If Only the Ayatollah Learned Fairness in Kindergarten

Watching the Iranian election, Karsh reminded me about a study I had read about in Wisdom of the Crowds that emphasized the importance of the perception of fairness in human society.

The study went something like this: you and I would sit across from each other, and the researcher would give me $10. I could then divide up the $10 between you and me however I wanted. I could take all $10 for myself and give you $0 in fact. The catch, though, was that if you rejected the amount I gave you, we both got nothing. Most people split the $10 down the middle, $5:$5, or slightly skewed to the person making the offer, $6:$4.

Now let's go back to the two of us sitting across from each other. I get the $10, and I decide to give you $1, and I take $9. What would you do? Do you accept? If you accept, it would make rational economic sense, since you would have one more dollar than if you reject (remember, we both get $0 if you reject).

What the researchers found was that in most cases, people would reject an offer of $3 or less. People cared more about fairness in the interaction than they did about the economically rational move.

The author of Wisdom of the Crowds, James Suroweicki, goes on to explain that they did studies on income disparities between the rich and poor in various industrialized countries, and the United States came out with one of the higher disparities. Poor Americans, though, were among the most satisfied with the income distribution. Why? Suroweicki points to the perception of the American Dream. The poor Americans believed that with hard work and dedication they could be rich too - it was a system that was perceived to be fair (though that's easily disputed).

The perception of fairness is just so powerful. One of the most remarkable moments in American history was the first change in power between political parties. Historically, despots would be overthrown and political factions would war with one another instead of giving away power. In the United States, not a single ounce of blood was shed or riots started over the change in power. It was peaceful; the election of leadership was a system that enough people bought into and believed was fair.

The protests in Iran did not start because Iranians hate Ahmadinejad (though many of the protestors do) - they started because Iranians didn't believe the elections were run fairly. They bought into a system of government where their votes would be counted, and they perceived that the Ayatollah changed the rules. The protests are now about more than just the fairness of the election system, and discontent has certainly been brewing in Iran for a while, but the fairness of the election is what set this whole thing off.

I find it fascinating to look for the perception of fairness and the systems that people buy into to create that perception. The systems are everywhere - from lottery drawings to admissions processes - and don't underestimate the stir people can create if a system isn't fair. Sometimes it can overthrow governments.

Why Is Health Care Spend Worse Than iPod Spend?

What makes health care spending particularly "bad?" I mean, we're trying to limit our health care spend as a country, but why would health care spend be any less of a productive use of money than say buying an iPod?

Harvard economist Greg Mankiw today juxtaposed a statement by Barack Obama forewarning that health care costs could rise to 30% within 30 years with a study that showed that optimal health care spending was over 30% of a peron's income:

Economists Robert Hall and Chad Jones, writing in the QJE a couple years ago:

Over the past half century, Americans spent a rising share of total economic resources on health and enjoyed substantially longer lives as a result. Debate on health policy often focuses on limiting the growth of health spending. We investigate an issue central to this debate: Is the growth of health spending a rational response to changing economic conditions—notably the growth of income per person? We develop a model based on standard economic assumptions and argue that this is indeed the case. Standard preferences—of the kind used widely in economics to study consumption, asset pricing, and labor supply—imply that health spending is a superior good with an income elasticity well above one... In projections based on the quantitative analysis of our model, the optimal health share of spending seems likely to exceed 30 percent by the middle of the century.

Amazing what economic models can show you. What makes health care spend a "bad" cost to me though is that it's too often an unmanageable financial burden, namely for:

1. Government. The major driver of our budget deficit is an exponential rise in health care spend. The government will go bankrupt unless it lowers costs and/or cut back coverage.
2. Individuals. According to the Center of Economic Advisers, about 17% of individual bankruptcies result from catastrophic health care expenses. The "rational consumer" who "smooths consumption" doesn't plan for those outlier events of severe injuries and illness. Extending life may be worth the financial burden, but it too often bankrupts a person.

The Center of Economic Advisers report other positive externalities from health care reform, such as higher GDP , lower unemployment, and more discretionary spending for families.

Health care spend, in itself, is not inherently "good" or "bad." I think the key is to find a way to make health care costs manageable for both government and individuals.

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• Obama Pushes Theme That Health Reform Is Good Economics (blogs.wsj.com)

The $2M School Teacher

Venture capitalist Bill Gurley posted about a Korean company called Megastudy that provides online courses for students. The company sells each lesson for somewhere between $20-$120, and it shares a quarter of its revenue with its teachers. The business has reached a billion dollars and it has paid a teacher as much as $2M in a year.

