‘Incentives’ Category

Or, The High Cost of Subsidies

A few weeks ago there was an arti­cle in The Wall Street Jour­nal, What’s a Degree Really Worth. In it the reporter Mary Pilon dis­cussed the esti­mated dif­fer­ence in the aver­age life­time earn­ings between indi­vid­u­als with and with­out the col­lege diplo­mas, and she men­tioned a few prob­lems – but only a few of the prob­lems – with some of those calculations.

We don’t have much to say about those bad cal­cu­la­tions other than the esti­ma­tion meth­ods aren’t very sophis­ti­cated. The one method involved mul­ti­ply­ing some over­all dif­fer­ence in aver­age annual earn­ings by 40 years – the pre­sumed length of one’s work career. Among other things, that sim­ple prod­uct doesn’t include oppor­tu­nity costs – e.g., wages lost while not work­ing dur­ing time in col­lege – or dif­fer­ences in growth rates of com­pen­sa­tion through time or time-​value-​of-​money considerations.

So, while we don’t have much to say about the cen­tral idea in the arti­cle, we do have (1) a com­ment about tuition infla­tion and (2) a related cri­tique about col­lege as white-​collar, vo-​tech train­ing (and the impli­ca­tions of that).

1. All things equal, gov­ern­ment sub­si­dies to con­sumers increase prices – in this case tuition – which can then spi­ral upwards.
2. All things equal, higher tuition costs induce stu­dents to become more professionally-​oriented, and that has sev­eral impli­ca­tions, includ­ing a de-​emphasis of the lib­eral arts, and that per­mits anti-​social and silly behav­ior and the­o­ries to per­sist in what has become the fig­u­ra­tive back­wa­ter of the academy.

(1) Gov­ern­ment Sub­si­dies & Tuition Increases

In the arti­cle, Ms. Pilon briefly men­tioned that aver­age, annual, under­grad­u­ate tuition and fees at pri­vate col­leges increased from $15,518 to $26,273 dur­ing the past ten years.

That 70% increase is twice as great as the change in con­sumer prices– of about 35% – and that’s noth­ing new. This table at http://​www​.finaid​.org/​s​a​v​i​n​g​s​/​t​u​i​t​i​o​n​-​i​n​f​l​a​t​i​o​n​.​p​h​tml shows that tuition infla­tion has been greater than gen­eral infla­tion for at least the past 50 years.

Hmm, now what other indus­try has shown per­cent­age price increases greater than the rate of infla­tion for a long period of time? You know, that indus­try that com­prises about 16% of GDP? Could it be health-​care? Why, yes, it could – although to be pre­cise, health-​care infla­tion has been sub­stan­tially less than tuition inflation.

So, is it a mere coin­ci­dence that two of the indus­tries that have his­tor­i­cally been the most-​subsidized in the U.S.A. are also two indus­tries with very large and sus­tained price increases over a long period of time? We don’t think so.

Here is an exam­ple of how sub­si­dies increase prices.

We recently had a con­ver­sa­tion with the par­ent of a high school senior. He told us that he had bud­geted a cer­tain amount for his child’s tuition next year; let’s say it was $7,500.

Any tuition cost above that amount would have to be funded with grants, loans, work-​study pro­grams, and scholarships.

By the way, the reader should think of schol­ar­ships from col­leges as noth­ing more than dis­counts from list prices. Often, they are awarded based upon merit and are called aca­d­e­mic schol­ar­ships, but that’s not always the case. Col­leges have much more pric­ing flex­i­bil­ity than most par­ents know, and for what­ever arbi­trary rea­son, col­lege recruiters can con­sider some stu­dents more desir­able than oth­ers and offer those prospects price con­ces­sions.¹

Any­way, con­sider some­one like our acquain­tance who has $7,500 per year to spend on col­lege. To keep it sim­ple, assume no other sources of funds – no sub­si­dized loans – except a pos­si­ble fed­eral grant of, say, $2,500.

With­out the grant, the max­i­mum that any col­lege could get from the fam­ily is $7,500 per year. With the grant, the max­i­mum is $10,000.

With­out the Grant

Let’s con­sider our acquain­tance as an aver­age par­ent. If on aver­age, fam­i­lies have up to $7,500 to pay for col­lege expenses, then on aver­age, col­leges have to find ways to oper­ate (as going con­cerns) with $7,500 per stu­dent. Actu­ally, due to their abil­ity to price dis­crim­i­nate, col­lege would charge more and then have to offer schol­ar­ships to more stu­dents. That’s because stated tuition rates are noth­ing more than list prices, and one would expect the list price to be greater than $7,500. In that way, the col­leges can find ways to charge higher prices to wealth­ier fam­i­lies with above-​average bud­gets and offer dis­counts – err, we mean schol­ar­ships – to every­one else.

Regard­less, col­leges wouldn’t be able to get more than $7,500 from our aver­age parent.

