Ideas, Opinions and Speculation

All the God's Men put Humpty Dumpty back again

geapen@decisionoptions.com (Gill Eapen) — Sat, 21 Nov 2009 03:08:00 +0000

In the relative safety of the European Union, the high flying CEO of an investment (commercial) bank recently described, how his subordinates, if not himself, are doing God's work. It is unclear if he had a crisp definition of what God's men are supposed to do, but on the surface it appears to be a compelling statement. I am sure even God will be happy making $35 Mil/day, doing His work, whatever that turns out to be. In this case, it may be saving the world by lending money generously provided to them by the Federal Reserve or perhaps using the "bailout" that did not require a "payback." to pay themselves bonuses. In either case, one has to tip her hat to both the chief and his country club followers, to save the world from the perils of depression and the possibility of making a few Mil $ less per day. After all, such generosity is seldom seen.

As the God' Men strived to put the Humpty Dumpty together again, on the premise that a broken Humpty Dumpty will spell trouble for the county club, the country and the world, many have asked whether we need the Humpty Dumpty at all. Less superior Humpty Dumpties have gone bankrupt with no significant impact on the world, with the Sun rising on the East and and settling in the West, every day - even after their demise. Hence, it is difficult to believe that the failure of the Golden Humpty would have stopped the Sun from going around the Earth.

As a large part of the country's wealth is invested in HIN1 flu free God's men, one has to ask whether the country needs the Humpty Dumpty at all. What if the God's men stop doing the God's work tomorrow? Will the world come to a screeching halt or will we enter a less inflationary regime with less money printed?

Leadership

geapen@decisionoptions.com (Gill Eapen) — Fri, 20 Nov 2009 04:05:00 +0000

Recently, I received an education on leadership from somebody I do not yet know. It appears that the term “leadership” means different things to different people. For some, the iconic leader is Rambo – who takes matters into his own hands and has only scorn for facilitation and consensus building. A leader, apparently, is somebody who steamrolls over everybody else in an attempt to accomplish some set objectives, even at the face of new or conflicting information. It appears that any attempt to understand opposing views or to debate differing ideas will automatically disqualify somebody from being a leader. Rambo never attempted anything like that as such constructs only reveal weakness, a bad quality for a leader.

Such a notion of leadership that is circulating in the halls of corporate America and the chambers of lawmakers is idiocy at the highest level. A leader is somebody who makes things happen by combining different perspectives and ideas, who is able to build consensus by logical discourse, who adheres to a clear set of principles and who ultimately makes a different in the World, not for herself, but for the populace. We have many examples of good leaders - both historical and contemporary. It is important that the concept of leadership is part of the education of the next generation, confused by the caricatures of popular leaders. A true leader makes a difference to the World in silence and to her own satisfaction.

Artificial Intelligence

geapen@decisionoptions.com (Gill Eapen) — Thu, 19 Nov 2009 02:54:00 +0000

Lately, an old theme has been surfacing again – that insurmountable fear of grown men that computers ultimately are going to take over the world. Artificial intelligence was a high flying area in the 80s – many students and academics, yours truly included, had dreams of making machines think and act like humans. It seemed like such a natural course to take. The brain is like a computer and hence a computer can be designed to act like the brain. It is possible that we went wrong on both of these assumptions. Unfortunately, a worse outcome may be awaiting humanity – humans are now acting like computers and taking over work that computers can easily handle.

This momentary lapse of reason for the brain was due to the fact that computers are linear thinkers and the last 50 years, people have been training themselves to behave like computers. In manufacturing floors and the glass houses of financial services, humans have been slowly taking over the computers. They have trained to think logically and programmatically, they trained themselves to be most efficient and most importantly they have created specifications and rules for every thought and action.

Computers have underestimated the human’s ability to squeeze out any bit of creativity left in their brains and perpetuate efficient processes and supply chains across all industries, handled exclusively by them. Computers have underestimated the human’s ability to design organizations in prescriptive pyramidal structures led by human robots making decisions to hire, fire and retain. Computers have underestimated the rise of consultants, willing and able to cut and paste with incredible precision, as they help contemporary companies to the edge of precipice. Computers have underestimated the human’s ability to add risk linearly in spread sheets and crash when non-linear and unexpected events occur in the penthouses of high finance. Computers have underestimated the human's ability to create policies assuming that linear forecasts will hold for decades as precisely as a Pentium chip, devoid of any uncertainty

Computers are unlikely to take over the world as humans have already taken over the computers..

Water, water - Everywhere

geapen@decisionoptions.com (Gill Eapen) — Fri, 13 Nov 2009 23:41:00 +0000

Purveyors of extra-terrestrial life have been obsessed with water. Although such obsession may be understood in the narrow context of Carbon based life, it has created chaos in many other areas. For example, missions to Mars and the rekindled interest in the Moon have been squarely focused on this innocuous chemical that takes two atoms of the most abundant Hydrogen and one of the lesser known Oxygen. Some of these are based on the idea of finding life and others on the possibility of transporting the mighty human from Earth. Lately, this obsession has bled into an incredible panic of running out of water on our beloved Earth, which is made largely of water. This has led to such insane ideas of investing in water companies (as proposed by market fortune tellers) to certain countries making “strategic plans” to corner the remaining water sources on Earth.

