Government Defaults - Why is Japan Not Bankrupt?

In the previous post the fundamentals of government defaults were examined. Given the fundamentals, how is Japan not bankrupt? The debt level is over 2x GDP and there is no end of deficits in sight. Why isn't there a run on the Yen today?* One approach is look at the Japanese situation under the national accounting formula (see twin deficit theory), propensity to pay, and ability to monetize.
1) According to the national accounting formula, Budget deficit = Savings + Trade Deficit - Investment. Japanese savings rates are high, have not shown to decrease significantly despite an aging demographic, and the residents tend to keep their cash within the country. Japanese households not only save, but they save in Yen. There have been signs that high savings have recently begun to slacken.
2) Because of deflationary trends over the last twenty years, the Japanese government has been able to monetize its current debt through the central bank. The central bank has expanded its balance sheet significantly.
3) The Japanese government has been able to monetize its current debt from investors through negative real rates. Simply put, over the last eighteen months Japanese bonds have paid less than the inflation rate. This is similar to having someone pay you for the opportunity to lend you money.
4) The Japanese governments have shown political will to pay. There aren't rumors flying about minority parties saying that they will simply default.

That keeps things limping along. However, according to the fundamentals, Japan has no good options left. Escaping the present problem is not because of a fault of courage or competence, and it is not driven by government corruption. It is not like the movie "Dave," where if those in charge can just put their heads together and put special interests aside they can find the solution and come up with the money. Defining "survival" as "not defaulting, technically or otherwise," the historical survival rate for countries in similar situations is zero. The Japanese miracle would be navigating the next ten years without default. What are some potential options?
- Productivity improvements, which necessitates upending many aspects of the social and labor structure. This was supposed to be the "third arrow" of Abenomics (reforms named after the Prime Minister) but it is politically difficult and has yet to make its appearance. Mark as doubtful.
- Population growth, which necessitates either having more children or importing immigrants preferably at least a medium skilled or high potential. Incentivizing people to have more children is very difficult, and concerning immigration, those that are more familiar with the political conditions in Japan tell me this is a complete non-starter. Mark as doubtful.
- Narrow or zero out the current deficits, then thread the needle between nominal interest rates, inflation, and GDP growth. This is theoretically possible, especially because of the prefecture system. It is similar to the United States in that the federal government runs deficits and transfers money to smaller government sub-entities. The Japanese national government can dramatically lower the transfers to prefectures and run at least primary surpluses (revenue minus spending excluding interesting payments). Mark as possible.
- Monetize - Central bank threads the needle between hyperinflation and hitting the print key and gobbling up the debt. This is already occurring, as the central bank's balance sheet has nearly doubled over the last two years, but it will prove ever more difficult to implement.
- Asset/liability balancing - The Japanese government has a huge relative amount of assets on its balance sheet compared to other countries. If these assets are only tapped at critical junctures to navigate this process, it might be just enough lifeline to pull through.

It is a very difficult situation, and I would put even odds on a technical default in some form in the next ten years.

*For the sake of both simplicity and the fact that there are others leagues more knowledgeable than I, I won't delve into the complex banking/government financing structure and its corresponding risks

Government Defaults - Why is Venezuela Bankrupt?

Japan's debt to GDP is over 200%, while Venezuela's is around 50%. Why is it that Venezuela is in the middle of a cash crisis but Japan is not yet? A few facts on the Venezuelan economy:

- Accuracy: Exact numbers on debt, GDP, and inflation do not have high confidence. Negative impact.

- Debt to GDP: Estimates of debt to GDP put it around 50%-65%. This can be positive (low) or negative (high) depending on the other factors.

- Propensity: The government has defaulted five times in the last twenty-five years. Negative impact.

- Collateral: Overseas seizable assets. Positive impact.

- Budget deficit: Venezuela's budget deficit zeroes out only when oil is above $117.

- National Account Theory: Budget Deficit = Savings + Trade Deficit - Investment. Savings are low in a high inflation environment. Investments have been historically low as well. In order to run a trade deficit, a capital inflow is needed.

- Oil: Oil has accounted for 96% of its export revenue, and the price of oil has dropped by nearly half over the last year. Negative impact.

- Cutting spending: There are a few options, many of which have historically led to coups and unrest. Negative impact.

On net, this is why Venezuela's government is in dire straits. There are some holding out, believing that the upside is there, but the consensus is heavily in the default camp barring a dramatic increase in oil prices in the near-term.

Understanding Government Defaults

With the recent fall in oil prices, the analysis and rumors have been flying about the government default by oil revenue-dependent nations. Also, there has been a resurgence of prediction of the imminent demise of the Japanese government's finances by its mind-boggling debt ball. Now is an opportune time to review the fundamentals of government defaults, and why they are not nearly as simple as many believe.

Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.

Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.

Current trajectory - The current and near-term forecast of deficit spending.

Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).

Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.

Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.

Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.

With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.

Type	Variable	Japan	Greece	Italy	Spain	US
Load	Gov Debt to GDP, 2013	227%	175%	133%	92.1%	102%
Trajectory	Federal Deficit, % GDP, 2013	-7.6%	-12%	-3%	-6.8%	-2.8%
Cut/Tax I	Total Gov Spend / GDP, 2013	42%	52%	50%	45%	42%
Cut/Tax II	Fed Deficit / Spend	-53%	-26%	-6%	-18%	-19%
Grow	GDP Annual Growth, 2014	-1.9%	1.9%	-0.5%	1.6%	2.4%
Populate	Population 5 year CAGR	-0.1%	-0.2%	0.4%	0.2%	0.7%
Market	Bond 10Y, Dec 2014	0.4%	7.3%	2.0%	1.8%	2.3%

(Source: tradingeconomics.com)

While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.

Body Snatchers

Continuing on the Management Frameworks post, I'd like to think that I have a good eye for evaluating employee potential. Of course, in interview situations I side with Google in that I, like most managers, haven't much of a clue how the employee could turn out. However, in the day-to-day grind in a collaborative work environment, I am pretty good at looking past what most consider glaring flaws and evaluating characteristics that drive value. A principal reason for this is that I've been considered at various points in my careers as someone with glaring flaws. For example, two complaints I have received in the past are that I talk too fast and do not possess enough gravitas, Nevertheless, I was able to demonstrate this to others as a strength as I deconstructed a potential decision into the assumptions underpinning the framework. I could then not only make recommendations based on data and assumptions, but also point out critical weaknesses where the decision could come crashing down if certain events did not go as planned. The management decision could be made (make vs. buy, acquire vs. divest, expand vs. contract) together with parallel decisions to contain the risks of taking that action. I am now better at talking slower, assuming the listener is less familiar with the issue than I am, and even, perhaps, letting my dulcet baritone voice lend to my gravitas. Over time I gained a reputation for structured decision making and providing a clear framework for my direct reports. Perhaps because I have gone through an experience like this, I've learned to ignore a little better my natural biases (e.g., He's tall, dark, and handsome; he must be leader!) and look for underlying traits that drive value creation. I have my mental checklist to check off as I'm working with colleagues: understands quickly and asks questions when they do not understand, takes a holistic approach on the impact to the company, does not "write off" colleagues and does not take criticisms as a personal affront, etc.