With the Grant

Now, it’s quite pos­si­ble that an aver­age par­ent could say to his college-​bound child, “we had $7,500 to spend for col­lege but luck­ily you have a grant for $2,500; so, we’ll only spend $5,000 of our own money, and your tuition bud­get remains the same: $7,500.” It’s pos­si­ble, but it seems unlikely. Unless tuition is less than $10,000, we’d expect that fam­i­lies who com­mit $7,500 would be will­ing to spend that amount under many circumstances.

So, if the fam­ily spends any­thing above $5,000, then the col­lege gets more than with­out grants. If par­ents com­mit their entire $7,500, then the col­lege gets $10,000. That increases the incen­tive for the col­lege to raise tuition to extract the entire amount avail­able from the fam­ily. So, it seems rea­son­able to con­clude that the tuition rates would be higher than they would be with­out sub­si­dies. Clearly, the col­lege would still try to get as much as pos­si­ble from wealth­ier fam­i­lies (and from every­one else, too).

In those instances, where the fam­ily com­mits the entire $7,500, it is no bet­ter off, but the col­lege cer­tainly is.

How­ever, it’s worse than that when the gov­ern­ment “attempts to help make col­lege afford­able” over time. Imag­ine the first year after the gov­ern­ment begins offer­ing grants, if our think­ing is cor­rect, then one would expect col­leges to increase tuitions. That means that the dif­fer­ence between tuition rates and parental bud­gets – say, a con­stant $7,500 – would grow. If that dif­fer­ence causes Con­gress and the Pres­i­dent to offer larger grants, then we have the begin­ning of an infla­tion spi­ral. The fam­i­lies that con­tinue to spend $7, 500 are no bet­ter off than with­out sub­si­dies. The fam­i­lies that spend less ben­e­fit some­what, but we’d expect that they would be in the minor­ity. The col­leges are def­i­nitely better-​off (and fat­ter) and tax-​payers are strictly worse-​off (as usual).

From each family’s per­spec­tive, given that grant pro­grams exist, then receiv­ing a grant is obvi­ously ben­e­fi­cial because it pro­vides more flex­i­bil­ity and capac­ity to meet high tuition pay­ments. How­ever, col­lec­tively, if every­one – or enough stu­dents – receive grants, than no one is better-​off because tuition demanded by the col­lege is higher only because those grants are avail­able, and the col­leges get fatter.

(2) Spec­u­la­tion on High Tuition Costs, Career Train­ing & their Unin­tended Implications

Or, Does Out­ra­geously High Tuition Doom the Lib­eral Arts to a Ghetto of Anti-​social Silliness?

Note up-​front that like much of what we write this cri­tique is rather spec­u­la­tive and requires sev­eral assump­tions. Admit­tedly, we ignor­ing many impor­tant gen­eral eco­nomic and demo­graphic fac­tors, and we make sev­eral, very gross gen­er­al­iza­tions, but (obvi­ously) we think our analy­sis is com­pelling nonetheless.

Note also that:

• From this site, one can see that government-​provided finan­cial aid began in the 1940s for vet­er­ans and was revised in the 1950s. It then expanded to seg­ments of the gen­eral pop­u­la­tion in the 1960s and ‘70s and expanded beyond grants to include sub­si­dized and guar­an­teed loans.
• From the link near the top of this post, the reader can notice that tuition infla­tion has out­paced gen­eral infla­tion for at least fifty years.

As we explained above, we think that the sec­ond point is an impli­ca­tion of the first. So, we’ll assume that such sub­si­dies increase the cost of higher edu­ca­tion. (It would be truly remark­able, would it not, if sub­si­dies to fam­i­lies reduced tuition rates and made col­leges more effi­cient than they oth­er­wise would be – whether that sub­sidy is via a grant or a cheap, guar­an­teed loan. In many ways, the long-​term phe­nom­e­non is no dif­fer­ent than the early 21^st cen­tury hous­ing price bub­ble cre­ated by Fan­nie Mae and Fred­die Mac’s loose and sub­si­dized credit standards.)

So, what could be the unin­tended con­se­quences of very high tuition costs? We have two in mind, though the sec­ond one depends upon the first one.

Col­lege as White-​Collar, Vo-​tech Training

We think that it is pos­si­ble to argue that higher col­lege costs, along with the asso­ci­ated large sac­ri­fices and bor­row­ings by house­holds and stu­dents, have induced many of them to take myopic, careerist approaches to higher edu­ca­tion, e.g., “we’re spend­ing a lot of money and bor­row­ing a lot of money, so you bet­ter get a good job when you’re done.”

