There is a lot in the news on the international front just at this moment. A civilian airliner has been shot down over Ukraine and the Israelis have invaded Gaza. I try to take a longer view in these posts so the specifics of either of these events is not my primary focus. But I was already thinking about both areas when I started thinking about the subject at hand.
These two currently red hot hotspots join a much longer list of merely hot hotspots. There is Syria, which merits two entries. There is the "chemical weapons" entry and the "ongoing civil war" entry. Iraq is breaking wide open. There is the "what to do about al Maliki" issue, the ISIS "Sunni eruption" issue (which can be linked to the "Syria civil war" entry), and the "what to do about the Kurds" issue. Iran too gets two entries; one for the "nuclear" negotiations and one for its participation in Syria/ISIS (and possibly Palestine support, which is related to the Gaza invasion issue). Then there is Afghanistan, which has just completed disputed elections and is the object of some sort of a U.S. military withdrawal. There are other hotspots on the International front but I think we now have a list that is plenty long enough.
One could find a number of commonalities in this list but the one I want to focus on is "negotiations". A hotspot will flare up and immediately someone, and frequently several some ones, will immediately call for negotiations. In more long run crises the periodic hew and cry for "negotiations" is a standard feature of their evolution.
The idea is simple: "jaw jaw is better than kill kill". If people are talking they are not shooting and if they are not shooting people are not dying. That's the theory anyhow. But negotiations don't seem to have a very good track record. The current Gaza situation is a classic example. I am going to skip the long and complicated history here and focus on just focus on the events of the last few days. Israel started bombing Gaza and threatened an invasion. The U.S. immediately popped up and made loud "negotiations" noises. Egypt jumped on the U.S. bandwagon and came up with a deal that the Israelis accepted. But then Hamas balked and the "deal" never happened. At a more micro level both sides agreed to a "5 hour" cease fire but the terms were widely violated. And at this hour the Israeli military is rooting around on the ground in Gaza. This is a particularly depressing example of negotiations failing but it is far from unique. What's going on here?
Several hundred years ago white settlers "negotiated" a sale of Manhattan Island from the local Indians for chump change. This is an example of a negotiation that went badly wrong for one side. But since then most people have gotten wise to how negotiation works. So you can still find situations where one side or the other gets taken to the cleaner but this now rarely happens. The art of negotiation has been an area of serious study for many decades now. You can read books or get degrees in how to conduct negotiations. So the chance of someone pulling off a coup against the other guys is very small these days. And the situation is actually worse. People have been "horse trading" for millennia. It is easy to find examples of disadvantaged people who do fine in a negotiation. Somehow or other they turn out to be to be good at it.
This was driven home to me many decades ago. It is another lesson from the U.S. experience in Vietnam. On one side you had smart sophisticated Americans. The U.S. team was led by Defense Secretary Robert McNamara. Before becoming Defense Secretary he had been President of Ford Motor Company. There he had cut his teeth negotiating with auto unions. So he knew a thing or two about negotiation. On the other side you had the North Vietnamese. North Vietnam was half of a third world country, for God sakes. On paper they stood no chance. The whole thing should have been a repeat of the Indians and the Dutch in Manhattan. But it wasn't. The North Vietnamese more than held their own at every stage of the years long negotiations. Beyond that I learned that negotiations don't get anywhere until both parties want them to get somewhere. The North Vietnamese in particular thought that they could win by continuing to do what they were doing outside the setting of the negotiations. This resulted in a comic situation. It took over two years to decide what the shape of the negotiating table would be. Would it be round, where all parties would be on an equal footing or would it be square so each party would have its own side. (It's been so long now I don't member what the final outcome was.)
My take away from this is that negotiations can't get you anywhere until all sides actually want to come to an agreement. Part and parcel of this is that what each side wants must be what the other parties are willing to let them have. The Vietnam negotiations did eventually come to a successful resolution. The North Vietnamese wanted the U.S. out of Vietnam and a negotiated "settlement" as a necessary condition for that to happen. The U.S. wanted to "declare victory and leave". A "successful" negotiation gave them the fig leaf they needed to pull this off. The other parties involved were too weak to affect the outcome. Ultimately, the North Vietnamese were right. Continuing to do what they were already doing eventually led to them winning the war. The U.S. had concluded but couldn't publicly say that the war effort was doomed to failure. The South Vietnamese held on long enough so that the U.S. could pretend that the U.S. withdrawal and the takeover of all of Vietnam by the North Vietnamese were two separate events. So in a "cut your losses" sense, the negotiations were ultimately a success for the U.S. too.
This left me with the belief that negotiations don't settle anything until the parties are ready for them to be settled. I expect negotiations to fail whenever I think that the underlying positions are still in conflict. If there is a formula then the parties can find it quickly. If there is no formula then nothing will come of negotiations. Having depressed you with a situation where the U.S. fared badly let me talk about a situation where things went surprisingly well. This is the whole "chemical weapons in Syria" issue.
It has long been known that Syria had large stockpiles of relatively modern chemical weapons and the military means to use them. When the whole Syrian revolution went hot a lot of people became seriously concerned. The concern was justified. At some point the Assad regime started actually using them. Previously President Obama had drawn a "red line" around the use of chemical weapons in Syria. The first evidence seemed to be pretty much small bore. Obama tried to hand wave this away in the reasonable belief that if he had to do something he didn't have any good options. This resulted in some criticism but it wasn't just the President that saw no good options. Then Assad launched a chemical attack that was big enough it couldn't practically be ignored. That put the fat in the fire.
Then, as Obama is weighing his many bad options, the idea was floated to do a deal where the weapons would be taken out of Syria and destroyed. In a remarkably short time a deal was struck and all of the known chemical weapons have since been removed from Syria. Any doubt about how good this news was got dispelled when ISIS declared a caliphate in eastern Syria and western Iraq. Assad rates high on the "bad guy"-o-meter. But ISIS rates an eleven. The world is a better place now that we don't have to worry about ISIS getting its hands on chemical weapons. It seems very likely that they would use them aggressively. Saddam used them in Iraq against the Kurds not that long ago in the same part of the world. So it is a very good thing that the weapons are gone. And it appears negotiations played a key role in making that happen. And that's true. But, having set up the background I want to talk about why they succeeded this time.
Chemical weapons were first used on a large scale in World War I. But the WWI experience taught two lessons: In the right circumstances they can kill a lot of people and they are very hard to control. So the "right circumstances" are much harder to come by when you most need them. Immediately after the end of the war various efforts were made to ban them. And they were not used to any extent in World War II. Now various horrific techniques were used: torpedoing of neutral ships, bombing of largely civilian targets (London, Berlin, Tokyo), extermination camps, firebombing, drone attacks, rocket attacks, and the Atomic Bomb. The case can be made that chemical weapons are no more horrific than these other techniques that were used. So why not use them too? The reason is this whole "control" thing. It is hard to make sure the large scale use of chemical weapons kills the bad guys without killing the good guys. All these other techniques could be much more easily controlled.
The modern fear industry does not talk about this when discussing chemical weapons. It would interfere with their ability to make us afraid of whatever they want us to be afraid of today. But the people involved in the negotiations were aware of this disadvantage. Both the U.S. and Russia saw advantage in being on the side of eliminating them. Assad was put under pressure from the Russians. But he also saw that he could be equally effective militarily without chemical weapons. And the other tools in his military toolbox did not carry the heavy propaganda cost of using chemical weapons. So he did not put up that much of a fight when the Russians pressured him. And ultimately everyone (Assad, the rebels, the U.S., the Russians, other less important players) cooperated to get the weapons removed under horrific wartime conditions.
Here we had a deal that everyone could sign on to and that everyone saw some personal benefit in being a party to it. Once all the parties figured this out the deal came together very quickly and has since been carried out. With this perspective in mind let me run down the list and see how things fit (or don't) in these other situations.
Ukraine - The Ukrainians have suffered from a spate of bad governments in the post-Soviet era. This resulted in Putin seeing an opportunity and engineering the annexation of the Crimea to Russia. Having succeeded there Putin fomented unrest in the eastern provinces of Ukraine, which contain large numbers of people who are culturally Russian. Incompetence and disorganization on the part of the current Ukrainian government contributed to a belief that he would be successful here too. But this annexation has not been going as smoothly as the Crimean one did. And now we have the latest event where a Malaysian civilian jetliner was shot down over the disputed territories. Over, above, around, and through all this have been various calls for negotiations. The official U.S. position on the "unrest" in eastern Ukraine is a call for negotiations between the current government of Ukraine, Russia, and possibly others.
I believe it is too soon to expect anything. But we may be close to the time to sit down and start taking. The Ukrainian government seems to be quickly getting its act together. The "rebels" started out with a lot of support from the local population and even more support from Russia. But they have played their hand badly. I see the Russian role as opportunist. Putin styles himself as a great Russian nationalist who is a champion of Russian interests. Annexing Crimea was a success because it was cheap in terms of both blood and treasure and was well received (for the most part) by the population involved. It definitely advanced the interests of Greater Russia - we are powerful and successful and we are the champion of Russian people wherever they are. But Ukraine is turning out to be a much more expensive proposition.
The Ukrainian government, after a number of early stumbles has started reacting effectively. And the shooting down of the airliner is a giant black eye. Russia has long been seen as a bully by its neighbors during the Putin era. Crimea, eastern Ukraine, and now especially the airliner shoot down feed that narrative. And if Russia is ultimately unsuccessful in annexing eastern Ukraine that is a blow to the whole "Greater Russia" narrative. It's not even necessary for the effort to fail. It is only necessary for important interests in Russia to decide it is likely to fail or to be too expensive, As a basically opportunist endeavor Russia will want a graceful exit as soon as they decide the whole thing is a bad idea. In the same way that the U.S. objectives changed in the Vietnam negotiations the Russian objectives will change in the eastern Ukraine negotiations. At that point successful negotiations become possible. I don't think we are there now but I think we could be soon.
