Detailed Abstractions

Over at HBR Amar Bhidé has written an article discussing the housing market and subsequent crash (very interesting – entire thing here) and proposes that among the causes of the crash, a sort of self restriction had taken the market from a vibrant one to one controlled by centralized authority:

The modern economy creates and spreads unprecedented prosperity by drawing on the resourcefulness and enterprise of the many, not by blindly following the dictates of a few. Individuals today make and act on their own judgments to a degree that would have been unimaginable to our forebears….

In recent times, though, a new form of centralized control has taken root—one that is the work not of old-fashioned autocrats, committees, or rule books but of statistical models and algorithms. These mechanistic decision-making technologies have value under certain circumstances, but when misused or overused they can be every bit as dysfunctional as a Muscovite politburo….

His argument is one we’ve heard from the military and other agencies as well – what they needed was more human intelligence on the ground, not more technical complexity from high.

He continues:

…Consider what has just happened in the financial sector: A host of lending officers used to make boots-on-the-ground, case-by-case examinations of borrowers’ creditworthiness. Unfortunately, those individuals were replaced by a small number of very similar statistical models created by financial wizards and disseminated by Wall Street firms, rating agencies, and government-sponsored mortgage lenders. This centralization and robotization of credit flourished as banks were freed from many regulatory limits on their activities and regulators embraced top-down, mechanistic capital requirements. The result was an epic financial crisis and the near-collapse of the global economy. Finance suffered from a judgment deficit, and all of us are paying the price….

Even going so far as to invoke Hayek to make the case:

The great twentieth-century thinker Friedrich Hayek made the classic argument for decentralized choice in his essay “The Use of Knowledge in Society.” The stability of the economy depends on constant adjustments to small changes, he believed—“B stepping in at once when A fails to deliver.” No single individual has the knowledge to make those adjustments; rather, it is widely dispersed across many individuals. But information about “the circumstances of the fleeting moment” cannot be quickly and accurately communicated to a central planner. Therefore, individuals who have on-the-spot knowledge must be allowed to figure out what to do….

Adaptation to changes—the focus of Hayek’s article—is only part of the story. The success of the modern economy also depends on innovation. As it happens, decentralization beats central planning here, too. Innovations are unprecedented, one-of-a-kind developments. Even incremental ones require imagination. An innovator cannot simply rely on historical patterns in placing bets on future opportunities. Knowing what has worked before and what hasn’t is but a starting point. Innovation also requires considerable trial and error. Unforeseen technical problems—or customers not doing what they had told market researchers they would—demand recalibrations that combine on-the-spot observations and historical knowledge with leaps of imagination….

Of course like most writers who seem to espouse the virtues of decentralization, he still thinks some things need centralized control which don’t:

Technologically advanced societies couldn’t function without some centralized control, of course. Governments need to regulate how businesses drill for oil, develop genetically modified crops, and pick the paints they use in toys, for instance….

Either way, he goes on to argue that the financial industry, using mathematical formulas and statistical models, embraced a sort of top-down control giving rise to “Mechanistic Decision Making” & “Robotic Finance”.

This basic line of reasoning isn’t exactly new.  Wired had an article in February of 2009 (here) about the risk formula which killed Wall Street.  The formula worked well for 5 years as investors used it as a way to measure pooled risk in MBSs (mortgage backed securities), but the formula:

…still hadn’t solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there’s a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there’s a higher probability they will default, too….

Now while both articles point to specific issues which helped the collapse, like most they conveniently left out all discussion in reference to the government’s role in perverting the incentives, but together I think they present an interesting challenge to those of us who believe in decentralization as a good (DA post on decentralization here).

& that is – can there be mechanisms put into place which actually help foster decentralized control since our history, both long term and recent, seems to indicate humans have a tendency towards centralized control at certain levels of complexity.

We see this through various disciplines such as anthropology, archeology, and history, that over the past 10,000 years or so, humans made a mass migration from the nomadic lifestyle which was practiced for nearly 200,0000 years, to villages, towns, and cities.

Using agricultural knowledge to help spur this transition, humans also started growing in population.  As more land became developed and could support more people, villages and towns grew into large cities & states.

With the advent of these new societal structures, came new power structures.  In nomadic communities, authority is handled from a tribal point of view.

This means that people don’t really have positions of authority which is spelled out by any specific power structure.  Their authority comes from their ability to influence.  So elders with specific knowledge are sought after for wisdom and help, without a formal power structure of say a judicial system.

With the growth of society, came the growth of power structures as they became necessary to handle the population explosion.  Things such as basic sanitation and clean water were large public work projects which required the control of enough resources (labor mostly) which heretofore had been impossible.

These beginning power structures, would eventually evolve into the world in which most of us find ourselves today: a world in which more of our daily lives are coming under scrutiny from centralized power structures.

& we’ve seen what these power structures are capable of doing, both good and bad.  While it allowed for greater sharing of knowledge through vibrant cities which pooled resources in denser areas, it also allowed for the pooling of resources for war.

Either way, in this case the centralized authority we can normally blame was there in multiple areas, but for this specific factor it was self imposed.

Indeed in looking at human history, it seems given some level of complexity we seek out centralized forms of control.  It might seem today as if humans would never pick governments and politicians as idiotic and with as much power as they have today, but these were gradual changes over generations.