If that per­spec­tive is ram­pant and con­sumers of edu­ca­tion over-​emphasize career train­ing, then col­lege is not a place – or is less-​of-​a-​place – where one can gain gen­eral knowl­edge and the abil­ity to think clearly about a vari­ety of prob­lems and pos­si­bly – just pos­si­bly – a bit of wis­dom. In fact, if that is the case, then col­lege becomes lit­tle more than white-​collar, voca­tional train­ing that requires a few other required courses and elec­tives.²

That’s not a new com­plaint and per­haps we’re just pro­ject­ing our own youth­ful moti­va­tions and expe­ri­ences as an under­grad and MBA stu­dent – so we imag­ine that every­one is as money-​hungry as we were – but there does seem to be a ter­ri­ble empha­sis on how “use­ful” a course will be, where “use­ful” is usu­ally defined as some­thing related to some task that one hopes to per­form for some prospec­tive employer.

Unfor­tu­nately, (1) the une­d­u­cated – i.e., stu­dents – by the nature of their igno­rance are usu­ally not in good posi­tions to deter­mine what’s use­ful or not (or what should be taught or not), and (2) “rel­e­vant” or “prac­ti­cal” white-​collar voca­tional train­ing often reverts to a kind of monkey-​see, monkey-​do mimicry.

Such thought­less mim­icry isn’t nec­es­sar­ily opti­mal for stu­dents, their prospec­tive employ­ers, or soci­ety. For exam­ple, con­sider the very bad finan­cial mod­el­ing that helped cause the world­wide finan­cial cri­sis in 2008. Many col­leges taught – and con­tinue to teach – tech­niques and algo­rithms that were in use, but weren’t/aren’t par­tic­u­larly use­ful (or appro­pri­ate). So, rather than empha­size strengths and weak­nesses of dif­fer­ent tech­niques and abstrac­tions, the empha­sis was on teach­ing tech­niques because that’s what stu­dents and employ­ers wanted – but not nec­es­sar­ily what soci­ety needed (or needs): yet another form of myopia.

So, read­ers sym­pa­thetic to our posi­tion may read­ily accept our sup­po­si­tion. For those unper­suaded we have a ques­tion: of every for­mer, cur­rent, and prospec­tive col­lege stu­dent (and their fam­ily) that you know, how many have men­tioned a rea­son other than salaries or careers as their rea­son to attend­ing col­lege? Be hon­est and con­sider the percentages.

Note that all things equal, given the fixed num­ber of cred­its that need to be earned to grad­u­ate, an over-​emphasis on sup­pos­edly “prac­ti­cal” career train­ing almost always means an under-​emphasis on other courses that could increase gen­eral knowl­edge and help develop think­ing skills as well as (per­haps) help stu­dents acquire a bit of wis­dom.³

And what are the costs of that careerist, vo-​tech approach to col­lege study? Many are well-​known and frequently-​made com­plaints about MBAs and engi­neers and other pro­fes­sion­als: short-​sighted, lack the abil­ity to learn and adapt and syn­the­size, etc., but we don’t want to focus our atten­tion on stu­dents who become employ­ees. Instead, let’s con­sider what that careerist per­spec­tive does within col­leges and universities.

First, we’ve already men­tioned – or at least insin­u­ated – it “dumbs-​down” stud­ies within par­tic­u­lar fields, par­tic­u­larly in pro­fes­sional schools and for pro­fes­sional degrees where the focus is often on what’s done (or what’s to be done) rather than what is known (and unknown) about the world or a phenomenon.

The Irrel­e­vancy of Lib­eral Arts

Sec­ond, the enhanced inter­est in sup­posed prac­ti­cal, job-​oriented train­ing has led to an under-​emphasis on non-​professional courses and areas of study. (You know, those required courses that enter­pris­ing stu­dents view as the col­le­giate chaff of the pro­fes­sional , vo-​tech wheat that they seek.)

To us, that lack of inter­est and the view that such course­work is a “nec­es­sary evil” of get­ting a degree (and a job) means that (many) stu­dents take those courses less seri­ously and view par­tic­i­pa­tion as a cost min­i­miza­tion prob­lem to solve, rather than as a value max­i­miza­tion prob­lem. In oth­ers words, they pre­sume such courses are worth­less and attempt to find the eas­i­est ways to sat­isfy require­ments and other con­straints (while attempt­ing to main­tain a high GPA, because, you know, “that’s what employ­ers like to see”).

That has a num­ber of impli­ca­tions, includ­ing a desire by pro­fes­sors to pan­der to stu­dents via the offer­ing of silly and worth­less courses, which, of course, turns the stu­dents’ ini­tial per­cep­tions into self-​fulfilling prophe­cies and per­mits the such profs to (cor­rectly) view most stu­dents as short-​sighted, money-​grubbers with no intel­lec­tual curiosity.

