Is the Scalability Principle behind increasing inequality in the UK?

At the Liberal Democrats’ party conference last week, Vince Cable highlighted the growing level of income inequality in the UK. While on average, the economy is growing, the benefits are disproportionately going to those who are already at the top of the ladder.

I thought I would dig into the topic of inequality a little deeper and I found this website with informative data on income and wealth disparity in the UK. It was quite shocking to learn that the poorest 10% of the population have not seen a rise in their average real incomes in the last decade, and two fifths of the real increase in incomes went to the people who were already in the richest 10%.

This trend isn’t just affecting the UK. According to Wikipedia, the Gini coefficient (an econometric measure of income inequality), has been rising since the 1980s in the USA, China, India and Brazil as well as the UK.

Why might this be happening?

One contributing factor could be the ‘Scalability Principle’ which I wrote about earlier this year. Scalability is a quality of certain tasks which means once they are performed once they can be replicated (‘scaled up’) millions of times with little marginal cost. A hundred years ago there were relatively few scalable professions. But technological advances in general, and computing in particular, has greatly increased the number of scalable professions. In this sense technology has increased the number of fields with a ‘winner takes all’ reward structure.

We need to think carefully as a society about what level of wealth disparity we are willing to accept. And if we feel things are already too unequal, perhaps we need a new approach towards what we think of as ‘progress?’

'Multi-layered' problems are best solved with a touch of Obliquity

On a recent flight across Europe I read John Kay’s recent book Obliquity. Short and easy-going, the book focuses on the idea that solving problems using ‘direct’ methods based on logical deduction and algorithms often results in an imperfect solution. In many cases, he points out, an indirect or ‘oblique’ method arrives at a better solution.

As an example, someone travelling across London may, out of habit, look at the Tube map and travel from their starting point to the station closest to their destination. However, this direct method may be inappropriate in the cases where it is actually quicker to walk than take the Tube*. Kay relates how he once took the Tube from Paddington to Lancaster Gate because he didn’t realise how close the two are above ground (Londoners reading this should be smiling at this point).

He applies this ‘Obliquity’ principle to many problems with varying degrees of abstraction. For example, he suggests that ‘the most profitable companies are not the most profit-oriented’ and ‘the wealthiest people are not the most materialistic.’ He goes on to attempt to explain reasons why indirect solutions beat direct ones so often, bringing the concepts of complexity, incompleteness, abstraction and pluralism into the narrative.

To Kay’s list of reasons why direct, supposedly-rational approaches to problem solving fail I would like to add one contributor: the ‘multi-layered’ nature of most tricky problems. Often we approach a problem with one line of thinking, but as we investigate further we find further layers of complication in the problem. In that sense, tricky problems are like onions. However, as you peel away layers of an onion you can tell when you’ve found the core. Problem-solving is not like that: you never know whether you have reached the ultimate level of understanding or whether there is another level of complexity beyond your grasp.

One of my favourite examples of the ‘multi-layering’ of problems is the debate over energy efficient light bulbs (abbreviated to EE bulbs henceforth). Let’s start with the proposition ‘anyone who switches to EE bulbs will save energy.’

At the most basic level one might conclude that this is true, as by definition EE bulbs use less energy to produce the same amount of light as normal bulbs. But let’s look a level deeper. The additional energy used by non-EE bulbs is released as heat. This is normally considered to be wasted. But what if you get your heating from electrical heaters anyway? If you do, then switching to EE bulbs will mean you need to put your electric heating on more, thus you do not save energy. You may even end up using more.

I’ve seen this debate play out several times. Going a level deeper, one could argue that lightbulbs tend to be near the ceiling, and heat released at ceiling height just stays there, and is therefore wasted. But going a level deeper, one could argue that heat is mostly released by radiation and reaches all parts of the room. Ultimately the debate never gets resolved.

As John Kay points out in the conclusion of ‘Obliquity,’ the recent past is littered with examples of poor decision making by people in power. Clearly there is a long way to go before we really understand where we are going wrong. In the meantime, the pursuit of better problem-solving methods is a worthy goal.

Notes
*I love this innovative re-design of the Tube map, which depicts relative geographic lay-out of stations more accurately.

What Baseball has to Teach Us About Business Success - a Review of Michael Lewis' Moneyball

I’ve just finished reading Moneyball by Michael Lewis, a writer made famous by his banking classic ‘Liar’s Poker.’ One of the modern classics of sports writing, Moneyball follows the story of a baseball team, the Oakland Athletics, which employed the unorthodox tool of statistics to pick players and win games.

