Market-Based Management®

Heatball: Was Ist Das?

Quoting from the German-only website, "was ist das" Heatball^®?

Heatball^®, my friends, is a tribute to the entrepreneurial spirit.  Well, at least a testament to the creative smart-a#$ in all of us that bucks at one too many rules imposed upon our lives.

Heatball^®, is, well....  Reuturs puts it best.  "A German entrepreneur is bypassing a European Union ban on light bulbs of more than 60 watts by marketing his own brand [of light bulbs] as mini heaters."

That's right: the plane-jane light bulbs that we all grew up with (as opposed to the fancy, squiggly ones that throw off a sickly spectrum of light) are now being sold as "heaters" as a way to get around a bureaucratic imposition.  "Siegfried Rotthaeuser and his brother-in-law have come up with a legal way of importing and distributing 75 and 100 watt light bulbs -- by producing them in China, importing them as 'small heating devices' and selling them as 'heatballs.'"

Let's think about this.  Here you have two, entrepreneurial engineers: this is the type of folk that most societies want as citizens.  And what do the incentives of that society urge them to do?  It's urged them to use their problem-solving skills on finding loopholes in red tape; it's impelled them to use their creative drive to market a useful product that already exists but is unavailable; it's made profitable and special what would normally be a cheap commodity. 

Is that how entrepreneurs create real value is society?

One of the underlying assumptions of MBM is that we want to harness the natural tendencies of individuals.  For example, people tend to be creative, entrepreneurial and self interested.  If the way to get ahead in a society is to creatively take advantage of loopholes, entrepreneurially get around laws, and self interestedly attempt to earn a profit for your family, most people will follow those incentives.  

Similarly, we assume that employees in an organization rationally follow incentives.  If the incentives are set up for them to act entrepreneurially, they tend to do so.  If they're set up--usually inadvertently--to encourage being quiet even when you see a problem (if your boss yells at you for pointing out mistakes), to encourage staying alive vs. being productive (if automatic pay raises are guaranteed each year), or to encourage going along with the status quo (if bureaucratic policies gum up the works) then employees tend to follow those incentives. 

The light-bulb-turned-heater entrepreneurs, according to Reuters, describe the mini heaters as "resistance against legislation which is implemented without recourse to democratic and parliamentary processes."

How do the incentives of your government, of your work group, of your projects compel individuals to act?  This funny article has made me re-think what incentives I set up day to day--are they beneficial or perverse?

ht: Willie Will

p.s.  If you're concerned about the environmental issues at play, again from Reuters: "Rotthaeuser has pledged to donate 30 cents of every heatball sold to saving the rainforest, which the 49-year-old sees as a better way of protecting the environment than investing in energy-saving lamps, which contain toxic mercury."

Healthcare, Democracy, Market Signals, and 'the Sanest Man on the Planet'

OK, I don't know about the "sanest man on the planet" stuff, but I just watched these videos and found them to be very interesting.  In them, Daniel Hannan, member of the European Parliament, does an excellent job comparing and contrasting the American system for deciding laws with that of Great Britain and other European countries.  

In it, he discusses what it means to believe in "Jeffersonian" principles, many of which bolster our view of the Science of Liberty (the basis for Market-Based Management).  Enjoy, and ht to the American Legislative Exchange Council (ALEC).

[Part 1-3 below]

 

Hi-Ho Fed-O

This is one of the “Man Controlling Trade” sculptures in front of the Federal Trade Commission building.  According to the Smithsonian folks, "this heroic, human figure strains to control a powerful horse…symbolizing the purpose of the Federal Trade Commission."

Is this an apt metaphor of how human minds need to be active--to some degree–-in controlling the powerful forces of markets, or is this a naive view of what’s really going on?  If you're not a fan, what metaphor would you chose instead?

If you must use a horse to symbolize the market, I think I prefer this one--it's much more hopeful, if you ask me.  [And yes, that's a circa 2002 Andy Gillette.]

 

Economics and Entrepreneurship

This is a guest post by Chris Cardiff. In Chris's words he, "struggles to teach and apply MBM as a member of the Charles G. Koch Charitable Foundation MBM team."

