes­sages sent and received among peers, supe­ri­ors, and subordinates.

But, no wor­ries, we have a solution.

A Bet­ter MIS than E-​mail

That above-​mentioned lack of con­sid­er­a­tion is shame­ful because nowa­days, sur­pris­ingly afford­able, very user-​friendly, open-​source soft­ware and web appli­ca­tions exist that bet­ter serve the MIS purpose.

Those appli­ca­tions allow orga­ni­za­tions of any size to very effi­ciently and effec­tively cre­ate and use internet-​based infor­ma­tion sys­tems, and those surprisingly-​inexpensive meth­ods have the poten­tial – nay, the high prob­a­bil­ity – to pro­vide tremen­dous long-​term benefits.

• The best part is that there is very lit­tle – actu­ally, noth­ing for most employ­ees – to learn. If they can write e-​mails, cre­ate MS Office doc­u­ments, and attach files, they already have the exper­tise that they need to use a dif­fer­ent plat­form. (We’re amused by the fact that it doesn’t seems that most devel­op­ers of those sys­tems appre­ci­ate their use­ful­ness of them as the front-​end of data­bases because they tend not to be employed by large organizations.)

Note: we’re not rec­om­mend­ing the whole­sale elim­i­na­tion of e-​mail. Instead, we rec­om­mend replac­ing it for cer­tain func­tions with web-​based pub­lish­ing sys­tems that, for exam­ple, will auto­mat­i­cally notify intended recip­i­ents that new con­tent is avail­able, which if you think of it, is very sim­i­lar to receiv­ing an e– mail mes­sage. (Here’s one sign your firm may need a dif­fer­ent sys­tem: if impor­tant top­ics gen­er­ate an nearly end­less chain of mes­sages and replies. Those chains should be com­mu­ni­cated and stored out­side of an e-​mail sys­tem but we don’t mean in MS Office-​based doc­u­ments. We mean web-​based pub­lish­ing systems.

• The other best part is that every­thing that employ­ees write or com­ment upon is search­able (by them­selves and oth­ers) because it is stored in a well-​protected, cen­tral­ized, free, open-​source data­base. (We use MySQL to store our musings.) If per­mis­si­ble, that access is imme­di­ate and per­ma­nent. So, what is assumed and dis­cussed today is not lost in the future. That means that insti­tu­tional knowl­edge can be saved and cheaply re-​used thereby mit­i­gat­ing the age-​old prob­lem iden­ti­fied by George San­tayana: “Those who can­not remem­ber the past are con­demned to repeat it.”
• The other best part is that form of the qual­i­ta­tive data and infor­ma­tion and the result­ing data­base is dynamic and adap­tive (and infor­mal) so that infor­ma­tion cre­ators and providers, say, finan­cial ana­lysts or sales­men, can (rather uncon­sciously) add to and change the struc­ture with­out any inter­fer­ence or delay by “IT” depart­ment admin­is­tra­tors. Respon­si­ble users with the cor­rect level of per­mis­sion can re-​categorize con­tent and add new key­words or fields (as eas­ily as they add new “records” that fit exist­ing fields, top­ics, and categories).

Note that the last bul­let is enough to send most “IT” man­agers into apoplexy.

The sad fact that many such “IT” man­agers would never per­mit such evo­lu­tion­ary processes when learn­ing occurs and/​or as the envi­ron­ment changes is the huge oppor­tu­nity cost of their rigid, bureau­cratic nature and processes. (We ask as an aside: how many “IT” folks start projects by ask­ing: “what deci­sions do you make?” or how many con­sider the behav­ioral impli­ca­tions of sys­tem struc­ture and design? How many pro-​actively ask whether infor­ma­tion require­ments have changed with­out prod­ding or requests by oth­ers? Maybe they should write the acronym, “iT” or just plain “T” because in our mind, there is lit­tle empha­sis on pro­vid­ing infor­ma­tion – lots of data, to be sure, but not much info.)

Despite our well-​reasoned and con­vinc­ing prose, we’re skep­ti­cal that large, bureau­cratic orga­ni­za­tions would ever con­sider using such excel­lent sys­tems as a replace­ment for some cur­rent func­tions of e-​mail. (So, we’ll focus our mar­ket­ing efforts on small and mid-​sized firms that, with any luck, will grow into intelligently-​managed, prof­itable, grate­ful, and gen­er­ous large firms.)