About two years ago I stole a "low value" employee from another team with little protest. He was performing glorified data entry/adjustments for account reconciliations. He was very young (23) and a bit rough around the edges in some areas, but he definitely possessed nearly all of the primary characteristics of a dream candidate. I would certainly score him as higher potential in the critical attributes than I was at his age. A year later he was considered one of the highest potential employees. Two years later he was rotating through teams, mostly independently of my work, and doing the same restructuring and optimization that I had done for the last two years. He was slated to move into a mid-management position in 2015, with a target of senior management within four years. Then the other shoe drops. A competitor swoops in, based on the recommendation of a former employee who was let go and jumped to the competitor, and makes an offer for a very solid mid-management position at a great salary. He isn't quite ready for the position, but I know that after some missteps and learning, six months from now he will be doing fine. The position accelerates his career and will probably be more entertaining than his current path. All I could say to him was good luck. This was the first time that one of the high value employees that I have grabbed and groomed has jumped ship.

Some would make the argument, "what's the point of developing them if they are only going to head to another company?" I would answer that I had 15 months of stellar performance from an employee, and if I can't develop other employees to perform similarly I am not much of a manager or leader.

Mixed Messages in Housing Policy

In the school of hard knocks, you graduate either through class participation or observation. However, some never seem to graduate.

In 2009 there was a rare moment of consensus between Main Street, Wall Street, K Street, and every street in between: over-leveraged individuals, companies, commercial banks, and investment banks create an unstable system, even if you really really think this time is different and this nifty model says so right here. On the mortgage side of the equation, the Boston Fed released a landmark study:

"The empirical evidence on the role of negative equity in causing foreclosures is overwhelming and incontrovertible. Household-level studies show that the foreclosure hazard for homeowners with positive equity is extremely small but rises rapidly as equity approaches and falls below zero. This estimated relationship holds both over time and across localities, as well as within localities and time-periods, suggesting that it cannot result from the effect of foreclosures on local-level house prices." (emphasis mine)

Two years later, mainstream opinion writers like Felix Salmon (among many others) were still pointing out that, "If you take one group of loans with a 20-25% down payment, and a second group of loans with a 15-20% downpayment, then the second group, on these numbers will have a delinquency rate 56% higher than the first."

But five years later... well, a lot can change in five years. And, if it cannot change, at least it can be forgotten. This past week the director of the Federal Housing Finance Agency (the US agency that regulates Fannie Mae and Freddie Mac) announced:
"As I said earlier, there are creditworthy borrowers in today’s market who have the income to afford monthly mortgage payments but do not have the money to make a large down payment and pay closing costs. Purchase guidelines that allow for 3 percent down payments will provide an opportunity for access to credit for some of these borrowers."

Yes, the majority are creditworthy borrowers, but a large interconnected and securitized financial system cannot be sustained if 20% of the borrowers default during the next downturn. Let us hope that this time truly is different.

Macro Instability - The Ring of Fire

One benefit of aging demographics is that it decreases the percentage of the most volatile demographic of society, 18-30 year old males. Generally, a key ingredient in a country's internal instability is young men that have too much time on their hands. (There is far more controversy over this statement than you might think in terms of which ways the causation go, but here is one place to start if you're interested.) Youth unemployment is a step to understanding instability, which is why this interactive graphic from ILO is intriguing:

To aid the visual, the colors could have been toned down to a maximum of 40%. Upon closer examination, both visually and in the underlying data, there is a clear hot spot. It's what one could call "the ring of fire." Average youth unemployment for the region is over 25%.

Whether it's called Arab Spring, Mediterranean discontent, separatism, or Southern European unrest, this is a factor that a lot of on the ground managers have in the back of their minds, but is rarely explicitly stated. Greater unrest translates into lower tolerance for capital commitments. If "stuff can go south," there's a natural inclination to hedge, and those who commit the most into these situations are either very savvy on local conditions or subject to a series of winner's curses. Whether it's the world of leveraged buyouts or multinational expansions, one should take a good look at local players before making the leap.

Dealing with Certainty

I don't struggle dealing with uncertainty. I can gauge assumptions and risks quite well. Despite this, I also have no problems with a "ready, fire, aim!" mentality when urgency is required. If the train is pulling away from the station and the debate is jump or not, now is the time to make the decision. We move forward confidently knowing that we are acting with the best available information.

However, I do struggle with those that cannot deal with uncertainty, or rather, those that are 100% confident all of the time. Those few moments in which they do change their minds, they flip to 100% certainty the other way and say, "I was so dumb before, because I didn't know everything I know now." These are the "passionate" that show no difference in knowing 10% of the relevant information and 100% of the relevant information. In my experience, this is far more common in large corporations than small companies. One gets found out too quick in the small company.

When collaborating with this type, I've tried an array of strategies, but the vast majority of the time it bounces off like frozen marshmallows on a tank. Eventually I end up simply discounting their opinions and information, but that's not a long-term play at building a coherent team. I don't plan on giving up, and, like many things, the best approach, in most situations, is "one of these twenty approaches might work, because everyone is different." What is under my control is developing the toolkit to handle the situation. Here are a few approaches I've used with varying success:
- Unassuming simple questions: "What are some of the potential outcomes for this decision?"
- Redirect: "I see what you're saying, but there are also a lot of different ways to attack this problem. Let's brainstorm a few different ways we can go at this."
- Backup request: "Send me over the data you have after this meeting so I can combine it with what's already been submitted and distribute. We can finalize the decision on Wednesday."
- Direct feedback: "Good input. Thank you. We still need to make sure we cover all of our bases and have a sure footing if this is the direction we take. How can we further develop these specific points?"
- Buddying up: "What do we have so that we can convince others and defend this decision?"

In my personal experience, the most successful long-term executives are those who maintain a positive attitude and outlook with others, regardless of position and they have a solid understanding of the assumptions that they are making in the thousands of business decisions that they make throughout the year. However, when they were not in a position of direct power, I've seen executives with a solid history of success hit a brick wall attempting to collaborate with the "certain." Those that have succeeded demonstrated Herculean patience, which I know is an attribute that, because of necessity, I have worked to develop further.

When Insurance Fails - Reflecting on AIG

This Planet Money episode on homeowners insurance reminded me of when I first learned about insurance market failures in college. Insurance markets tend to fail when at least one of three factors is present:

• Moral hazard The insured takes on more risk or incurs costly activities because the insurer is going to pick up the tab. Phrases that I have heard, half serious and half in jest: "Sure I can go skiing! I have hit my max deductible on my health insurance." "I don't mind if my glasses break. Insurance covers another pair this year anyway." "I need to make sure I get my doctor checkups, eyes checked, and dental cleaning. I don't need it, but I'll pay loads more when I switch plans next month."
• Adverse selection A narrow market emerges because the insured possesses much more information than the insurer. My wife and I learned about this in 2008 while evaluating insurance for pregnancy coverage. When we looked at the cost of coverage we discovered that because of the premiums and caps, on an NPV basis the coverage made sense to purchase only if my wife became pregnant within the next six months. A baby was not in the immediate plan, but the insurers did not know that. While the point of insurance is to transfer the risk for a price, a six month breakeven NPV is far outside the range of most people's risk appetites. This limits the number of people applying for coverage to the truly risk averse and those who plan on getting pregnant in the very near term.
• Correlated risks Large-scale meteor strikes, war, and 1918 Spanish flu-style outbreaks do not have insurance products. Either the event never occurs and the insurer walks away with the money or the event occurs and the insurer must pays off everyone at the same time and the insurer does not have sufficient assets to pay out. Accordingly, neither a rational buyer nor the rational seller should enter into the contract.