But those oppos­ing neg­a­tive opin­ions are not the only con­se­quences of the bad equi­lib­rium. Worse is that such indif­fer­ence (by stu­dents and oth­ers, includ­ing employ­ers) per­mits rad­i­cal­ized and poorly-​trained fac­ulty to flour­ish and hire oth­ers with sim­i­lar tastes and predilec­tions. They’re not chal­lenged within the acad­emy, because, frankly, other than a few crit­ics on the right, nobody cares. (Did you hear JP Mor­gan is on cam­pus today?) That’s true of admin­is­tra­tions that empha­size careers, stu­dent ameni­ties, and NCAA Divi­sion I sports teams.

In our mind, that’s why so much thought­less, knee-​jerk rad­i­cal­ism has thrived within (that por­tion) of acad­e­mia since World War II.

Such rad­i­cal­ism and silly inquiries and teach­ings are come at quite a cost to soci­ety; how­ever, we think that their effects are over­stated, and, again, that’s because the vast major­ity of stu­dents are too busy seek­ing career train­ing and sum­mer intern­ships. (Did you hear GE is on cam­pus today?)

And, that’s the true tragedy. The high cost of col­lege – par­tially to due gov­ern­ment involve­ment – induces stu­dents to obsess about career fac­tors, so they don’t get the edu­ca­tion that they deserve. Well, they don’t get the edu­ca­tion they could have received in a dif­fer­ent real­iza­tion of the world, and that edu­ca­tion would include, well, an edu­ca­tion, includ­ing exten­sive expo­sure to the clas­si­cal, lib­eral arts.

P.S. Like many of our longer posts, we’ll likely edit the errors and typos and pos­si­bly expand our analy­sis as we think more about the issues.

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Foot­notes:

Actu­ally, a New Idea to Mit­i­gate the Problem

Update: after pub­lish­ing this post very late Sun­day (or very early) Mon­day, we noticed the col­umn, Toward a Dif­fer­ent Fis­cal Future, by Glen Hub­bard. His essay is sub-​titled, tax increases can’t plau­si­bly address the com­ing enti­tle­ment cri­sis, and that fits very nicely with our pro­posed mitigation.

We admit that the title is a bit over­stated, because we don’t know if any sin­gle and fea­si­ble idea can solve the bank­ruptcy prob­lem; so, we’ll look to mit­i­gate it a bit with a few long-​term recommendations.

We’ve heard for years that Social Secu­rity and Medicare will go bank­rupt within the next sev­eral decades. To the best of our mem­ory – i.e., with­out search­ing the web – we recall read­ing that with­out fur­ther changes in laws, Social Secu­rity will become insol­vent some­time between 2020 and 2040, or maybe it was a few years later.

Let’s take those pro­jec­tions as given because the exact year is far enough away that it doesn’t affect our pro­posed mitigation.

So, we ask: besides rais­ing pay­roll taxes, which are already out­ra­geously high, what other solu­tions exist?

Well, ben­e­fits could be cut, but any bill propos­ing such cuts would be unlikely to pass Congress.

That means that get­ting the great­est num­ber of cit­i­zens work­ing (and not col­lect­ing ben­e­fits) is the best way to stave-​off bank­ruptcy. You may have already heard how when the pro­gram began in the 1930’s there were more than ten work­ers for every recip­i­ent and now that ratio has dras­ti­cally shrunk (to some­thing like four:one or three:one today).

Already, the age to col­lect full ben­e­fits has been pushed back from age 65 to 67 for those of us born after 1960. (Actu­ally, it’s a grad­u­ated scale that you can see here.) All else equal, that forces older folks to con­tinue work­ing (and pay­ing taxes) while delay­ing receipt of their checks.

We sus­pect that laws will be passed to fur­ther delay full-​retirement age – for us and for those born after us. (We can’t imag­ine retir­ing any­way; so, those changes won’t affect us.) How­ever, unless the full-​retirement age is increased to 80-​or-​so (a com­pletely wild-​a** guess on our part) that exten­sion alone won’t elim­i­nate the problem.

So then the ques­tion becomes: once full-​retirement age is max­i­mized at an age greater than 67, say, at age 70, what other solu­tions exist?

Some folks call for more immi­gra­tion as a way to increase the ratio of workers-​to-​recipients, but there are other ways to increase the size of the work­force with­out per­mit­ting an influx of new­com­ers. (By the way, our solu­tion to ille­gal immi­gra­tion–well, actu­ally to what to do with ille­gal immi­grants – would help with the social secu­rity prob­lem, too.)

Now, the gov­ern­ment could imple­ment pro-​family poli­cies that, at the mar­gin, would induce par­ents to have more chil­dren. (That can’t hurt, and we see no rea­son to wait until the USA is fac­ing neg­a­tive pop­u­la­tion growth – like Japan and cer­tain coun­tries in Europe now face – before imple­ment­ing such policies.)