This obsession with water at multiple levels is misplaced. For starters, looking for water as the starting point for finding extra-terrestrial life outside the Solar system is not any more arrogantly stupid than assuming that Earth is at the center of the universe. The fact that water is an important aspect of the only known life, that is Carbon based, is not sufficient reason to make it the driving factor. Second, the assumption that Mars, Moon and other such near Earth bodies have to be prepared for eventual human transport is an equally arrogant notion. Humans are still perpetuating barbaric acts with no sign of any advancement in fundamental knowledge here on Earth and the transportation of this species elsewhere will not be a good thing. And finally, those who stay awake at night, afraid of running out of water just need to remind themselves that water is the most abundant on Earth. It is not water we are likely run out of, it is energy. With sources of energy, one can always create any amount of water.

Water, thus, is the most uninteresting chemical – in extra-terrestrial life finding explorations, attempts at terra-forming and here on Earth.

Is ignorance a crime?

geapen@decisionoptions.com (Gill Eapen) — Thu, 12 Nov 2009 02:21:00 +0000

Ignorance is considered a valid defense in many white collar crimes. If the perpetuator can reasonably demonstrate that she did not know something and that led to the alleged crime, in many cases that is considered to be an acceptable defense. However, in situations where it is reasonable to assume that the perpetuator "should have known," the information she claims not to have known, ignorance does not qualify as a viable defense.

This question can also be asked of executives of firms or leaders of countries whose actions lead to the failure of their respective organizations. If such actions emanate from ignorance, can they be held accountable for the outcomes? Does the test, they "should have known," apply in such situations? For example, can the CEO of a firm whose actions bankrupt the company be prosecuted for the crime? The end outcome of her actions may have robed many of their dreams, careers and life. Since this is akin to "crimes against humanity," as it affects a large number of people, or in many cases, a large percentage of the population in an area with cascading negative effects in the region, should such a crime be punishable at a higher level? Can such executives plead not guilty on the basis of ignorance?

In a famous case of a bankrupt energy company, the CEO claimed that he did not know "accounting" although he was a graduate of an illustrious business school and an equally famous strategy consulting firm. Since the "crime" was clear in this case, the "ignorance defense" failed because it was apparent that he "should have known." The bankruptcies and failures of many firms today affect as many people, if not more. Since there is no "apparent" crime, the society (and prosecutors) give these executives an easy pass. One could easily argue that the executives of failed companies should be held to the same standards if their actions explicitly resulted in the failure of their companies. Such crimes should be punishable at the highest level - as crimes against humanity.

In structuring such a system of effective disincentives to deter ignorance in the executive suites, it is important that the measurement is in the outcomes and not in the process. It has been said that nobody ever got fired by hiring a large and well known technology company for building their systems. It does not matter if the decision is a good one or even if the technology company delivers anything. If regulations are designed to measure nonperformance of executives against standard process metrics (as in the case of the widely admired but costly Sarbanes-Oxley legislation), this can easily backfire. As doctors tend to overdo tests to avoid getting sued, executives will simply follow standard templates (perhaps provided to them by consultants) to demonstrate that they did everything they could to avoid failure. If the measurement is the outcome itself - then only those who are willing and able to take such jobs will be there. Standard hiring and promotion practices - that generally elevate incompetence to executive suites - will disappear.

Similarly, if the actions of the leaders of countries or regions have resulted in the failure or nonperformance of the area, it should be considered a crime as well. This will increase the ability of policy-makers in general as this will deter those who are not adept at the job from applying for it. Since countries and regions do not have a market based price, it is more difficult to measure the net effect of the actions taken. However, it may be possible to construct a holistic set of metrics - such as per capita real GDP, growth rates, employment rates, inflation, health, education and other societal factors - and these should be set prior to the election process.

Ignorance is a crime for those who willingly take positions of power and thus assume accountability for the outcomes that affect a large number of people. They diminish the dreams and lives of many, if they are incompetent and ignorant. This is no less a crime than anything else.

The executive option

geapen@decisionoptions.com (Gill Eapen) — Sat, 07 Nov 2009 02:12:00 +0000

Most of us know that the value of an option increases when the uncertainty of the underlying increases. This is because options provide asymmetric payoff to the holder, allowing her to exercise the option in favorable circumstances and simply walk away in other situations. In a similar fashion, executives in large companies seem to hold management options provided to them by the shareholders of the firm. As uncertainty increases, the value of these management options increase. They allow the managers to exercise them if the company does well and claim “no-fault” if it does not. This has led to the culture of “no-consequence” management in which the chiefs claim high bonuses if the company (and the economy in general) gets lucky and blame everything else if things do not work out.