As I reflected on the podcast and some long ago college lectures, I couldn't help but see the parallels with this and AIG's Financial Products division. AIG wrote credit default swaps to insure collateralized debt obligations. In layman's terms, if a pool of mortgages started to default above a certain rate, AIG would be forced to pay the losses. Companies would approach AIG and offer to pay premiums if AIG were willing to assume the risk. To some degree I see all three forms:

• Moral hazard Anything that could make it through the AIG filters would be pushed through. If the price is identical, the first CDOs in line for credit default swap are the lowest quality relative to the perceived risk. 
• Adverse selection In late 2006, I spoke with a regional mortgage broker who referred to a section of his loan portfolio as "hot potatoes." All the due diligence boxes were checked, but because he was closer to the market, he was more familiar with the underlying risk than the standard scoring mechanisms would show. He was in a hot market, and he knew that the buyers who purchased, rebundled, and securitized would be none the wiser. One fascinating fact here according to a comprehensive FDIC report is that while it is true that, "the loans small lenders sold into the secondary market had both higher default risk and higher prepayment risk," the same was not true for the larger banks. Fortunately for AIG, the larger banks kept the loans with higher default risk, but lower prepayment risk. The data on adverse selection in the collateralized debt obligation market is a mixed bag and AIG ended up lucking out as it could have been much worse.
• Correlated risks While I recognize that many believed that real estate movements were not correlated on a national level because historically that was not the case in the United States, nationally correlated real estate prices had occurred at different intervals across many countries over the last fifty years. A friend once told me of a financial risk conference he attended in 2006, and while "across the board decline in real estate prices" was on the board of one of the primary presentations, it was listed in the "very low probability" bucket. While hindsight is 20-20, this was considered a known risk, and insuring it on this scale is like betting all-in against a pop star becoming addicted to cocaine. Sure, it hasn't happened yet to this person, but are you ready to bet the company, the largest insurer in the world, on it not happening?

While adverse selection and moral hazard can run losses for a company, if there are no correlated risks and the ramp up in underwriting volume is not large, the losses will start to pile up and corrections will be made before it gets too bad. Correlated risks, however, were the doozy that sank the company.

Leadership - Leading

Continuing on a previous post, there is a difference between management and leadership. Unfortunately, this phrase has been an overused cliché and become a blank canvas to project whatever one wishes into the paradigm. With that enormous caveat, below is a description of my experience of when I have felt that I have been led versus when I have been managed.

When I am led, I feel that the leader and I have the same goal. It isn't a single word like "Vision" or "Passion," Of my own volition, I choose to want the same thing that my leader wants. Since individuals want different things at different points in their life, depending on the situation, leading can be incredibly difficult. Consider some of the potential objectives for each employee or team member:
1) Avoid work
2) Positioning for outside company move
3) Job security
4) Maximize compensation 
5) Positioning for advancement inside company
6) Praise and recognition
7) Feel superior
8) Winning
9) Team survival
10) Creation

When I'm being managed, I feel like my manager is appealing to any of the first seven items in the list. "Hit your target and get your bonus." "If we do this well, senior management will recognize it." "We can outdo the sales of those B-listers in the other division." "This will look good on your résumé."

When I'm being led, I feel like my leader is using one of the last three items in the list. "We are this close to the best customer experience in the industry." "We have come a long way, and if we can see this result come May, the bankers will give us the green light." "Pulling this off will forever change the industry. I believe that you can do this."

Because individuals are unique, and some are more difficult than others to lead, leadership will always be difficult, a unique attribute, and contrary to what many believe, an inconsistent attribute. People and circumstances will always change. However, recognizing that the appeals to the first group as primary motivators does not feel like leadership is a good step at rising above hum-drum management and taking a shot at the next level.

Leadership - Management Frameworks

One of my favorite analogies is the fire triangle. It's simple, familiar, and applies well in a variety of situations.

(Image from the peer reviewed journal, Wikipedia)

Anything with three primary elements that breaks if any one part is missing is fire triangable. Learning? Existing knowledge, transmission, and retention. Body building? Calories, muscle exhaustion, and repetition. Fire triangle created. Since it seems nearly every framework comes in threes, and a large percentages of these frameworks are co-dependent, the fire triangle becomes ubiquitous.

Take one fire triangle for leadership and team management:
Knowledge - What is the plan? Does the employee know what (not know how) they are supposed to do? What are the priorities, KPIs, process, routine?
Ability - Is the employee presently capable of achieving the objective?
Motivation - To what level is the employee committed to achieving the goal? How much oversight and followup is needed to keep the employee on task and giving all of their effort?

When all three are present, I see a functioning team. Everyone knows their place, is capable of doing their job, and is committed to following through to the goal. What I find most interesting, however, are diagnostic failures. I have often talked over plans of what to do with "underperformers" with managers. There are cases in which the environment has no direction or plan, but the manager believes the employee is incapable. At other times the employee simply does not have the skills to perform a function, yet the manager still believes that one more pep talk just might do the trick. Finally there are those employees who "just aren't capable," yet they switch managers and become a rising star. Misidentification is a mistake we all make, but once you recognize it, testing the hypothesis before throwing the employee out can yield surprising results.

Reputations - Expectations and the Wow

I studied at a university that is at the frontier of brand management. Messaging, positioning, maneuvering, strategy, and tactics were drilled into us. A company is its brand. A team is its brand. An individual is its brand. However, once I arrived in the day-to-day operations of a company and customer management I realized that independent of the myriad directions that one could take on a brand strategy, in the long run the reputation and brand of a company, team, or individual follows the history of customer experiences. Brand positioning must be aligned with the customer experience; otherwise, contrary to what the conspiracy theorists may say, customers stop believing the marketing. Watching the success and failure of various brands in a number of countries, I've witnessed brands gravitate to the customer experience, and the customer experience is at its best when 1) customer expectations are met, and 2) the "wow" factor is then thrown in. Below are two examples. The first is one of my favorite stories of customer service, and the other is about me.

Hampton Inn is not the highest-end brand in the hotel segment, but they strive to establish a brand that fulfills customer expectations. However, with the occasional "wow" factor thrown in during downtime, they can push the brand even further. In the "Additional Requests" field on a Hampton Inn online reservation, one guest wrote, "Please place a framed picture of Alfonso Ribeiro on the nightstand." As Hampton says, "We love having you here." Delivered as requested.

I had taken over a new department with about 30 employees. Results were okay, but not great. This was one of the few departments I had taken over that had a somewhat successful manager before my arrival, and I knew that there were misgivings about me. In the country I was working, it was nearly impossible for anyone to read every word of every document that requires a notarized signature from an authorized board member. And it seemed that every document needed a notarized signature. Accordingly, a high volume of paper came across my desk. On my second day in the role, an employee presented a document to sign, and after a five-second glance I pointed out a typo in a single number in the middle of the page. Next, an employee entered asking for help with a problem with his department. I had some familiarity with the problem from previous experiences. After about three minutes and my asking a few of the right questions to guide his thinking and get buy-in, we were able to restructure the work flows, establish KPIs, and create accountability in his team. The two of them left in awe and shared their experience with others, and it helped me immediately build trust with a new group. Now, I'm probably not nearly as smart they think. However, I at least skimmed everything I signed, and I'd seen a lot of different types of problems by this point. By going back to the team, asking how things operate, pointing out new things I learned from them, and offering feedback, I hope I was able to establish and meet expectations. However, the occasional "wow" factor can really help things along.

Disruptive Technologies, Part X - The Left Out

I commented at the beginning of this series on a few areas where I see the largest potential developments:
- Autonomous vehicles
- Energy storage
- Customized electronic education
- Water desalinization
- Terrorism

The first three I've covered in previous posts. Autonomous vehicles have an enormous cross-industry impact, but only once the truly autonomous part is achieved. Energy storage developments would increase efficiencies in the developing world and lead to large productivity and quality of life increases in the developing world. Customized electronic education provides higher quality education to motivated individuals (or parents) all over the world.

