Market-Based Management®

Creative Shirkers, Creative Employees

Two days ago, I wrote about how bureaucratic laws in society can encourage entrepreneurial folks to spend time creatively getting around laws as opposed to finding ways to create value for society.

In a similar way, organizations can create policies and norms that encourage entrepreneurial employees to use their creativity, ingenuity and opportunity-focused minds to find ways to avoid annoying, bureaucratic work as opposed to finding ways to satisfy customer desires.  

I have a self-indicting story to illustrate the point.  In our offices, we have no light switches.  Instead, we have motion-sensors connected to the overhead lights.  You leave your office, and five minutes later the lights automatically click off.

I used to manage a great guy named Brent.  Brent, you see, was a very even-keeled fellow who would spend hours reading a book (for work) at his desk, nearly motionless.  This is fine, except that every five minutes and ~click~ the lights would go out.  B-unit (as I would call him) would stop reading, flail his arms until the lights went on, and then would go back to Hayek or Mises or whomever.  

One day I asked him, "Brent, is that annoying?"  He responded in the affirmative, and I spent over 30 minutes one Wednesday trying to jerry-rig a system of tape, wire, dangling filament and paper that would 'trip' the lights as air from the vents twirled a piece of tissue hanging in front of the sensor.  [I reasoned that if the constant interruptions slowed his work flow over the course of a year, 30 minutes of my time would be worth it.]

So here, we have a well-meaning policy about lights and energy usage.  What do I do?  Instead of spending 30 minutes writing lesson plans or working on other projects, I spend 30 minutes cutting out tissue paper.  

Now, frankly, the likelihood of me doing anything remotely productive in any 30-minute period is slight, BUT you could imagine that most employees are smart and entrepreneurial, and could otherwise be productive during that time.  You would want them focused on their value-creating projects as much as possible, and not dealing with bureaucratic minutiae of modern office life.

Am I unfairly picking on an office policy that--when you look at the big picture--probably makes sense?  Potentially.  But, it offers us a good reminder: to paraphrase Mr. Koch, we should evaluate our policies frequently.  Do they urge us to be productive and entrepreneurial, or do they urge us to follow commands and 'wait for someone to tell me what to do'?

Do any examples of unintended consequences come to mind from your work experience or stories you've heard?

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."

While We're On the Topic of Incentives....

Don't know why, but I've been on incentives kick lately.  These links were accordingly fascinating to me.

Blatantly stealing from Tabarrok over at the wonderful Marginal Revolution blog (which you should definitely check out), here's a fun question:

What is the smart response to this sign (assuming you're carrying drugs)?

And Seth Godin's Blog gives us this little gem relating to incentives and transaction costs.  He notes that in New York City, following the mandatory insertion of credit-card capabilities in taxi cabs, "tips are up, way up."  He explains that it's only one or two clicks on the screen to give a pre-defined $2 or $3 tip; to be a cheapskate and only give $0.75 on that short taxi ride, you have to bear the cost of additional clicks and precious seconds--in technology terms, the equivalent of running a marathon uphill....

Finally, and in similar transaction-costs-and-incentives fashion, a new employee that I work with has used glucose-based incentives to great effect (to protect her anonymity, I'll call her Shaq-Attack (because she's awesome (and because her name resembles one of the words))).  

Shaq-Attack has an office tucked off in an out-of-the-way corner of the office.  Despite this, she receives more friendly visits than most of us.  It's hard to determine causality, but it's either her dry wit or bottomless bowl of candy.  Good candy, too, not those little traffic-cone-Halloween things or knock-off Jolly Ranchers.  Either way, I'm there at least once a day....

Hooray incentives!

The Use of Incentives for Those of Us Who Don't Run Organizations

When it comes to following incentives, I have no problem.  A recent conversation proves this.

Ann: Hey Andy, will you help me brainstorm for this project?

Me: Hmm, I'm kinda busy....

Ann: I will buy you a chocolate Frosty from Wendy's.

Me: BAM!  I'm in!

However, when it comes to applying incentives, I struggle.  For years, I just kind of approached this Dimension as "Yep, incentives matter.  Point taken.  But I'm not a manager who is setting wages or salaries or benefits.  Let's talk about decision rights now...."