The way Lewis describes it, the vast majority of the baseball industry relies on experience, intuition, and tradition to make these choices. In a sport that generates a vast trove of statistics on players’ and teams’ performances, only a small group of fans, known as ‘sabermetricians,’ used to bother subjecting the data to hard analysis. This changed in the late 1990s when Billy Beane, general manager of the Oakland A’s, realised that to stand a chance against wealthier teams he would have to organise his team differently. Together with Harvard graduate Paul de Podesta he set about analysing baseball to determine, amongst other things, how you can use historic performance statistics to value players (and work out which attributes are underpriced in the market), and which tactics help you win games. On both these questions the conventional wisdom was wrong, and using their analysis Beane and de Podesta put together a successful team on a low budget.

I myself am not a big baseball fan, but I was drawn to the book by references to it in a number of modern business books. The story Lewis tells has some wider messages that resonate far beyond the baseball diamond.

1. When used properly, statistics can be a goldmine

The rest of the industry were not ignoring statistics. They were simply focussing on the wrong ones. They had never subjected the raw data to a statistically valid analysis using the tools of probability, hypothesis testing and regression analysis. This attitude – taking basic statistics such as means, medians and ranges – leads to simplistic conclusions and overlooks the value of deeper analysis. Proper use of statistics can give a business an advantage over its competitors. It can also have great effect in non-competitive sectors such as public services or international development.

2. When a competitor is being unexpectedly successful, don’t dismiss this as an aberration

This is a mistake big businesses make all too often. They assume that a competitor’s success is down to luck, temporary trends, or the unique success of a single initiative or product. While this might be true, a competitor which consistently outperforms is probably doing something substantially better than you. There is no denying that baseball contains a strong element of luck. So when the Oakland A’s had a couple of good seasons, competitors were not too concerned. However even when the A’s continued to outperform year after year, with ‘winning streaks’ of historic length few competitors stopped and questioned how they did it. Even after Moneyball was published, much of the industry remained in denial about the power of statistics.

3. Don’t just accept the conventional wisdom – and don’t be afraid to look for a new way

The conventional wisdom in baseball was that you need to hire star players to make a team better. Billy Beane did not have the budget to hire stars – but he didn’t accept the conventional wisdom either. He looked for another route to success – one his competitors would have overlooked – and he found it. This is a step that many successful businesses, investors and entrepreneurs have taken, ranging from Toyota reinventing the way car production is organised to Apple’s launch of the iPad, a product in an entirely new category overlooked by every other electronics firm in the world.

As a book Moneyball has a great deal to offer sports fans in general and baseball fans in particular. But it also contains lessons that are useful to a wider audience, namely: look to the numbers, and if they conflict with the conventional wisdom, then the conventional wisdom is probably wrong.

Why I'm a fan of 'The Seven Habits'

A few weeks ago I had dinner with an old friend. Having noticed my reviews of several business books, he asked me to recommend my favourite ever book on ‘personal effectiveness.’ I didn’t have to think for long before responding: the book I have found most compelling has been ‘The Seven Habits of Highly Effective People’ by Stephen Covey.

I’m not an expert on the ‘success’ and ‘self-improvement’ literature, but I’m not a cynic either. Several of my friends would never pick up a book of this genre, believing that they’re aimed at people who have low self-esteem, who lack confidence or who otherwise feel that they are in some way flawed. While some proportion of self-improvement books is aimed at this kind of audience, I have found many titles with a lot to offer readers who are already confident and well-adjusted individuals.

‘The Seven Habits’ is one of these. It has several great things going for it:

• Stephen Covey is an expert in what he is writing about. He has a thorough knowledge of the existing success literature which he has studied at length. His depth of knowledge shows through in what he writes.
• Covey acknowledges up front the low quality of much of the self-improvement literature. He has a clear disdain for books that promise a ‘quick fix.’ This honest approach make much of what he recommends that bit more compelling.
• His writing style is very accessible; he illustrates all his points with anecdotes either from his own experiences of those related to him by others. This puts all of his ‘Seven Habits’ into context and prevents the book becoming dry and overly theoretical. He includes some ‘thought exercises’ which engage the reader, but not to the point it reads like an instruction manual.
• The content itself makes a lot of sense, but without coming across as something obvious. Each of the ‘Habits’ stands up by itself as useful advice. Added together, they mesh into a sensible structure giving an overall picture which is more than the sum of its parts.