Obvi­ously, many large orga­ni­za­tions spend mil­lions if not hun­dreds of mil­lions if not bil­lions of dol­lars on data pro­cess­ing, but, again, we don’t data col­lec­tion and trans­ac­tion pro­cess­ing. We mean the actually-​used man­age­ment infor­ma­tion sys­tems, and are we writ­ing about intel­li­gently gen­er­at­ing, sav­ing, and access­ing both qual­i­ta­tive and quan­ti­ta­tive infor­ma­tion. That means mak­ing every word that would have otherwise-​appeared in an erst­while MS Word doc­u­ment is imme­di­ately search­able by any­one (with per­mis­sion) by post­ing it to a cen­tral data­base using a web form/​editor that looks very sim­i­lar to Word. The future is now – if your firm and staff is ready for it.

If fact, the rec­om­mended pro­ce­dures aren’t much dif­fer­ent than writ­ing this post or read­ing this post or search­ing our site or receiv­ing an RSS feed on par­tic­u­lar cat­e­gories or top­ics or tags.

That’s why we see the cap­ture, trans­mis­sion, reten­tion, and retrieval of both stan­dard and non-​standard qual­i­ta­tive infor­ma­tion as a huge ben­e­fit to firms hooked on some­thing as inef­fec­tive as e-​mail.

With inex­pen­sive form-​generation soft­ware and with (auto­mated) scripts, it is quite easy (and cheap) to cap­ture quan­ti­ta­tive infor­ma­tion as well as stan­dard­ized, qual­i­ta­tive infor­ma­tion and data. How inex­pen­sive? You would be amazed!

Con­tact us for more information.

We’ll likely add to this post and con­tinue to revamp it in the near future.

Copy­right © Spero Con­sult­ing 2009

William McGurn has an excel­lent col­umn in today’s edi­tion of The Wall Street Jour­nal. It is enti­tled, “My Big Fat Gov­ern­ment Takeover.”

In the col­umn, he decries those in favor of gov­ern­men­tal solu­tions to all man’s ills, and he men­tions that lack of humil­ity of those like Pres­i­dent Obama and his ilk, who believe that a few “smart” peo­ple with cen­tral­ized power can solve the nation’s (and the world’s) prob­lems. (Yet, they can’t pre­vent party-​crashers to a state din­ner. Good luck with that.)

We want to empha­size the hubris (and the mis­guided and mis­placed faith in them­selves) because it is the per­fect mes­sage on this date, Decem­ber 8, the Feast of the Immac­u­late Conception.

Whether know­ingly, by coin­ci­dence or through the Grace of God, Mr. McGurn’s col­umn relates well to the bible read­ings (and we’re sure to many of the hom­i­lies) on this Holy Day of Oblig­a­tion for Catholics.

As many Catholics know – and all of them should know – today is the Feast of the Immac­u­late Con­cep­tion, which cel­e­brates Mary’s con­cep­tion and per­pet­ual state of grace. (A fair num­ber of Catholics con­fuse the Immac­u­late Con­cep­tion with the Annun­ci­a­tion, when Mary is vis­ited by the Angel Gabriel, and learns (and accepts) that she is to be the mother of our Lord. That’s partly their fault for not pay­ing atten­tion and partly because the Gospel read­ing for today is, in fact, the Annunciation.)

The first read­ing, from the Book of Gen­e­sis, recounts Man’s Fall from Grace, while Luke’s Gospel of the Annun­ci­a­tion gives the Angel Gabriel’s greet­ing, “Hail, full of Grace! The Lord is with you.”

The fail­ure to con­sider and appre­ci­ate that dis­tinc­tion between her grace and the Fallen Nature of every other per­son is why big-​government solu­tions always fails – either in the short-​term due to bureau­cratic inep­ti­tude or in the long-​term due to total­i­tar­i­an­ism (or both). In the extreme cases of total­i­tar­i­an­ism, when the gov­ern­ment attempts to get rid of the imper­fect true-​believers in it, there is no short­age of imper­fect folks to elim­i­nate. That, of course, is the impe­tus for the gulags and the killing fields.

Because we attended this morning’s Mass for the parish school’s chil­dren, our excel­lent new Parochial Vicar – who recently replaced our excel­lent and trans­ferred Parochial Vicar and friend, Fr. Sean – tried to empha­size that dis­tinc­tion between the grace of Mary and every­one is the Church– and the world, for that matter.

He asked the stu­dents three ques­tions: (1) How many of you always lis­ten to your par­ents and do as they ask? (2) How many of you always lis­ten to your teach­ers and do as they ask? And (3) How many of you always lis­ten to God and do as he asks?