Now for the other two that haven't been mentioned up to this point. Because I follow both of these subjects, I'll simply give an overview without excessive links. I imagine I'll be covering these themes periodically in future posts anyway.

How does a technological advance occur in the terrorism space? Generally it's done by weaponizing an existing technology and then applying it in a way to maximize the psychological impact. Drive a plane into building. Grow ricin and put it in the mail. Put a bomb on a train or crowded area. Hack into a server and steal/publish personal and sensitive information. Et cetera. Thankfully, up to this point terrorist attacks have not been very creative. However, these developments in technology are opening up new doors to terrorism. What's been prevented or missing so far is a motivated individual or group, weaponizing the technology, and opportunity to implement. Advancements in technology provide more opportunities to implement, but also more opportunities to control. While I am quite bearish on the mass implementation of wearables in the short- to medium-term, I believe law enforcement will be using them widely within the next five years. Auto facial recognition scans, license plate scans, etc. will likely be allowed under the law in most countries. Combine wearable tech with the big data behind it, and a formidable security apparatus with all of its accompanying concerns is created. It's an arms race among security, terrorism, and liberty.

Developments in water desalinization are important for many reasons. Millions count on desalinization to provide them water. Water is running out in many areas of the world, Yemen being the most obvious example. Precipitation irregularity with an expanding population base will increase demand for additional water sources. Water scarcity is increasing, and there are many tools to help manage that scarcity. Desalinization breakthroughs, whether from Lockheed, universities, or various Middle East-backed projects, will create a price ceiling for water in every area bordering the ocean and prevent massive potential unrest in populated arid regions. On the world's current trajectory, water management needs to be improved significantly. Populists policies tend to fail in water management. One way to avoid this battle over a scarce resource is to improve the supply through technology. Water desalinization is the best bet for expanding the supply of water through technology, and billions of dollars are being spent to develop it. It might take a little luck, but this innovation is significant, especially compared to the status quo trajectory.

Disruptive Technologies, Part IX - Energy

This is my final entry commenting directly on the contents of the Disruptive Technologies MGI paper. I'll have one more entry on where I see some important elements that were either omitted or glossed over.

Returning to the generation, transmission, storage framework mentioned earlier, we'll break down the developments in energy mentioned throughout the paper by the authors.

A few points before diving in. There is an important point highlighted by the authors concerning peak demand. Energy is generally most efficiently produced when there is an even load. However, energy demand is not even for 24 hours per day. There is a big peak in the afternoon to early evening. From page 101, "To meet peak demand (when generation prices are highest), utilities can either build excess generation capacity or purchase electricity from other utilities or from specialized peaker plant suppliers." Accordingly, reductions in peak demand—even if that peak is merely shifted to other parts of the day—can produce huge savings. The paper's authors focus quite a bit on improvements in smaller scale batteries outside of the larger grid. However, from their writing and from my reading elsewhere, it is incredibly difficult to predict both developments and impact in this space.With this in mind, especially for the transmission and storage elements, below I've focused more in developments at the level of the general electric grid, household consumption, and business consumption.

Generation a) Oil and gas improvements - There have been incredible developments in natural gas over the last eight years. Hydraulic fracturing and horizontal drilling are global game changers in the energy industry. However, the cutting-edge advancements have primarily been implemented only in the United States and Canada. As other nations implement similar technology, and the technology progresses further (e.g., well renewal and other methods), the global energy industry will be very different from what we see today. As the authors put it (page 135), "No one can predict the geopolitical implications of such developments; there are simply too many variables in play."

Generation b) Renewables - Solar and wind continue to progress, but still have a ways to go. Solar will always have the upper limit cap on how much energy the sun produces, but there have been fairly constant efficiency gains in both the technology and production techniques. Solar does okay in certain high intensity deserts (no clouds and more hours of sunlight), but outside of them the economics need to change significantly before coming close to par with fossil fuels. Wind power simply does not appear to be viable until an improved energy storage solution comes into play. Wind is actually close to par with existing fossil fuels, but wind power exacerbates the peak load issues, as wind tends to blow more at night than the day and sometimes the wind does not blow at all. This is also true for solar because of intermittent cloud cover. The key to this is in the storage section below. If interested, one of my favorite TED talks is from a physicist on a realistic description of what green energy needs to look like going forward. going forward.

Transmission - This area was highlighted in the chapter on the internet of things. The estimate from MGI was a potential 2-4% reduction in peak demand, lower loads on the grid, and improved energy management techniques from customers. Nothing earth-shattering, but some decent improvements. One area that was not mentioned in detail was improving the regulatory structure to vary prices for customers depending on demand and supply. Consumers, however, would need to stay informed (perhaps through the internet of things) on the going rate of energy. This aspect alone could capture a significant portion of this benefit.

Storage - I've heard that there are many in the venture capital world working with prototypes of improved storage capacities, but very little is publicly available and there is not much information in the MGI report. The MGI authors do admit this is a slightly longer shot than many other points discussed, but the impact would be enormous. Just in energy production on general energy grids, we could see a 5%+ utilization impact of free energy that is currently lost because of frequency stabilization or inefficient storing of power. Wind power would instantly become far more economical. Plants could even out loads, driving efficiencies across the sector. This would also signify large impacts in the developing world, as intermittent energy is a large blow to productivity and quality of life.

There is a lot of potential in the energy industry. Drilling improvements have already been discovered and are very likely to continue and expand to the rest of the world. Storage improvements at the grid level is potentially disruptive with large worldwide benefits, but it is also the longer shot. I'm eagerly looking forward to the information on developments trickling out of the venture capital arena. Many companies should be aware of storage improvements, as the implementation would likely come quickly, and the effects would ripple through industries in both the developed and developing economies.

Side Comment: Driving in the developing world

From my previous post:

"One final note. Unlike some of the other improvements listed in the report, autonomous vehicles will likely have only a marginal impact on the developing world for both safety and infrastructure reasons. Those who have driven in these environments know how complex driving can be (more construction areas, worse road conditions, lower compliance with traffic laws, safety concerns, etc.), and that autonomous vehicles still have a ways to go before being able to navigate even just the urban areas of cities in the developing world."

One of my favorite stories about this is when I was working for a time in an office relatively close to a sketchy neighborhood. I was checking out the streets in street-view mode on Google maps. I clicked forward into the neighborhood. As I and the Google van advanced with each click, a group of shirtless young men in their late teens or early 20's appeared in the distance in the middle of the street. The Google van approached closer each time I clicked. The next picture showed the young men standing across the road in an intimidating fashion, all looking up at the Google van. I clicked forward one more time, but there were no more options to click further for street view into the neighborhood. The Google van had fled.

Disruptive Technologies, Part VIII - Autonomous Vehicles

The Disruptive Technologies MGI paper emphasized one area of which I have quite a bit of direct knowledge, autonomous vehicles.

The "self-driving car" has been progressing over the last six years or so. Google has been pushing the hardest, but other high-end manufacturers have also explored and participated within this area. First, let's start with a framework for analyzing autonomous vehicle development. Progress in this area can be broken into three distinct steps:
- Driver assistance technology. Cruise control, automatic braking, and accident avoidance falls into this category. These are not new, but certain areas show promise of progressing significantly. The primary benefits of this technology are to make driving a little less tedious and improve driving safety. These incremental benefits are good, but not revolutionary.
- Autopilot technology. Specific basic driving tasks are taken over by the vehicle's computer system. This includes parallel parking, stop-and-go heavy traffic, and highway driving. This is similar to autopilot technology in an airplane. The basic steps are taken by the computer, but if any desirable changes wish to be made or out of the ordinary events occur, the human needs to take over. The key impact here is safety. The toll in human lives and property damages from vehicle accidents is enormous. MGI estimates (page 81) that we could see 150,000 accidental deaths prevented per year by 2025. This is a great improvement, but it's still not revolutionary or particularly disruptive.
- Autonomous vehicles. The key difference between autopilot and autonomous is that the human can sit in the back seat or not be in the vehicle at all. This is a disruptive technology with revolutionary impact.

