Hicks Roundup

I have very deep reservations about the stimulus bill now making its way through Congress, which is probably no surprise if you’ve been reading me for a while. I’ll try to avoid the politics and just comment here on the economic theory, the standard macroeconomic models that concern capital and investment flows, government spending and debt and labor supply and unemployment generally treat labor as a commodity. This was fine for the models back in the 30s and even the 70s when the large majority of workers in the US had a high school education or less. Today we have a labor force that is mostly at least partly college educated, but definitely more skilled and more specialized. This means that stimulating demand for labor via government projects will not necessarily provide good employment for those more specialized workers. Also, the government’s successful promotion of home ownership over renting means the workforce is also less geographically mobile, particularly so given people’s reluctance to sell into a down market. All this means that the government’s ability to reduce unemployment via borrowing to do make-work projects is far, far reduced from 70 and 40 years ago when Keynes and Galbraith laid the theoretical foundation for the type of stimulus the government is likely to try. The labor force is neither as interchangeable nor as mobile as it used to be.

My take is that it’s just as likely to make our economic problems worse rather than better, I don’t see increasing borrowing as the right medicine for a country that is overleveraged. I don’t see Congress making investment decisions nearly as efficiently as business managers, though they’ve shown their fallibilty recently. Members of Congress are subject to the same cognitive biases but have even worse incentives and generally lack training or experience in making business investments.

I write a blog inside my employer's firewall. I've come to realize that some of the things I write about might have some interest outside the company. So I'll start cross posting some of those in this space. I'll try to clean up the company-specific stuff and links behind our firewall, apologies in advance if my copy editing skills don't measure up. Here's one from June, 2008:

I recently wrote about scarcity rents and as I was defining the term "rent" I mentioned that it generally has a negative connotation. Upon reflection I think that's because a rent is generally thought of as money earned from sources other than labor. I think we humans intuitively believe that hard work should be rewarded and that gains from rents are morally inferior. It's quite natural to think of speculators profiting from oil market volatility as parasites earning big money while contributing nothing of value to society. It's also why many people are now upset with oil companies, they tend to believe that Big Oil would have pumped and sold the oil at $50 per barrel, so now selling it for $130 or more represents some kind of unearned gain that should be punished givens its deleterious impact on ordinary citizens.

Of course those of you who have been regular readers know that I'm quite happy with both of those forms of profit. In the first case, the speculator makes plenty of people happy, every time they buy they make someone who wants to sell happy and vice versa when the speculator sells. The oil companies, if nothing else, are being rewarded with high prices today for oil they had the guts to drill for many years ago when the price was much lower. They are being fairly compensated for assuming some pretty big risks with their capital.

The fundamental disconnect between me and most people is our intuitive notions about value creation. The labor theory of value was the primary pillar of Marxist economics and I don't bring that up as any kind of smear, merely to point out that it doesn't really hold true. What I mean by the term is the belief that the value of some product or service can be computed by how much human effort went in to making it. As I mentioned, this idea has a lot of appeal because we generally feel like people should be praised or rewarded if they worked hard and tried their best even if they didn't achieve the desired result. However, this theory leads to strange conclusions such as that a ditch dug by 20 people with soup spoons is more valuable than an identical ditch dug by one person with a shovel. In other words, it neglects capital input. More fundamentally though, assuming the ditches are identical, there is no reason to value them differently at all. How they got there is fairly irrelevant to how much they are worth.

Now there is much legitimate debate about what constitutes value from an economic perspective (stay with me, I'm going to get around to a relevant point eventually) but it's not hugely controversial to believe that value is created when human wants are satisfied. Prices are then determined by marginal costs for producers and marginal utility for consumers which create supply and demand curves and all that. Now you see why I don't mind the speculators, I don't care how hard they did or did not work, they earned their value by satisfying wants of others with each voluntary transaction they engaged in. But my main point is that value is deeply results-oriented and not based on effort.

As a manager I'm constantly faced with incentive, objectives and evaluation decisions. What am I to do with someone who works very hard but has a poor outcome? There wasn't any value created, so should the company reward that person? The answer is never obvious of course, but what follows is how I approach these problems. First you have to accept that incentives and rewards are always forward looking. That is, each decision must be made with an eye to how we are going to achieve the best possible results next month, next year or the next 5 years.

Thus when I approve a bonus for achieving an objective from last year, it's not really to reward last year's achievement as much as it is to demonstrate that I keep my promises and to earn your trust. Then when I say I'll pay you a bonus next year for achieving certain results, you have good reason to believe me. It's a subtle distinction but very important because without this forward looking approach you would only look at results and outcomes. When you come to me and say that you worked really hard and tried some possibly risky strategies that didn't pay off and had no results, I'm likely to find a way to reward that behavior anyway. Why? Because I know those behaviors are predictive of future results and all compensation is oriented to retaining and motivating you in the future. It's not at all to give you a consolation prize for trying hard. I want you to be willing to work really hard again and still be willing to take risks (well, hopefully not exactly the same ones, let's try to make new mistakes next time!) to hopefully achieve better results next month, year or decade.

My company's performance review system recognizes the distinction between results and behaviors and has separate sections for each but honestly it is heavily tilted towards the results section. All the bonuses are based on results and generally so is your rating. Generally I tend to favor a more behavioral basis for a performance measurement for a new employee and gradually hold employees more and more accountable for actual results as they become more senior. A department manager in my center had better deliver some working software. Though even there is significant leeway for making sound decisions based on the information available at the time even if the results don't ultimately pan out. Our new employees should have more weighting given to effort and the behaviors likely to produce positive results in the future, though it's important to include some accountability for results.