Think about that for a minute: a school teacher that makes $2M.

Before the internet, the economics of a teacher were constrained to the size of their classroom. If I teach 25 kids in a class for a year, it limits the amount of money I can make. People bemoaned the millions that football players made in comparison, but each football player entertained millions of people through television, where teachers could only reach 25 at a time.

The internet has a remarkable ability to lift prior scale restraints. One teacher can now reach millions of students through the internet, and they can start making a football player's salary.

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• Tech Company Helps South Korean Students Ace Entrance Tests (nytimes.com)
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The Newspaper Cartel Hearing

Strange enough, C-SPAN seems to be my station of choice while exercising. This time around I watched a Senate hearing headed by John Kerry on the demise of the newspaper industry. Both sales and profits of physical newspapers are being demolished by digital/online newspapers, as people increasingly switch media.

In this hearing, physical newspapers were looking to be able to coordinate pricing online for a limited amount of time - a newspaper cartel, if you will. Right now, they have a sort of Prisoner's dilemma going on. If all the online newspapers could get together and agree to charge for content, then people would have no choice to pay for online content. But without the ability to coordinate (antitrust law prevents it), if the Miami Herald, for instance, became a "pay" site, people would just switch to the Washington Post or the Associate Press online. The stories have been commoditized. The newspaper's solution is to lift antitrust law and allow them to set prices together.

If this type of legislation feels wrong to you, it should. See the fundamental process going on in the newspaper industry right now is that it's getting more efficient. Where there once might have needed to be 10 reporters writing the same story about Obama's trip to Canada, now there only needs be two or three. The stories those two or three write is then disseminated to everyone over the Internet. Whenever you can have two or three people do the job of ten, that's a boost in productivity, which Fareed Zakaria calls the "elixir of modern societies."

On the other side of that, Senators were lamenting the decline of investigative journalism and quality reporting. Who will uncover the scandals? The thought process is that if we have more trained eyes on these stories then we'll uncover more scandals. While this makes sense in theory, there's the correlation issue. If each of these reporters were really bringing enough different perspectives to the table, then their content wouldn't be commoditized - I would need to read the 10 perspectives to get the whole story. As it stands now, though, their content is too similar - their perspectives too correlated - and so one story suffices online. Passing legislation allowing cartel activity will mean that consumers have to pay an artificially high price to keep these unproductive reporters around.

Senators were also complaining about inaccurate reporting online. Where a reporter might have an editor that oversees them, a blogger has no such oversight. A blogger can post whatever facts they want. While this is true, it's the reality they are going to have to face, regardless of whether newspapers die or not. Additionally, I think that there's an important place online for trusted brands. When nytimes.com writes a story, it has significantly more credibility than when random blogger writes it. The NYTimes is then paid for this credibility through links from websites citing the facts. Once again, the number of these trusted newspapers sites will diminish, but they will not go away altogether because they play an important role online.

It's also important to remember in all of this that while newspapers are hurting, television news is not. I would bet that the internet has enhanced CNN viewership instead of hurt it. These large media companies still maintain quality reporters on staff, and I don't see that going away any time soon.

So if you can't tell, I'm strongly opposed to repealing antitrust legislation for the sake of the newspapers. I think it props up inefficient companies and places a larger burden on consumers than is worth the cost. The newspaper industry is going to go through some shrinking pains until they either find a new business model or reach an equilibrium point, but I don't think it will be catastrophic to the quality of news Americans receive in the least. A few trusted brands will be left standing in the end - the majors like NYTimes, Washington Post, and LA Times - and a few will be created. And it would be a mistake to interfere with that natural process.

Greenspan: Financial Crises Are, By Definition, Unforeseeable

The other day, I watched former Fed Chairman, Alan Greenspan, talk on C-SPAN to the Economic Club of New York, and it was absolutely fascinating. It gave me a new lens to look at the economic downturn. Unfortunately, C-SPAN doesn't let me edit to the interesting parts, but the most enlightening part for me was during the question and answer period in the last 30-minutes:

http://www.c-span.org/Watch/watch.aspx?MediaId=HP-A-15576

Here were my five highlights from the speech:

1) Financial Crises Are, By Definition, Unforeseeable. A financial crisis only happens when there is a swift discontinuity in the prices of assets over a short period of time. If the markets had foreseen the discontinuity in price, it would not have become a crisis because the opportunity would have been arbitraged away.

For instance, with large deficits, people expected the collapse of the dollar and took defensive positions against the possibility. As a result, the dollar steadily declined, but there was no crisis because a collapse was foreseen. On the other hand, when people were holding subprime mortgages which they believed to be triple-A rated, which they subsequently found out out to be toxic, the economic crisis hit from the discontinuity in pricing.