This has been ably demonstrated recently by investment banking executives who have claimed high bonuses in good times and appealed for bailouts in bad times. More subtly, the same phenomena have been happening in every other company. Managers of most large companies typically claim that the success of the company is due to their hard work but often blame the economy, government and other factors if the company fails. This is an option held by the managers of the firm. They exercise these options to their own benefits in good times and simply walk away in bad times.

Executive options will increase in value when the uncertainty of outcomes increases. The value of the executive, thus, is higher under chaos than in a stable regime. This means that it is dominant for executives of firms to increase uncertainty that automatically enhances their own value. A chaotic economy, thus, provides the executives of firms (especially the large ones) an automatic increase in worth. To correct this situation, negative bonuses and other creative incentives have to be implemented to make the pay-offs symmetric. Otherwise, we will prolong the “no-consequence” management culture that will make the economy worse off, save the executives.

Time tracking to bankruptcy

geapen@decisionoptions.com (Gill Eapen) — Sat, 31 Oct 2009 22:36:00 +0000

Many companies and organizations continue to measure time taken to complete defined activities and continue to use that as a proxy for productivity. When the end output is well defined and has low uncertainty in quality and quantity, such measurements may provide reasonable estimate of productivity. However, if the end product is not a tangible good or it shows significant uncertainty in quality, the time taken to complete the activity that aids in its production is not necessarily related to productivity.

For example, consider a car manufacturer who produces a tangible good (cars) with clearly measurable quantity output. Intuition may tell us that employees’ time spent inside the factory is a good proxy for the company’s profits (and hence the productivity of the employee). But this is not necessarily so. If the quality of the automobile has a significant impact on the buying habits of existing and future customers, it is not the production quantity that is related to profitability - it is the quality of products. Hence, measuring raw time spent inside the factory (that is related to quantity of production) is not useful in measuring productivity.

Similarly, if the company is producing intangible goods such as information (pharmaceuticals, hi-technology), measuring time of employees is not useful to manage the company better. Status-quo managers, some of them growing up in the industrial era and some others educated in the process-centric institutions and consulting firms may not only waste valuable resources by implementing time tracking systems but also create wrong signals on how to manage the company better. It is the implementation of such antiquated ideas of productivity measurement and management that is driving many large companies to the brink of disaster. Unless shareholders understand this and promptly remove such managers from these companies, the end outcomes will likely become more predictable.

More proof, less clear hypothesis

geapen@decisionoptions.com (Gill Eapen) — Sat, 31 Oct 2009 02:50:00 +0000

If a hypothesis predicts an outcome and the observations far exceed the predictions in a measurable quantitative scale, is the hypothesis proven to be just correct, more correct or possibly incorrect? A recent story in the Times of London, poses this question in terms of climate change. It appears that the melting of the ice caps far exceed the predictions from simulations based on green house gas emissions, using the most pessimistic inputs. Supporters of the end of the world by CO₂ hypothesis, may use this observation to convince themselves that, indeed, the world is fast progressing toward disaster. However, if observations do not quite fit the predictions, then, we may want to step back and consider a reformulation of the hypothesis.

There are both long cycle and unknown effects superimposed on short cycle and possibly known effects on the climate. The net effect of these phenomena is difficult to determine precisely. It is clear that pumping massive amounts of green house gases into the atmosphere may not be a good thing. But part of this comes from cows and Methane emitting volcanoes in the Atlantic in addition to aircrafts and automobiles. It may well be advisable to dial back our own emissions but that may not have much impact on the short cycle phenomena. To make matters worse, we are the victims of unknown long cycle phenomena that may have an even higher impact on what may happen to the climate.

As environmentalists lose sleepless nights cursing industrial development and ignorant automobile enthusiasts, worrying about the melting ice caps and rising sea levels, they may also want to consider the possibility that much of it is unavoidable.

Value = f (Innovative Education, Efficient Intermediation)

geapen@decisionoptions.com (Gill Eapen) — Sun, 25 Oct 2009 18:42:00 +0000

Amid the billions of $ wasted in the financial industry in forecasting financial asset values based on historical prices and financial statement analysis, two basic principles seem to have been forgotten.

(a) Financial assets are a mechanism to divide real asset values and transact

(b) Financial asset values are driven only by the underlying real asset values

Since financial asset values depend both on the current and future expectations of real asset values, any forecasting of the future, if need to be undertaken, has to start in the real markets. In real markets, value increases only by innovation and entrepreneurship. Contrary to popular belief, the behemoths of the industrial era, churning out yesterday’s products at a faster rate, aided by a low currency and the temporary appetite for status quo products from developing countries, add little value to the real economy. To improve real asset values, innovation rate has to increase and market conditions for entrepreneurship have to improve.

There are two major problems here for the economy - one strategic and the other tactical. On the strategic side, we have to create conditions that nourish innovation. Education is an important component of it. However, status quo designs of education systems rely on ideas from the last century – when prescriptive syllabus aided by physical experimentation was considered best. Such education may not improve innovation and may create a generation of educated people looking for jobs when no such jobs are available. A modernization of the education system and significant investment in this area will ultimately improve innovation and real asset values.