With­out any cal­cu­lat­ing any­thing, we doubt that pro-​baby poli­cies would be suf­fi­cient to grow the nation out of the Social Secu­rity prob­lem. (How­ever, we do have a quick ques­tion: if the esti­mated 30 mil­lion or so aborted babies had been born since the early 1970’s, how many more work­ers would be avail­able to sup­port those cur­rently receiv­ing ben­e­fits and how much further-​off could insol­vency be put?)

So, what else can our soci­ety do?

If the sup­ply of poten­tial work­ers is fixed (or already max­i­mized) and it’s not fea­si­ble to get them to work to an older age, then the only option left is to get them to…start work­ing earlier.

We don’t mean per­mit­ting child labor as some other nations do. We do mean: (1) motivating par­ents to have their child(ren) start kinder­garten at a younger age so that they can grad­u­ate from high school a year ear­lier. That would move the aver­age start­ing age back closer to five than six, and means that many stu­dents would grad­u­ate an entire year ear­lier than they oth­er­wise would have. That pol­icy can be eas­ily imple­mented by chang­ing state laws, which can be “influ­enced” by fed­eral laws and grants.

We also mean pro­vid­ing incen­tives to induce those in col­lege (and grad­u­ate school) to begin their careers – or at least begin work­ing full-​time – at a younger age. There are sev­eral ways to do that. We’ll men­tion a few and prob­a­bly add more through time.

One way would be to limit under­grad­u­ate loans and grants from the gov­ern­ment to four con­sec­u­tive years begin­ning the year of high school grad­u­a­tion (with sim­i­lar types of restric­tions for grad­u­ate schools).

Another would be to (a) induce more stu­dents to attend col­lege part-​time, espe­cially for grad­u­ate school, and (b) simul­ta­ne­ously induce grad­u­ate schools to offer more degrees on a part-​time basis. One way to do that would be to make tuition ben­e­fits for col­lege and grad-​school com­pletely tax-​free when paid by employ­ers or com­pletely tax-​deductible when paid by work­ers (with earned income).

A third way to reduce the aver­age time spent in col­lege would be to pro­vide more rig­or­ous ele­men­tary and sec­ondary edu­ca­tions so that stu­dents are better-​prepared for col­lege, and one way the fed­eral gov­ern­ment can (indi­rectly) do that is to make fed­eral grants and loans for col­lege – like aca­d­e­mic schol­ar­ships – con­di­tional upon test scores and/​or grades.

A fourth way would be to pro­vide a tax credit (or a per­ma­nent reduc­tion in pay­roll tax rates) for cit­i­zens who enter the full-​time work­force at a younger age.

The gen­eral idea is to get twenty-​somethings in col­lege to grad­u­ate and mature ear­lier than they do now so that they seek gain­ful employ­ment at an ear­lier age and, there­fore, begin pay­ing taxes sooner. We don’t see how that is harm­ful to any­one. In fact, hav­ing them grow-​up sooner seems ben­e­fi­cial to everyone.

P.S. Like many other top­ics that we write about for the first time, we’ll likely revise this post as we think more about it.

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.)

…To Pro­pose a Ban on Prop Trad­ing at Insured Institutions

We applaud Pres­i­dent Obama’s pro­posal to elim­i­nate pro­pri­etary trad­ing at insured insti­tu­tions. In fact, long-​time read­ers will recall that we first rec­om­mended a ban on this site on Octo­ber 1, 2008 – near the height of the finan­cial panic.

Our rea­sons are simple.

One can argue about the need for fed­eral deposit insur­ance, but if such insur­ance exists, we see no rea­son that tax pay­ers should sub­si­dize risk-​taking at insured insti­tu­tions. If one wishes to ben­e­fit as a ward of the state, then with those ben­e­fits and sub­si­dies come oblig­a­tions and restric­tions. That’s as much a moral and eth­i­cal argu­ment as any­thing else, but there are com­pelling eco­nomic rea­sons, too.

With­out restric­tions the government’s guar­an­tees exac­er­bate the quite seri­ous moral haz­ard prob­lems that already exist because the banks are limited-​liability cor­po­ra­tions. As it seems to cur­rently stand, not only do bank share­hold­ers not have to cover losses, but they get to retain some per­cent­age stake in their firms despite bail-​outs.¹ Thus, banks share­hold­ers have an even bet­ter call option than for most other cor­po­rate share­hold­ers: all on the upside, none of the down­side, and some or much of any future upside (after the downside).

As we have men­tioned in the past, at the mar­gin, there’s not much dif­fer­ence between cer­tain types of cus­tomer trades, prop trades, or asset/​liability man­age­ment trades/​tactics. So, all things equal, we’d expect that if firms want to main­tain a high risk pro­file, a ban on prop trad­ing would lead to higher risk char­ac­ter­is­tics in both their cus­tomer trad­ing books and their bank asset-​liability management/​treasury func­tions (than cur­rently reported).

