Tag Archives: emergence

CEO compensation – a symptom of institutional decay

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So reading Emergence sprouted another thought regarding the increasingly bankrupt (literally and figuratively) model of the classic bureaucratic organizations. Again I point to Umair Haque’s post on the recent financial crisis:

The first step in building next-generation businesses is to recognize the real problem boardrooms face – that we’ve moved beyond strategy decay. Building next-gen businesses depends on recognizing that they are not about new business models or even new strategies.

The stunningly total meltdown we just witnessed in the investment banking sector – the end of Wall St as we know it – was something far darker and more remarkable. It wasn’t simple business model obsolescence – an old business model being superseded by a more efficient or productive one. The problem the investment banks had wasn’t at the level of business models – it had little to do with revenue streams, customer segmentation, or value propositions.

And neither was it what Gary Hamel has termed “strategy decay” – imitation and commoditization eroding the returns to a once-defensible strategic position, scarce resource, or painstakingly built core competence.

It was something bigger and more vital: institutional decay. Investment banks failed not just as businesses, but as financial institutions that were supposedly built to last. It was ultimately how they were organized and managed as economic institutions – poor incentives, near-total opacity, zero responsibility, absolute myopia – that was the problem. The rot was in their DNA, in their institutional makeup, not in their strategies or business models.

I think Umair is on to something and that CEO salaries may make for a great case in point.

For many years the left has decried growing CEO salaries as a sign of the market’s excesses – or worse, of a broader culture of greed. But excessive senior management salaries are, from an investors perspective, are a symptom of a staggeringly flawed institutional model. If your business depends that much on the one person at the top – if the current and future value of the entire organization rests in the hands of one person… then yikes! Shareholders beware.

The idea that a CEO is worth 1000, or even 100 times more than the “average” workers in an organization isn’t just a problem from a morale or ethical perspective (it may or may not be). If your average worker isn’t contributing that much value in relation to their ultimate superior than you have a massively top heavy – and hierarchical – organization. One where, I suspect, Umair would find there are poor incentives, near-total opacity, zero responsibility, absolute myopia. To be sure, ideas are probably not being floated about, and they are almost certainly not successfully emerging from the bottom up.

In short, it isn’t a happy place to be. And it turns out the markets may not think it is so good either.

The Crash: The beginning of the end…

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The response to the post on complexity theory and the financial crises has been very positive. Been recieving lots of positive feedback, thank you to any who have written or commented.

Several people, including Steven Johnson, the author of Emergence, posted a link to this great piece “The Economy Does not Compute” that I encourage everyone to read.

Dave D. emailed me with this fascinating story from the New York Times that arguably pinpoints the moment the incentives in the market were shifted that started us down the road to the present crises. Entitled Fannie Mae Eases Credit To Aid Mortgage Lending the piece is dated September 30th, 1999. This excerpt below really summarizes the underlying logic and benefits for initiating the change as well as predicts the ultimate catastrophe that it would unleash (remember, written in 1999):

”Fannie Mae has expanded home ownership for millions of families in the 1990’s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. ”Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.

”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

The article shows us the challenges around blaming any one individual – except possibly Blll Clinton – as once the incentives for embracing a higher risk group were altered it vastly increased the chance that more and more people would cater to them and expose themselves to that risk.

The other fascinating thing about this piece is how the web is now getting to be old enough that it is becoming a fantastic tool for historians. Think of how much richer our history is going to be when critical documents like this one are both more accessible and easier to locate.

The Great Crash vs. Emergence (re-mixed)

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So it is with impeccable timing that about 3 weeks ago I started listening to John Kenneth Galbraith’s “The Great Crash: 1929.” (Indeed, I wish I had similar impeccable timing when planning my RRSP, 401k and stock purchases). Obviously the events of the last week, and more precisely the events of yesterday make this essential reading for everyone.