The one thing I can see putting off some readers (particularly English ones) is Covey’s earnest tone. To quote Kate Fox’s classic, ‘Watching the English:’

“At the most basic level, an underlying rule in all English conversation is the proscription of ‘earnestness ’… seriousness is allowed, earnestness is prohibited. …To take a deliberately extreme example, the kind of hand-on-heart, gushing earnestness and pompous, Bible-thumping solemnity favoured by almost all American politicians would never win a single vote in this country.”

With this health-warning aside*, I would highly recommend ‘The Seven Habits.’ Even if you have never thought of reading a ‘self-improvement’ book in your life, I think you would find it accessible, practical, stimulating and altogether a worthwhile read.



Notes: *In writing this I realise that this blog is sometimes guilty of excessive 'earnestness' (!)

How a Trip to the Pub Reminded Me, ‘There’s No Such Thing as a Free Lunch’

I’m always on the look-out for articles that educate, stimulate and generally challenge my view of the world. This week I found one in an unexpected place: the JD Wetherspoon pub chain’s company magazine. Sitting in the pub, leafing through the magazine, I was anticipating finding commentary on their latest pub openings and newest real ales. Instead I found myself reading an intelligent editorial piece on the troubles in the Eurozone by Tim Martin, Chairman of JD Wetherspoons.

While criticising the Euro is now in fashion due to the sovereign debt crisis, Tim Martin has long been opposed to the idea of the single European currency. He recounts in his article how he campaigned, in his capacity as a business leader, against its introduction in the UK. At the time, the accepted wisdom in intellectual circles was that the Euro would strengthen trade with Europe and would be an asset to the UK economy. He came up against politicians, economists and financial journalists all clamouring for its acceptance. But, along with hundreds of other citizens who rejected the idea of surrendering more powers to bureaucrats on the continent, he vocally rejected the Euro.

He characterises the debate over the Euro as pitting the intellectual elite, with their neoliberal economic agenda, against the ordinary citizen who values local freedoms (such as the control over our own currency) more highly than the theoretical benefits of global integration. And in the case of the Euro, his side appears to have won.

This got me thinking whether simple, unsophisticated, folk wisdom might triumph over complex theorising in other areas of business and finance. For example, how much management theory applies in real life? Do economic models include too many assumptions to really reflect reality? Is all the effort we spend making quantitative forecasts really much better going with your gut feeling?

One piece of folk wisdom that the world of business and finance would do well to learn from is “you can’t get something from nothing” (or, more familiarly, “there’s no such thing as a free lunch”). This simple maxim seems to have been forgotten in the pursuit of quick profits – but the profits prove illusory when the hidden costs are taken into account. For example, in business, switching to a cheaper supplier might seem like an easy win – but no switch comes without risks that might end up costing you. In finance, increasing your leverage is an easy way to flatter your return on equity – until a crunch arrives and you wind up with nothing. In economics, keeping interest rates low seems like an easy win in terms of stimulating the economy – but excess credit sows the seeds of the next bubble.

How the Eurozone debt crisis plays out will be fascinating and potentially terrifying to watch. As such, I am thankful to Tim Martin and others for opposing the Euro in the UK. And I am also grateful to him for reminding me that even the best theoretical ideas frequently fall flat on their faces when confronted by reality.

The Trouble with Financial Services: Why Regulators Fail

Last year I wrote about the difficulties inherent in organising healthcare services. Another industry with in-built instability is financial services. Several characteristics of this sector make it especially difficult to regulate effectively. I have explored some of these below.

Financial regulation is in a constant state of tension between two approaches. The ‘Laissez-faire’ (i.e. hands-off) approach advocates minimal interference, based on the assumption that the best interests of society are served through free markets. The alternate approach (‘interventionist’) suggests that free markets often act irrationally; they require close supervision and restrictions to avoid damaging financial crashes, amongst other problems.

The decision of where in the regulatory continuum between these two extremes a particular regulator should sit is fraught with difficulty. I’d like to draw attention to four particular problems.

1.) Complexity
Financial systems are full of feedback mechanisms that we don’t completely understand. The actions of millions of market participants combine to set asset prices, provide capital and transfer risks. What happens in the markets affects their behaviour, which in turn has an effect on the markets. George Soros calls the feedback patterns ‘reflexivity’ and blames the recent financial crisis on it.