Gaza - Here I expect failure into the foreseeable future. Hamas still thinks it can outlast Israel. For political reasons within the Arab world Hamas receives enough support so that they have the luxury of continuing to hold that position. Israel believes it is confronted with an existential crisis. They believe that if Hamas wins then Israel will cease to exist. These are incompatible positions. They have been firmly held on the Israeli side since the country came into existence in the late '40s. And the position has been supported by one Palestinian faction or another over the same period of time. That faction has always been powerful enough to veto any Palestinian peace initiative. Until this changes negotiations are doomed. I don't see this changing any time soon.
Syria - I have discussed the chemical weapons situation. Let me move on to the civil war. Here both sides see themselves in an existential situation. Until that changes I see no hope for negotiations. But unlike the Israeli/Palestinian situation, where nothing material has changed in decades, the Syrian situation is in flux. ISIS has a strong potential for upending the playing field. I believe that ISIS has a real possibility of creating a country consisting of eastern Syria and western Iraq. The current boundaries were drawn up by the British and French at the end of World War I. Then make no geographic or cultural sense. ISIS may cause some of those boundaries to be redrawn along lines that make much more sense geographically and culturally. The big barrier to ISIS success that I see is the question of whether ISIS can actually govern. This is hard to predict. But if they actually turn out to know how to govern then I think they have a real chance of creating a country. Whether it is a caliphate or not is a minor consideration. And its politics might not be what the west and the U.S. will prefer but that won't stop it from happening. Frankly, I don't know what the cultural map of Syria looks like if you slice the Sunni east out. So I don't know how an ISIS success will affect Syria. But there is too much in flux for negotiations to be worth the trouble at this time.
Iraq - Here I think my crystal ball is clearer. I think Iraq in its current form is doomed. The three main factions in Iraq are Sunni, Shiite, and Kurd. The Kurds have already signaled where they stand. They want their own country. The al Maliki government in Bagdad is too weak to stand in their way. Considering the alternatives the outside world may decide that an independent Kurdistan is better than the alternatives. It is up to the Shiites in Iraq to decide how important it is to do something about ISIS. I think the U.S. will have little influence on that decision. There is talk about replacing al Maliki with someone else. That was tried by the U.S. in South Vietnam. It didn't work then. I don't think it will work now especially given that no competitor has emerged so far. I think that the Shiites are stuck with al Maliki. One possible outcome is that the Shiites in Iraq will unite with the Shiites in Iran. I think this is an interesting possibility but unlikely. The Iraqi Shiites are Arabs. The Iranian Shiites are Persian. The Arabs and the Persians have been fighting for several millennia. I so no reason to believe it will stop any time soon. So what I see is a Shiite Iraq, a Sunni caliphate (for lack of a better term), and a Kurd Kurdistan. I think all this will happen relatively soon but not right now. So right now negotiations are a waste of time.
Iran - I have already covered the Iraq/Syria/ISIS issue. Let me move on to the nuclear negotiations. The "deadline" for talks to conclude has just been extended. This is a less than shocking development. Nuclear weapons share some similarities with chemical weapons. They are not that controllable. Sure, you can explode one exactly where you want. But they tend to be too big. And they are a propaganda disaster. The only benefit seems to be the prestige angle. "I am a big bad nuclear power who has to be accorded due respect." But several countries including Brazil and South Africa have decided they are more trouble than they are worth. Everybody assumes Israel has nuclear weapons but officially they won't admit it. Where's the prestige in being a nuclear power if you don't brag about being a nuclear power? And other countries seem to be willing to go after Israel anyway. So the prestige looks vastly overrated. Then there is North Korea. They are a nuclear power and everybody knows it. But they are still seen as a pipsqueak country. So North Korea represents another blow to the prestige argument.
What Iran says is that they want to be a nuclear power in the sense that they process nuclear fuel. Their official position is that they don't want a bomb. Some people think they are telling the truth about this and some people think they are lying. But either way it represents the basis for a deal. The U.S. and other western powers said they didn't want Iran processing nuclear fuel at all. But all the international treaties say it is OK for Iran to process fuel. The deal consists of Iran not making a bomb in exchange for Iran being allowed to have a heavily monitored nuclear fuel industry. I think that's a feasible deal. And I think there is enough prestige in being a fuel processor to make up for what ever prestige they miss out on by not being a nuclear power. So Iran gets the prestige they want. On the other side Iran gets to do what treaties already say it can do, namely process nuclear fuel. But that nuclear fuel industry ends up being heavily monitored. In short I think there is a deal to be had here. But there is also the art of the deal.
A deal must be sold to both sides. Going in each side promises its supporters that it will come away with more than it actually gets in the end. This has to be dealt with. The standard method is "we got as much as we could and the deal we got is better than no deal". The specifics of the deal (in this case the prestige for Iran of being a nuclear processor balanced against the fact that they are a heavily monitored one) is what you use to manage the second problem. The standard technique for handling the first problem is brinksmanship. First, you set up a "hard deadline". Then you go past the deadline. Then you reach a middle of the night deal after the deadline. It may be ugly but it works. I think there will be an Iranian nuclear deal along the lines outlined above. I think it is a "win/win" all around. But the western public has been promised that the Iranian nuclear capability will be wiped away completely and the Iranian public has been promised that the Iranian government will not be pushed around by the "running dog" west. Most Iranians probably don't want Iran to be a nuclear power but they also don't want their government to cave to the west. By going to the last minute and beyond each side can credibly argue that they got the best deal they could get. Without the drama and brinksmanship the argument is much harder to make. So I predict more brinksmanship but ultimately a deal.
Afghanistan - If I had my way the U.S. would be completely out of Afghanistan. Iraq is falling apart because the fissions in its society keep growing and there was no opposing force to shrink them. We have much the same situation in Afghanistan. The Northern Alliance represents Pashtuns but not the other components of Afghan society. There is rampant corruption coupled with bad government. This results in a classic "the center is not holding" situation. We need to get out of the way and let the Afghans sort this out. They need to figure out how to do this on their own. Otherwise they will never build the strong institutions necessary for long term success.
Then there is Pakistan. Pakistan has subsisted on blackmail from various foreign powers since it came into existence when the British relinquished control of India in the late '40s. The U.S., the Chinese, the Russians, the Saudis, and others have been pouring money into Pakistan at various times for various geostrategic reasons. Currently the U.S.'s reason is that Pakistan squats on the supply lifeline to our troops in Afghanistan. If we have no troops there then we have no reason to continue to pay the blackmail. Getting all of our troops out of Afghanistan gives us a much better position vis a vis Pakistan.
Getting all of our troops out of Afghanistan cleanly may not be possible. But our leverage in Afghanistan is weak. If we can do something about making sure the election was not rigged then so much the better. But that's about it. We should tread very carefully with respect to any commitment beyond the end of 2014.
Finally, let me return to the whole "talking is always better than fighting" argument for why negotiations are supposedly always a good idea. There is a cost to full tilt negotiation. You lean on one or both sides to try to lever concessions out of them. If the negotiations ultimately fail there is a cost associated with this kind of power diplomacy. We may have pressured one side into a concession that is no longer worth it after negotiations fail. But the concession may stay hung around their necks anyhow. And countries do not like to be leaned on any more than people do. They resent it. So strictly "going through the motions" calls for negotiations are probably OK because the costs are low and in line with the benefits ("we are pro-peace types"). But the kind of negotiations the U.S. has engaged in between Israel and Palestine have been full bore enough so that the costs of the ultimate failure may be significant.
I have very little good to say about George W. Bush. But I think he made the correct decision to not push hard for Israeli/Palestinian peace. It was not in the cards then. I don't think it is in the cards now. I salute George Mitchell and John Kerry for trying. But I think it is important that these efforts be realistic. If there is a deal to be had, great. Charge ahead full steam. But if the deal is not really there make sure that your efforts are not counterproductive.
Of course none of this will in any way diminish the vast volumes of hot air that will continue to be expended on why negotiations should be forced into existence immediately and everywhere. Nor will it diminish the micro-criticism of the people engaged in or not engaged in any particular set of negotiations. But hopefully this piece will make us all more informed spectators.
Saturday, July 19, 2014
Wednesday, July 2, 2014
Tech bubble 2.0
If you follow the stock market closely there has recently been talk about a new "tech bubble". In layman's terms this means that some analysts are floating the idea that the prices of tech stocks are overvalued (too high) and that we are about due for a correction (sharp drop in prices). This is entirely normal. Conventional wisdom says that if the market goes in the same direction for three to five years it becomes time for the trend to switch direction. Since stocks have been going up since the market bottomed in early 2009 it is time for them to start going down. Interestingly, there doesn't seem to be much talk of the general market correcting, just tech stocks. And at this point it is just a few voices. So what's with this "bubble" thing?
In 1841 (over a hundred and fifty years ago for those who are keeping track) Charles Mackay wrote a book called "Extraordinary Popular Delusions and the Madness of Crowds". The book is so influential you can buy it new from Amazon to this day. In that book Mackay popularized the term bubble to describe situations where large numbers of people pay extraordinary prices for things. The most famous (and to the modern sensibility ridiculous) example from this book is Tulip bulbs. But the events Mackey relates actually happened. The "bubble" of prices inflated and inflated and inflated. And it ultimately popped just like a soap bubble.
Mackay examines a number of other bubbles (and several other delusions not related to investment or finance). It is an interesting book and I recommend it. And investment mavens have been reading it and recommending it to other investment mavens for as long as the book has been in print. And, of course, bubbles have come into existence and popped many times since Mackay's book came out. That's why each generation of savvy investors keeps reading the book and keeps trying to be on the lookout for bubbles so they won't get caught when they pop. They, and I include myself in this particular "they", have had limited success. Why? It's hard, man. Let's look at "tech bubble 1.0" to see what I mean.
The modern era where the stock market pretty much seems to go up, except for the odd correction lasting at most a few months, is abnormal. Let me contrast it with another abnormal period where pretty much the opposite happened. On February 9, 1966 the Dow closed at 995.15. The economy looked good so people expected the Dow to "break 1000" for the first time in history within a day or so. It didn't. Instead that turned out to be the high for the year. The Dow see-sawed around and eventually broke 1000, and 1100, and 1200, and 1300. But each of those milestones were accompanied by lots of ups and downs and took many years. Then the Dow started to go down. Eventually the Dow bottomed at 776.92 on August 12, 1982. Over a 15 year period the Dow had dropped over 20%. By this time there was a lot of pessimism to mirror the optimism that had surrounded the 1966 high.