Approximately 17 jillion people have seen the Keynes vs. Hayek "Fear the Boom and Bust" rap video now (if you have not, prepare yourself for a video that even non-economists enjoy). The Wall Street Journal continues to spread the meme with a recent profile of Professor Peter Boetkke titled "Spreading Hayek, Spurning Keynes." The article credits Boetkke with reviving the Austrian economics tradition over the last decade. It goes on to discuss how Austrian ideas of government non-intervention in the economy are gaining even more traction now as the tidal wave of Keynesian spending not only failed to spur the economy but contributed to making it worse.

MBM is signifcantly influenced by general economic thinking and Austrian economics. Opportunity cost, marginal analysis, creative destruction and more are rooted in economic thought. But what about central planning? Austrians argue against it for the economy but don't we need it in the firm?

In the "Use of Knowledge in Society," Hayek was careful to differentiate between "central planning" by the government, which he thought was harmful, and decentralized planning by individuals and organizations which led to beneficial competition. “This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals.” Translating this into the firm, if all the planning is done by one authority at the top of an organization it will inherit some of the same problems of trying to centrally plan an economy.

Both society and organizations face a similar problem: how do you establish an environment that maximizes the entrepreneurial efforts of individuals? The entrepreneur and a dynamic economic environment are at the heart of Austrian economics. As supervisors and individuals, what do you do in your teams to foster Principled Entrepreneurship?

Thanks to Chris for his contribution. If you'd like to submit a guest post for potential publication on this blog, please email drafts to Ann at ann.zerkle (at) cgkfoundation.org.

Grounded in Reality

Today I re-watched the movie "Enron: The Smartest Guys in the Room." The Associates watch this movie during the first couple of weeks of KAP, and this year I'll be leading the session. We use the movie as an example of a decline in a company and pair it with Hayek's Road to Serfdom, which shows the decline of a society.

This is probably the fifth time I've seen this movie, and I found myself thinking a few things throughout the movie:

• "Egos" and "greed" aside, the lack of grounding in reality was rampant.
• Don't confuse value creation with profit.
• The movie claims that Jeff Skilling was an advocate of free markets and tried to foster free-market thinking in his firm. However, the Enron culture blatantly ignored how freedom of speech and standards (among other things) translate into the firm. I hope my family doesn't watch this film and think that I believe he was a free-market kindred spirit.
• With the rise of wide-spread internet use and decreasing costs in communication, could such a spectacular fall happen again? Would employees out their employers?
• Moreover, where were the whistle blowers? Was everyone top to bottom okay with the behavior or were people just leaving?
• I don't think we'll ever really know everything that went on there.

I'm looking forward to hearing what the Associates have to think about the movie. They always seem to surprise me with interesting questions that I can't answer (those are the best kind of questions). 

If you've seen the film, what did you think about it? What questions would you ask to people who are new to Market-Based Management?  

What is Liberty?

One of my favorite movies is The Princess Bride - and I especially enjoy the character Inigo Montoya, who after listening to his boss Vizzini say the word "inconceivable" for the umpteenth time in reaction to several events, says, "you use that word a lot... I do not think it means what you think it means."

The latest Cato Unbound will be devoted to the meaning of Liberty.  It's a cherished ideal and a word we throw around a lot... and Inigo's lament might apply more often than we'd be comfortable admitting.

So if you're curious, head on over to Cato Unbound and watch the discussion unfold.  The lead essay is by the authors of "A Brief History of Liberty," David Schmidtz and Jason Brennan.  Participants engaged in writing reaction essays and participating in the debate will be Tom Palmer (Atlas Foundation, author of Realizing Freedom), John Christman (Penn State), and Philip Pettit (Princeton).

Someone Finally Takes the Time to Analyze the Housing Bubble

In an age where everyone seems to boil complex issues down into simple platitudes, such as “greed,” it is nice to see that Dr. Arnold Kling has taken the time to dissect the Financial Crisis of 2008. Of course, any comments I have on the paper will do it little justice, but (with apologies to Dr. Kling) I will endevour to try and provide some summary for our busy blog readers who may not have the time to read the entire paper.