Here are a few of the effects of autonomous vehicles:
1) Real estate - Commutes become less important as average speeds to destination increases, and the commute becomes much more pleasurable. This causes the competitive advantage of near-urban suburbs to fall, and boosts that of exurbs. Also, since vehicles can roam to a parking space, urban centers can become far more efficient in their land use.
2) Vehicle ownership - Forget even having to own a car. The incentive to own a vehicle for personal use would fall, creating an opportunity for those who can efficiently move into a new age of fleet management. Also, for those who do own a vehicle, any time it is idle it can be sent roving for passengers and become a revenue producing asset.
3) Taxis/Rental Car - Forget Uber and traditional rental cars. One calls a car, it picks them up at home, and takes them to the destination. No driver costs and minimal transaction costs.
4) As mobility is enhanced, there will be many other difficult-to-foresee benefits and effects cascading through the economy.
The progress up to just before the point of autonomous vehicles is good, but not particularly disruptive or revolutionary. There will likely be many hiccups along the way to improve safety, and these improvements will likely be incremental on a fairly limited but consistent basis. However, the steps up to the point of autonomous seem far more achievable in the medium-term. Contrary to the MGI statement, "Technology is not likely to be the biggest hurdle in realizing these benefits," technology is still a very large obstacle for moving to the autonomous phase. The primary disruptive and revolutionary segment is technology challenging. To my knowledge, you can take the best near-autonomous vehicle to date, drop it in midtown Manhattan, and it will... do nothing. Contrary to what is said in some circles, I believe Google took the smart approach by abandoning the traditional self-driving Lexus design and instead replacing it with a glorified self-driving golf cart. Beginning from the glorified golf cart, Google can initially implement on a larger scale, and then more easily scale up the technology from there. Also, the self-driving cart within retirement communities can already begin producing benefits for a segment of the population that can benefit most from the technology, and the private roads in these communities can allow Google to experiment with little government interference. However, Google's transition does put a damper on those believing that autonomous vehicles will be a near-term phenomenon.

One final note. Unlike some of the other improvements listed in the report, autonomous vehicles will likely have only a marginal impact on the developing world for both safety and infrastructure reasons. Those who have driven in these environments know how complex driving can be (more construction areas, worse road conditions, lower compliance with traffic laws, safety concerns, etc.), and that autonomous vehicles still have a ways to go before being able to navigate even just the urban areas of cities in the developing world. 

Disruptive Technologies, Part VII - Cloud Technology

I was torn on the fourth section of the Disruptive Technologies MGI paper. This is an area in which I have fewer contacts and am less familiar with the majority of the areas highlighted. Based on the material presented, I am not yet convinced that cloud technology will be disruptive and transformative over the next 10 years. It is certainly possible, but I would put it as unlikely for a number of reasons.

1) Cloud technology has had incredible advancements already over the last 10 years, and the case that "the low-hanging fruit is gone" should be weighed against the case that there is potential for acceleration (pg 62).
2) While there is potential for dramatic improvements, the scope seems fairly limited, and further improvements will be necessary for cloud technology to have the impact predicted. For example, many small and medium-sized enterprises can use cloud technology to reduce costs and put themselves on a more competitive footing with larger players. Part of this benefit would stem from easily scaling operations up or down over a much shorter period of time. However, is the difference in IT capability a significant enough barrier that this change would be clearly evident? I am not so sure. It certainly bridges some of the gap, but there are many other reasons that smaller and larger firms have their competitive advantages.
3) Cloud technology is heavily dependent on bandwidth. If the bandwidth magic bullet strikes (see previous post), cloud technology can be extremely disruptive and transformative for many industries. However, to my knowledge that is a big "if." MGI admits as such in the section on potential barriers.

Disruptive Technologies, Part VI - Internet of Things

The Disruptive Technologies MGI paper is quite optimistic on the "Internet of Things." In essence, more sensors, more communication, and more data to connect the world. However, for most areas it is difficult to be convinced that the rapidly growing areas will produce increasing and disruptive returns to the market. Most of the examples given appeared to be areas with diminishing returns. The authors do place a number of caveats, "[T]he cost of sensors and actuators must fall to levels that will spark widespread use." "Progress is also needed in creating software that can aggregate and analyze data and convey complex findings in ways that make them useful for human decision makers or for use by automated systems." "Few organizations are ready to deal with this sheer amount of data and have personnel who are able to do so." In most areas, I believe the internet of things requires a longer time frame as chip costs fall, the heavy lifting on data-based actions is performed, and incremental and new applications are discovered.

However, one area appears ripe for the internet of things: public infrastructure and services. Traffic, water, electricity, and waste management are all areas for significant potential improvements by the internet of things because of a) significant existing physical investment and b) large potential savings. These areas are also likely low-hanging fruit because of a lack of competitive pressures to implement improvements over the last decade. Many governments at all levels have waited out implementation for a variety of reasons, from waiting for risks to decrease as technology improves further to corruption. This is one of the prime areas—if not the prime area—for improvements from the internet of things to be achieved in the near term.

Disruptive Technologies, Part V - Automation of Knowledge Work

The Disruptive Technologies MGI paper is very bullish on the automation of knowledge work. Some of the areas mentioned appear quite optimistic. However, the emphasis on the introduction of technology in education seems spot on. From page 45, "The economic impact of such tools in education would come from improving instructional quality and enabling teachers to provide more one-on-one attention and coaching. New self-teaching tools could also enable fundamental changes in scheduling: courses could be tied to subject mastery, rather than semesters or quarters, allowing students to progress at their own pace."

The primary elements of a basic education consist of
- Information: The knowledge must be first obtained held by the person or machine that is considered the source.
- Presentation: The information is effectively communicated to the recipient. In previous posts it has been mentioned that this is a large weakness in many developing countries.
- Motivation: The structure, instructor, or self motivates the pupil to learn the information.
- Retention: The pupil retains the information for later use.
- Accreditation: The pupil has signalling power to demonstrate the initiative taken and knowledge received.

Tyler Cowen argues in his book Average is Over that Information, Presentation, and Retention have developed significantly with technology. Accreditation is likely not far off. However, Motivation will be the primary distinguishing characteristic of future workers. There will be workers that have unfaltering motivation and will tirelessly work through seemingly dull or repetitive tasks to perfection. There will also be workers with varying motivation that tend to advance in short spurts of time. Finally, some workers will not be motivated, and will focus on obtaining just sufficient information to achieve near-term goals. In effect, those that are motivated, especially those in the developing world, will have access to become the new knowledge employees of the future. This is only possible because of the incredible recent advancements and advancements to come in the automation of education. The potential worldwide disruptive effects will be significant, as the world becomes more flat because of more equalized educational opportunities, with the caveat that this would be most true for basic and technical education, while leaving the most advanced and theoretical fields mostly intact.

Disruptive Technologies, Part IV - Impact of Mobile Technology

Further comments on the Disruptive Technologies MGI paper. Today's focus is the impact of mobile technology/smart phones in the developing and developed worlds.

Some time ago, I listened to a podcast that had a panel of Silicon Valley venture capital investors. One of them made a passing comment that has stuck with me on smart phones. The comment was to the effect, "The impact of smart phones on the developing world is an order of magnitude difference than the impact on the developed world in people's day-to-day lives."