On the tactical side, we have to remove the impediments that currently exist for efficient flow of capital to those who seek to advance ideas. Arrogance from getting lucky in the 90s and related incompetence is prevalent in financial intermediaries, who are supposed to be helping this process. Printing money and giving it out to large institutions in the hope that they will spread it around efficiently is a bad policy. A new financial system has to take shape – one that is much smaller and nimble and one that understands value is actually created in real markets and not in bank vaults and trading floors.

Unless we focus on both improving innovation through a redesign of the education system and improving capital flow by a redesign of the financial system, any short term gains seen in financial assets will remain, short-term.

Keep profits, bail-out losses

geapen@decisionoptions.com (Gill Eapen) — Sat, 24 Oct 2009 00:49:00 +0000

Investment banks who architected monopoly positions in the recent financial crisis, have been riding high again. With profits and bonuses soaring, some have been reestablishing themselves as the rulers of the universe and the keeper of the most of the world’s brain cells. Some have even paid back the “bailout” money – at least the ones that came through the front door but not the back door. The “smart” ones have been able to convince the public that the money that they received in insurance payments from the troubled insurer are theirs to keep and even to pay bonuses for its elite.

More troubling than the arrogance is the short memories of these companies. They appear to have already forgotten that the reason the US tax payers bailed their incompetence out was the possibility of the complete collapse of the financial system. They made this happen by taking excess leverage – granted to them by ignorant regulators of the past. But they seem to be set to play the movie again – hoping that the taxpayers will come to their rescue next time they lose big. I would love to have an uncle too who will let me gamble and keep the profits but bail me out when I lose.

Judging by the enormous profits taken in by the extremely smart investment banks lately, it looks like the taxpayers will be on the hook again soon. But this time, they may not have the grand father in the treasury to keep them out of trouble.

Gambling returns have no alpha

geapen@decisionoptions.com (Gill Eapen) — Fri, 23 Oct 2009 00:22:00 +0000

Many have been perplexed by the ups and downs of financial markets, disconnected from the real markets. Some may argue that the recent rise in the value of the financial assets has been predictable from analyzing the trends – technology waves, slow-down in foreclosures and other such metrics. Many such analyses describe why profits could rise in the future but point out the risks of them not materializing. Some are sure of the end outcome but unsure of the time it may take.

Extrapolating real market trends into financial markets is dangerous as known information generally do not produce trends. If a trend is seen in the financial markets, it is generally driven by artificial liquidity – money chasing money. Such trends have a tendency to break catastrophically. For example, some may argue that they could have easily predicted Apple’s stock price rise – driven by its popular iPhone platform. What they are forgetting however is an important aspect of investing. If one bought Apple at a low price just a few months ago and made a handsome profit, it is because she was gambling and some win in gambles, sometimes. When one buys a stock, however, she also buys the risk of the stock not performing. For technology companies such risk is high. Apple could have easily gone down if its new technology platform were not a hit.

Making money in the stock market is not rare but doing it consistently is. Large amounts of money can be made by taking commensurate amounts of risk. Risk adjusted excess return, alpha, however has been fleeting.

Assumptions bounded rationality

geapen@decisionoptions.com (Gill Eapen) — Wed, 21 Oct 2009 01:10:00 +0000

If human behavior is rational, one would expect actions that maximize long term utility. Since each individual is free to be strategic within constraints, the actions of the individual should reflect an attempt at maximizing long term utility. However, such actions are affected by the individual’s assumptions about the present and the future. This basic set of assumptions is what defines each individual and not the actions taken in accordance with them. It is possible that actions can be predicted if assumptions are known and hence the individual is only differentiated by her assumptions. Assumptions, however, are formed over time – influenced by the environment, friends, culture, religion and the society at large that constantly interact with the individual.

All catalysts for behavioral modifications – through incentives in private markets such as companies and profits in public markets – work on influencing the individual’s actions given generic assumptions. The theories that explain the working of the firm and the markets, implicitly assume that bounded rationality occurs because of limited information. It may not be the lack of information that bounds rationality – perhaps it is the excess of it. Since assumptions are based on information gathered by the individual over time through various actions, the more information is available, the more varied the assumptions are likely to be among individuals. This is because assumptions are the result of the processing of information by the individual, affected by unique environmental characteristics. Hence, we may find rationality is bounded because of variety in assumptions aided by excess information.

Thus, it is possible that rationality cannot be defined in the absence of assumptions. If assumptions are hidden, rationality cannot also be tested. Since assumptions are defined by the individual, they cannot be rejected. It is likely that rationality will be high under two conditions. A complete lack of information may mean generic assumptions and thus an ignorant individual is possibly rational. Similarly, a lack of variety in assumptions – as may happen if human society advances to the next level - may enhance the probability of rationality. So, it is not lack of information that creates bounded rationality; it is the variety in assumptions held by the individuals.