We now know the Dow turned the next day. And it proceeded to shoot up. Wall Street was very happy. But as the market kept going up they started worrying. And guess what? On October 19, 1987, roughly five years later, the market crashed. The crash was big enough and scary enough that the day was nicknamed "Black Monday". But the market quickly turned back up only to crash, but less spectacularly exactly a year later. And again it recovered quickly, climbed past its old all time highs and just kept going. For the most part it is still going today.
At about the time of the 1982 bottom a bunch of brokerage firms got together and decided it was time to modernize. The New York Stock Exchange had a trading floor, literally a room where people stood around yelling at each other and filling out pieces of paper. You had to literally be on the floor to buy or sell a stock. They decided that these new fangled things called computers could replace the trading floor. Then people could buy and sell stocks from anywhere. This exchange started going by the acronym NASDAQ (National Association of Security Dealers Automated Quoting system).
The PC was introduced at about the same time and quickly became popular. And people quickly started forming corporations to cash in on the popularity of PCs. Back then these were small companies so they ended up on the NASDAQ. In those days the Dow was made up of big companies that listed on the NYSE so the Dow was a proxy for how NYSE stocks were doing. Stock indexes are a good marketing took so the NASDAQ put together one of their own. And the NASDAQ Index was made up of stocks that traded on the NASDAQ exchange. So it had a lot of those small computer companies in it. And those small computer companies did very well. They did well in business but their stock prices did even better. So the NASDAQ Index shot up. On March 10, 2000 it closed at 5048.62. That turned out to be the all time high.
Bubbles are usually caused by or aggravated by insiders. The economic crash of 2008 is a classic example. The key players were all Wall Street types or were aided and abetted by Wall Street types. Another classic book is "Reminiscences of a Stock Operator" by Edwin Lefevre. This book is nominally fiction but it lays out real schemes used by operators to manipulate the prices of stocks and other commodities. You had to be an insider or be allowed to work through insiders to be able to pull off the schemes described in the book. "Reminiscences" was published in 1923, years before the crash of '29. But this book is another example of how old this type of behavior is. The technical details of the schemes change but the basic principals don't.
Anyhow, the stock prices of a wide range of tech companies spiraled up and up and up. Normally a close examination of the market would reveal the fingerprints of various operators in or closely associated with Wall Street. But not this time. What was going on was very simple. Small investors loved these computer related tech stocks. So they bought them. Wall Street's initial reaction was "yippee - more suckers to fleece". So they would get into these stocks with the intention of riding them up to the top then dumping them before the suckers caught on. But a funny thing happened. These stocks did not seem to have a top. They kept going up and up and up. Smart money on Wall Street kept missing out on further price increases.
This behavior feeds on itself (see "Extraordinary"). People see other people making tons of money by riding these tech stocks. In the early days some of these stocks (Apple, Microsoft, others) were a "good" investment. They showed an ability to make money then make more money. But a lot of these stocks didn't seem to have any kind of plan for eventually turning a profit. And their stocks went up right alongside the "good" tech stocks. Wall Street was completely flummoxed. They eventually figured you that you bought tech stocks no matter how bad their business plan was because if you closed your eyes and just bought you made tons of money.
So the market went up and up and up. By the late '90s it was primarily powered by these NASDAQ tech stocks. During this period the NASDAQ Index rose much more than the Dow did. The Wall Street smart money was completely confused. And I was right there with the Wall Street people. And that's the thing. You could find stories coming out by the bushel basket all through the late '90s. They all said the same thing: "tech stocks are in a bubble. The bubble is going to burst any day now". The problem is that if you followed this eminently sensible advice you lost out on the opportunity to make a lot of money. So everyone got swept along, even the smart money. The problem was that everybody knew the bubble was eventually going to burst. But every smart prediction of when this would happen turned out to be wrong. The bubble just kept growing and growing. All you could do was fasten your seatbelt and hang on.
Eventually the bubble burst in 2000, about 5 years after most people (me, most of Wall Street) thought it should. All the major Indexes, not just the NASDAQ, dropped sharply. And all of them except the NASDAQ eventually recovered. The Dow surpassed its all time record from this period years ago. The S&P 500 (considered the best of the major indexes by most professionals) also recovered and moved on to record territory years ago. But not the NASDAQ. Currently it is more than 500 points off it's 2000 all time record. This is in spite of the fact that its pattern of ups and downs has been broadly similar to the Dow and S&P once it bottomed after the 2000 crash. It went so high then that it has not been able to get back there since.
And that brings me back to the current situation with tech stocks. A lot of them went under after the 2000 crash. The remaining ones recovered generally along the lines of the broader market. They crashed in 2008 and have since recovered, again generally along the lines of the broader market. But they have been doing rather well in the last few years. The 3-5 year cycle says they are about due for a correction. So will they? I think not but I could be wrong.
Let me spend a little time comparing the current situation with the one in 2000. In 2000 there were lots of tech companies that lacked the usual fundamentals companies are traditionally rated on. Wall Street likes growth and these companies were growing at spectacular rates when measured by their customer base. But in a lot of cases these customers were not generating revenue. And, as a result, profits were nonexistent. In fact many of these companies were running up big losses. This was not necessarily a bad thing. The old saw goes "you have to spend money to make money". Often it is necessary to make a big up front investment in order to generate big profits later. Railroads must spend a lot of money laying track in order to later make a profit on passengers and freight. But these companies were spending a lot of money creating large customer bases but they had no idea how to "monetize" their customer base (get money out of them).
These companies said "we'll figure that part out later" but many of them never did. They ended up being washed away in the crash of 2000. What was left behind were the companies that had revenue streams and, in many cases, actual profits. And new companies came along. An example of a new company was Amazon. The business model for Amazon was "sell stuff". They started with books but quickly branched into other areas. Wall Street could understand the Amazon business model. In the specific case of Amazon, Wall Street has always been unhappy. Wall Street wants Amazon to have a higher profit margin but a lot of the general public is ok with Amazon's thin margins and resulting small profits. And Amazon has been able to maintain a high growth rate so Amazon's stock has done well.
But Amazon turns out to be atypical of the new generation of tech companies. Companies like Twitter and Facebook have gone with a different business model: advertising. Most of the post 2000 tech companies have gone down this road. Attract a lot of eyeballs and then put ads in front of those eyeballs. There has been a little of the previous cycle's "trust me" going on. But it has been "trust me - we will figure out how to pull in lots of ad revenue". Investors trusted the companies and they have generally delivered on the promise of lots of ad revenue.
But that brings me to the bubble I am actually concerned about and that's the ad revenue bubble. The trend of increasing ad revenue actually goes back a hundred years or so. Back in the day the ways you spent money on advertising were billboards and other signage, newspapers, and magazines. Then radio came along in the '30s. The "soap opera" type of show was actually created to sell soap products on the radio. The radio advertising model transitioned to TV in the '50s. Initially there were the "big three" TV networks, who reached into the home through local affiliates. Then cable came along and we had all those "cable only" channels. There are now hundreds of them.
Advertising agencies were not a big deal until radio came along. Before then the dealt mostly with magazine advertisements. But radio opened up new markets and gave advertisers the opportunity to spend a lot more money. Then TV came along and even more money could be spent. Production costs for radio ads were modest. Lots of money could be spent to make a TV spot. Then lots more money could be spent buying ad time on the Superbowl. The need for more and more elaborate ads got even greater with the advent of hundreds of cable channels. An ad really had to stand out or nobody would notice it.
In the beginning a billboard or sign could last years. Newspaper ads could be pretty basic and thus pretty inexpensive to put together. With radio production costs started to spiral. And TV and later cable just accelerated the spiral of production and distribution costs. The percentage of their overall budgets that the typical company dedicates to advertising and marketing keeps going up and up. And now, of course, we have the Internet. For the most part the old channels haven't gone away. There are still billboards and other signage, still radio channels, still TV channels, still cable channels. As a new channel opens up the percentage of advertising and marketing dollars devoted to the old channels goes down but in most cases that absolute amount doesn't. Mostly what we see is new dollars going into the new channel. And that is true with the Internet. Some of the money comes from cutting back elsewhere but a lot of it is new money.
And there is a fundamental truth about advertising. The point where on balance new advertising was generating new sales was reached decades ago. We are all subjected to ads for more goods and services than we can possibly purchase. This has been true for decades. And we have gone from ten times oversaturation to a hundred times to a thousand times or more. At best an advertisement diverts us from purchasing one thing in order to purchase something different. Or an ad causes us to keep purchasing something rather than switching to purchasing something else.
What has been going on for decades now is an ad war. On one side we keep putting up better defenses to advertisements while on the other side advertisers keep coming up with techniques for breaching those defenses. There is a novelty factor. I remember when they started running ads along with the trailers (actually just ads for other movies) that run before the movie starts in a movie theater. I am sure that when this started those early ads were effective. They were coming at us from a new direction. The same is true for the early internet ads. We had not yet built up our defenses against ads coming from this direction. But it doesn't take long. Then marketers have to come up with even more intrusive methods for getting in our face.
It was recently disclosed that Facebook did an extensive study (without telling any of the victims) of just what the tolerance levels of Facebook users were. I use a number of news web sites. They have all slowed down? Why? Because various delays are now built in while the extensive ad content loads. The page you want to view does not come up until all the add content is in place. Another trick they now use is to run a video (with an ad on the front) automatically whether you want to see the video or not. I tried switching to other news sites. But they all deal with the same ad agencies who all force them to use the same intrusive ad infrastructure. The latest advertising frontier is smartphones. But all the rules that work for web sites work equally well for smartphone screens. It is simply a matter of tweaking the technology to be smartphone compatible. I believe that particular technology problem has already been solved. Amazon has just released a "fire" smartphone that has been optimized to meet Amazon marketing needs.