Either out of (1) hubris or (2) incor­rectly antic­i­pat­ing the answers that he sought or (3) con­sid­er­ing which of Santa’ lists they hoped to be on so very near to Christ­mas, many of the younger chil­dren answered affir­ma­tively to all three questions.

Our priest then asked sim­i­lar ques­tions to the par­ents and other adults present, and no hands were raised. In fact, like every other priest that we know, he admit­ted to being a sin­ner and noted that he could not raise his hand for any of the questions.

That’s makes us won­der why those seek­ing cen­tral­ized solu­tions would (likely) answer in con­cert with first-​graders in the pews rather than with the adults?

By itself, there’s no prob­lem think­ing that you’re bet­ter than oth­ers. In many sit­u­a­tions, a healthy self-​confidence in one’s God-​given abil­i­ties is often a nec­es­sary con­di­tion for success.

The prob­lem is that much of the empir­i­cal evi­dence one observes about one­self often doesn’t sup­port that hypothesis.

So rather than inter­nal­iz­ing those flaws, an eas­ier way to main­tain the dis­tinc­tion or mirage of supe­ri­or­ity is to demo­nize oth­ers and attribute the basest of motives and behav­iors to them. In other words, imme­di­ately believe the worst that you hear about them, while main­tain­ing skep­ti­cism when you’re told good things about them.

A friend of ours men­tioned that prior to serv­ing as the head of a rather con­tentious orga­ni­za­tion, he would often view those with oppos­ing view­points as being either evil or stu­pid or both. After being lob­bied by both sides of var­i­ous issues for a few years, he real­ized that folks can have dif­fer­ent opin­ions and per­spec­tives and objec­tives with­out nec­es­sar­ily being evil or stu­pid. (We joke that those who dis­agree with us need not be evil or stu­pid, they may sim­ply be igno­rant and not know any better.)

In that regard, we would hope that both the faith­ful and non-​believers could agree with the first phrase of Alexan­der Pope’s famous quote: “To err is human…”

And, like Mr. McGurn, we would hope that indi­vid­u­als with respon­si­bil­ity for var­i­ous social, polit­i­cal, and eco­nom­ics orga­ni­za­tions would take their own flaws and the flaws of oth­ers into con­sid­er­a­tion when design­ing insti­tu­tions and poli­cies for those insti­tu­tions. After all, that type of orga­ni­za­tional and man­age­r­ial con­trol is one of our spe­cial­ties at Spero Consulting.

The “Czars” Are Proof It’s Broken

We have to admit that we never heard of Van Jones before last week. Now that we’ve heard about him, it’s great to know that we’ll no longer be pay­ing the salary of some­one who believes that ⁹⁄₁₁ was an “inside job,” but that’s not really why we’re writing.

As we under­stand it, the Obama admin­is­tra­tion has 33 “czars” who have not been sub­jected to any con­fir­ma­tion process. While it’s pos­si­ble that many of the folks were offered “czar” posi­tions rather than cab­i­net posi­tions because they would not be able to with­stand the scrutiny of con­fir­ma­tion hear­ings, let’s assume that Mr. Jones was a sin­gu­lar anom­aly. In other words, let’s assume that the other 32-​or-​so “czars” would have breezed through the con­fir­ma­tion process. (Yeah, we know it’s a stretch, but let’s run with the supposition.)

In our mind, that indi­cates and even big­ger prob­lem: the fed­eral gov­ern­ment is unman­age­able and does not work.

Why do we reach that conclusion?

From a quick search of the web, it seems that there are over 500 appoint­ments that require con­fir­ma­tion, includ­ing the fif­teen depart­ment secretaries.

So, why is it that the gov­ern­ment needs 33 uncon­firmed “czars” on top of those sec­re­taries and mil­lions of fed­eral employ­ees? Shouldn’t the fif­teen sec­re­taries and their min­ions of assis­tant sec­re­taries and under sec­re­taries and assis­tant, under sec­re­taries be suf­fi­cient or does the sys­tem just not work?

So we ask: would a well-​functioning sys­tem need 33 “czars” work­ing out­side the nor­mal chain-​of-​command? What would you, dear reader, think if your firm – in an ad hoc man­ner – hired a few dozen very senior advis­ers to get things work­ing, again? Wouldn’t you hope that your chief exec­u­tive would attempt to reor­ga­nize and stream-​line and elim­i­nate the inef­fec­tive and inef­fi­cient depart­ments and man­agers? Wouldn’t you hope that the CEO would replace – rather than just sup­ple­ment – the dys­func­tional units and depart­ments? Why does that seem too much to ask of our pub­lic ser­vants?

What do we get instead? Big­ger gov­ern­ment and more chiefs?