In that vein, we pre­fer bank reg­u­la­tors to have a nar­rower focus on better-​understood, more-​standardized prod­ucts than be forced to over­see the addi­tional prop trad­ing books, where it seems that (1) more inno­va­tion occurs and (2) rules are more dif­fi­cult to inter­pret, which usu­ally leads to (3) even more rules, inter­pre­ta­tions, and uncer­tainty. In other words, all things equal, make the bank reg­u­la­tors’ jobs as easy and as well-​understood as possible.

In addi­tion, there seems to be no short­age of wealthy firms and indi­vid­u­als will­ing to invest in unreg­u­lated trad­ing oper­a­tions, i.e., hedge funds et. al. So, we see any such lim­i­ta­tions on banks as boon to (most) hedge funds and traders – unless those funds are “picking-​off” the banks.

We sus­pect most traders would be hap­pier (and better-​compensated) at unreg­u­lated firms; so, what’s not to like? [2.Alternatively, if we’re wrong on that count, customer-​trading might become more com­pet­i­tive, which would be ben­e­fi­cial to bank cus­tomers. Also, such a ban doesn’t elim­i­nate expo­sure to prop trad­ing because many large banks pro­vide prime bro­ker­age ser­vices to hedge funds, etc. So, those banks would still be exposed to risks asso­ci­ated with the prop trad­ing indus­try, i.e., they would still face credit risk that is a func­tion of market-​risk and can be very dif­fi­cult to mea­sure, but in some way those risks seem to be once-​removed and dif­fer­ent tools are avail­able to mit­i­gate them.]

We sus­pect that some com­men­ta­tors and ana­lysts will com­plain that the pro­posal is gov­ern­ment intru­sion into mar­kets and “free enter­prise.” At best, such com­plaints are very silly. Ban­ning prop trad­ing at insured insti­tu­tions isn’t intru­sive. Deposit insur­ance (and other guar­an­tees) intrude into mar­kets. As we men­tioned above, one can debate the effi­cacy of such pro­grams, but if the gov­ern­ment is offer­ing insur­ance, it has every right to demand that its cus­tomers behave in par­tic­u­lar ways. If the cus­tomers don’t want the restric­tions then they need not buy the insur­ance. While our cur­rent sys­tem is far from free enter­prise, there’s no rea­son it should be about “free” losses.

No won­der banks stocks declined yes­ter­day. If there is a chance that mas­sive losses will no longer be sub­si­dized, then the implicit option in com­mon equity is – jus­ti­fi­ably – worth less.

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.

“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.)

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.

Last night, we caught a glimpse of one of the evening talk shows where some­one com­plained to the host that no Sen­a­tor or Con­gress­man has the time to read and under­stand pro­posed amend­ments and bills that are often longer than one thou­sand pages.

It’s a valid com­plaint, and reminded us to write a sec­ond time about our pro­posed solu­tion to bureau­cracy. We first wrote about it last Decem­ber 24, but it turns out that inter­est and read­er­ship isn’t very heavy on Christ­mas Eve. (Hey, we write when we can.)

The com­plaint about long bill length and short delib­er­a­tion time isn’t new, but it seems to have been made more fre­quently dur­ing the past few weeks and months when mas­sive changes (gov­ern­ment inter­ven­tions) have been pro­posed. In par­tic­u­lar, Repub­li­cans leg­is­la­tors (and cit­i­zens, too) have demanded addi­tional time to read the details and intri­ca­cies of bills that they are expected to vote on involv­ing top­ics like health care and the envi­ron­ment. Many of the Tea Party and Town Hall protests dur­ing this past sum­mer arose because of this rush-​to-​passage.

We are com­pletely sym­pa­thetic to their com­plaints. Our motto–thought before cal­cu­la­tion–and our Hip­po­cratic mantra–first, do no harm–point to our cau­tious nature, but it’s really our utter dis­dain for the very dam­ag­ing unin­tended con­se­quences of big gov­ern­ment that induce us to remind read­ers of our solu­tion to gov­ern­ment bureaucracy.

We first wrote about it here: Our Solu­tion to Fed­eral Gov­ern­ment Bureau­cracy.

We real­ize that unless the fed­eral gov­ern­ment suf­fers a deeper cri­sis, there is lit­tle hope that our idea will be imple­mented. That’s because our solu­tion is dra­con­ian and would destroy the leg­isla­tive bureau­cracy that has arisen and grown dur­ing that past sev­eral decades. For exam­ple, the bud­get to oper­ate Con­gress is over $4.4 bil­lion per year, and more than 20,000 folks work are employed in var­i­ous leg­isla­tive offices. Sen­a­tors have bud­gets of sev­eral mil­lion dol­lars apiece.