The MGI paper forecasts the breakdown of benefits for the developed and developing world (Exhibit E4, pg 17). The forecast for mobile internet going forward is 50% developed and 50% developing. Over time, I've come to appreciate more the venture capital investor solution and appreciate less those around me hyping the latest iPhone. Take a few examples,
- Price - In the developed world, the smart phone is like a computer in your pocket. However, computers are still relatively expensive, while smart phones (in the developing world) are not. Accordingly, the ever cheaper smart phone (see pg 33) is at a price point that can connect billions of the world's poorest to the internet for the very first time.
- Education: The developed world has apps to help memorize subjects to supplement current education opportunities. For many in the developing world, the smart phone is or can become the primary source of education because schools are too far from home or that instructors are absent, drunk, lack knowledge, or otherwise ineffective.
- Finance: In the developed world, we don't need to go to the bank to deposit a check. For many in the developing world, they now have access to modern banking for the first time.
- Purchasing: In the developed world, we can purchase more during previously idle time. In the developed world, large groups of vendors and customers are meeting together for the first time.

The proper comparison for the developing world is to benchmark the smart phone to limited or no access, while in the developed world we can generally benchmark to the computer or telephone. Uber makes car services more convenient, adds some suppliers, and upsets taxi regulation distortions. Airbnb does the same for its industry. However, on a marginal basis, are these companies that revolutionary? The solutions that these companies provide are solutions to what many would consider "first world problems." Unquestionably there is value created by these companies as they shake up the mobility and hotel industries, but the developed world shakeup is not comparable to cars taking the place of horse-drawn buggies. However, for the developing world, there is the potential to make this comparison.

MGI's own "the future could be" example (page 31) demonstrates this phenomenon of the difference between the developed and developing world. Compare the impacts in the two scenarios presented.
Developed world impact:
- Alarm to remember train's departure time
- Targeted advertising
- Product information accessed more quickly
- Account balances accessed more quickly

Developing world impact:
- Online instruction in irrigation techniques lead to increased farm productivity
- Purchasing of seed, fertilizer, and equipment.
- Pooling resources with other farms to minimize costs
- Optimized timing to sell agricultural products
- Bank payments and receipts

Mobile technology has the potential to make an order of magnitude impact in just one of these scenarios. As long as increases continue in processing power, the data pipe, and to some degree energy cost and storage, the potential for mobile technologies in the developing world is the most significant technological change listed in the report.

Disruptive Technologies, Part III - Generation-Transmission-Storage Framework

I would reference the source if I could find the first time someone used the "generation, transmission, storage" framework, as I am sure that I am not the first to approach problems and development in this way. This framework is incredibly useful, especially while analyzing the Disruptive Technologies MGI paper.

The essence of the framework is that as technology progresses we see a changes in volume, speed, and origin in the steps of generation, transmission, storage. Take IT processing and your smart phone. The phone processes some information on its own (generation), it sends and receives information (transmission), and it or the cloud saves information (storage). As processing speed improves, it changes the equation of what should be going where and creates new possibilities outside of the IT space. The same can be said for transmission and storage.

A simple way to conceptualize this is to recognize that as the scale, cost, and power at each stage changes, the origin of the generation, the direction of the transmission, and the amount and location of storage changes.

Take the example of solar energy. First, where does the generation of energy occur? A far away solar plant or on top of a house? Is large scale needed for cost effectiveness? Second, does transmission of energy go from the central power plant to the grid, or can the house provide for its own energy needs and transmit the rest to the grid? Third, can the house or power plant save excess energy in a cost-effective manner? Walking through these steps illuminates the potential technological disruption in many of these industries, whether in IT, energy, water, or many other industries.

Dramatically improving one step of this process can disrupt the status quo and provide a leapfrog moment to technological progress. To take the IT example above further, if transmission of information were nearly costless and could be done at current fiber optics speeds or higher, nearly all processing could shift onto the cloud and the cost of a smart phone would plummet. As the cost plummets and the processing power increases (servers are faster than phones), developing countries like India would connect into the global economy at a much accelerated rate. This development would alter the markets in these countries, mostly for the better. One can then start playing through scenarios of these changes in agriculture, banking, etc.

Disruptive Technologies, Part II - Healthcare

A small detour before kicking off the commentary on the disruptive technologies paper.

While some disruptive technologies have healthcare benefits, many wonder why there isn't more commentary on the coming healthcare-specific revolutionary and disruptive technologies. From what I've gathered from those who study breakthroughs in healthcare, there are two primary reasons: rarity and predictability.

Although there are always ubiquitous predictions of dramatic potential benefits of healthcare advancements, rarely do medical breakthroughs actually have far-reaching significant effects in the short-to-medium term. Medical breakthroughs rarely occur and are difficult to foresee. While there have been a few breakthroughs in medicine that dramatically improved human health, the majority of the benefits from these discoveries occurred slowly. For example, benefits from vaccines took over 100 years to make a significant global impact. Many only consider one health advancement to fall into the "high broad based impact in the near-term" category: penicillin.

Penicillin's direct impact was miraculous and significant. It had an immediate impact on infection mortality rates, and was one of the three critical elements (together with water and vaccines) that took down the three leading causes of death and led to falling infant and childbirth mortality rates. Surgery in the modern sense suddenly became possible. This opened a new world of transplants, cancer treatments, and heart disease mitigation. Antibiotics truly were one of those advances that "changed everything."

I prefer to look at the future on a marginal basis. What is the current path of events, and how can one push that path in a different direction? In the current path, antibiotic resistance appears likely and with grave consequences. (See this excellent post which links to another excellent post which links to other posts which link to an excellent book which...) A disruption to our current path would be finding a way to contain antibiotic resistance or discovering an antibiotic in which few resistances would develop. However, the probability of this at the moment is, sadly, remote. That leaves us to hoping that antibiotic resistance either a) develops very slowly, or b) the resistant genes are more aggressively selected against in the bacteria universe when not in full-blown infection mode. Nonetheless, even though I have my critical hat on right now, I'd never be so much a fool as to completely short humanity. As the severity of the problem increases, more human ingenuity will be dedicated to fight against it with a race to the finish. In the long game, the smart money is on mankind.

Disruptive Technologies, Part I - The Technology that Truly Matters

Upon reviewing McKinsey Quarterly's top ten articles of 2013, I was not surprised that what topped the list was the 130-page comprehensive study on the disruptive technologies that will change the world between 2014 and 2025. For those not willing to invest the time, the executive summary is very well done. In the next few posts we will walk through some key sections of the report, discuss impacts and likelihood, and reassess some areas left out by the authors. Although I believe existing data and probabilities of breakthroughs point us in another direction than the authors suggest, the framework used to identify these disruptive technologies is very solid. The authors define a technology that truly matters is one that has:
- a high rate of technological change
- broad scope of impact
- large economic value
- and substantial disruption potential

The framework is simple and complete. However, I often see those in technology circles short-change the second item listed. A broad scope of impact technological change has the potential to impact changes of an order of magnitude in the lives of those impacted and the overall economy. For example, take the printing press. Gutenberg did not "invent" the printing press or even movable type, but what he did do was invent the mass production of interchangeable movable type. Suddenly, anyone could learn to print, and they could do so at a relatively low cost. This breakthrough, coupled with other advancements in raw paper materials, resulted in the cost of a book dropping by an order of magnitude. Inexpensive books meant cheaper distribution of knowledge, mass distribution of religious texts, and the ability for individuals to publish facts and opinions. Drastically decreasing the per unit cost of this one form of communication had an order of magnitude impact across the economies and societies of Europe and eventually the rest of the world. Forecasting economic value and disruption can be difficult when assessing a technology. Many at the time underestimated the disruption and value of mass production of movable type because the printing element of the economy was relatively small. However, it was arguably one of the greatest small steps of mankind. The same can be argued regarding the initial developments in steam power, the agronomy revolution, semiconductors, and the internet. I will argue, at the end of this series of posts, that the same can be said for autonomous vehicles, inexpensive water desalinization, energy storage, bio/chemical terrorism, and customized education. Most of these areas overlap in some aspects of the McKinsey Global Initiative (MGI) report, but I'll add a few more details as to why they could be emphasized differently or viewed in a different light than that presented.