In summary, the current business model for tech companies is to generate sufficient ad revenues to meet profit targets. This depends on there being enough ad revenues to support whatever new company is coming down the pike. But the market for ads has been massively oversaturated for decades. Companies must dedicate more money to advertising and marketing in spite of the fact that the effectiveness of these expenditures keeps diminishing. We are all bombarded with vastly more advertising than we can use. We are in a situation similar to the cold war when the question was "is nuking Moscow ten times over enough or should we plan on nuking it fifteen times over". Once the first bomb has gone off the marginal value of subsequent explosions is pretty much nil.
As in the case with tech companies in the '90s where the bubble went on far longer than it should have, the ad bubble has already gone on far longer than it should have. And we have already established that I am a lousy predictor in these situations. So I can't predict when the ad bubble will burst. My guess is that the advertising bubble will keep inflating for a while longer. So I will restrict myself to the prediction that the cause of the bursting of the current tech bubble will be the bursting of the ad bubble and leave it at that.
In 1841 (over a hundred and fifty years ago for those who are keeping track) Charles Mackay wrote a book called "Extraordinary Popular Delusions and the Madness of Crowds". The book is so influential you can buy it new from Amazon to this day. In that book Mackay popularized the term bubble to describe situations where large numbers of people pay extraordinary prices for things. The most famous (and to the modern sensibility ridiculous) example from this book is Tulip bulbs. But the events Mackey relates actually happened. The "bubble" of prices inflated and inflated and inflated. And it ultimately popped just like a soap bubble.
Mackay examines a number of other bubbles (and several other delusions not related to investment or finance). It is an interesting book and I recommend it. And investment mavens have been reading it and recommending it to other investment mavens for as long as the book has been in print. And, of course, bubbles have come into existence and popped many times since Mackay's book came out. That's why each generation of savvy investors keeps reading the book and keeps trying to be on the lookout for bubbles so they won't get caught when they pop. They, and I include myself in this particular "they", have had limited success. Why? It's hard, man. Let's look at "tech bubble 1.0" to see what I mean.
The modern era where the stock market pretty much seems to go up, except for the odd correction lasting at most a few months, is abnormal. Let me contrast it with another abnormal period where pretty much the opposite happened. On February 9, 1966 the Dow closed at 995.15. The economy looked good so people expected the Dow to "break 1000" for the first time in history within a day or so. It didn't. Instead that turned out to be the high for the year. The Dow see-sawed around and eventually broke 1000, and 1100, and 1200, and 1300. But each of those milestones were accompanied by lots of ups and downs and took many years. Then the Dow started to go down. Eventually the Dow bottomed at 776.92 on August 12, 1982. Over a 15 year period the Dow had dropped over 20%. By this time there was a lot of pessimism to mirror the optimism that had surrounded the 1966 high.
We now know the Dow turned the next day. And it proceeded to shoot up. Wall Street was very happy. But as the market kept going up they started worrying. And guess what? On October 19, 1987, roughly five years later, the market crashed. The crash was big enough and scary enough that the day was nicknamed "Black Monday". But the market quickly turned back up only to crash, but less spectacularly exactly a year later. And again it recovered quickly, climbed past its old all time highs and just kept going. For the most part it is still going today.
At about the time of the 1982 bottom a bunch of brokerage firms got together and decided it was time to modernize. The New York Stock Exchange had a trading floor, literally a room where people stood around yelling at each other and filling out pieces of paper. You had to literally be on the floor to buy or sell a stock. They decided that these new fangled things called computers could replace the trading floor. Then people could buy and sell stocks from anywhere. This exchange started going by the acronym NASDAQ (National Association of Security Dealers Automated Quoting system).
The PC was introduced at about the same time and quickly became popular. And people quickly started forming corporations to cash in on the popularity of PCs. Back then these were small companies so they ended up on the NASDAQ. In those days the Dow was made up of big companies that listed on the NYSE so the Dow was a proxy for how NYSE stocks were doing. Stock indexes are a good marketing took so the NASDAQ put together one of their own. And the NASDAQ Index was made up of stocks that traded on the NASDAQ exchange. So it had a lot of those small computer companies in it. And those small computer companies did very well. They did well in business but their stock prices did even better. So the NASDAQ Index shot up. On March 10, 2000 it closed at 5048.62. That turned out to be the all time high.
Bubbles are usually caused by or aggravated by insiders. The economic crash of 2008 is a classic example. The key players were all Wall Street types or were aided and abetted by Wall Street types. Another classic book is "Reminiscences of a Stock Operator" by Edwin Lefevre. This book is nominally fiction but it lays out real schemes used by operators to manipulate the prices of stocks and other commodities. You had to be an insider or be allowed to work through insiders to be able to pull off the schemes described in the book. "Reminiscences" was published in 1923, years before the crash of '29. But this book is another example of how old this type of behavior is. The technical details of the schemes change but the basic principals don't.
Anyhow, the stock prices of a wide range of tech companies spiraled up and up and up. Normally a close examination of the market would reveal the fingerprints of various operators in or closely associated with Wall Street. But not this time. What was going on was very simple. Small investors loved these computer related tech stocks. So they bought them. Wall Street's initial reaction was "yippee - more suckers to fleece". So they would get into these stocks with the intention of riding them up to the top then dumping them before the suckers caught on. But a funny thing happened. These stocks did not seem to have a top. They kept going up and up and up. Smart money on Wall Street kept missing out on further price increases.
This behavior feeds on itself (see "Extraordinary"). People see other people making tons of money by riding these tech stocks. In the early days some of these stocks (Apple, Microsoft, others) were a "good" investment. They showed an ability to make money then make more money. But a lot of these stocks didn't seem to have any kind of plan for eventually turning a profit. And their stocks went up right alongside the "good" tech stocks. Wall Street was completely flummoxed. They eventually figured you that you bought tech stocks no matter how bad their business plan was because if you closed your eyes and just bought you made tons of money.
So the market went up and up and up. By the late '90s it was primarily powered by these NASDAQ tech stocks. During this period the NASDAQ Index rose much more than the Dow did. The Wall Street smart money was completely confused. And I was right there with the Wall Street people. And that's the thing. You could find stories coming out by the bushel basket all through the late '90s. They all said the same thing: "tech stocks are in a bubble. The bubble is going to burst any day now". The problem is that if you followed this eminently sensible advice you lost out on the opportunity to make a lot of money. So everyone got swept along, even the smart money. The problem was that everybody knew the bubble was eventually going to burst. But every smart prediction of when this would happen turned out to be wrong. The bubble just kept growing and growing. All you could do was fasten your seatbelt and hang on.
Eventually the bubble burst in 2000, about 5 years after most people (me, most of Wall Street) thought it should. All the major Indexes, not just the NASDAQ, dropped sharply. And all of them except the NASDAQ eventually recovered. The Dow surpassed its all time record from this period years ago. The S&P 500 (considered the best of the major indexes by most professionals) also recovered and moved on to record territory years ago. But not the NASDAQ. Currently it is more than 500 points off it's 2000 all time record. This is in spite of the fact that its pattern of ups and downs has been broadly similar to the Dow and S&P once it bottomed after the 2000 crash. It went so high then that it has not been able to get back there since.
And that brings me back to the current situation with tech stocks. A lot of them went under after the 2000 crash. The remaining ones recovered generally along the lines of the broader market. They crashed in 2008 and have since recovered, again generally along the lines of the broader market. But they have been doing rather well in the last few years. The 3-5 year cycle says they are about due for a correction. So will they? I think not but I could be wrong.
Let me spend a little time comparing the current situation with the one in 2000. In 2000 there were lots of tech companies that lacked the usual fundamentals companies are traditionally rated on. Wall Street likes growth and these companies were growing at spectacular rates when measured by their customer base. But in a lot of cases these customers were not generating revenue. And, as a result, profits were nonexistent. In fact many of these companies were running up big losses. This was not necessarily a bad thing. The old saw goes "you have to spend money to make money". Often it is necessary to make a big up front investment in order to generate big profits later. Railroads must spend a lot of money laying track in order to later make a profit on passengers and freight. But these companies were spending a lot of money creating large customer bases but they had no idea how to "monetize" their customer base (get money out of them).
These companies said "we'll figure that part out later" but many of them never did. They ended up being washed away in the crash of 2000. What was left behind were the companies that had revenue streams and, in many cases, actual profits. And new companies came along. An example of a new company was Amazon. The business model for Amazon was "sell stuff". They started with books but quickly branched into other areas. Wall Street could understand the Amazon business model. In the specific case of Amazon, Wall Street has always been unhappy. Wall Street wants Amazon to have a higher profit margin but a lot of the general public is ok with Amazon's thin margins and resulting small profits. And Amazon has been able to maintain a high growth rate so Amazon's stock has done well.
But Amazon turns out to be atypical of the new generation of tech companies. Companies like Twitter and Facebook have gone with a different business model: advertising. Most of the post 2000 tech companies have gone down this road. Attract a lot of eyeballs and then put ads in front of those eyeballs. There has been a little of the previous cycle's "trust me" going on. But it has been "trust me - we will figure out how to pull in lots of ad revenue". Investors trusted the companies and they have generally delivered on the promise of lots of ad revenue.
But that brings me to the bubble I am actually concerned about and that's the ad revenue bubble. The trend of increasing ad revenue actually goes back a hundred years or so. Back in the day the ways you spent money on advertising were billboards and other signage, newspapers, and magazines. Then radio came along in the '30s. The "soap opera" type of show was actually created to sell soap products on the radio. The radio advertising model transitioned to TV in the '50s. Initially there were the "big three" TV networks, who reached into the home through local affiliates. Then cable came along and we had all those "cable only" channels. There are now hundreds of them.
Advertising agencies were not a big deal until radio came along. Before then the dealt mostly with magazine advertisements. But radio opened up new markets and gave advertisers the opportunity to spend a lot more money. Then TV came along and even more money could be spent. Production costs for radio ads were modest. Lots of money could be spent to make a TV spot. Then lots more money could be spent buying ad time on the Superbowl. The need for more and more elaborate ads got even greater with the advent of hundreds of cable channels. An ad really had to stand out or nobody would notice it.