Although there are many insights in the paper, perhaps the most profound is Dr. Kling’s discussion of how the regulatory remedies for past financial crises ended up contributing to the future ones. For example, after the record number of bank failures and home foreclosures in the 1930s (a problem exacerbated by regulatory prohibitions on bank branching), the government began encouraging 30 year mortgages, introduced the mortgage tax deduction, and added depositor insurance. Although very popular (the mortgage tax deduction is very popular with me), these measures rewarded indebtedness and encouraged folks to spend more on housing. If we fast forward to the rampant inflation of late 70s and early 80s, we find savings and loans holding portfolios of 30 year mortgages whose values were rapidly being destroyed by inflation. Additionally, the S&Ls were forbidden from raising the interest rates they paid above a specified “Q” rate. As potential depositors could get more for their money in money markets with the same amount of liquidity, they withheld their funds from the S&Ls. Subsequently, the S&Ls found themselves in the lose-lose situation of holding imploding assets and facing a dry creek for cash flow. Desperate, and with the knowledge that the government insured their customers’ deposits, many S&Ls went “long” on high risk deals with the potential to save them. Eager to keep these institutions open, regulators complied (another underlying current in Kling’s article is that the supposedly “un-greedy” regulators appeared at best indifferent and at worst played cheerleader to the actions of “greedy” bankers). After many S&Ls went bust, regulators started to explore ways of avoiding what had caused the S&L Crisis. The Q rate was phased out, but the problem of inflation eroding mortgage assets remained. The solution was to encourage the securitization of mortgages.

Securitization promised increased lending to poorer potential homebuyers while supposedly spreading the risk. However, the Basel Accords (an agreement reached in 1988 among the central bankers and regulators of ten countries including the U.S.) inadvertently increased the risks associated with securitization. As far as I can tell, the Basel Accords included a provision which attempted to set standards for capital reserves held by banks. However, banks often held reserves in many different forms (cash, government bonds, corporate bonds, and mortgaged-back securities). Basel tried to get regulators to agree on how “valuable” each of these different types of reserves were according to their risk, which was assessed by a risk multiplier against their face value. For example, as cash and government bonds hold little risk, every dollar of cash or bond counted as a dollar in capital reserves. Since corporate bonds are considered riskier than government bonds, a bank holding corporate bonds in reserves could not count them at face value but at a discount. For example, $1 in corporate bonds may only count as $0.50 worth of reserves. Although not in the top tier of gash or government bonds, guess which type of financial instruments were considered to have the next least risk? Yes, mortgage backed securities! Accordingly, the banks loaded up on them. This overvaluation of mortgaged-backed securities essentially allowed banks to lend more and keep lower capital reserves. Unfortunately, when the price of these mortgage-backed securities collapsed, banks’ reserves fell below minimum requirements leading to what is best described as the insolvency of the banking system.

Of course, there are many more worthy points to mention (for example how in 1968 the government used Fannie Mae and Freddie Mac as vehicles to keep government subsidized housing debt out of the federal budget deficit and thus avoid a budgetary procedure that allowed Congress to challenge appropriations for the Vietnam War), but the core of Kling’s argument is that over the course of seventy years the government created a regulatory environment that elevated mortgage lending above other forms lending (commercial lending for example). All that being said, I do not want to make out that the article is a government-bashing blame game; the article is an impartial look at the incentives created by regulatory structures. As a society and through a free and fair political process, a majority decided that we valued housing enough to subsidize it. Unfortunately, the realities of economics dictate that when you subsidize something, you tend to get too much of it.

The Free Market: Fact or Figment?