So, let's think about what "incentives" mean in an MBM sense.  

First, it's a whole Dimension, so that's a pretty big deal.  I mean, there's only five of them....  Second, from a Science of Liberty perspective--where we're looking at what key things allow societies to prosper, and where we get ideas for how to manage the mini societies called organizations--the concept that it's important for individuals to be motivated to do things that create value is fundamental.  In all, two big reasons why we'd agree with economists who say "Incentives matter."

In those mini societies we work in, it's important that individuals are motivated to do things that create value, too.  At first blush, this is easy: SALARY!  BENEFITS!  And if you get creative, NON-FINANCIAL REWARDS!  

But if you're not the CEO or setting salary levels for others, it can be hard to see how focusing on this aspect of MBM is useful.

On Thursday (~suspense!~) I'll write about some strategies I've used as a non-CEO to get results with the application of incentives.

BUT, I want to hear about your strategies!  How has thinking about incentives or motivators or fulfillment changed how you act or how you motivate others--peers, children, bosses--to act?  

As an extra incentive, if you have some unique applications of this concept I'll throw them into the next post this Thursday!

Compensation

That got your attention.  Many have read Daniel Pink's interesting popularization of some research studies that claim money can sometimes be a de-motivator. (Drive: The Surprising Truth About What Motivates Us.)  Here is Pink in a TEDTalk presenting his experience writing the book:

Recently, Russ Roberts had an extended discussion with Daniel Pink over at EconTalk.org.  I found it to be engaging.   The conversation provides a richer exploration of the ideas in Drive than just reading the book itself.  I admire Roberts' ability to question and challenge in a way that promotes learning and discovery in conversations - something we should all strive to emulate. 

If you manage an organization, large or small, for profit or non-profit, I encourage you to consider the following questions as you read, watch, or listen to all (or any) of the above:

• What is the purpose of compensation?
• What is the role of vision, decision rights, knowledge processes, and virtue and talents in the determination of compensation?
• Remember that whatever the "game" being played, there is always a bigger game being played around it.  Consider the larger questions: what is the role of business in society?  What does it mean to have a job?

I hope some of these questions help you dive even deeper into the material to make it more useful.  Feel welcome to comment and start a discussion around any of the above.

MBM Readings

Frequent reader and commenter Tammy C asked in Ben's recent post: “I want to learn more about free markets/economics and how it can relate to me, as a manager…. What would you recommend to someone for their first book on how the idea of prospering societies was used to create the MBM philosophy?”

I thought this was an excellent question and one that others might experience, so I threw together a few thoughts.

Of course--as Ann mentioned--one of the best places to start is The Science of Success which succinctly lays out a myriad of philosophical ideas and how they apply to economics. 

 

Other than that, though, you have to do a little of the connection-making yourself.  We've found that pairing two readings--one philosophical and one managerial--is a good way to see how the big ideas impact the day-to-day.  Below are some thoughts on such pairings that Ann, I, and the rest of the MBM team have put together over the years.

• Incentives--Tocqueville's essay on “Interest Rightly Understood” and Adam Smith's thoughts on “Justice & Beneficence” discuss how individuals are self interested (both found in Boaz' The Libertarian Reader), and Sowell's Basic Economics discusses what motivates individuals in society (chapter 6 "The Role of Profits--and Losses" and chapter 9 "Productivity and Pay").  This can be paired with Abernathy's The Sin of Wages which looks at the problems with typical motivation systems in many organizations.
• Decision Rights--The importance of property rights are vividly discussed in both DeSoto's The Mystery of Capital or Anderson/Hill's The Not So Wild Wild West.  But how do feelings of ownership and accountability transfer over to management?  A good place to start is with Freedman's Corps Business (chapter on "Directing People," pg. 97).
• Knowledge Processes--I don't have a good reading about free speech and how that helps societies share knowledge, but Sowell's Basic Economics (chapter 2 "The Role of Prices" and 6 "The Role of Profits--and Losses") does a great job of explaining how prices, profits and loss share knowledge.  This could be paired with Senge's The Fifth Discipline (chapter 11 "Team Learning") about how you can help your team share and use knowledge productively.
• Virtue and Talents--Hayek's The Constitution of Liberty (this one is pretty dense) has a good set of chapters that discusses the concept of the Rule of Law and how important that is to creating stability and equality of treatment in societies (chapters 10-16).  In a similar way, we want productive cultures inhabited by employees we can trust--which creates organizational stability: a few good books could be Corps Business (chapters on "Developing Mangers," "Motivating People," and "Culture") and Collins' Good to Great (chapter 3 "First Who...Then What").
• Vision--The concepts of "creative destruction" (see Schumpeter's "The Process of Creative Destruction" in Capitalism, Socialism and Democracy (and if you're just starting out, I wouldn't suggest reading more than just that section)), "spontaneous order" (see Hayek's Law, Legislation and Liberty, chapter 2), and "experimental discovery" (see Hayek's essay “Competition as a Discovery Procedure” [PDF]) look at how free people interact and find ways to better themselves and others.  This can be paired with Senge's "Shared Vision" discussion (chapter 11) in The Fifth Discipline.  I see the connection as you want to create the boundaries in which your smart employees have freedom to act entrepreneurially in a way that no central planner could manage.