In the beginning a billboard or sign could last years. Newspaper ads could be pretty basic and thus pretty inexpensive to put together. With radio production costs started to spiral. And TV and later cable just accelerated the spiral of production and distribution costs. The percentage of their overall budgets that the typical company dedicates to advertising and marketing keeps going up and up. And now, of course, we have the Internet. For the most part the old channels haven't gone away. There are still billboards and other signage, still radio channels, still TV channels, still cable channels. As a new channel opens up the percentage of advertising and marketing dollars devoted to the old channels goes down but in most cases that absolute amount doesn't. Mostly what we see is new dollars going into the new channel. And that is true with the Internet. Some of the money comes from cutting back elsewhere but a lot of it is new money.
And there is a fundamental truth about advertising. The point where on balance new advertising was generating new sales was reached decades ago. We are all subjected to ads for more goods and services than we can possibly purchase. This has been true for decades. And we have gone from ten times oversaturation to a hundred times to a thousand times or more. At best an advertisement diverts us from purchasing one thing in order to purchase something different. Or an ad causes us to keep purchasing something rather than switching to purchasing something else.
What has been going on for decades now is an ad war. On one side we keep putting up better defenses to advertisements while on the other side advertisers keep coming up with techniques for breaching those defenses. There is a novelty factor. I remember when they started running ads along with the trailers (actually just ads for other movies) that run before the movie starts in a movie theater. I am sure that when this started those early ads were effective. They were coming at us from a new direction. The same is true for the early internet ads. We had not yet built up our defenses against ads coming from this direction. But it doesn't take long. Then marketers have to come up with even more intrusive methods for getting in our face.
It was recently disclosed that Facebook did an extensive study (without telling any of the victims) of just what the tolerance levels of Facebook users were. I use a number of news web sites. They have all slowed down? Why? Because various delays are now built in while the extensive ad content loads. The page you want to view does not come up until all the add content is in place. Another trick they now use is to run a video (with an ad on the front) automatically whether you want to see the video or not. I tried switching to other news sites. But they all deal with the same ad agencies who all force them to use the same intrusive ad infrastructure. The latest advertising frontier is smartphones. But all the rules that work for web sites work equally well for smartphone screens. It is simply a matter of tweaking the technology to be smartphone compatible. I believe that particular technology problem has already been solved. Amazon has just released a "fire" smartphone that has been optimized to meet Amazon marketing needs.
In summary, the current business model for tech companies is to generate sufficient ad revenues to meet profit targets. This depends on there being enough ad revenues to support whatever new company is coming down the pike. But the market for ads has been massively oversaturated for decades. Companies must dedicate more money to advertising and marketing in spite of the fact that the effectiveness of these expenditures keeps diminishing. We are all bombarded with vastly more advertising than we can use. We are in a situation similar to the cold war when the question was "is nuking Moscow ten times over enough or should we plan on nuking it fifteen times over". Once the first bomb has gone off the marginal value of subsequent explosions is pretty much nil.
As in the case with tech companies in the '90s where the bubble went on far longer than it should have, the ad bubble has already gone on far longer than it should have. And we have already established that I am a lousy predictor in these situations. So I can't predict when the ad bubble will burst. My guess is that the advertising bubble will keep inflating for a while longer. So I will restrict myself to the prediction that the cause of the bursting of the current tech bubble will be the bursting of the ad bubble and leave it at that.
Monday, June 16, 2014
The OJ Trial
We just passed the 20th Anniversary of The Simpson Murders. This has resulted in a spike of media interest in the "Trial of the Century". It wasn't but it is definitely one of the most important trials in the twentieth century. I am going to spend most of this post talking about the trial. But, in the interests of completeness and in an effort to reduce confusion let me briefly present some background.
OJ (technically Orenthal Julius) Simpson became famous as a College football player. He went on to have a distinguished carrier as a professional. His tenure as a pro was of intermediate duration. He was extremely talented. But at that time professional football made no attempt to protect franchise players from injury. Since he was the heart of the offense defensive players focused on him and punished him with excessively viscous hits. It was considered part of the game to "injury out" players on the opposite team. So his carrier was not as long as it should have been because a series of injuries reduced his performance.
Simpson was one of the first black professional athletes to try and parlay sports fame into success in other endeavors. He became the spokesman for the Hertz rent-a-car company. He did a number of well received commercials featuring him jumping over things like luggage in airports. (This was a simpler time and on one saw this sort of thing as a security problem.) He also had parts in a number of movies, most notably the "Naked Gun" movies. He became one of the regulars on "Monday Night Football" in the era when this was a very highly rated show that was carried on ABC rather than a sports cable channel.
In all these endeavors he had considerable success. But in all these endeavors he was one of the first blacks to do this. There were few black actors. There were few blacks starring in commercials. There were few blacks in the announcer booth on sport shows. And he was never accorded appropriate respect. I think he would be the first to admit that he was not a great actor. But he never represented himself as such. He pretty much played himself. His Hertz commercials were a big success. They drove a lot of traffic the company's way. And he was just trying to provide "color" and a little insight on "Monday Night Football". He might not have been the most brilliant but he was not an embarrassment either. In my opinion he was never in any of these endeavors accorded the respect he would have gotten had he been white.
At the time of the events we are going to be involved in his star had waned. He was past his peak in all the endeavors I have mentioned above. But he had been well paid for them so he was in excellent financial shape. And along the way he married a beautiful blond white woman named Nicole Brown. Then Nicole Brown Simpson, as she came to be known, and her boyfriend Ron Goldman were found brutally murdered on June 13, 1994. The police quickly focused their attention on OJ. On June 17 the famous "Bronco Chase" occurred. OJ was supposed to turn himself in to the police on that day. Instead he was found to be cruising the LA freeway system in a white Ford Bronco that was being driven by Al Cowlings, a friend. All the LA TV stations had news helicopters equipped to transmit video. By the time it was done the "chase" took 4 1/2 hours, plenty of time to get the 'copters airborne and on the air. As it was going on it became a national story being covered wall to wall, even by the networks. This event marked a major the transition of what passes for journalism on TV toward trash TV.
The "story" of the chase was significant enough to justify coverage by local cable news channels in LA. It was not significant enough to justify coverage on national cable news channels and certainly it did not deserve to have the networks break into regular programming and broadcast a Bronco driving sedately down the freeway followed by a bunch of cop cars with all lights flashing. But it was ratings gold. And that's all that counts. So you could literally not find anything else on TV while it was going on. And it went on for hour after hour after hour. The Bronco finally pulled into the driveway of Simpson's house. Negotiations ensued and Simpson was taken into custody without further incident. This all set the stage for "The Trial of the Century".
It was not. But it was one of the most important trials of the twentieth century. It was potentially precedent setting but in the end no precedents were set. It could have broken new legal ground but in the end no new legal ground was broken. But, although legally insignificant, the trial was of major importance from a cultural perspective.
The trial ran from November 1994 to June 1995 and featured live TV cameras in the courtroom. OJ ended up being acquitted and no one has ever been convicted in a criminal court of perpetrating the crimes. So as a crime it is still officially unsolved. The heirs and relatives later sued Simpson in civil court and won. And, in a ridiculous coda, OJ is now in the slam as the result of being convicted in a case involving OJ sports memorabilia. And that's part of what I want to talk about.
There are those who think the original jury got it right. There are those who think the trial was ultimately a massive miscarriage of justice, I fall into neither of those camps. Oh, I think OJ did it. But I would characterize the trial as a routine, middle of the road, miscarriage of justice. To see why, let's first delve into the cast of characters. On the prosecution side we had Marcia Clark aided by Christopher Darden. These were two competent but not superstar advocates. The only thing of note here is that Darden is black.
On the defense side we have superstars. The most obvious of these initially was F. Lee Bailey. He was a high profile defense attorney in the style of the fictitious Perry Mason. What the trial showed was that he was long past his "sell by" date. As the trial progressed he was shoved aside by Johnny Cochran. The Simpson case made Cochran's reputation, and justifiably so. He demonstrated that he was the black F. Lee Baily. Cochran came up with the most memorable line to emerge from the whole trial: "if it doesn't fit, you must acquit". His work was as good or better than anything Bailey had done in his prime. Unfortunately, Cochran died less than ten years later and was very ill for the last part of his life. So he could not completely capitalize on his newfound fame. But that's not the end of the list.
Another member of the defense team was Alan Dershowitz. Dershowitz had become famous ten years earlier in connection with the Claus von Bulow case. Von Bulow was accused of murdering his wife. She was bedridden and died in suspicious circumstances. Dershowitz used a scorched earth tactic of attacking every piece of the prosecution case large or small, important or unimportant. He succeeded in throwing enough "reasonable doubt" up to get von Bulow off. With few exceptions (see below) the Dershowitz model was followed in the Simpson case.
There were a number of other superstar lawyers on the defense team (including Robert Kardashian of reality TV family fame) but the only other one I want to point out is Barry Scheck. He has specialized in the use of DNA in criminal cases and has been active in "The Innocence Project" a group that has been able to get over two hundred convictions reversed by using DNA to prove that identifications, especially "eye witness" identifications, were wrong. The OJ trial was the first high profile trial to involve DNA evidence.
Now let me move on to another critical courtroom player, the presiding judge Lance Ito. I credit Ito with being one of the people most responsible for OJ's acquittal. What was his contribution? He was a big fan of Johnny Cochran. One of the big problems the prosecution had was they had a complicated case to present. Part of their job was to help the jury keep everything straight. But Cochran kept popping up with trivial objections. This would interrupt the flow of the point the prosecutions was trying to make. This made it nearly impossible for the prosecution to manage the roadmap jurors needed to keep straight in their minds in order to understand the prosecution's case.
The defense had a much simpler problem. All they had to do was punch one big hole in the prosecution's case. They didn't need a roadmap so a strategy of lots of prosecution objections would not have disrupted them. Ito should have contained Cochran and given the prosecution a fair chance to put their case on. But he didn't. It turns out that the famous "if it doesn't fit, you must acquit" is actually not true. But the explanation is complicated. And, as I will cover below, the jury wanted to acquit OJ. They just needed a reason.