But they’ll be able to effi­ciently and effec­tively man­age health care? Yeah, right.

The quote below – cour­tesy of a tran­script pro­vided by The Wall Street Jour­nal–was stated by Pres­i­dent Obama at his health-​care reform rally in Grand Junc­tion, CO.

What you can’t do — or you can, but you shouldn’t do — is start say­ing things like, we want to set up death pan­els to pull the plug on grandma. I mean, come on. (Applause.) I mean, I just — first of all, when you make a com­ment like that — I just lost my grand­mother last year. I know what it’s like to watch some­body you love, who’s aging, dete­ri­o­rate, and have to strug­gle with that. So the notion that some­how I ran for pub­lic office, or mem­bers of Con­gress are in this so that they can go around pulling the plug on grandma? I mean, when you start mak­ing argu­ments like that, that’s sim­ply dis­hon­est, espe­cially when I hear the argu­ments com­ing from mem­bers of Con­gress in the other party who, turns out, spon­sored sim­i­lar provisions.

So, let’s take the Pres­i­dent at his word – that he didn’t run for office to specif­i­cally imple­ment national poli­cies in favor of euthanansia.

Unfor­tu­nately, by them­selves, good inten­tions alone are insuf­fi­cient and can lead to more harm than good. (We do love that quote about the road to hell by St. Fran­cis de Sales.) Is there a bet­ter place than the mas­sive, inef­fi­cient, and intru­sive fed­eral gov­ern­ment to find sup­port­ing evidence?

What Pres­i­dent Obama needs to real­ize – and what we wish he and his leg­isla­tive allies would con­sider – is that his pro­pos­als could very well lead to such “care-​giving” poli­cies and other such “unin­tended con­se­quences.” (Yes, scare quotes are aptly named.)

That is, we wish he would live by a motto of some­thing like “thought before action.”

At a min­i­mum, we wish that Mr. Obama would push for a small-​scale exper­i­ment of his plans, in, say, a will­ing state or region, before propos­ing it for the nation as a whole. Oh that’s right, it’s been tried in a few states like Mass­a­chu­setts and doesn’t seem to be work­ing out very well.

By the way, any plan that requires simul­ta­ne­ous adop­tion through­out the nation is a bit trou­bling to us. The claimed neces­sity for such a tac­tic reminds us of those amor­phous and gos­samery and poorly-​understood, explained, and real­ized syn­er­gies that have been so often used to ratio­nal­ize large cor­po­rate acquisitions.

Talkin’ ’bout the Older Generation

No, this isn’t about the low level of clean­li­ness in Eng­lish hos­pi­tals although we have a post script about that.

It’s about an excel­lent edi­to­r­ial in the The Wall Street Jour­nal, By Squalor Pos­sessed, and what it has to do with Obama’s pro­posed health-​care leg­is­la­tion. Unfor­tu­nately, it is only avail­able as a PDF or in the paper edi­tion because it is from the August 28, 1969, edi­tion of The Wall Street Journal.

Yes, by the editorial’s title and date you should be able to tell it is about Wood­stock, the con­cert. Do read it if you have the time.

We par­tic­u­larly like this two-​sentence excerpt from three para­graphs of a speech that are quoted in the col­umn.¹ “It is not mawk­ish to love one’s coun­try. The coun­try, with all of its agony and all of its faults, is still the most gen­er­ous and the most open soci­ety on earth.” (Com­pare those sen­ti­ments to those of our Pres­i­dent, who on many recent occa­sions has felt com­pelled to ap0logize for our coun­try. See our post Read It and Weep.)

The speaker of those lines, Lawrence Lee, then pleads for those old enough to be grown-​up to, well, actu­ally grow-​up. “Ours (gen­er­a­tion) is ask­ing yours to be men rather than chil­dren, before some fright­ened tyrant with the aid of other fright­ened and igno­rant men seeks to make all of us slaves in reac­tion to your irresponsibility.”

Well, it hasn’t played out exactly that way because – more often than not – it has been the government’s own social poli­cies that have fos­tered and fed the irre­spon­si­bil­ity. But, unfor­tu­nately, it’s not THAT dif­fer­ent than where we stand today, and more impor­tantly the end result may be exactly what Mr. Lee pre­dicted if respon­si­ble cit­i­zens remain pas­sive and ret­i­cent. Now is the time to remind your elected rep­re­sen­ta­tives and sen­a­tors that they are pub­lic ser­vants–your pub­lic ser­vants–with heavy empha­sis on the ser­vant part.