Historic disruptive technologies have impacted most if not all of the following areas: transportation, communication, water and sewage, agriculture, energy, and manufacturing productivity. Inexpensive movable type, steam power, the agronomy revolution, semiconductors, and the internet can put a check next to most if not all those categories. Many of the technologies listed in the MGI report meet this criteria, but the potential scope of the different technologies presented vary significantly.

We are, however, talking about the future, and it does tend to have its own agenda. Although we might not have fusion to power our flying cars, we can still assess these likely impacts, and the MGI report is a perfect starting point kicking off an analysis.

Operating in a Country with an Adverse Business Climate? Remember that Nimble is Relative!

Non-value added activities are a part of every company, especially large ones. As lean six-sigma has become a part of nearly every major company, “master black belts” have begun a seek-and-destroy mission against non-value added activities. Unfortunately, many non-value added activities are still required to continue operations. However, what many do not realize is that non-value added activities can differ significantly depending on the region, country, culture, industry, etc.

 Tax code complexity and legal compliance vary greatly by nation. Security concerns make non-value added activities in one country a significant value-added activity in another. Selective government enforcement of contracts and laws rewards otherwise overly cautious behaviors. Facilitation payments may be tempting to keep processes from getting bogged down. Labor laws or work rules can restrict what employees would otherwise be willing and capable of doing, coerce a company into using unskilled labor, and consume management’s time with proper forms and filings. Once these different areas start stacking on top of the other, the non-value added elements of “normal” processes can reach staggering proportions.

There are three “successful” outcomes for a firm in this extra burdensome situation described above. 1) Remain small enough that non-compliance is not an issue. 2) Perform the best you can given the constraints in place. 3) Regulatory capture of those responsible for compliance. Assuming that you want to keep growing, option 1 is not viable. Also, either for moral or Foreign Corrupt Practices Act reasons, let’s assume option 3 is not viable. However, knowing of these two different options is important because it gives you an idea of the competition you will be up against.

“Doing the best you can” does not sound appealing. However, the one-eyed man, the tallest pygmy, and the sprinting sloth can all be champions given the right environment. “Nimble and dexterous” is a relative description, not an absolute one. Additionally, doing the best you can is the best strategy of the three options above because small players can never reach economies of scale and large players engaging in unethical practices encourage a stagnant and corrupt culture.

From my experience, I have learned three key lessons on how to succeed in this situation: Start Now, Recognize Reality, and Be Positive.

1) Recognize Reality – Before you build, sit down to count the cost. Recognizing “critical paths” of implementation is an essential consideration in the creation of a successful strategy. Beginning with the end in mind is essential, but the complex process of tracing it to action today means your dreams must be based in reality. Do not assume that the pieces will automatically fall into place, even if you have an excellent team put together. Is doubling your footprint in the country in 18 months a key part of your strategy? Know exactly what resources will be required, such as government applications, the average speed of negotiations, inspections, public infrastructure evaluation, etc. Once the critical paths are identified, then the route can be traced between the vision and the present.

2) Start Now – The easiest way to turn a boat is to start early and make adjustments along the way. Although counterintuitive, being nimble in a difficult environment requires far more advanced planning and accountability than many would initially believe or are accustomed to. Strategy cannot be made up on the fly or simply copied and pasted from a different environment. Once a successful strategy is identified and committed to, successfully implementing this strategy will have many more moving parts than you may think. A combination of execution and control by a very limited number of people, with buy-in and input from a much larger range of individuals is usually the best combination.

3) Be Positive – Yes, I know that sounds like utter feel goodery, but it works. Let yourself laugh at the insanity, then take a breath and get to work. Many managers are unable to get past this and remain eternal pessimists. Unless these people are your lawyers, drop them. Do not fall in the trap. Watch yourself and watch your team. Proactivity can heal a thousand cuts, but reactivity and negativity will put your company into a coma. The rule with my team is, “Always have at least one potential solution when presenting .” This one rule has preserved all of our sanity, as we never go to someone else exasperated. The bleeding stops, and we can move forward.

Yes, there will be deadweight you may not be accustomed to and every day may seem like a slow motion 100 meter dash, but everyone else is racing with moon shoes too and victory tastes just as sweet.

The Consequences of Failing to Understand Basic Exchange Risk

I once participated in the negotiation of a decently large franchisee renewal. The franchisee was solid enough and was renewing its contract with corporate to continue operate in a few smaller countries. However, the negotiations got hung up on one crucial point. The franchisee was not willing to assume unlimited currency risk. Or, let me put it another way, the corporation was insisting on having a minimum annual guarantee in a currency foreign to the region where the franchisee operated. By the time I got involved both sides were issuing ultimatums and unwilling to back down. I was embarassed of my employer and the vice-president refusing to budge on an issue in which he was clearly out of his element (his primary experience was US only operations). After failing to convince this executive how... imprudent... the position was, I decided to subtlety cut down his position by explaining to and convincing some of the executive's colleagues that this decision was "unwise to pursue at this juncture." At the end of this process, there were two key lessons for me: 1) be willing to be wrong and solicit the feedback of those more knowledgeable than myself, and 2) a lack of understanding of a simple concept (an unforced error, as I like to call them) can consume significant amount of time at all levels of the organization.

Show Me the Money II - Statistics

I wrote a couple weeks ago on short-sighted corporate cultures. However, 20/400 near-sightedness is not just a "some corporate cultures" type of problem. It's a human problem. We see it when those who eat the marshmallow now seem so cool, exciting, and hip as they munch that delicious morsel and get invited to all the parties. I would take a swipe at politicians, but that's too easy, so I'll go one step above and go for myself -- those of us who rely on aggregated statistics and believe that they are comparable and assume everything else we haven't included in our models isn't very significant anyway. I'll use GDP as an example.

Besides GDP being an estimate of economic well-being, it's also an accounting identity. GDP = C + I + G + (X-M). Just add up consumption, gross investment, government spending, and net exports. There are many criticisms (most of them are marginalized) of GDP. I'll focus on just one: G, or the government spending component.

GDP is supposed to accurately depict the economic well-being of a society. Voluntary transactions, consumption, even the (quite subjective in my opinion) human development index can be a gauge of well-being. Government spending, however, is not. Here are a few examples:

1) A government spends $10M developing a new bomb. That money is now added into GDP. The economy is supposed to be better off by $10M.

Some people erroneously believe that war helps the economy (e.g., "World War II got us out of the Great Depression!"). Large amounts of spending on war simply manipulates GDP to no longer represent the economic well-being of a society. People producing large amounts of tanks, bombers, and guns don't make a society "richer" than when those same people produce butter, hair cuts, and buildings. Now, of course survival makes one better off than death and defense is a crucial part of this. However, GDP equates bombs with corn flakes. I'd prefer to not need the bomb and eat my corn flakes, but GDP states that I'm just as well off if I have no corn flakes and the bomb is made. Of course I prefer survival, but survival and corn flakes is even better than survival and no corn flakes. GDP doesn't make this distinction.