Finally, let me introduce one more player Mark Furman. He was the lead cop on the investigation. The OJ defense team was able over the course of the trial to hang him out to dry. The LA police have run a very effective PR operation for many decades. The Jack Web "Dragnet" shows and others have portrayed the LAPD as square jawed honest upholders of the law who are interested in "just the facts, mam" and don't indulge in hanky panky. The evidence is overwhelming that the reputation is not justified. Any number of 'noir Hollywood movies from several decades have done a much better job of showcasing the bad behavior of the LAPD than I could. And Mark Furman is a poster child for this sort of thing. The trial highlighted a number of instances of Furman taking shortcuts, violating procedures, and otherwise engaging in bad policing. The defense took advantage of this and there was again nothing the prosecution could do about it. The OJ case was high profile from the start. You would think the LAPD brass would have put their top people on it. But they didn't. Besides the Furman antics there was sloppy lab work and other examples of shortcomings on the part of the police.
And this brings me to a larger point. OJ is black. Most of the jury was black. The black community in LA has been the victim of bad and frankly racist policing for decades. If you could get honest answers out of them I am sure it would have turned out that jurors had a very poor opinion of the LAPD. True or not, and I'm inclined to the opinion that there were many cases of "true", the black community felt that the LAPD had railroaded innocent black people into jail and let guilty white people who had committed heinous crimes against black people off the hook. So "if it doesn't fit, you must acquit" was good enough for them. I think they were wrong but they weren't that wrong.
And there is another similar point. OJ was rich. And even if he hadn't been the case had such a high profile that it would attract top tier talent to the defense team. This is not true of most cases. Usually the defendant is poor and the case is not that interesting. This means that the defense does not have the resources to put on a Perry Mason quality (or F. Lee Bailey quality or a Johnny Cochran quality) defense. One reason for Mark Ferman's behavior was that he was used to getting away with it because the defense did not have the resources to catch him out. This is also true of the lab work. I don't think the lab got anything wrong but their procedures, documentation, etc., were shaky enough to give the defense something to talk about. This is again a case where most defendants do not have the resources to uncover this sort of thing and exploit it. This sort of thing usually cuts in favor of white defendants, especially rich ones (i.e. Claus von Bulow and everyone Perry Mason ever defended) but in this case it cut in favor of a black defendant.
I have tremendous sympathy for the Brown and the Goldman families. As far as I can tell the victims were both nice and good people. The did not deserve to be brutally murdered. And if they must be murdered then the guilty party should have been found, convicted, and put away for a long time. But many many many black people who were nice and good people have been murdered in Los Angeles. And, as a result of bad policing the crime was not prevented and the guilty party or parties were not arrested, convicted, and put away for a long time. The best thing would be for the LAPD to do its job well. Lacking that, OJ getting off is not the worst thing that could happen.
This next point will sound harsh. As I have pointed out the victims did not deserve to die and OJ got away with it. But, as I have also pointed out above, he did not really get away with it. He ended up in the slam in the end. And what about all those black men that would take OJ as a model and start killing white women wholesale? I was never worried about that outcome. And let me point out that, in fact, the opposite did and does happen. White men have killed black men and women with impunity in far too large numbers. And a significant number of them have gotten off. And this actually did encourage other white men to kill black men and women on the theory that they could get away with it. Again the best situation would be for killers, black or white, to get caught and appropriately dealt with whether their victims were black or white. But we still have not gotten to that point. Absent that then the OJ case can be said to balance the scales. It is a bad outcome but not the worst outcome.
I pointed out above that the defense adopted a scorched earth approach to most of the prosecution case. As an example there was a pair of gloves. They had OJ try them on late in the case. They did not fit even though they were OJ's because they had shrunk in the mean time. (That's the hole in the Cochran argument.) But the visual of OJ struggling to get the gloves on was compelling. They attacked the lab work and other physical evidence. But one thing they did not touch was the DNA evidence. As I said above, DNA was not as well understood then. This was the first time it was being used in a high profile trial. At the time everyone was wrestling with what the proper procedures for collecting and analyzing DNA. They were also wrestling with the proper interpretation of a DNA result. So thee was plenty of room for mischief on the part of the defense.
At the time Barry Scheck was the most experienced lawyer on the subject of the proper use of DNA in the courtroom. So the defense had the capability to put on a show and cast doubt here too. But ultimately they didn't. I was relieved. As a "science guy" I felt at the time that DNA held out a lot of promise. But I was concerned that it's reputation would be sullied as a side effect of this case before it had a chance to establish a solid reputation. Since the defense chose to not challenge the DNA evidence no one puts "DNA evidence" and "The OJ Trial" together. Today, due to procedures and techniques developed after the OJ trial, DNA evidence is now the accepted "gold" standard. It is even more golden than the old standard, fingerprints. So my biggest worry (seriously) about potential negative effects to the broader society caused by the OJ trial, namely calling DNA evidence into question, did not materialize.
It would be nice to be able to say that the LAPD learned its lessons. It should have improved its investigatory procedures and moved on to a more color blind approach to policing. I think the LAPD has made progress on both fronts but it still has a long way to go.
The trial was covered "wall to wall" on a cable channel called Court TV. Court TV got massive ratings. It tried to repeat its success with other trials but never quite could. And Court TV has since morphed into something called "tru TV". But the trial has left its mark on the cultural landscape. Cable TV routinely covers sensational trials, sometimes for months on end. Sometimes there is a TV feed from the courtroom as there was in the OJ trial. If not then they get creative and find ways to fill hour after hour after hour without it. Judge Ito has been broadly criticized for how he ran the trial. He's still on the bench but his reputation, generally good before the trial, was in tatters by the end. No judge wants to suffer the same fate. So they are much more careful in how they handle lawyers in these situations. I'm sure that attorneys on both sides have absorbed lessons. But since neither side in the OJ trial really did a bad job the lessons are much more small bore. And it is still easy to get a good argument going as to whether the verdict was right or wrong even though its 20 years later. There are very few trials for which that is true and that's why it is such an important trial.
Finally, I have some sympathy for OJ. He was a brilliant athlete. Most of the time he seems to have comported himself well and seems to have generally come off as a nice guy. He tried hard (both creatively and just in terms of effort) to leverage his sports stardom into a more durable carrier off the football field. That's commendable. But he did not get the success and especially the respect his skill and efforts deserved. He had a temper. Under the circumstances that is understandable. He should not have (presumably in a fit of temper) killed two people. That is not forgivable but it is understandable.
OJ (technically Orenthal Julius) Simpson became famous as a College football player. He went on to have a distinguished carrier as a professional. His tenure as a pro was of intermediate duration. He was extremely talented. But at that time professional football made no attempt to protect franchise players from injury. Since he was the heart of the offense defensive players focused on him and punished him with excessively viscous hits. It was considered part of the game to "injury out" players on the opposite team. So his carrier was not as long as it should have been because a series of injuries reduced his performance.
Simpson was one of the first black professional athletes to try and parlay sports fame into success in other endeavors. He became the spokesman for the Hertz rent-a-car company. He did a number of well received commercials featuring him jumping over things like luggage in airports. (This was a simpler time and on one saw this sort of thing as a security problem.) He also had parts in a number of movies, most notably the "Naked Gun" movies. He became one of the regulars on "Monday Night Football" in the era when this was a very highly rated show that was carried on ABC rather than a sports cable channel.
In all these endeavors he had considerable success. But in all these endeavors he was one of the first blacks to do this. There were few black actors. There were few blacks starring in commercials. There were few blacks in the announcer booth on sport shows. And he was never accorded appropriate respect. I think he would be the first to admit that he was not a great actor. But he never represented himself as such. He pretty much played himself. His Hertz commercials were a big success. They drove a lot of traffic the company's way. And he was just trying to provide "color" and a little insight on "Monday Night Football". He might not have been the most brilliant but he was not an embarrassment either. In my opinion he was never in any of these endeavors accorded the respect he would have gotten had he been white.
At the time of the events we are going to be involved in his star had waned. He was past his peak in all the endeavors I have mentioned above. But he had been well paid for them so he was in excellent financial shape. And along the way he married a beautiful blond white woman named Nicole Brown. Then Nicole Brown Simpson, as she came to be known, and her boyfriend Ron Goldman were found brutally murdered on June 13, 1994. The police quickly focused their attention on OJ. On June 17 the famous "Bronco Chase" occurred. OJ was supposed to turn himself in to the police on that day. Instead he was found to be cruising the LA freeway system in a white Ford Bronco that was being driven by Al Cowlings, a friend. All the LA TV stations had news helicopters equipped to transmit video. By the time it was done the "chase" took 4 1/2 hours, plenty of time to get the 'copters airborne and on the air. As it was going on it became a national story being covered wall to wall, even by the networks. This event marked a major the transition of what passes for journalism on TV toward trash TV.
The "story" of the chase was significant enough to justify coverage by local cable news channels in LA. It was not significant enough to justify coverage on national cable news channels and certainly it did not deserve to have the networks break into regular programming and broadcast a Bronco driving sedately down the freeway followed by a bunch of cop cars with all lights flashing. But it was ratings gold. And that's all that counts. So you could literally not find anything else on TV while it was going on. And it went on for hour after hour after hour. The Bronco finally pulled into the driveway of Simpson's house. Negotiations ensued and Simpson was taken into custody without further incident. This all set the stage for "The Trial of the Century".
It was not. But it was one of the most important trials of the twentieth century. It was potentially precedent setting but in the end no precedents were set. It could have broken new legal ground but in the end no new legal ground was broken. But, although legally insignificant, the trial was of major importance from a cultural perspective.
The trial ran from November 1994 to June 1995 and featured live TV cameras in the courtroom. OJ ended up being acquitted and no one has ever been convicted in a criminal court of perpetrating the crimes. So as a crime it is still officially unsolved. The heirs and relatives later sued Simpson in civil court and won. And, in a ridiculous coda, OJ is now in the slam as the result of being convicted in a case involving OJ sports memorabilia. And that's part of what I want to talk about.
There are those who think the original jury got it right. There are those who think the trial was ultimately a massive miscarriage of justice, I fall into neither of those camps. Oh, I think OJ did it. But I would characterize the trial as a routine, middle of the road, miscarriage of justice. To see why, let's first delve into the cast of characters. On the prosecution side we had Marcia Clark aided by Christopher Darden. These were two competent but not superstar advocates. The only thing of note here is that Darden is black.
