Category Archives: Outcomes

When Goals Limit Solutions

One of the simplest concepts in economics is the rational person trying to achieve a single goal. A consumer trying to buy an ice cream, for example. Most people have goals and most are not as simple as buying ice cream. Still the nature of the goal can have important consequences in how you obtain it. For instance, if you need ice cream but have no money, then robbing an ice cream truck is one of your only alternatives. Having just two dollars expands the number of choices and routes to your goal immensely.

This analogy has a corollary in public choice. Activists often proclaim the need to end practices still prevalent in society. In a recent article on domestic violence in the Guardian, the author concluded: “We need to end domestic violence entirely”. Similar positions have been voiced by law enforcement advocates calling for the end of crime, or environmentalists calling for the end of pollution, or anti-war advocates calling for world peace. Each position is an absolute one; That a negative aspect of society must end.

Two of these positions have been tested. Strong support for harsh criminal penalties in the 1980s and 1990s brought a shift towards mandatory minimums, three-strikes rules, and death penalties. Yet after 20 years, the data and policy studies are not sure what this harsh penalty absolutism has gotten us besides lots of prisoners. (see David and Goliath by Malcolm Gladwell) Ultimately, Gladwell arrives at the economic conclusion that eliminating crime or even reducing it too much can have too high a cost. Essentially, eliminating crime from society suffers from a marginal benefit problem as more criminals are locked up.

Likewise, after numerous studies and suggestions on how governments can reduce pollution and greenhouse gases, little progress has been made. The best solutions are carbon taxes or a carbon market which would allow the trading of “carbon credits”. Neither solution is commensurate with the extremes of the two opposing voices: industry and environmentalists. As a result, even the structure by which future progress might be made is left languishing in sub-committees. The problem with absolutism is that, even if technically possible, the all-or-nothing demands restrict the routes through which progress can be made.

World peace was the choice cause of the 70s. Now it’s a pejorative for all similarly idealistic and unlikely wishes. No one blinks an eye when Obama suggests re-entering Iraq or Putin sends troops into Ukraine. This is the folly of absolutism, idealism is likely to turn to realism and then to satire and then disregard. For progress to be made by a movement, progress must be made while it is still alive. The fault, however, lies not simply in idealism meeting realism but in limiting the paths to success.

By declaring an absolute goal, a lot of possible allies are alienated. Calling for the end of pollution renders pollution-reducing science useless, opposes industry and it’s employees, and makes the jet travelling activists easy targets for scorn. In reality, the scientists working for industry will be the first allies needed to reduce pollution once legislation is enacted; the industry employees would benefit just as much from the lack of pollution literally in their backyards and work places; the industry itself could benefit if efficient solutions saved money as well as reduced pollution; and finally, activists wouldn’t look like hypocritical idealists.

The desired goal, then, in these cases limits the solutions as well as eliminates possible allies. The goal creates the structure of the solution set, and in the absolutist case, a much smaller solution set. Few people, especially moderates, are likely to find these solutions acceptable. The results benefit only a minority. Most cases where the opponents are equally matched (industry vs. environmentalists) nothing happens. On the other hand, where the sides are unmatched (criminals vs. enraged society), extreme positions actually get implemented and hurt society as a whole (as happened in California). Better solutions abound but are not explored because moderates are not the ones calling for change. For the benefit of society, we must end absolutism [wink] and start discussing other routes to the valid goals espoused by these movements.

Corporate Structure and Outcome

The past couple decades have seen some giant corporations disappear overnight. Enron, Lehman Brothers and Bear Stearns disappeared in a matter of days. The past couple decades also had some of the worst corporate oversight ever. The two oversight bodies of a traditional firm are the shareholders and the the Board of Directors. The Board is usually charged with the presentation of the shareholders’ interests to the management of the company (i.e. the CEO, CFO, COO, etc). Increasingly throughout the 1980s and 1990s, the Board’s chairman would also be the CEO. In other words, having the CEO in charge of his own supervision became a norm.  The increased power of the CEO in America’s corporations led to higher compensation, higher risks, disregard of shareholders and spectacular failures. The saga that follows has two parts: the story and the structure/behavior relationship.

The first important question is why would shareholders ever relinquish their oversight power to the CEO? The trend toward unsupervised management began during the huge growth in the technology sector called the dot-com bubble. Normally when a startup goes public and sells shares of stock in an IPO, the new responsibility to shareholders forces tough choices between growth and profit maximization. The dot-com bubble was famous for IPOs that sold spectacularly with no revenue or even plans for revenue. When investors finally realized that their investments were simply monetary alchemy with all free services and no profitable outlook, the market crashed. Throughout the dot-com bubble and even after, the tough choice between growth and profit was never forced.  Shareholders had traded in their power for profit, buying into the idea that their management must respond quicker and make bigger bets in an ever-changing world. Sadly, the CEOs of the Fortune 500 tried to bring the same management structure into their companies. The result was needless bets and shareholder marginalization.

Fundamentally, structure gives rise to behavior. CEOs who have more power and freedom, essentially have the company riding on their shoulders. Management likes this because it can justify higher salaries and allows them to make a name for themselves. A CFO who doubled earnings per share could move on to CEO at another company. This structure emphasizes short- term risk taking for short-term benefits. The average investor going long on a stocks prefers stability and year-over-year revenue growth. Additionally, investors would prefer the CEO and management not be a single point of failure. Therefore, CEOs who must answer to their Boards and shareholders must focus on improving the fundamentals and working on the margins. Neither of these tasks are all that glamorous. As a result, shareholders are at odds with the “entrepreneurial” CEO structure.

The choice of corporate structure and behavior should result from the outcome desired by the shareholders. Small-cap stocks and IPOs are chosen for growth and are allowed to take risks. The startup culture that has grown since the early 1990s is predicated on the startup management taking risks, making bets and staying flexible. Profit is almost never the primary goal. Growth is paramount. For instance, Facebook (FB) has never made a profit for its shareholders. Nevertheless, it is valued at 163% of earnings because it continues to grow. No one complains that Mark Zuckerberg of Facebook is both the CEO and Chairman of the Board. In this environment, the risks are not only necessary but also preferred by investors.

On the other hand, blue-chip stocks (large market cap) are chosen by long-term investors for their stability. Top-level competition and rivalry for rankings in Fortune’s CEO list doesn’t benefit shareholders. Nobody loses out from the short-term betting and risk-taking more than the 401k investors who invest in blue-chip indexes like S&P 500. Since the 1950s, turnover (think failure rate) in the Fortune 500 list continues to be faster and faster. This isn’t reflective of higher competition. Rather its a reflection of the jungle that the C-suite of corporate America has become. Fortunately, the hedge fund and 401k managers have begun to fight back. Demands for new board members and new voting rules have increased from these new shareholder champions. They’ve realized that changes to the top management are meaningless so long as the structure benefits risk takers and screws the shareholder.

The lesson here is that structure defines behavior and behavior defines outcome. Shareholders who want stability and less risk must choose the appropriate structure and exercise their rights. The bonus lesson is that systems should be environment appropriate. Risk-taking should be allowed when necessary and restricted when unnecessary. As we shall see, these principles are also applicable to the government stalemates in America.