The death of prognosticators

geapen@decisionoptions.com (Gill Eapen) — Sat, 17 Oct 2009 02:22:00 +0000

Lately, in the financial press and television as well as in quite corners of the local drinking holes, you find many who describe how they saw the whole thing coming – the financial meltdown, the real estate bubble, the commodity bubble, the hedge fund collapse – everything. It was so clear – the leverage was high, the debt levels unsustainable and “smart guys’ in Wall street were making stupid bets on everything. If any of these people had such infinite wisdom just 24 months ago, they could have retired the richest in the world. So, the question keeps popping up why these sages still work for a living or why they are drinking their sorrows away.

The answer may be simple – in hindsight everything is crystal clear. But since neither special theory of relativity nor quantum mechanics allow a safe passage to the future, such retrospective knowledge is as good as garbage. The ability to “see” what has happened is of no value – but if some believe that history will give them guidance for the future, they are entering fool’s paradise. Conventional wisdom appears to be that the world is ending – the Mayans prescribed the violent end to civilization in 2012. The prognosticators see troubles everywhere – private equity, US debt levels, US $ hyperinflation – it is the most deadly cocktail of problems. If any of these prognosticators shorted the US stock market, consistent with their beliefs just 6 months ago, they would have been carried out on a stretcher by now. Not to be left behind, many academics have also jumped on the bandwagon to hell – some predicting the end of humanity earlier than 2012.

If the world is expected to end in 2012, the discounted value of the world just a mere 2 years away to today will be nearly zero. Since the asset values have not collapsed to zero, there is a probability that we may find each other at the long side of 2012. But then, the doomsayers may be right as well. If the world does end, the most satisfying outcome will be the elimination of the prognosticators themselves.

In the belly of the beautiful bell curve

geapen@decisionoptions.com (Gill Eapen) — Fri, 16 Oct 2009 00:55:00 +0000

An average of a set of observations is an alluring metric and many decisions are currently made on this wonderfully and holistically sounding statistic. Hypothesis testing is often conducted based on the assumption of normality when observations are presumed to fall on both sides of the average in a beautiful bell curve. Many scientific disciplines – medicine, engineering and economics – routinely employ averages and normality assumptions in making critical decisions.

However, averages can be quite deceiving when the normality assumption does not hold. It has been said that the average IQ in the living room with few people dramatically shot up whenever Einstein walked in. Similarly, performance of many funds is tolerable if you remove a few extreme observations. Weather is forecastable, except when it is not. Diseases can be conquered with medicines that sometimes kill you. Similarly, if earth’s polarity shifted many times in less than 10K year cycles and there were few episodes when nothing happened for millions of years, average time between episodes will be high but that is not comforting.

In a histogram of historical observations, it is often the case that the average is significantly shifted to the right of the mode (most likely outcome). Both the use of averages in decision-making as well as the use of hypothesis testing based on normality assumptions is fundamentally faulty as most events show skewness in the time between occurrences as well as the severity of an occurrence. In business, financiers and economists often use average cash flows in calculating a net present value of an investment or stock. In pharmaceutical research, bell curves are used to accept outcomes by discarding the probability of extreme events as small. In engineering, failure data provides a safety margin based on averages. In all these cases, the decision-maker is being coxed into a level of comfort by the misguided power of normality statistics. None of these decisions are likely optimal as they are based on the wrong assumptions. Higher moments (skewness and kurtosis) are necessary ingredients in making any decisions based on historical observations.

Flexible experiments

geapen@decisionoptions.com (Gill Eapen) — Tue, 13 Oct 2009 00:25:00 +0000

Experiments in Physics, Biology and Economics have become increasingly more expensive and they, unfortunately, produce no or irrelevant results. The scientific process, that helped humans navigate early years of science and technology, has become a major hindrance to advance knowledge further. The idea has been to create a hypothesis that fits with the status quo framework and then design experiments to prove an aspect of the framework. The success of the experiment, thus, does not prove the theory and only increases the probability of the theory being correct. As the complexity in theory increases linearly, the complexity in experiments needed to prove components of the theory seem to have increased exponentially.

CERN’s attempt at producing the Higgs boson in the Large Hadron Collider is one such situation. The existence of this elusive particle does not prove the hypothesized framework but only enhances the probability of it being correct. More importantly, the existence of the Higgs boson may create challenges to other established notions such as the irreversibility of time – making it very difficult to understand why we would spend over $10 Billion to do so. In such cases, it may be better to suspend physical experimentation as we may have reached the complexity threshold and further knowledge increase is unlikely to happen by following the conventional processes of hypothesis creation and attempting to find physical proof.

Humans have gone through these types of situations before. Our ability to abstract a situation moved us from the need to physically see something before we act. Art allowed us to imagine and add color to both observable and imagined things. We are approaching this threshold in science as well, where abstraction is more efficient – with mathematics being the dominant tool. Experiments, if needed, may have to be designed to be flexible – i.e. not to prove a hypothesis but to keep the end outcome undefined. Such experiments may have a higher probability of advancing knowledge at a much lower cost to society. As complexity increases, the frameworks are likely to switch faster and thus flexible experiments that have a higher probability to shift knowledge is more valuable than those with prescribed and rigid outcomes.