Market-Based Management is predicated on the assumption that business has a lot to learn from the free market. Unfortunately, a perusal of the comments section of most economics blogs (and yes, most economists do tend to like free, or freer, markets) will typically turn up the following snarky comment: “you silly free market folks, there is no such thing as a free market; your beliefs rest on figment—you can offer little more than “faith-based” arguments, rather than solid facts.” I have always found this argument specious, un-thoughtful, and shallow, but if I am going to think such things, then I had better back them up—so here it goes:

1. Those making the statement do not know what is meant by free market: The term free market is a metaphor for allowing more and more mutually beneficial exchanges between consenting human beings. Perhaps a better term would be freer markets, because any exchange is naturally encumbered by something. There is no perpetual motion in markets. For example, I am free to exchange with my neighborhood grocery store on a wide variety of items, but I still must get off my duff to facilitate the exchange. Accordingly, a free market is still a free market even if it is encumbered by natural realities. It is the manmade realties that determine how free a market is.

2. Those making the statement cannot explain why encumbered markets work while free markets would not: If, as a paradigm, the market is so weak that a free one will not function, then logically a market suffering any encumbrance won’t be able to work either. Huh? A simple journey to any grocery store or shopping mall says different. Every product one observes will have faced numerous natural and government barriers to get from willing producer to willing buyer. Valuable goods may have encountered any number of barriers (unrest in the producing country, customs, rivers, taxes, regulations, etc., etc.), yet the market managed to get the goods to the customer despite all of this. In fact, consider the American market for illicit substances; the government spends billions and is willing to shoot to stop these trades, but they still appear. If free markets will not work, then why bother with wars against them? According to those attacking markets, the best way to stop illicit markets would be to free them up and allow them to collapse under their own ponderous freedom.

3. Those making the statement argue that there has been no such thing as a market free of government, ergo, free markets have never existed. This statement is completely at odds with the archaeological record. The free market began whenever the first two humans (actually, probably pre-human hominids) gestured and grunted their way to exchanging some fruit for Wooly Mammoth steak. Whenever archaeologists dig a hole, they keep finding stuff that should not belong in the locale—even stuff left from historical periods classified as “anarchy.” During the lawless “Dark Ages,” Byzantine coins still ended up in Norway and Middle Eastern coins in the British Isles. Chinese silks and spices still pressed into a decaying Roman Empire and the succeeding barbarian kingdoms. Despite being under siege from Viking pirates and internal strife, the Carolingian Empire was still presented with (and accepted) the Eastern practice of using forks. The historical record demonstrates that markets will function without government and in spite of government. However, based on flows, varieties, and quantities of goods, the historical record also indicates that government can enable markets by providing protection, rule of law, etc. This begs another cheap shot taken at free marketers—that we somehow don’t believe in government. This is not true. Markets will function in anarchy, and they will function under the worst oppression; but they will function best when government dedicates itself to creating a fertile environment for mutually beneficial exchange. A market operating in such an environment can still be considered a free market, or, at the very least a freer market than what currently exists in most of the world.

4. Those making the statement fail to address the impossibility of the free market’s antithesis. If the free market will not function, then its antithesis (a centrally planned and directed system of production and distribution) should prove both functional and superior. If a system of consenting human beings voluntarily trucking, bartering, and trading is impossible, then true prosperity must spring from a few enlightened human beings directing all the other human beings as to what, when, how, and where they should produce and consume. Sadly, humanity’s experiences with the latter—be it in ancient Sparta, declining Egypt, disintegrating Rome, or modern North Korea—have been disastrous. Incidentally, careful study of the Soviet Union has revealed that its “command and control” economy only somewhat functioned because of underground markets and informal relationships between government officials. The latter involved government officials taking stock of the resources under their control and swapping with other officials who had what they needed (you know, like a market). Of course, these markets were horribly inefficient, but they allowed a walking disaster of an economy to limp along for 70 plus years (with a little help from guns put to heads and high oil prices in the 70s). Anyone seeking to understand the impossibility of an effective command and control economy need only undertake the mind-blowing exercise of counting all of the goods and services in an economy, picking a particular good or service, and then asking oneself how it should be made, how much should be made, who should make it, where should it go, and who should consume it? After running through this process once, simply wash and repeat with everything from jumbo jets, to haircuts, to corndogs. It should only take a few seconds for even the brightest to realize the impossibility of this task. Accordingly, it is odd that those decrying a supposed impossibility (a free market), often turn around and advocate—umm—an antithesis which is a theoretical, practical, and proven impossibility.