Of course, this is just our thoughts.  There are many, many other resources out there, and no book will ever take the place of simply going out and trying to apply MBM, but these can spark good ideas for how to better manage people and resources. 

Please let us know if you have other ideas or suggestions!

Responsibility, Accountability and Authority

I've struggled with the practical application of decision rights. Allow me to use a clip to motivate my questions:

I appreciate that responsibility, accountability and authority are the elements of getting things done, but I'm not sure that a project driver needs to have all of them to appropriately align incentives. For instance, I have been a project lead where I have had little authority, but still had responsibility and accountability. I didn't have much authority because I lacked the perspective and track record to have high potential to make optimal decisions for the project. 

What do you think? How do accountability, responsibility and authority interplay to get the best results? In your experience, what are the trade offs between having all three with one person versus pulling the authority to a higher level? 

Economics Everywhere

I decided to study economics in undergrad (and graduate school) because I enjoy neat explanations about the world.  

For instance, the Consumerist brings you "How Bags of Oranges Cost More than Coke." The article and comments connect this phenomena to the increasing American waistlines. I don't need a high powered regression to buy into this idea. The Wendy's right outside the office has started a program where you get a free frosty with every purchase (once you buy a little card for $1). Every time I decide where to go for lunch that free frosty enters my calculation and has changed my behavior! 

If you enjoy these types of thought exercises, I highly recommend the book MoneyBall by Michael Lewis. While many people prefer the "pizazz" of Freakonomics, I find Moneyball more satisfying. It ties the power of correlations to results. The real life story shows people combining economic thinking, statistics and risk-taking to win games. 

What other books or articles have you enjoyed that show some interesting economic thinking? 

Thanks to Steve Church for the Consumerist tip. 

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 Mortgage Mess Explained (Sort of)

I get a lot of questions in class regarding the current mortgage mess and subsequent credit crisis. While I try my best to answer, I think the honest truth is that no one really knows what exactly has happened and whatever the truth is often distorted by pundits and ideologs. So here it goes—my best effort to explain this mess the best I can, and, as always, corrections and knowledge sharing is more than welcome.

One thing must be made clear—the mortgage market is not a free market—it is pricked and prodded at nearly every point by government activity that has distorted the process. True, there is much involvement by private entities, but we shall see how their actions merely responded to incentives offered by government manipulation of the market.

So it all begins with depositors leaving their money with the bank. Since deposits are insured by the Federal Deposit Insurance Corporation (FDIC), depositors need not do due diligence on the financial institution they leave their money with and don’t care if the latter make silly loans. Flush with cash from reassured depositors, the banks look to loan it out. Say Joe Schmo wants to buy a home, but Joe has lousy credit (we will avoid the usual credit points system and just give Joe a CCC rating). If Joes was a company looking to borrow money, then the bank may think twice, but there are no worries with the mortgage—Joe may not even have to put any money down—just pay the fees and Joe has his loan. Why would the bank do something so foolish? Because, it is not foolish. The bank doesn’t have to hold onto the mortgage and wait for Joe to default. In fact, the bank probably wants to get rid of Joe’s mortgage as fast as possible. Luckily for the bank, there is always a willing buyer for troublesome mortgages like Joe’s. Fannie Mae and Freddie Mac (two technically private entities chartered by the federal government) will buy the mortgage from the bank. The bank now has more money to lend out to the Joe Schmo’s of the world (who also may or not be real estate speculators) and also has the incentive to repeat this cycle over and over again.