2) A farmer receives a $5M subsidy to plant nothing. The economy is supposed to be better off by $5M. The result is higher agriculture prices and a deadweight social loss that comes from the transfer of money through government There also might be secondary effects as savings drop as more income is spent on food. The economy is better off according to GDP.

3) A state spends $15B on the biggest public works project in the state's history. It's the biggest public works project in history because it went triple over budget and time. Let's call it a Dig that is Big. The fact that it went over budget is a plus for GDP, not a minus. Cases like this beg the question, "How much quality am I receiving per dollar spent?" Tyler Cowen makes the convincing case in The Great Stagnation that the marginal dollar of government spending is very important. The first 10% of GDP in government spending of GDP is generally spent on courts, police, and preventing starvation. The final 50-60th % of GDP in government spending is spent on subsidies, four year unemployment benefits, bike paths, and free stuff. When GDP is calculated, involuntary transactions are weighted equally with voluntary transactions. We then take these GDP numbers and compare them across countries with very different levels of government spending and assume that they are equivalent.

And, yet, I turn around and use the metric because... what else do I use? What else is available? I use the tools that I have even though my results are likely systematically biased. This is the principal reason why I love to dive, without the narrative of others, into the random minutiae in a process or among operational or "line" teams. I have the chance to see some of the ways it can all go wrong when we aggregate it up and take decisions. It forces cluelessness, and, hopefully, humility.

Show Me the Money - Corporate Cultures

As a friend was engrossed in reviewing the execution of a failed initiative, an executive walked over to his desk, mentioned a few things, then stated "It's the 25th and we need to find more money for the month. I'm heading to Accounting." ... Let that soak in. The first time you hear it, the alarm bells should start going off. The twentieth time, you think it's funny and laugh about it with some colleagues. The hundredth time? You might be responding, "How can I help?"

“Vice is a monster of so frightful mien, As to be hated needs but to be seen; Yet seen too oft, familiar with her face, we first endure, then pity, then embrace”
-Alexander Pope

Short-sighted corporate cultures don't focus on value creation. Managing by the quarter (or month) is like driving a car with the top two-thirds of your windshield blacked out in a snowstorm. Once you get to the point that executives have no fear of reprisal and say it out loud, you realize that everyone else on the freeway had their windshield blacked out as well. Some of your top-performers end up heading for the exit lane. Some potential top-performers never become such because they're stunted or take the exit as well. Others find a niche of the company where hopefully they can hide out until after the massive pileup. It's a culture where, like political dictatorships, the worst tend to make it to the top. Is the ensuing crash inevitable? Will it be public? Who will make it out? If you're asking the question, your answer will probably be, "I'm not going to wait around to find out."

Labor Union Strategies for the 21st Century

Organized labor’s continued pursuit of a strategy created in the early-mid 20^th century has decimated—and will eventually finish off—organized labor’s remaining influence in the 21^st century. Labor’s influence increased dramatically starting the 1920’s, peaked in the 1950’s, and is now at its weakest level in more than a century.

Source: http://unionstats.gsu.edu/

The private sector labor movement is dying. The 20^th century model of labor unions destroys the employees in the 21^st century. The 20^th century model writes work rules that prevent the worker from performing multiple tasks. The 20^th century model creates very high overtime costs or forbids working more than a set number of hours. The 20^th century model couples high pensions with extracting as much immediate monetary compensation for the worker as possible, creating a burden that puts a company at a disadvantage compared to its non-union rivals. This model dooms the 21^st century employee because it prevents employees from being flexible, autonomous, and skilled in a variety of tasks. Instead of negotiating for training that would enhance a worker’s productivity and marketability, unions negotiated for a compensation and work rules package that emphasizes the wrong set of benefits.

Devoid of revenue, unions turned to the growing government sector to maintain at least some level of support. At face value, this strategy would seem to make sense. A union shop can go bankrupt when faced with non-union competition, but a city/state/country has plenty of revenue streams and almost no competition. However, this strategic shift was a mistake. A unionized government sector combined with shrinking private sector influence places the unions on the opposing side of the general public.
2009 was the first time government sector employees exceeded the number of private sector employees.¹ This is a psychological tipping point for the general population. For example, when the Department of Labor or the AFL-CIO tries to sell the labor movement to the general public, they use graphs such as this one:

Source: http://www.aflcio.org/Learn-About-Unions/What-Unions-Do
This graph appears to be a selling point. The hope is that the public might think, “If only I were in a union, then I would be making more money.”

However, once the tipping point between government and private sector employees has been reached, the labor movement is painted in a completely different light. The public begins to think, “Look at all the government employees taking money from my paycheck, working fewer hours, taking more vacation days, and making more than me.” Equating unions with public employees will continue to push public opinion against the labor movement.

Turning to the public sector allows the dinosaur labor model to survive, with no innovation necessary. However, the labor unions are now on the other side of the negotiating table from taxpayers. Every dollar is extracted from taxpayers’ pockets. Additionally, unions want trade barriers, which also harm the public. This creates a tight spot for the unions. An entirely different marketing strategy must be adopted. How do you not get everyone to hate you?

At this point the labor movement is left to appealing to emotion. In the last decade this message has distilled into two forms, a positive and negative message. The positive message focuses on a positive emotional tie to the public. For example, “[Insert public occupation with positive image] are priceless!” Regardless of performance or current rate of pay, vacation, hours, etc., more funds are needed. The other message is to marginalize or demonize opponents. For example, “[Insert political target or wealthy] hate [public occupation from first message].” Maintaining these two types of messages is costly and can still lose in the long run as the public realizes that a zero-sum game is essentially in effect.

What Other Option is Available?
First, a successful labor movement strategy must include the private sector in order to avoid the trap outlined above. Second, a successful strategy must prepare its members for employment in the 21^st century. This means that its members must learn to be flexible, autonomous, and skilled in a variety of tasks. In the long run, the labor movement will die out in the private sector if this is not the case. Non-union corporations will drive out the union corporations with greater productivity and better talent. Third, the labor movement must identify areas where it can utilize its core competencies of leverage and employee goodwill.

It is not in the best interest of a company to provide skills and training to employees that are not directly applicable to their current position and that would make the employees more marketable to outside firms. However, a worker needs to continually expand her skill set to succeed in the 21^st century. The labor movement would be in an ideal position to bridge this gap.

Instead of the anti-productivity slogan “People over profits!” the labor movement can adopt the pro-productivity slogan “Promoting people promotes profits!” This can be accomplished by the union voluntarily tying one of its hands behind its back. The union can reserve the right to represent, intercede on behalf of, and provide a channel of grievance from the employee, but the union can also include in its charter that it does not reserve the right to negotiate compensation or work rules. The union does not even need to refer to itself as union, but rather as a learning and training federation. The union can negotiate training funding and hours during the work day for training from the corporation, while at the same time requiring nominal union dues from members who wish attend the training. Employees will enjoy the break from work and appreciate the training and skills. The outcome for the corporation may be neutral or positive, as training and employee morale increase productivity. The labor movement can continue to live up to its mission as the supporter of “the working man/woman.” The public enjoys a positive economic benefit from a workforce that enjoys lifelong training and improvement. The transformation of the union into an educational enterprise will produce the positive message and impact that the public needs and wants.

“Promoting people promotes profits” is a radically different approach from the current strategy. However, the current trajectory of the labor movement will leave a handful of legacy industries and public servants demanding the general public to pay up and implement net negative economic policies. A positive transformation and strategic shift will create a lasting labor movement for the 21^st century.
¹http://www.bls.gov/news.release/archives/union2_01222010.pdf.