Before con­tin­u­ing, how­ever, let’s take a very short tour through a few of the irre­spon­si­bil­i­ties that we have observed?

• Too fat? Must be some fast food chain’s fault.
• Spilled hot cof­fee on your­self? Must have been the restaurant’s fault? The hot cof­fee is too hot.
• Don’t have health insur­ance? Can’t afford both insur­ance and smokes; can’t get free cig­a­rettes from any­one, but can get many types of free health-​care. Some­thing has got to give, and, you know, nico­tine is an addiction.
• Got a mort­gage that can’t be paid unless the house dou­bles in value and you can sell? Blame the “greedy” banks who funded the loan.
• Lost hun­dreds of bil­lions of out­ra­geous bets? Not the board’s or management’s fault. Every­one else was doing it.
• Spent thirty years and untold bil­lions and can’t design an auto­mo­bile that cus­tomers want? Not your fault. Those clever, bad for­eign­ers have bet­ter stuff, you deserve a “do-​over.”
• Can’t behave. It’s not a lack of dis­ci­pline. It must be some dis­ease! It’s not your fault.
• Can’t grow crops effi­ciently. Don’t worry, here’s some cash.
• Dri­ving while drunk? It’s the bar­tenders fault.
• Can’t run Medicare and Med­ic­aid or pre­vent bil­lions in fraud? Blame the “greedy, mis­an­thropic” insur­ance com­pa­nies, drug com­pa­nies, for-​profit hos­pi­tals, char­i­ta­ble hos­pi­tals, and physicians.

Ad nau­seum – until we are left with our nearly infan­tilized and sis­si­fied cul­ture.²

It is not a fright­ened tyrant and his min­ions that seek to con­trol more of the econ­omy and more of our lives.³

Instead, they are seem­ingly benev­o­lent (though still quite igno­rant) men and women who want to exer­cise con­trol over another sixth of the econ­omy – mainly because so many of our fel­low cit­i­zens don’t seem to be able to han­dle the respon­si­bil­ity of their own lives.⁴

If one lis­tens to Mr. Obama and his sup­port­ers, the solu­tion to “the health-​care prob­lem” is nearly free and cost­less. Bet­ter care, lower costs. What’s not to like?⁵

Why, to lis­ten to them you would think that their plan is pure arbi­trage. The gov­ern­ment will exploit “mar­ket” inef­fi­cien­cies caused by the “demonic” insur­ance com­pa­nies, the “greedy” drug com­pa­nies, the “inef­fi­cient” hos­pi­tals, and the “par­a­sitic, self-​serving” physi­cians who rip healthy ton­sils from the throats of chil­dren all for a few more dol­lars. Once they are tamed and con­trolled, cen­tral­ized bureau­crats will solve the prob­lem bet­ter than decen­tral­ized, self-​motivated indi­vid­u­als. Good grief! ((See Like the State Liquor Stores? You’ll Love Obama’s Health­care! and When Dupli­ca­tion of Effort Saves Money, which is sub­ti­tled, “The High Cost of Cen­tral­iza­tion at the Defense Depart­ment,” for sim­i­lar notions. If you live in states with­out liquor con­trol boards, think of the DMV.)

Yes, it’s pos­si­ble that Mr. Lee’s feared dystopia could still come to pass, but we are encour­aged by the reac­tions of our fel­low cit­i­zens at the var­i­ous town-​hall meet­ings dur­ing the past few weeks. The strong, silent types are los­ing their ret­i­cence. (See We Like Her, but She Is Wrong and The Cost of Insu­lar­ity for related posts.)

More­over, as we have writ­ten before, we sus­pect that Obama’s four years – like Carter’s – will prove to be an excel­lent incu­ba­tion period for the next gen­er­a­tion of con­ser­v­a­tives. (We wrote about that on July 1^st in Pro­hi­bi­tion, “Black Liquor,” and Free­dom. See the last half.)

Wouldn’t it be cool, man, if that gen­er­a­tion and the Wood­stock gen­er­a­tion matured at the same time? Oth­er­wise, “turn on, tune in, drop out” may refer to some type of government-​mandated euthana­sia just about the time that the health-​care-​related deficits explode, and the old­est boomers reach advanced old age.