However, Joe’s mortgage does not stop with Fannie and Freddie. Fannie and Freddie take Joe’s loan and combine it with other mortgages to create mortgage-backed securities, which they then sell to investors. Fannie and Freddie then use the money to buy more mortgages from banks who loan the money out again. So what self-respecting investor would buy a security backed by shaky mortgages? The answer is a conservative investor adverse to risk. “Huh?” you say, “why would a conservative investor buy something backed by a bunch of mortgages taken out by folks with lousy credit?” At this point the investor neither knows nor cares about Joe and his credit. When Fannie and Freddie sell a mortgage-backed security to an investor, they guarantee the mortgage payments. As far as the investor is concerned, the mortgage-backed security is sound as a pound. It was for this reason that mortgage-backed securities proved popular with traditionally risk adverse financial institutions such as insurers (like AIG) and hedge funds. Since a mortgage-backed security guaranteed a stream of interest payments, investors found all sorts of uses for them. A common use was as an interest rate swap, where a company looking to hedge against cash flow difficulties would swap its cash flow for the guaranteed stream of interest payments from the mortgage-backed securities. In short, mortgage-backed securities appeared to be a great way for companies and financial institutions to hedge against risk.

Unfortunately, what looked to be a firm foundation ended up being made of sand, because behind all those “good as gold” mortgage-backed securities lay Joe Schmos with rotten credit. The problem was that when credit rating agencies looked at mortgage backed securities, they didn’t see Joe and his CCC credit but guaranteed financial instruments which gleamed AAA and imparted this shine to the institutions holding them.

So what happened? Many of the loans had been made at adjustable, rather than fixed, rates. Since many folks had borrowed much more than they should of, even a small increase in interest rates meant big increases in mortgage payments. Not surprisingly, more and more people began defaulting on their mortgages as rates increased. Conventional wisdom had held that this would not be such a big deal for the holders of defaulted mortgages. After all, the house could always be sold to cover any losses. However, the prolonged slump in the housing market meant homes sold at greatly reduced prices or not at all. Entities such as Fannie and Freddie found themselves held to guarantees that they could not meet. Deprived of their guaranteed interest payments from mortgage-backed securities, investors (and the credit rating agencies) began to see what really backed the securities—homeowners with poor credit living in much depreciated housing.

This is when the house of cards fell down. No longer able to simply make dodgy loans and sell them to Freddy and Fannie, the banks started being more careful about who they leant to. The tightening of credit led to even less home buying and further depressed the market, which pushed the value of mortgage-backed securities even lower. Meanwhile, at the other end of the spectrum, investors discovered the real worth of the mortgage-backed securities they held. Many venerable institutions suddenly found themselves writing off billions of dollars in assets, and some, like Bear Stearns, simply imploded. To make matters worse, the use of interest rate swaps meant that companies with no real connection to the mortgage market saw their cash flow hedges dry up. In the meantime, consumers started worrying about paying their mortgages and fiercely reined in their spending, which caused the economy’s aggregate demand curve to shift back (or to the left). The subsequent evaporation of demand is now driving down prices, eroding profits, and producing layoffs, which are, in turn, leading to more defaults and further depressing consumption. To be blunt, we are in for a very rough tide. However, barring nuclear war, things always get better over the long-term. The good news about sharp recessions is that they are often over the fastest. Furthermore, as I blogged about earlier, the government’s reaction has been nowhere near as pigheaded as in the past, but will more government oversight stop this from happening again? Probably not, the chief culprit behind this mess has been the government’s thirty year drive to encourage homeownership in America. While this is a worthy goal, it depends on cheap credit given to those who may not be entirely credit-worthy. Somehow, I do not think this policy will change anytime soon, and it will only be a matter of time before those on Capitol Hill call again for easy lending, and then we start all over again.