Taken with the most recent example of self selected centralization, it may be we need to consider the possibility that humans tend towards this direction with or without institutions directly promoting centralized control.

More thoughts on complexity here

Over @ HBR Blogs, Jeff Goldsmith asks the following question: Has the U.S. Health Technology Sector Run Out of Gas?.  Looking historically, he notes the amazing progress since the 1970s, but a decline in that growth since 2000:

…Technological innovation — in pharmaceuticals, biotechnology, medical devices including imaging, and enterprise IT — exploded in the thirty year period 1970 to 2000…

…Then about a decade ago, the US medical technology sector entered a prolonged innovation drought. In pharmaceuticals, new drug introductions declined by almost two thirds, while drugs patented in the latter part of the boom period lost protection, this despite a near tripling in R+D outlays. (New drug introductions rebounded modestly in 2008 and 2009, but still haven’t regained their 2004 levels)….

He goes further to note that this dip in activity wasn’t just about new drugs:

…The drought wasn’t confined to pharmaceuticals and biotechnology. Imaging, a dazzling success story for three decades, has seemingly run out of gas. Imaging equipment sales collapsed precipitously in the US, by roughly 40%…

…Enterprise clinical information technology seems to have hit a similar flat spot. The major commercial IT platforms for hospitals and health systems are more than a decade old.

& all of that makes complete sense based upon what we know about the last couple of decades.

Since the mid-1990s (well really, since the 1960′s), we have increased regulation on the medical industry on a constant basis.  From minor changes in who qualifies, to new regulations such as HIPA, to very large new regulatory pressures such as the Medicare Prescription Drug Benefit, resulting in an explosive growth in government expenditures of health care:

There have also been additional pressures.  Increases in financial and IT regulations through SOX and other legislation have increased companies’ weariness to put themselves at risk and increased costs of doing business.

These pressures in increasing the costs of doing business, combined with the federal government expenditures crowding out private spending, has resulted in higher costs for businesses and therefore consumers as well.  The new heath care and financial overhaul bills will continue this pressure.

The big cost however is what the author notes:  the lack on innovation.  When the government seeks to consistently erect new and more costly barriers to entry, competition will naturally decline.  The correlation to that behavior is that costs will grow more rapidly as we know competition in the long-term generates downward pressure on prices.

As we see now – prices are increasing, availability is decreasing, as the government decreases the availability of future competition in industries the government tightly controls such as health care.  Conversely with those industries with fewer barriers to entry have downward pressure on prices, such as cell phone or internet providers.

While I consider this failure of centralized control as a major factor, Mr. Goldsmith posits three contributing factors, risk aversion from management, size and increasing bureaucracy, and the fact that we are losing out globally for scientific talent:

1. Firms that used to be run by scientists and engineers are now run by attorneys and marketing executives….
2. Their ability to foster innovation has succumbed to a bureaucratic management culture….
3. Bright young foreign science and technology graduates are returning to India or China instead of staying here and creating new products or companies….

While I agree with all of these things, I think reasons 1 & 3 can be combined easily to a more basic point about government interference and centralized control.  Indeed they are symptoms of the problem and not necessarily the disease.

Having said that, I think it’s also important to note that reason number 2 exists due to the same thinking reasons 1 & 3 do – the belief that centralized control is a nominal good (DA post on business trends here).

The author seems remiss in not making the connection, even if he did eloquently, maybe unwittingly, stumble across it when writing about global competition:

…If they have more freedom to innovate in their home countries, that’s where they’ll go….

For as long as we continue to discuss symptoms and not the actual disease, we will continue to miss the point.

Proving how little we truly understand about addiction, a new study (via UK Telegraph here):

Bingeing on junk food is as addictive as smoking or taking drugs and could cause compulsive eating and obesity, a study has found.

According to the research, rats when given junk food, will crave it in a similar fashion to much harder drugs, as it all uses the same pleasure center:

…As these pleasure centres become less and less responsive the animals quickly develop compulsive overeating habits, consuming larger quantities of high-calorie, high-fat foods until they become obese.

The very same changes occur in the brains of rats that over consume cocaine or heroin…

I wonder if this will put to rest the nicotine is addictive as cocaine meme?  Or possibly destroy the idea of heroin addiction altogether?  Whatever it does do in the end, it should give us pause anytime we hear “as addictive as…”

John Stossel on government testing (here).  Among the other illuminating information, you can read about GAO’s audit of energy star products, including this gem:

…The GAO attached a feather duster to a space heater, sent the photo to the EPA, and got approval in just 11 days…

All told:

GAO sustained Energy Star certifications for 15 bogus products, including a gas-powered alarm clock.

Via WSJ, In War Between States and Feds, Utah Strikes Latest Blow:

All is not well between the states and the federal government….states in recent months have signed sovereignty statements….last week, more than a dozen states sued to strike down the new federal health-care law…..Now….Utah Governor Gary Herbert on Saturday authorized the use of eminent domain to take some of the U.S. government’s most valuable parcels….

This should get interesting.

Lastly, an interesting idea via HBR (here).  Asking CEO Tim Brown:

…what does it take to bring about such mass behavior shifts? Are there approaches that businesses could use, too, to influence behaviors on a micro level, and gain benefits on a macro one?…