Chasing the fish

geapen@decisionoptions.com (Gill Eapen) — Sun, 11 Oct 2009 02:21:00 +0000

A recent study describes the results from a simulation of global warming resulting in changes in fish catches – lower in the tropics and higher at the poles - but no difference is seen in aggregate quantities. This is a reminder that global warming is going to produce winners and losers and not all effects are not going to be negative. Weather patterns are going to shift as well – some areas ushering in more temperate weather and others severe. Over time this is going to create dramatic shifts in Earth’s topology and this may lead to massive migrations from one place to another.

This has happened before. Earth has gone through many such cycles in the past. The current trend is much more gradual than most others. There are many counter cyclical effects at work as well – including the possibility of a magnetic pole reversal – the net effects of which cannot be easily determined. Overall, the end state of such a complex non-linear system, subjected to a variety of man-made and natural shocks, is nearly impossible to predict.

Thus, environmental policies should not be prescriptive – attempting to counter precise forecasts of the future. Rather, they should be flexible, able to manage a variety of possible future scenarios. Such flexibility is critical to move the system to a more favorable position regardless of future outcomes – that are impossible to precisely predict.

The inspiring William Kamkwamba

geapen@decisionoptions.com (Gill Eapen) — Fri, 09 Oct 2009 01:11:00 +0000

A recent book, “The boy who harnessed the wind,” by William Kamkwamba details how he created a wind mill from limited materials and with even limited information. This inspiring story shows what is good with the world but it also points to why innovation continues to decline in most of the world. William did not have the Internet and Google and all he had was a book from the library. He studied it, thought about it, studied again and then he innovated within the constraints of materials and information. Such energy and persistence is lacking with most with nearly unlimited access to materials and apparently infinite information.

It appears that innovation is inversely related to available information to the innovator. Most of us “Google” or “Yahoo” everything. What is conveniently forgotten in this process is that these services accumulate not just information but noise. Noise is an order of magnitude higher and continues to increase its share in the information spectrum. It is thinking that is correlated with innovation. It is not access to resources but the ability to conceptualize that is important. It is not the collection and scanning of noise ridden information from various media, it is the creation of information that is critical. Those who train to be slaves to data and available information are unlikely to ever innovate.

The "Accounting Recession" is over

geapen@decisionoptions.com (Gill Eapen) — Tue, 06 Oct 2009 00:59:00 +0000

In the business world, the corporate finance departments of many companies spend countless hours of non-productive time to “massage” the Earnings Per Share (EPS) of the company, on the false belief that investors are generally stupid. Many accounting techniques exist to precisely meet or exceed the forecasted EPS number such as stuffing the channels with tangible goods or recognizing forward licensing revenue for intangible goods such as software. This accounting dance – forecasting precise EPS number and deploying “accounting flexibility” to meet them precisely - is well known. Investors, contrary to the beliefs of the finance chiefs, unwind the clever accounting gimmicks promptly and apply a discount on the companies who do so. This destroys business productivity and generally destroys shareholder value.

Recently, this disease seems to have spread to the macro-economy. Economists and policy-makers have recently declared “the recession over,” on the pretext that it grew a meager 0.5% on the 3^rd quarter. What they failed to mention was that the growth came from such programs as CARS – that forced many to “forward buy” automobiles – not dissimilar from the action of stuffing the channels by companies to meet the EPS number. Using such numbers to conclude an end to the recession is as ignorant as the actions taken by accountants in corporate finance departments. If this is true, they may want to unleash a new set of programs to force people to forward buy washers, dryers, ovens or any such tangible good. With such well planned programs, policy makers can even accelerate the growth of the economy in the 4^th quarter. It’s time that the economists and accountants put away their sharpened pencils, pocket calculators and nice looking spreadsheets and took a peak at the real economy.

Body-less language

geapen@decisionoptions.com (Gill Eapen) — Fri, 02 Oct 2009 22:21:00 +0000

From the beginning of the humans till recently, we communicated with each other, face-to-face. Those who were adept at analyzing visual clues from the body language had a survival benefit. Success today also depend much on such skills – both passed on from generation to generation as well as nourished in traditional educational institutions. As we enter the digital age, however, the skills needed to effectively communicate depend less on body-language and more on body-less language. Large communities are forming across social network media every day. Many of the participants never met one another but they share common interests. We are now forming “friends,” electronically not by assessing visual clues but language clues and such proxies as education, age and political affiliation.

The traditional development skills, thus may have to be redefined. Education systems, largely catering to norms of the last century, will be left obsolete with its graduates trained to interact personally but not through other means. For example, a focus on learning by doing and by observing physical things (as in a laboratory) has been rendered less efficient. Sequential learning is also not useful anymore in the presence of information that is growing exponentially. Cultural and other biases of the current and transitional generation have held sway in the debate of how to better adapt education and training systems to cope with the new age. Countries where traditionalism dominates are in a worse position to make this transition.