P.S. Regard­ing the Eng­lish hos­pi­tals men­tioned in the very first line, we recently had a con­ver­sa­tion with a man who had retired from the British mil­i­tary and was in the States vis­it­ing rel­a­tives. He com­plained that the unsan­i­tary con­di­tions and high infec­tion rates in Great Britain were caused by ille­gal immi­grants per­form­ing the jan­i­to­r­ial tasks. We doubted that hypoth­e­sis, because we doubt that there are pro­por­tion­ally fewer ille­gals per­form­ing that work in the USA. More­over, we men­tioned that if our sup­po­si­tion were cor­rect, then the dif­fer­ence likely related to man­age­r­ial con­trol and incen­tive issues and the gen­eral supe­ri­or­ity of pri­vate solu­tions to government-​imposed ones.

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Foot­notes:

With Oba­macare, You May Wish it Were So

If you read The Wall Street Jour­nal only at work and don’t work on Sat­ur­days, then you may have missed a very excel­lent essay that appeared in Saturday’s edi­tion: Man vs. Mutt. In it, Theodore Dal­rym­ple, a.k.a. Anthony Daniels, com­pares Great Britain’s nation­al­ized, human health­care with its pri­vate vet­eri­nary care for dogs. It is well worth reading.

As you might guess, care for canines comes out on top.

Here are a few lines that we par­tic­u­larly like: “…for equal­ity has the con­no­ta­tion not only of jus­tice, but of hard­ship and suf­fer­ing. And, as every­one knows, it is eas­ier to spread hard­ship equally that to dis­sem­i­nate bless­ings equally.” And, “…I mean no dis­re­spect to the proper func­tion of gov­ern­ment when I say that gov­ern­ment con­trol, espe­cially when highly cen­tral­ized, can sap the will even of highly moti­vated peo­ple to do their best.”

Mr. Dal­rym­ple notes that even indi­gent dogs receive health­care in Great Britain. We’ve often made a sim­i­lar point about human health­care in the USA. While not every­one has insur­ance, just about every­one who needs it and seeks it can find care.

Cur­rently, we with insur­ance pay for those with­out it. With more gov­ern­ment med­dling, we’ll still pay for those with­out it, but we’ll also pay for legions of new gov­ern­ment bureau­crats who do lit­tle of value, i.e, they “admin­is­ter,” say, the 110,000 pages of Medicare regulations.

In fact, in our mind, pay­ing for those bureau­crats leaves less money for actual care and that leads to rationing and less care for every­one, includ­ing the indi­gent. (By the way, how many of our “indi­gent” lack cell phones, cig­a­rettes, and calo­ries? Much of liv­ing is a mat­ter of choice, includ­ing — or espe­cially — obe­sity, which is far more preva­lent among the indi­gent than the wealthy or middle-​class.)

So, we ask: why is dimin­ished care for all prefer­able to the cur­rent sit­u­a­tion where insured tax-​payers pay for the unin­sured? (See Like the State Liquor Stores? You’ll Love Obama’s Health­care! and When Dupli­ca­tion of Effort Saves Money, which is sub­ti­tled, “The High Cost of Cen­tral­iza­tion at the Defense Depart­ment,” for sim­i­lar notions.)

One answer that we’ve received is that it is demean­ing for the indi­gent to seek such char­ity, and those hurt feel­ings should be elim­i­nated. We think that folks are a bit too sen­si­tive, and while some may suf­fer from such embar­rass­ment, per Mr. Dal­rym­ple, why replace it with a sys­tem that is demean­ing to every­one? More­over, why replace it with a sys­tem that also pro­vides infe­rior and delayed and expen­sive care to all?

Finally, as we asked in our defense depart­ment essay, why replace flawed, fail­ing, and expen­sive cen­tral­ized sys­tems like Medicare and Med­ic­aid, with (a lot) more of the same?

The High Cost of Cen­tral­iza­tion at the Defense Department

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 18^th 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 ofOur 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) dis­plicine 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.

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Foot­notes:

There is an arti­cle in today’s edi­tion of The Wall Street Jour­nal that attempts to frame Citi’s pay “dilemma” with trader Andrew Hall of its Phi­bro unit as some type of Gor­dian Knot: Citi in $100 Mil­lion Pay Clash. It’s not.

It seems that Citi­corp will legally owe Mr. Hall about $100 mil­lion for his com­pen­sa­tion in 2009, but Citi’s senior man­agers are con­cerned about the polit­i­cal ram­i­fi­ca­tions of pay­ing such a large amount. The last time we checked, Citi had taken about $45,000,000,000 – yes, $45 bil­lion – from wealthy, middle-​class, and poor tax­pay­ers, and those tax­pay­ers had guar­an­teed losses of a few hun­dred bil­lion more.