On the defense side we have superstars. The most obvious of these initially was F. Lee Bailey. He was a high profile defense attorney in the style of the fictitious Perry Mason. What the trial showed was that he was long past his "sell by" date. As the trial progressed he was shoved aside by Johnny Cochran. The Simpson case made Cochran's reputation, and justifiably so. He demonstrated that he was the black F. Lee Baily. Cochran came up with the most memorable line to emerge from the whole trial: "if it doesn't fit, you must acquit". His work was as good or better than anything Bailey had done in his prime. Unfortunately, Cochran died less than ten years later and was very ill for the last part of his life. So he could not completely capitalize on his newfound fame. But that's not the end of the list.
Another member of the defense team was Alan Dershowitz. Dershowitz had become famous ten years earlier in connection with the Claus von Bulow case. Von Bulow was accused of murdering his wife. She was bedridden and died in suspicious circumstances. Dershowitz used a scorched earth tactic of attacking every piece of the prosecution case large or small, important or unimportant. He succeeded in throwing enough "reasonable doubt" up to get von Bulow off. With few exceptions (see below) the Dershowitz model was followed in the Simpson case.
There were a number of other superstar lawyers on the defense team (including Robert Kardashian of reality TV family fame) but the only other one I want to point out is Barry Scheck. He has specialized in the use of DNA in criminal cases and has been active in "The Innocence Project" a group that has been able to get over two hundred convictions reversed by using DNA to prove that identifications, especially "eye witness" identifications, were wrong. The OJ trial was the first high profile trial to involve DNA evidence.
Now let me move on to another critical courtroom player, the presiding judge Lance Ito. I credit Ito with being one of the people most responsible for OJ's acquittal. What was his contribution? He was a big fan of Johnny Cochran. One of the big problems the prosecution had was they had a complicated case to present. Part of their job was to help the jury keep everything straight. But Cochran kept popping up with trivial objections. This would interrupt the flow of the point the prosecutions was trying to make. This made it nearly impossible for the prosecution to manage the roadmap jurors needed to keep straight in their minds in order to understand the prosecution's case.
The defense had a much simpler problem. All they had to do was punch one big hole in the prosecution's case. They didn't need a roadmap so a strategy of lots of prosecution objections would not have disrupted them. Ito should have contained Cochran and given the prosecution a fair chance to put their case on. But he didn't. It turns out that the famous "if it doesn't fit, you must acquit" is actually not true. But the explanation is complicated. And, as I will cover below, the jury wanted to acquit OJ. They just needed a reason.
Finally, let me introduce one more player Mark Furman. He was the lead cop on the investigation. The OJ defense team was able over the course of the trial to hang him out to dry. The LA police have run a very effective PR operation for many decades. The Jack Web "Dragnet" shows and others have portrayed the LAPD as square jawed honest upholders of the law who are interested in "just the facts, mam" and don't indulge in hanky panky. The evidence is overwhelming that the reputation is not justified. Any number of 'noir Hollywood movies from several decades have done a much better job of showcasing the bad behavior of the LAPD than I could. And Mark Furman is a poster child for this sort of thing. The trial highlighted a number of instances of Furman taking shortcuts, violating procedures, and otherwise engaging in bad policing. The defense took advantage of this and there was again nothing the prosecution could do about it. The OJ case was high profile from the start. You would think the LAPD brass would have put their top people on it. But they didn't. Besides the Furman antics there was sloppy lab work and other examples of shortcomings on the part of the police.
And this brings me to a larger point. OJ is black. Most of the jury was black. The black community in LA has been the victim of bad and frankly racist policing for decades. If you could get honest answers out of them I am sure it would have turned out that jurors had a very poor opinion of the LAPD. True or not, and I'm inclined to the opinion that there were many cases of "true", the black community felt that the LAPD had railroaded innocent black people into jail and let guilty white people who had committed heinous crimes against black people off the hook. So "if it doesn't fit, you must acquit" was good enough for them. I think they were wrong but they weren't that wrong.
And there is another similar point. OJ was rich. And even if he hadn't been the case had such a high profile that it would attract top tier talent to the defense team. This is not true of most cases. Usually the defendant is poor and the case is not that interesting. This means that the defense does not have the resources to put on a Perry Mason quality (or F. Lee Bailey quality or a Johnny Cochran quality) defense. One reason for Mark Ferman's behavior was that he was used to getting away with it because the defense did not have the resources to catch him out. This is also true of the lab work. I don't think the lab got anything wrong but their procedures, documentation, etc., were shaky enough to give the defense something to talk about. This is again a case where most defendants do not have the resources to uncover this sort of thing and exploit it. This sort of thing usually cuts in favor of white defendants, especially rich ones (i.e. Claus von Bulow and everyone Perry Mason ever defended) but in this case it cut in favor of a black defendant.
I have tremendous sympathy for the Brown and the Goldman families. As far as I can tell the victims were both nice and good people. The did not deserve to be brutally murdered. And if they must be murdered then the guilty party should have been found, convicted, and put away for a long time. But many many many black people who were nice and good people have been murdered in Los Angeles. And, as a result of bad policing the crime was not prevented and the guilty party or parties were not arrested, convicted, and put away for a long time. The best thing would be for the LAPD to do its job well. Lacking that, OJ getting off is not the worst thing that could happen.
This next point will sound harsh. As I have pointed out the victims did not deserve to die and OJ got away with it. But, as I have also pointed out above, he did not really get away with it. He ended up in the slam in the end. And what about all those black men that would take OJ as a model and start killing white women wholesale? I was never worried about that outcome. And let me point out that, in fact, the opposite did and does happen. White men have killed black men and women with impunity in far too large numbers. And a significant number of them have gotten off. And this actually did encourage other white men to kill black men and women on the theory that they could get away with it. Again the best situation would be for killers, black or white, to get caught and appropriately dealt with whether their victims were black or white. But we still have not gotten to that point. Absent that then the OJ case can be said to balance the scales. It is a bad outcome but not the worst outcome.
I pointed out above that the defense adopted a scorched earth approach to most of the prosecution case. As an example there was a pair of gloves. They had OJ try them on late in the case. They did not fit even though they were OJ's because they had shrunk in the mean time. (That's the hole in the Cochran argument.) But the visual of OJ struggling to get the gloves on was compelling. They attacked the lab work and other physical evidence. But one thing they did not touch was the DNA evidence. As I said above, DNA was not as well understood then. This was the first time it was being used in a high profile trial. At the time everyone was wrestling with what the proper procedures for collecting and analyzing DNA. They were also wrestling with the proper interpretation of a DNA result. So thee was plenty of room for mischief on the part of the defense.
At the time Barry Scheck was the most experienced lawyer on the subject of the proper use of DNA in the courtroom. So the defense had the capability to put on a show and cast doubt here too. But ultimately they didn't. I was relieved. As a "science guy" I felt at the time that DNA held out a lot of promise. But I was concerned that it's reputation would be sullied as a side effect of this case before it had a chance to establish a solid reputation. Since the defense chose to not challenge the DNA evidence no one puts "DNA evidence" and "The OJ Trial" together. Today, due to procedures and techniques developed after the OJ trial, DNA evidence is now the accepted "gold" standard. It is even more golden than the old standard, fingerprints. So my biggest worry (seriously) about potential negative effects to the broader society caused by the OJ trial, namely calling DNA evidence into question, did not materialize.
It would be nice to be able to say that the LAPD learned its lessons. It should have improved its investigatory procedures and moved on to a more color blind approach to policing. I think the LAPD has made progress on both fronts but it still has a long way to go.
The trial was covered "wall to wall" on a cable channel called Court TV. Court TV got massive ratings. It tried to repeat its success with other trials but never quite could. And Court TV has since morphed into something called "tru TV". But the trial has left its mark on the cultural landscape. Cable TV routinely covers sensational trials, sometimes for months on end. Sometimes there is a TV feed from the courtroom as there was in the OJ trial. If not then they get creative and find ways to fill hour after hour after hour without it. Judge Ito has been broadly criticized for how he ran the trial. He's still on the bench but his reputation, generally good before the trial, was in tatters by the end. No judge wants to suffer the same fate. So they are much more careful in how they handle lawyers in these situations. I'm sure that attorneys on both sides have absorbed lessons. But since neither side in the OJ trial really did a bad job the lessons are much more small bore. And it is still easy to get a good argument going as to whether the verdict was right or wrong even though its 20 years later. There are very few trials for which that is true and that's why it is such an important trial.
Finally, I have some sympathy for OJ. He was a brilliant athlete. Most of the time he seems to have comported himself well and seems to have generally come off as a nice guy. He tried hard (both creatively and just in terms of effort) to leverage his sports stardom into a more durable carrier off the football field. That's commendable. But he did not get the success and especially the respect his skill and efforts deserved. He had a temper. Under the circumstances that is understandable. He should not have (presumably in a fit of temper) killed two people. That is not forgivable but it is understandable.
Wednesday, June 4, 2014
The Stupidity of Corporate Management
The recent news that the pay (actually total compensation, a difference without a distinction that its meaningful in this context) of Fortune 500 CEOs has just topped $10 million seems an obvious justification for this post. But it actually stems from a conversation I had with an out of town cousin who was visiting recently. But, in case you missed the CEO compensation news, here's a link to one of many stories about it: http://www.npr.org/blogs/thetwo-way/2014/05/27/316336449/median-ceo-pay-tops-10-million-for-the-first-time. I am going to use The Boeing Company as a poster child for what I want to talk about. Why them? Because they are "the local boy" so I have followed them more closely than other companies. But I consider them typical rather than unique. The details may differ from company to company or executive to executive but the story line remains the same.
My academic credentials are nearly nonexistent on this subject. I took a single one semester class on Business Law in High School. I took some American Institute of Banking classes decades ago when I worked for a Bank. What you are getting is a worm's eye view of the situation, what things looked like from the other end of the organization chart. Like many, I have repeatedly asked myself "why did they do that?" when some particularly spectacular piece of management stupidity surfaced either at work or in the news. The same kinds of things kept happening over and over so there had to be some underlying method to the apparent madness. It took me a long time to extract the method as the "usual suspects" were of no use. None of what I am about to reveal is to be found in any MBA curriculum, academic publication, or in the prodigious output of the "business press" (Forbes, CNBC, etc.). But these are iron clad principles that have the force of law in actual business practice.