The world has changed and is changing at a much faster rate. Those who make education (and other) policies have to abandon traditions or make way to a new generation of leaders. Those who are driving the truck looking at the rear view mirror and making grand plans to enlarge the size of the mirror, may be missing the whole point. The needed changes are not incremental – they are foreign to those in policy-making positions today. Only a complete transformation of the education system – defining both the content and the process from scratch – is the only way to prepare for the next century.

Tackling poverty

geapen@decisionoptions.com (Gill Eapen) — Thu, 01 Oct 2009 00:40:00 +0000

Poverty rates have been rising across the country – some due to recession and some may be due to inadequate planning and preparation. Most compassionate people attempt to alleviate poverty by giving to the needy. Although such symptomatic treatment sooths the pain, it does not treat the disease. The experiences from other parts of the world where poverty has been persistent show that unless a systematic change is effected - that breaks the cycle - no long term improvement can be made.

To cure poverty, policy-makers have to focus on the causes of it. Lack of education early and inadequate skills preparation later have played a crucial role in the persistence and recent increase in poverty rates. From a policy-perspective, an investment into education and skills development pays handsomely not only to reduce future poverty rates but also to minimize healthcare related expenses. Education, thus, is a strategic way to contain poverty rates.

More tactically, provision of micro-financing and other such vehicles and introducing incentives for entrepreneurship can have a dramatic effect. In many poverty stricken areas of Southern Asia, micro-financing has been successfully applied. In the US, different instruments need to be designed – not just to feed the poor, but rather to help them break the cycle themselves. Policies have to get more creative in solving problems in the long run and not just apply cosmetic veneer on the visible symptoms.

Market entanglement

geapen@decisionoptions.com (Gill Eapen) — Tue, 29 Sep 2009 00:57:00 +0000

In Physics, the phenomenon of “entanglement” describes how quantum states can be “in communication” regardless of distance. This is to say, information transfer between two entangled quantum particles is instantaneous. An alternative hypothesis is that hidden variables programmatically drive the state of the quantum particle so as to make them appear to be in communication.

We have witnessed something akin to quantum entanglement in world markets in the last couple of years. Many smart people had hypothesized that the world is made up of different and uncorrelated markets and thus the shocks in one will not travel to another rapidly. However, if last two years are any guidance, information transfer between “these separate markets,” was instantaneous and unfortunately for may, clearly correlated. There is a question similar to quantum entanglement here – Did the markets transfer information to each other instantaneously or was it due to hidden variables – i.e. was there something programmatic driving markets so as to make them appear correlated.

Although it is difficult to say what may be driving the correlation, it is possible that we are witnessing programmatic actions of market participants. If this is so, it may cast doubts about the efficient market hypothesis (EMH) in that the actions of market participants can be predicted. For the proponents of the EMH, I hope this is a case of true entanglement and the correlations are due to instantaneous information transfer.

Distributed Business

geapen@decisionoptions.com (Gill Eapen) — Sun, 27 Sep 2009 20:09:00 +0000

The basis of large firms, as proposed by Ronald Coase at the University of Chicago, nearly a century ago, has been the minimization of transaction costs. It has held remarkably well for many decades, helping to explain the forward and backward integration of firms in many industries. Since the advent of Internet, however, transaction costs have been declining. Both the cost of computing and transactions are approaching zero and this has implications for contemporary companies based on the same ideas of scale and scope.

A larger firm has many disadvantages including bureaucratic friction, incompetent managers with excessive power and the inability to nourish break through innovation. Biased selection has been at work for nearly a decade now in larger firms and this has led to a level of stagnation that cannot be easily reversed. The returns to entrepreneurship has been increasing in spite of (not because of) inefficient capital providers who have managed to stem capital flow to the right opportunities. Zero transaction costs and comparatively lower returns from conventional scale should drive the optimal size of firms smaller and smaller. It is conceivable that the most efficient scale of firm is one and each individual may be better off as a firm rather than attempting to create traditional companies. We are likely approaching this scenario faster than anticipated.

Policy prescriptions have to take this eventuality into account. In healthcare for example, the advantages held by larger companies in negotiating prices will not be enough to hold them together. Thus for both the providers and payers of healthcare, it is time to think of more innovative products that cater to individuals rather than groups of individuals. Similarly, in crafting energy policies, the implications of distributed firms (individuals spread across larger geographical scope) have to be taken into account, In this context, it is not just generation of power that is important but the efficient distribution of power. It is clear from recent advancements that we are closing in on generation of a high percentage of power from alternative sources such as solar energy. However, such innovations appear to focus on concentrated generation. If a larger level of distribution is needed in the future, the losses can be significant. So, funding of innovation for more mundane materials sciences arena for efficient transmission materials is needed.

It is clear that the world is heading toward a distributed model of production and communication. Policies that aid the implementation of this in a more efficient fashion are needed.