We sup­pose that folks at Citi are con­cerned that the Obama admin­is­tra­tion and the pop­ulists in Con­gress will attempt to penal­ize the firm – or pos­si­ble incrim­i­nate the man­age­ment – for mak­ing such large com­pen­sa­tion pay­ments. (Note: since at least the found­ing of the FDIC in 1933, Con­gress has had the leg­isla­tive power to have ban such con­tracts, but has cho­sen not to do so.)

We’ve writ­ten a few times about the impor­tance of the rule of law, and it’s quite shame­ful that many of our elected offi­cials and rep­re­sen­ta­tives place such lit­tle value on it. (These are exactly the indi­vid­u­als that our Found­ing Fathers tried to pro­tect against.) It’s almost as shame­ful as Mr. Obama stu­pidly insert­ing him­self into the Gates/​Cambridge Police mess; he does need to learn to shut-​up.

We wrote about the AIG pay con­tro­versy in It Truly Is Dis­grace­ful! and Con­fis­ca­tory, Abu­sive Tax­a­tion: It’s Ali­men­tary (and Dan­ger­ous), and we don’t see this emerg­ing con­tro­versy as being any different.

That being said, we do believe that prop trad­ing should be elim­i­nated at insured insti­tu­tions, includ­ing Citi­corp, because we see no rea­son that tax­pay­ers, includ­ing our­selves, should sub­si­dize their risk-​taking. We first rec­om­mended it in Octo­ber in the aptly titled, Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions, and men­tioned it many time since then, includ­ing our recent post, Paul Vol­cker Has It Right.

It seems that Mr. Hall earned his huge com­pen­sa­tion award because he and his trad­ing group gam­bled and won big. How­ever, it was quite pos­si­ble for him to have lost (and lost big). That would have increased the size of Citi’s losses and required addi­tional tax­payer subsidization.

We don’t know Mr. Hall, but we do wish him every suc­cess in the world. We just have absolutely no desire to back­stop him (and it’s not just his pen­chant for mod­ern art).

We pre­fer that he work for a trad­ing unit of a non-​insured insti­tu­tion or run a hedge fund so that we don’t have to sup­port him if he fails. In fact, a very short arti­cle in the Journal’s Heard on the Street sec­tion, Hedge Funds’ Pro­pri­etary Advan­tage, describes how many hedge funds are cur­rently doing quite well (after many recent dis­as­ters last year). That’s the nature of the busi­ness. Let those will­ing to take the risks, reap the rewards AND bear the con­se­quences of fail­ure. (Is it too really much to ask?)

Per­haps Mr. Hall would like to pur­chase the Phi­bro unit from Citi and accept those same risks and rewards that other fund oper­a­tors face. It seems that clos­ing the sale before the end of the cal­en­dar year would (or could) be a grand out­come for both Mr. Hall and Citi. We think that ban­ning prop trad­ing at insured insti­tu­tions as of Jan­u­ary 1, 2010, would go a long way towards slic­ing through sim­i­lar knotty sit­u­a­tions at other banks.

One final note: in the tra­di­tion of horrendously-​arranged gov­ern­ment web sites, see the above-​mentioned FDIC site. It’s ugly and busy and has no focus, and it’s just what we expect from our bureau­cracy. Does the reader have any higher expec­ta­tions? Be honest.

“The Great Fire­wall of China”

Accord­ing to The Hol­land Ring, almost every Amer­i­can has heard of the tale of Hans Brinker. We’re not sure if that is true, but he is the lit­tle Dutch boy of fic­tion who noticed a small leak in a dike and plugged it with his finger.

Lit­tle Hans stopped the levee from fail­ing and pre­vented a flood that saved many fic­tional lives and much fic­tional prop­erty, and every­one lived hap­pily ever after. We heard the tale when we were a child, and being a skep­ti­cal youth, couldn’t imag­ine any­thing good hap­pen­ing at the break-​point of a levee. (That impres­sion was val­i­dated when we moved to St. Louis in the year of the great flood: 1993. Levee after levee failed, includ­ing one of the last ones in the Chester­field Val­ley. A nine square-​mile lake, approx­i­mately ten feet deep, filled overnight.)

While read­ing L. Gor­don Crovitz’s col­umn in today’s edi­tion of The Wall Street Jour­nal, we were reminded of that fic­tional lit­tle Dutch boy. The col­umn, High Tech’s Great Leap Back­ward, describes how the Chi­nese gov­ern­ment is attempt­ing to limit access to infor­ma­tion on the Inter­net and is try­ing to get West­ern man­u­fac­tur­ers, includ­ing U.S. firms, to assist them. That cen­sor­ship is noth­ing new. In fact, sev­eral firms, includ­ing Google, have a long and igno­ble his­to­ries of con­spir­ing with the Chi­nese gov­ern­ment to limit free­dom and the access to information.