That being said, we think our solu­tion would be far more effec­tive than term lim­its and requires no change in any­thing other than the fed­eral bud­get. It would have the imme­di­ate effect of elim­i­nat­ing the leg­isla­tive bureau­cracy and would seri­ously crip­ple the lob­by­ing indus­try that many cit­i­zens on both ends of the polit­i­cal spec­trum dis­like. More impor­tantly, it would have the long-​term effect of reduc­ing exec­u­tive branch bureau­cracy because Con­gress­men and com­mit­tees could no longer del­e­gate over­sight to staff work­ers; so, they would have to be more thought­ful when writ­ing and pass­ing bills.

Limit leg­isla­tive staffs to three peo­ple. (If we were a gov­ern­ment or cor­po­rate bureau­crat, we would have writ­ten three “FTEs” for “full-​time equiv­a­lents.”) In a fit a gen­eros­ity, we’ll per­mit large com­mit­tees to have one sec­re­tary but no other employees.

We rec­om­mend two office work­ers in D.C. and one worker in a sin­gle home office, and we don’t dis­tin­guish between rep­re­sen­ta­tives and sen­a­tors. That seems about right to us.

The job would be much less glam­orous and regal, and at the mar­gin that might reduce the num­ber of dbs that run for office. More­over, leg­is­la­tors would actu­ally seem like the pub­lic ser­vants they are sup­posed to be.

More impor­tantly, leg­is­la­tors could no longer rely on staff mem­bers to pre­pare reports and write speeches and tell them what to say. They would have to “do their own home­work” so-​to-​speak, and at the mar­gin, that means that they would either: (1) have to be bet­ter stu­dents or (2) be more poignantly exposed as igno­ra­muses or (3) learn to speak less. In our mind, those are all pos­i­tive outcomes.

Over­all, we see no way that 1,000 page bills could be pro­posed with small leg­isla­tive staffs, and in our mind, that is a very good thing (and that would greatly reduce the size of the exec­u­tive branch.)

For those who think that exec­u­tive branch bureau­cracy would sub­sti­tute for the elim­i­nated leg­isla­tive branch bureau­cracy, we argue the oppo­site. Con­gress was will­ing to expand the exec­u­tive branch pro­vided it was able to expand its own over­sight capa­bil­i­ties and retain its power. If that over­sight were elim­i­nated, we think Con­gress would starve the exec­u­tive branch by sub­stan­tially reduc­ing the size of the gov­ern­ment. That would be partly due to the fact that con­stituents could no longer be assured that they could get “their fair share” of the bud­get and more of them might then pre­fer to send fewer tax dol­lars to Washington.

Finally, there would be far fewer leaks and far fewer staff mem­bers and press sec­re­taries with whom reporters could speak. That should reduce the num­ber of reporters, and that doesn’t sound like a bad thing to us.

We will con­tinue to think about the issue and will likely update this post dur­ing the next sev­eral days, but wouldn’t it be lovely if next year can­di­dates for the 435 house seats and 33-​or-​so sen­ate seats were forced to take a pledge about lim­it­ing staff size?

By the way, the U.S. Con­sti­tu­tion and the 27 Amend­ments com­bined con­sume less than 20 pages (at 12 point, Times Roman, left-​justified, with decent mar­gins in OpenOf­fice Writer).

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.

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?

We hate it when one of our favorite quotes is used against us, but that is the nature of our queen and chair­man. (Although she does it in a good-​natured, light-​hearted, and humor­ous way, there is steely resolve in her teas­ing words.)

Actu­ally, she didn’t use the exact quote; instead, she updated it and made it more rel­e­vant to the sit­u­a­tion at hand. That made it all the more painful. Her ver­sion with ref­er­ence to today’s lunch, or shall we say the absence of lunch was: “The chil­dren who have eaten their Pani­nis are the nat­ural ene­mies of the chil­dren who have their (left-​over) pizza.”

That’s not very dif­fer­ent than Jeremy Bentham’s orig­i­nal quote from 1844. “The chil­dren who have eaten their cake are the nat­ural ene­mies of the chil­dren who have theirs.” In some sense, she just Ital­i­cized it.

By the way, we think Bentham’s one-​line quote, and the sur­round­ing text, which we show below, per­fectly describes the pet­ti­ness and envy that is exem­pli­fied by the Congress’s behav­ior regard­ing the AIG bonuses in the Spring, the cre­ation of the Obama administration’s silly “pay czar” posi­tion, and the recent pub­lic­ity regard­ing Andrew Hall’s $100 mil­lion pay dis­pute with Cit­i­group. Envy and power – much like in the Russ­ian Rev­o­lu­tion and many other sim­i­lar set­tings – are a ter­ri­ble combination.

Very shortly we hope to pub­lish our say on ways to resolve the dis­pute between Mr. Hall and Cit­i­group. It is a very inter­est­ing prob­lem: like a three-​person game of chicken. In fact, we were gath­er­ing our thoughts by the pool, when we decided to ven­ture into the house for her left-​over pizza. Unlike our gov­ern­ment or the Bol­she­viks, we had no chance to behave opportunistically.