Complexity in the markets might be seen as a good reason not to intervene, as regulators’ actions are liable to have ‘unintended consequences’. However it could also justify interventions which prevent increases in complexity (such as restrictions on derivative products). Regulatory rules may also help companies deal with the unexpected (such as capital requirements for banks). Market complexity is a double-edged sword that makes regulators’ jobs extremely difficult.

2.) Revolving Doors
The Oscar-winning documentary ‘Inside Job’ highlights how top roles in financial regulators are frequently filled by ex-bankers. This isn’t surprising, given the specialised knowledge these roles require. However it can reasonably cause concerns about conflicts of interest. Social ties, political contributions, and the ‘revolving doors’ between jobs in regulation, banking, and lobbying create strong disincentives to individual regulators taking hard line.

3.) Race to the Bottom
Financial services firms can base themselves where they like. As a result, some countries try to attract them by offering low regulatory burdens. The risk that firms will flee financial centres such as New York or London is a major disincentive to regulators in the US and UK from tightening up their supervisory regime.

4.) Financial Innovation
As Merton H. Miller explained in his 1986 paper on Financial Innovation, “the major impulses to successful financial innovations have come from regulations and taxes.” More specifically, financial institutions use new products as a way to get around regulatory restrictions, rendering them ineffective. (As an example, the US withholding tax on interest payments remitted abroad triggered the creation of the market for Eurobonds, to allow US firms to raise money outside of the US.) In addition, continuous financial innovation makes it extremely difficult for regulators to stay up-to-date with the latest financial instruments being created.

This is a very cursory treatment of a subject that could inspire whole volumes. I am sure I have missed out other important reasons behind the difficulty of regulating financial services. Ultimately, it will be the widespread recognition of these potential roadblocks to effective regulation that allows us to make progress overcoming them.

Too Big To Fail - The British Brains Behind the US Response to the 2008 Financial Crisis

I’ve recently read Andrew Ross Sorkin’s book on the Global Financial Crisis, “Too Big To Fail,” often described as the definitive account of how the events unfolded. It starts with the emergency rescue of Bear Stearns in March 2008, then plots the series of decisions which ultimately led to the collapse of Lehman Brothers, the takeover of Merrill Lynch by Bank of America and the bail-out of the banking system.

While I lived through these events and followed the press coverage eagerly at the time, the book sheds a fascinating light on the behind-the-scenes manoeuvring of the Wall Street CEOs and the government regulators. It has changed my perspective on some of the decisions that were made and reminded me of the magnitude of the task that was asked of the leaders in the banks, the regulators and the government.

One of the biggest changes in my view on the matter is a new-found respect for how effectively the British regulators reacted to the crisis, in comparison to their American counterparts. On a long list of issues, the British government and regulatory bodies took decisive action that the American regulators would not stomach – yet in many cases were later forced into copying.

• US regulators were strongly resistant to a ban on the short selling of financial companies’ shares, until they saw the positive effect it had in the UK.

• In the weekend before Lehman Brothers collapsed, Barclays was in negotiation to take it over. I didn’t realise before that this was blocked by the UK government. If a deal had gone through, Barclays could ultimately have been jeopardised, so it seems in hindsight to have been the right call.*

• In late 2008, when it became clear that wide-scale action was needed to help banks survive the write-downs on bad debts, the US government was planning to buy the poor-quality loans directly from the banks. This was the plan that was ‘sold’ to Congress. However, in practice it is barely workable – the government just does not know how much to pay for the loans. The solution was instead to make capital injections directly to the banks in exchange for an equity stake: the US chose this route after it had been successfully implemented in the UK.

• In a twist of irony, the UK bail-out was optional and several banks (including Barclays) were sufficiently strong they did not need to take government funds. In the US, which loathes government interference with ‘free enterprise,’ the top nine banks were forced to take bail-out funds (so that the weaker among them didn’t look bad).

The UK has a long history of showing leadership in the fields of economics and finance (I’m thinking in particular of the great economist J.M.Keynes). Reading this book made me realise that the UK still has an edge in these fields – one that will be required going forward as the country faces continuing challenges from fiscal tightening at home, the Eurozone debt crisis, and many other problems on the horizon.

Note
*Barclays later acquired the US broker-dealer unit of Lehman Brothers out of administration, getting the bit of the business they wanted at a knock-down price