High return education

geapen@decisionoptions.com (Gill Eapen) — Fri, 25 Sep 2009 21:22:00 +0000

In calculating the return on any investment, the investor has to take into account costs, risks, timelines and future potential. All of these are uncertain and hence traditional financial techniques such as Discounted Cash Flow (DCF) has been ineffective in determining true returns of most investments.

Take education for example. The investment in education by an individual has to take into account the option value of education, i.e. the ability to use education for profitable purposes in the future. Education is also valuable as an insurance against catastrophic loss of value of an individual in dire economic times. The future uncertainty faced by the individual and the society make education significantly more valuable than what can be forecasted by traditional metrics. For example, in the current financial distress, people with higher education have been able to do better than those without it. Education, thus, has significant option value aided by the ability to do significantly better in good times and less worse in bad times. The investment in education by an individual, thus, is value enhancing, unambiguously.

More importantly, investments taken by the society in the education of an individual is also valuable and utility enhancing. Such investments provide handsome returns (in taxes, charity and other vehicles) back to the society. Investments in education also reduce the required aid for individuals in bad times. Education also increases overall flexibility of the society, enhancing innovation and the ability to manage future uncertainty. Education also reduces life-style diseases, further enhancing overall return captured by the society. Education, thus, is the most important investment a society can make in an individual.

Although education as a utility has unambiguous positive effects on social welfare, it is unclear what is optimal for overall maximization of returns to society. It is possible that the base-line education of the entire population is less dominant to a higher variety in education. Countries that have focused on increasing literacy rates, for example, as a definition of base-line education, seem to have done worse than those who have nourished high variety and generalization in education. Also, countries that use conventional graduation metrics as a measure of education seem to be less innovative than those who have less prescriptive paths in education.

Thus, conceptually and practically, it appears that education has high returns for both the individual and the society. However, the architecture of education – universality v/s variety and prescriptive v/s generalized - determines the overall returns to the individual and the society. This is an important challenge to policy-makers as they have to not only allocate significant resources to education but also design the best architecture for it.

Sustainable development as an option

geapen@decisionoptions.com (Gill Eapen) — Sun, 20 Sep 2009 15:40:00 +0000

In economics, an option is the right but not an obligation to do something. Options always have a non-negative value as the owner of the option can exercise it when conditions are suitable or ignore it otherwise. In macro-economic systems, the use of natural resources in the creation of profits by private entities, the society as a whole often lose valuable options. If development is done in an unsustainable fashion, the society will lose options for future development. Most often, the value of such options are not internalized by the private entity and this leads to sub-optimal economic decisions.

The investments to assure sustainable development have to be viewed in this context. Since sustainability assures the maintenance of future development options, the level of investments that can be taken by society should be equal to the value of such options. More importantly, the costs to the private entity who may force abandonment of such options should be similar. These options can be valued using normative economic techniques and there is nothing that prevents us today to implement a system to track and trade such options.

The cap and trade for emissions is one such method. The one issue here is that the presumption of loss of optionality due to green house emissions is not entirely clear. Those who argue for and against seem to do so, focusing on the details of implementation. A debate on the conceptual merit of such a system is lacking. The necessary condition for proving utility in cap and trade is the demonstration of loss of future optionality by the society. This is a technical question as loss of optionality happens only due to irreversible actions. Since green house gases can be eliminated in the future by using energy, this is inextricably linked with the overall energy policy question.

So, the primary problem to solve is one of sustainability – i.e. do our actions result in a loss of optionality for the society that is irreversible. If the answer is yes, it is optimal to invest (or penalize the private entity undertaking the action) up to the value of such options.

The Real Recession

geapen@decisionoptions.com (Gill Eapen) — Sun, 20 Sep 2009 02:29:00 +0000

Fiscal and monetary authorities have already declared that the recession is over. The more important question is recession of what? Is it the recession in GDP, employment, exports or any other conventional metric? If so, such heart warming news may not mean much. The real recession is happening in two fronts – confidence and creativity – neither of which shows up in the accounting numbers.

The recession in confidence was ushered in by fraud and incompetence in the financial system. These are the same people who the US taxpayers are paying dearly to bail-out. It is the same people who want to pay the “money” back – the money they got through the front door but not the back door. It is the same people – some of whom are enjoying accommodations in federal penitentiaries. The recession in the confidence in the financial system cannot be relieved by academics driving interest rates to zero and demonstrating that the economy can grow by financial intermediation if not by any real products. The recession in creativity is helped by the lack of capital or the high cost of capital supporting innovation and new ideas. Capital, allocated by incompetent intermediaries either has stayed in treasury bills or in mattresses – some fearing the end of the world and others, the end of capitalism.

The confidence in the financial system can only return after the complete failure and removal of incompetent and fraudulent firms that control the process. The creativity can improve only when capital can flow to ideas at appropriate cost – not by traditionalists but by those who understand innovation. It is the recession in confidence and creativity that is holding us back. Bureaucrats and academics pouring over numbers of GDP, employment and money supply are simply missing the big picture.