A financial crisis must come from a shock to the system. And Greenspan argues that if that's the case, regulation should spend more time and effort ensuring the economy is flexible and can absorb these shocks, rather than trying to predict them.

2) We Have No Policy Against Asset Bubbles. Asset bubbles, as Greenspan explains it, is the result of a long stretch of economic growth, low interest rates, and low inflation. This period creates a sense of euphoria, and the belief that value will forever rise, which (of course) leads to financial crisis. Greenspan states that there is no policy that he knows of to suppress these bubbles that lead to crisis, but if there were, he would be a strong supporter.

3) With Risk Management, Long Tails of Failure Still Exist. Modern risk management means that banks keep enough of a capital buffer to prevent something like 99.5% of default risk. And banks make the deliberate decision to take that once-in-a-decade chance of default because the capital necessary to protect against 100% of default risks would be exorbitant. Greenspan goes on to suggest that we should reexamine how much capital banks store because a 10% capital to assets ratio may not be the right amount.

4) Humans aren't built to be afraid forever. Fear stems from an increase in uncertainty and people tend to withdraw when they're in a state of fear. This fear grinds the economy to a halt - but not forever. History has shown that people and markets are adaptable, and people won't be afraid forever. The question is when.

5) Enlightened Self-Interest Is Our First Line of Defense. Greenspan believed that enlightened self-interest would lead to effective self-regulation. Banks would manage their own risk appropriately to stave off insolvency. But, he said, euphoria infected even the most sophisticated player, which lead to a breakdown in risk management. Regulation needed to breakdown as well for the banks to be able to take on such a high risk profile. Any regulation system needs to rely on a measure of self-regulation to be effective.


My paraphrasing doesn't do Greenspan justice. I would watch Greenspan himself if you're interested.


Links:
Recession will be worst since 1930s: Greenspan

What's Not Going to Change?

I read a great interview (subscription required) with Jeff Bezos on HBR:

It helps to base your strategy on things that won’t change. When I’m talking with people outside the company, there’s a question that comes up very commonly: “What’s going to change in the next five to ten years?” But I very rarely get asked “What’s not going to change in the next five to ten years?” At Amazon we’re always trying to figure that out, because you can really spin up flywheels around those things. All the energy you invest in them today will still be paying you dividends ten years from now. Whereas if you base your strategy first and foremost on more transitory things—who your competitors are, what kind of technologies are available, and so on—those things are going to change so rapidly that you’re going to have to change your strategy very rapidly, too.

Certainly useful advice for downturns.

Answering Executive Compensation

Executive compensation has been highlighted lately because of Obama's cap of $500,000 for executives who receive TARP funds. Although I understand the sentiment behind it, my gut reaction is that a government ceiling can't be the best way to go about it.

In terms of salary, supply and demand still exists for executives at the top level. Let's say, for instance, you were one of the best corporate turnaround artists in the world, and you got a call from Citigroup. Would you really want to go work for $500k/year in the public spotlight with regulators breathing down your neck? Or would you go work for a private equity firm where you'd get paid millions? I think this cap only further weakens TARP companies' ability to recruit top talent.

Additionally, the TARP executives can only gain their restricted stock if the company pay back all TARP loans to the government first. BusinessWeek had a great decision tree (to the right) that showed that this hurdle to receive the restricted stock would lead executives to take greater risks in order to get the returns needed to get the restricted stock.

The HBR Editor's Blog wrote about a potential solution to tie executive pay to performance relative to competitors:

There is a smarter way to pay top executives. Former Kellogg Professor Al Rappaport wrote an article about it, back in March of 1999.

Rappaport argued that the proper way to reward CEOs was through granting them options whose strike prices were tied to an index of peer group of companies. If the company outperformed competitors, the manager got rewarded. If the company didn't outperform or did worse, there was no reward...

Unfortunately...when the economy heats up again, the war for talent will warm up with it. One of the easy ways for companies to compete in that war is by offering easy dollars. In that case, companies that stick to virtuous indexing may end up losing the best executives.

So the question we should be asking ourselves is not how we should be paying bosses - we've lots of good ideas about that-but rather how can we make fair pay schemes stick.

I think that this compensation structure is more in-line with market forces than the restricted stock reward structure that they have now. If a TARP execuitve can provide better returns than competitors, even though it doesn't reach the full amount of the TARP loan, the TARP executive should be rewarded for that performance because they delivered more repayment on the debt than any competitor did. Compensation should be incremental to performance - not a 1 or a 0.