There is so much more to write, but this post is long enough. We could go on to discuss the numerous times that “free markets” have been given the blame for things that are not their fault. However, I think that this is enough of a start for those of us who like freer markets to stick up for an institution that is more fact than faith, and that has done so much to benefit the billions of human beings who would be helpless without it (including those who rail against it).

Infrastructure, Markets, and Commerce

There is a lot of talk afoot of the need to rebuild the nation’s infrastructure, and a favourite charge of anti-marketeers is that markets cannot provide complete, integrated networks of roads, bridges canals etc. However, while the market may not provide transportation networks as extensive as those built, subsidized, or sponsored by government, the market would be more likely to provide transportation infrastructure where it would bring the most benefit to the most number of people, while maximizing the efficient use of society’s scarce resources. Of course, those wishing their teeny village a multimillion dollar bridge would be fresh out of luck. Furthermore, the public would be denied admittedly impressive but value-destroying white elephants, such as the Channel Tunnel or the Big Dig. However, this is not to say that the government cannot build worthwhile projects (anyone who has flown into Reagan National Airport can tell you it really needs a much longer runway), but the question remains that even if the market fails to produce a worthwhile public project, then will the politicians and the planners get it right?

I was recently reminded of this quandary while working my way through Tim Blanning’s The Pursuit of Glory: The Five Revolutions that Made Modern Europe: 1648-1815, which includes a chapter discussing the nature of roads and road-building in seventeenth and eighteenth century Europe. Relying on contemporary accounts, Blanning begins a typical historian’s gush about the grand nature of French road-building and the colossal task undertaken by tens of thousands of workers and vast expenditures by the central government. However, unlike most historians, he digs a little deeper and discovers that, for all the highways’ grandeur, few people bothered to use them. Consider the following quote from Arthur Young—an Englishman touring France in the early eighteenth century. Although much (and grudgingly) impressed with the French roads, he observed that they had emptied a mere ten miles out of Paris and while moving south he observed:

“In 36 miles, I have met one cabriolet, half-a-dozen carts, and some old woman with asses. For what all this waste of treasure?”

So why had such massive roadworks failed utterly to encourage commerce? The answer lies with who decided where the roads went. Eager to impress important persons at court, ministers built roads to serve the latter. Accordingly, the Duc de So and So might have a beautifully paved road running to his remote country chateau, while a major commercial hub went un-serviced. In addition to serving the powerful, the royal roads had also been built to convey the king’s post, edicts, and orders to the far corners of the realm. Thus, the French roads tended to shoot out like spokes in a wheel from Paris towards the regional centers of administration. Unfortunately, while this ensured a straight shot from Paris to many locations, getting from anywhere to anywhere else in France by royal road meant going through Paris. The Sun King’s roads may have radiated out from Paris, but they allowed little in the way of lateral movement, which greatly reduced their commercial utility (a fine road is of little value if one cannot get to it). Despite the dearth of traffic, Frenchmen could rightly take pride in their roads, but often reproducing Young’s fair-mindedness, French travelers to England declared her roads just as fine—If not better—than their French counterparts. According to visitors (French and otherwise), the problem with English roads was that they were too crowded with a steady movement of carriages and carts that one Frenchman described as “magical.”

So why were the English roads crowded and the French roads bare? A logical suggestion might be that the English government employed smarter planners or had a better road-building bureaucracy than the French. However, the truth of the matter is that while the French government dedicated huge amounts to road construction, the British government hardly lifted a finger. True, English locals did owe a customary duty to keep the roads in their district in repair, but this custom had long since degenerated into farce with the gatherings of workmen quickly degenerating into a combination of shirking, drinking, and brawls (not necessarily in that order). This all began to change in 1695 when an entrepreneur petitioned the British Parliament to allow him to build a road upon which he might charge a toll, which would be collected at either end and admission granted through the turning of a pike. No doubt encouraged by a share of the promised revenue, Parliament rapidly agreed. Seeking to maximize the volume of his turnpike, the entrepreneur picked a location that would serve the most traffic. Furthermore, in order keep the revenue flowing fast and furious, he made sure that the road remained in top condition and that the maximum amount of traffic moved smoothly. Following the profits of this first trail-blazer, numerous entrepreneurs began petitioning Parliament for the right to serve the public for a nominal fee. While the turnpike acts came slowly at first (only 25 passed in the 1730s), the improved roads apparently made it easier for members of Parliament to get to London to pass more turnpike acts. The number of turnpike acts increased to 37 in the 1740s, before exploding to 170 during the 1750s and an additional 170 the following decade. By 1770 an estimated 15,000 miles of roads had been built in Great Britain, while the traveling time between most places in the British Isles declined by a factor of four.