By quirk of luck (due to a recommendation by Mark Surman) I have also been reading Emergence: The Connected Lives of Ants, Brains, Cities, and Software by Steven Johnson. Emergence is about “the way complex systems and patterns arise out of a multiplicity of relatively simple interactions.” Possibly the most easily understood exmaple of emergence is seeing how ants or termites can create complex societies based on a few simple rules.

Interestingly, although Galbraith and Johnson almost certainly never met, and their books were written over 50 years apart, they are fundamentally writing about the same thing.

John Kenneth Galbraith’s The Great Crash is about an emergent system – the speculatory stock market bubble that lead to the 1929 crash. Indeed what makes reading these books simultaneously so interesting is observing how Galbraith describe an emergent system without the language and frameworks available to Johnson 50 years later. Consequently, Galbraith’s book is hints at a larger system even as he struggles to describe how the decisions of hundreds of thousands of individuals could be simultaniously coorindated but not directed. He intuits a distributed system, but simple can’t describe it as accurately as Johnson.

A great example of this struggle is visible when Galbraith’s describes his frustration with others efforts to pin the 1929 crash on a given, or set of, individuals. I’m willing to bet that, sadly, we are about to embark on a similar misadventure: I wager the next congress is going to launch a series of hearings to determine “who” caused our current financial crises. This, as Galbraith pointed out about “The Great Crash”, will be nothing short than a colossal waste of time and energy, one that will distract us from the real challenge. This is not to say illegal activities did not occurr somewhere on wallstreet (or K street) both in recent years and in the years leading up to 1929. I’m certain they did. Nor should they go unpunsished. They should. It is just that then, as well as today, they almost certainly did not cause this crisis. As Galbraith puts it:

“This notion that great misadventures are the work of great and devious adventurers, and that the latter can and must be found if we are to be safe, is a popular one of our time. Since the search for the architect of the Wall Street debacle, we have had a hue and cry for the man who let the Russians into Western Europe, the man who lost China, and the man who thwarted MacArthur in Korea. While this may be a harmless avocation, it does not suggest an especially good view of historical processes. No one was reponsible for the great Wall Street crash. No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not lead to the slaughter. There were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich. There were many Wall Streeters who helped foster this insanity, and some of them will appear among the heroes of these pages. There was none who caused it.”

There was no one who caused it. Remember that. Galbraith wants to pin it on something large and decentralized but can’t put his finger on what it is. Consider this line “No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of thousands of individuals. The latter were not lead to the slaughter. There were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich.” Throughout his book Galbraith keeps talking about a “collective lunacy” but cannot account for it. As he concedes, the desire to become rich is ever present, something in 1929 triggered a larger hysteria. Some emergent property made it vogue.

This is what we need to understand. In 1929 – as well as today – a group of people lived and worked in a system that had powerful incentives that encouraged them to engage in risky practices (in 1929 it was investing in stock on margin, today it was lending people money who simply could not afford it). Finding the people will achieve little compared to understanding the basic set of rules that created these incentives – removing the people will do little. Managing the incentives will do everything. A big part of this may involve new regulations, but probably more importantly it requires recognizing that whole new business models are required as these shape incentives far more than regulations. No business wants to go through this type of crises again. A business model that insulates them against it will be the one to copy. This is why Umair Haque’s post is so important.

Encouragingly and contrary to popular beleif, Galbraith doesn’t believe that the crash of 1929 caused the Great Depression. Depressingly he sites other problems that lead to the larger crisis – problems some of us might see as familiar:

  • A dramatic and uneven distribution of income (we got that)
  • Poor corporate structures (we got that one too)
  • Poor banking structure (check)
  • A uneven state of the foreign balance (check again, although in reverse)
  • Opaque economic intelligence (not so sure about this one).

Yikes, so we are batting 3, maybe 4 out of 5.

My biggest fear and suspicion is that this bailout, if it occurs. Will probaby not “rescue” the system. It will simply give us breathing room to adapt the system. Certainly that would have been the case in 1929, and history very much looks like an emergent system, beyond the control of a top down state, has once again taken over.