What is dif­fer­ent and news­wor­thy is that on July 1, all new PCs sold in China must include that very strict cen­sor­ship func­tion – although dys­func­tion is a much bet­ter word. (If you missed it, last week there was an arti­cle in which a U.S. soft­ware firm claimed that the Chi­nese gov­ern­ment had stolen its code for use in the new cen­sor­ship effort; we don’t have time to find the link.)

In the fic­tional tale, lit­tle Hans was able to stop the del­uge. We doubt that the Chi­nese gov­ern­ment will be so lucky, and that’s a very good thing for many peo­ple yearn­ing to be free. We’re sure there are a mul­ti­tude of earnest, yet mis­guided, Chi­nese Hans – what’s the plural of Hans and how would Gol­lum pro­nounce it – attempt­ing to stem the ris­ing tide of infor­ma­tion from both within and out­side of China. In fact, we’re hop­ing to get blocked by the most pop­u­lous nation in the world as it will give us some­thing else to write about. There is joy in being free and subversive.

At our site, after elim­i­nat­ing the large, domes­tic search engines, we get more hits from Being than any other loca­tion – most likely from web index­ing servers. (They don’t show on our vis­i­tors’ map because we don’t count them as vis­i­tors, so we keep them in the dif­fer­ent sta­tis­tics database.)

We think the ini­tia­tive will fail because peo­ple aren’t that much like North Sea water. Well, there are sim­i­lar­i­ties: many peo­ple can dirty, pol­luted, smelly, suf­fo­cat­ing, and many seek the low­est level (of what­ever their near­est), but in one cru­cial way, they’re dif­fer­ent. When the lit­tle Dutch boy was pre­vent­ing water from enter­ing the val­ley, he did not face any army of folks dig­ging in the other direc­tion, i.e., seek­ing it. Humans will respond and react accord­ing to their own, God-​given free will. (That’s why in our mind social sci­ence is more inter­est­ing than phys­i­cal sci­ence, includ­ing fluid dynam­ics and levee-​building.) So, we sus­pect the regard­less of the inge­nu­ity shown by the cen­sors, through effort and deter­mi­na­tion and cre­ativ­ity and divine inspi­ra­tion, freedom-​loving indi­vid­u­als will seek their free­dom. (We wouldn’t be sur­prised if they’re string­ing fiber-​optic lines in tun­nels under the Great Wall. Now wouldn’t that be a story!

If any Chi­nese bureau­crats do read our posts and pages, we’d like to direct them to our essay, Com­mon Man­age­r­ial Mis­takes in Decen­tral­ized Orga­ni­za­tions. See lit­tle Hans, you can’t have it both ways: your orga­ni­za­tion – whether its a firm or an econ­omy – can be cen­tral­ized or decen­tral­ized, but you can’t gar­ner the ben­e­fits of decen­tral­iza­tion – the energy, the cre­ativ­ity, the local knowl­edge, the faster, more informed decision-​making to name a few of them – with­out bear­ing some of the agency costs, too. Through intel­li­gent design of con­trol and incen­tive schemes, those costs can be mit­i­gated but they can­not be elim­i­nated with­out what some may refer to as “unin­tended consequences.”

In other words, it’s not the old Burger King slo­gan: you can’t have it your way.

When you elim­i­nate all of the costs of decen­tral­iza­tion, you elim­i­nate all of the ben­e­fits, too. That’s some­thing that Extrem­ists never, ever appre­ci­ate. You see, if you elim­i­nate all of the costs of auton­omy, you’re left with a cen­tral­ized organization/​command struc­ture, i.e., no auton­omy. That may keep you in charge, but it prob­a­bly won’t do much for your nation’s GDP or its abil­ity to feed its own peo­ple or take care of its elderly. (Please see the end of the above-​reference essay for a few exam­ples of dys­func­tional man­age­r­ial types.

Finally, this is for our read­ers that work at related hard­ware or soft­ware firms or search engines and who cher­ish their free­dom and who love The Lord of the Rings. We ask, when did it become your career goal to assist Sauron and strengthen the vision of his lid­less eye? “Don’t be evil,” my ass. You may want to con­sider the trade-​off that we addressed in Prin­ci­ples Lost and More.

There’s an excel­lent opin­ion col­umn in yesterday’s (May 28) edi­tion of The Wall Street Jour­nal. It is Crazy Com­pen­sa­tion and the Cri­sis by Alan S. Blinder.

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 16^th 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.