What was true in the eighteenth century is true today. Markets can and will provide infrastructure provided they are allowed to. Meanwhile, government sponsored infrastructure is more likely to serve the interests of politicians than the people. History is littered with “bridges to nowhere,” and that trend is unlikely to change anytime soon.

The Role of the Federal Reserve and the Housing Bubble

We recently received the following excellent question about our post on the current mortgage crisis.

Question: One of the solutions we have seen to the economic recession we are now in is to push down interest rates for home loans to help out the housing market. If these loans are once again made with implicit or explicit government guarantees to home buyers with less than perfect credit are we setting ourselves up for another crash?

Great question! The short answer is yes, but I would wager that we not dig ourselves a bigger hole this time (largely because the financial steam shovel that dug it is decidedly out of commission). I neglected to mention the role played by the Federal Reserve in the earlier post because everything already appeared complicated enough. However, the Fed played a very important role, which definitely deserves its own post. In the previous post I mentioned how depositors leave money in banks, which is then lent out as mortgages, which are then sold to Freddie and Fannie, who then sell them to investors. Thus, the cycle is fed by both ends as money from investors works its way (via Freddie and Fannie) back to the banks where it mingles with more money from depositors and is leant out again to begin the cycle afresh. What I did not mention is that banks have a third source of funds—the Federal Reserve. Essentially, the Federal Reserve lends money to banks (either through buying bonds from them or direct lending). The money supplied by the Fed is the source of the nation’s money supply and is simply created electronically and dwarfs the amount of physical currency in circulation, which is determined by the rate at which people want their electronic dollars turned into tangible ones. The Federal Reserve began its current policy of lower interest rates in 1997. Part of this policy was due to the fear that the Asian Financial Crisis would trigger a credit crisis in this country, which did not materialize (although there was a mild credit crunch). A less well known reason for this policy was a quiet agreement between the Federal Reserve, President Clinton, and the Republican Congressional leadership. Concerned about government deficits, Alan Greenspan persuaded the government to rein in spending. Politicians, however, were concerned that less government spending would slow the economy, so Greenspan agreed to offset any economic pain caused by budget cuts with lower interest rates. The lower interest rates fueled an economic boom, which turned to bust in 2000-2001 and was made worse by the dot.com bubble and 9/11. The perceived need to stimulate the economy has kept interest rates very low since then, which, of course, added more fuel to the monstrous circle of lending and buying mortgages.

But will these lower interest rates create a new bubble? As mentioned above, they probably will. However, we must recognize that this time the vicious cycle discussed in the earlier post should not re-materialize or do so on a much smaller scale. For starters, banks are being careful of whom they loan to, and Freddie and Fannie are broke and can’t buy the mortgages off the banks. Furthermore, having been badly burned, investors won’t be buying the mortgaged-backed securities that poured cash into Freddie and Fannie, which then made its way into the banks and resulted in more poor lending. That being said, this does not mean we will not see a bubble. No matter how noble the intentions, the economic paradigm remains—when something is subsidized you get too much of it. This is true for everything from credit and housing to ethanol. It was true in the 19th century, when government subsidization led to a railroad bubble and in the 21st when cheap credit fueled the dot.com and housing bubbles. Anyway, hope this answers your question, and thank you very much for sending it. While we don’t get a lot of comments, several hundred people read this blog every day. While this is flattering in itself, we would feel even better if we got more questions.