How­ever, rather than dis­cussing Mr. Hall’s par­tic­u­larly prob­lem, which involves the government’s (and pos­si­bly Citi’s) ex post oppor­tunis­tic behav­ior, we’d pre­fer to men­tion a quite gen­eral and viable solu­tion. It is so viable, that it is pos­si­ble that trad­ing firms have already imple­mented sim­i­lar schemes, but we doubt it.

We have in mind very for­mal and objec­tive shar­ing rules for daily trad­ing gains and losses com­bined with other objec­tive, long-​term per­for­mance (and risk) mea­sures. We think it would be worth­while to have cre­ate indi­vid­ual trust accounts, admin­is­tered by an inde­pen­dent third party, which set­tle each trad­ing day to accu­mu­late a trader’s share of his pro­pri­etary gains and losses. A sim­ple lin­ear con­tract that pays a per­cent­age of gains and the same per­cent­age of losses could work, but any­thing cal­cu­la­ble and under­stand­able would work, also. Each day, the account would set­tle – like any other daily set­tle­ment or clear­ing­house agreement.

Note that noth­ing in the pre­vi­ous para­graph pre­cludes such a con­tract from being long-​term in nature, nor does such an arrange­ment nec­es­sar­ily per­mit the trader to with­draw the funds at will (although like many 401K plans, firms could per­mit traders to bor­row against the accrued bal­ances at some mar­gin or hair­cut). More­over, noth­ing men­tioned above would pre­clude the use of claw­backs or other long-​term fea­tures – as long as they are objec­tive, and con­tractible in nature, and (there­fore) administer-​able by a third party.

The non-​opportunistic admin­is­tra­tion of the trust by a third party is the key. It elim­i­nates the pos­si­bly sub­jec­tive, capri­cious, and arbi­trary types of arrange­ments that we dis­cussed in Claw­backs: the Good, the Bad, and the Ugly. (We also men­tioned them in Incen­tives at UBS and in Gen­eral and Risk Con­cen­tra­tion, Con­cen­trated Losses and Incen­tives and a host of other posts.)

We’ll likely write more in the future on this type of arrange­ment. In our mind, if senior man­agers of trad­ing groups can’t spec­ify the major pro­vi­sions of such con­tracts, then they prob­a­bly don’t under­stand what their traders are doing and prob­a­bly shouldn’t be senior man­agers. So, if direc­tors forced such arrange­ments into trad­ing areas, there is a chance that over­all man­age­ment and con­trol would be improved. (After writ­ing that, we real­ize how hope­lessly naïve it reads.)

Of course, the above sug­ges­tions apply only to pro­pri­etary trad­ing, not for hedg­ing or trad­ing with cus­tomers. Also, because we – as a tax-​payer – have absolutely no desire to sub­si­dize prop traders – we get none of their gains – we think prop trad­ing at insured insti­tu­tions should be banned. More­over, we cer­tainly believe that the gov­ern­ment has the right to limit pay at insured insti­tu­tions, but those lim­i­ta­tions should be known and spec­i­fied before the con­tracts are signed, not after­wards as in the AIG exec­u­tives’ cases or pos­si­bly in Mr. Hall’s case.

Finally, if you found this inter­est­ing, you may like these related analy­ses: Incen­tives and the Finan­cial Cri­sis and Busi­ness Schools, Incen­tives, Uncer­tainty, and the Finan­cial Cri­sis.

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.

In the pre­vi­ous post, we men­tioned today’s brief edi­to­r­ial, The Right and Wrong Stuff, in The Wall Street Journal com­par­ing the eight years of progress between the time of Pres­i­dent Kennedy’s famous moon speech and the actual moon land­ing with the nearly eight years of very lim­ited progress in con­struc­tion at Ground Zero from ⁹⁄₁₁ until today. The edi­tors right­fully call the present cir­cum­stances a national disgrace.

We think that one of the rea­sons we like the com­par­i­son is that we’ve made sim­i­lar ones in the past.

We’ve heard about many cor­po­rate projects and ini­tia­tives that through lack of will or direc­tion or com­pe­tence take far longer to accom­plish (or merely end) than they should. When we’ve expe­ri­enced those sit­u­a­tions we’ve asked: (1) do you know that the Allies planned and launched D-​Day in less time than it’s taken for to get this project mov­ing, and (2) do you know that the U.S. and its allies defeated Ger­many and Japan in less time than this project has been alive?

Think about that the next time you waste away your day and life in a sta­tus meet­ing for an upcom­ing soft­ware con­ver­sion. (How many soft­ware revi­sions and gen­er­a­tions has the con­ver­sion lasted.)

Senior man­agers may want to con­sider what mech­a­nisms and poli­cies they’ve enacted that makes such lacks of progress accept­able tac­tics. Oh, it’s not your fault because you’re not directly involved? Are you sure it’s not?