But first, how could this be one of my posts without a digression? So let me digress, but only for a very short time, and ask "how do CEOs justify their large compensation packages"? Their answer is that "they work hard and they are smart". And by "smart" they really mean something more along the lines of skillful. They have to be very smart to understand the complex problems they wrestle with on a day to day basis. But they also have to apply the very best judgment to solving these problems. So more than just raw "smarts" are required. So, in their eyes, they really are very special. Let me first address the "hard work" issue as it can be easily dispensed with.
I have frequented several sandwich shops over the years. The ones I frequent (and here I am specifically talking about the non-chain shops, e.g. Subway) have been run in many cases by Korean women of a certain age. I have no idea how many hours they put in but its a lot. They are there from dawn till dusk. In one shop I now frequent all the pastries are baked on site every day. So the proprietor is there from before sunup until the shop closes late in the day. These ladies put in an unbelievable number of hours. And this applies to many small businesses. I have frequented establishments run by both sexes and all ethnicities. Many small businesses depend heavily on the proprietor. And they depend on that person putting in long hours every day and having the flexibility and skill to perform multiple duties. I would stack up the range of skills and the work ethic of these proprietors against any "ten million dollar man" (and they are nearly all men) helming one of these corporate behemoths.
The rest of this post will address the intelligence and judgment components.
General Ledger
Ok. I was not altogether honest. Because I need another digression. The term or art for the corporate books is General Ledger. Some of you may be familiar with Quick Books, an inexpensive software package designed for use by small businesses. And a thorough discussion of General Ledger systems would span several weighty volumes. But there are only a few things you need to understand. And those things can be covered quickly.
General Ledger systems have what's called a "chart of accounts". This is a list of buckets (e.g. accounts) into which items of income or expense are placed. There is a separate chart of accounts for each department. Each account for a department is "rolled up" to create a division total. These totals are rolled up through larger and larger portions of the corporation until you finally get to the top. Then all the top accounts are rolled together to figure out how the corporation as a whole is doing.
General Ledger systems fulfill several roles. So it is useful to have lots of separate accounts. In a store there can be an account in the "shoe" department for "men's shoes" and another for "women's shoes" and one for "socks" and so on. So each time a pair of men's shoes is sold the amount is added into the correct account. In a similar manner the sale of a pair of women's shoes goes into its account. And so on. And we can have an account for "sales tax" and other accounts for other things. So in order to find out how the department is doing you can add all these accounts together. But you can also add the accounts for "men's shoes" together from all the shoe departments in all the stores to see how "men's shoes" are doing over all. This should give you the flavor of how General Ledger works and why most General Ledger systems have lots of separate accounts.
And so far, I have talked about income accounts. There are also expense accounts. The shoe department might have a "salary" account. But, in the same way it was useful to have lots of income accounts, it might be useful to have an "overtime" account and a "bonus" account (shoe sales people might get an extra "bonus" for selling a particularly large amount of shoes). And there might be a "lighting" account and an "advertising" account and so on.
So that gives you a flavor of how General Ledger works at its most basic level. And I demonstrated how it might be useful to add the accounts up in different ways. Corporations of any size add the accounts up in at least three different ways. (1) They add them up one way to calculate their Income Tax bill. (2) They add them up a second way to produce the "Annual Statement" for stock holders. And (3) they add them up a third way to assist management in running the company. Why do they do this? Because each "way" serves a different purpose. In the first case the idea is so show the least profit so the Income Tax bill will be as low as possible. In the second case the idea is to show the most profit so the stock holders will be happy. In the third the idea is to shed light on what parts of the business are doing well or badly and which managers are doing a good or a bad job.
As an example of this, Boeing is one of several companies that is not profitable, at least when the accounts are added up in the proper way. How do we know? Because they have not paid any Income Tax in years. However, if we add things up in the "Annual Statement" way, Boeing is very profitable. So it is only fair that their senior executives should be paid millions. And, as far as I can tell, Boeing does a terrible job properly adding things up in the third way, the way that allows them to make good management decisions. Because they have made a lot of really boneheaded decisions over the past couple of decades. With that digression complete let me get back to the main line of analysis. My first issue of management stupidity is:
General Ledger Visibility
What do I mean? Well, a few years ago Boeing was going through hard times. This resulted in a laser focus on expenses. This in turn resulted in an edict from the top echelons of the company to trim the use of office supplies and to cut travel expenses. What? Boeing is a multibillion dollar company. In this environment accountants have a term for things like office supplies and travel expenses. It is "not material", as in "this will not have a material effect on the financial situation". So why did Boeing management highlight these two tiny expense categories even though completely zeroing out all expenses in these specific categories would not have affected Boeing's profitability in a noticeable way? It is because small though they are they are "visible" in General Ledger. Each department has a General Ledger account for each. If the amount of expense in either or both of these accounts goes down the reduction will directly increase profit. But, you say, what about doing something that would make a big difference like say making Boeing engineers more efficient?
There are lots of engineers. They have relatively high salaries (not senior management salaries but definitely not janitor salaries either). If you were to say increase the efficiency of engineers by 1% wouldn't that save lots more money than you would by dinging the office supply and travel accounts? It turns out surprisingly the answer is no? The thinking goes that Engineers are on salary. If you increase their efficiency by 1% their payroll cost does not change at all. They just end up sitting on their hands for a few minutes over the course of a week. So no number in General Ledger changes so there is no savings. Is this right? It doesn't matter. Management thinks it is right. So since, to management's way of thinking, reducing office supply costs and travel costs changes the numbers in General Ledger, albeit by a small amount, it is better to do that than to try to increase the efficiency of Engineers because the latter change will not show up in the General Ledger numbers.
This General Ledger Visibility problem raises its ugly head in even more perverse ways. One way to restate the problem is "General Ledger is more real than reality". In the early days of the space program there was a process called "ground truthing". NASA people would look at satellite pictures or other measurements. Then they would go out and actually look at what was on the ground, the ground truth. They wanted to understand how much of what the satellite said was really real. Then they could figure out how far to trust the satellite data. In many cases the satellite data gave a better picture of what was going on than you could get from the ground. In other cases there were various fixes and adjustments that were necessary to get the satellite data to align with reality. And in still other cases the satellite data was misleading and could not be trusted.
General Ledger systems are like satellite data. Sometimes they tell you what is going on better than any other method. Other times they can be trusted after the appropriate adjustments and fixes have been applied. And other times they just plain mislead you. Many executives, however, are true believers when it comes to the numbers General Ledger systems spit out.
Manageable versus Unmanageable Costs
Let me be clear what I am talking about here. If an executive believes that actions he takes can affect a cost then that cost is manageable. Otherwise, it is unmanageable. Let me give you an example, in this case an example that has nothing to do with Boeing. A company I worked for used a lot of natural gas. Now this cost was visible in General Ledger. It had its own little line in the chart of accounts in a particular department. And the amount was large, millions of dollars per year. So that was not the problem. The problem was that the company had almost no control over the cost of natural gas. So to a great extent the cost was unmanageable. Now they did what they could. They put a great deal of effort into using the gas efficiently so they used as little as possible. They also tried to be smart about how they bought gas. If the thought the price trend was up they would sign up for a long term contract at a fixed price. If they thought the price trend was down they would avoid long term contracts and buy on the "spot" market.
Now the above example is a set of specific circumstances. So I'm going to move on to a more general situation. (I don't know if it applies to Boeing but likely it does.) Companies occupy buildings. In some cases they own the buildings but the trend is toward leasing. These buildings involve operating costs, specifically power for heating, lighting, air conditioning and other machinery, etc. The prime consideration that goes into how most buildings are built is construction cost. They are typically built as cheaply as possible and no thought is given to whether this will result in high operating costs. So typically these buildings are very inefficient to operate. In the last decade or so a lot of effort has gone into studying this. And it turns out that a lot of ways have been identified to reduce operating costs, particularly costs associated with energy use. And some of these ways turn out to have very good cost/benefit ratios. I have a brother who has studied this area thoroughly. He says that a lot of these "retrofits" pay for themselves by reducing operating costs dramatically. A typical payoff period is 18 months. That is a fantastically quick return on investment.
But in spite of this it is very rare to see buildings retrofitted. Why? Well, let me trot out a very lame excuse first. Many building leases are "all in". The price of the lease requires the landlord to pay operating costs like energy bills. So if the building is retrofitted it will be disruptive to the company using the building and, since the rent is fixed, there will be no cost savings. This is lame. If the retrofit is done and the rent is reduced but by less than the savings both sides benefit. The land lord has more money left over after his operating costs have been deducted from the rent check and the tenant sees cost savings because the rent is now lower. So why doesn't this happen? Because management sees rent as an unmanageable cost. It doesn't matter how high it is. It's unmanageable so efforts are turned to reducing costs in other areas. Is management correct? No!
Red money, Green money, and Blue money
If you think at all about the color of money you probably think it's all green. A nickname for U.S. currency is "greenback" because that's the predominant color of our currency. I used to also believe that all money was the same color too. This led to a lot of frustration.
In a previous job (not at Boeing) I was responsible for selecting and procuring computer equipment. This was back in the old days when a nice computer ran several million dollars. So we are talking decisions that involved very high levels of management because the equipment was very costly. (The company was far smaller than Boeing so a million dollars was a very big deal.) I am going to skip over all the "do we really need to do this" part of the discussion. Let's assume that everyone has agreed that the investment needed to be made and we were just trying to figure out how the acquisition should be structured.
What I mean by "structured" is "buy, rent, or lease" and "new or used". The idea was to pick among the various possibilities. Now naïve old me, I cranked up the spread sheet and starting calculating the cost of the various options. My assumption was "all things being equal" (and I wrangled all the technical issues to make sure that all things in fact were equal) we just wanted to structure the deal to result in the lowest overall cost. This is where I learned the hard way about red money, green money, and blue money. What do I mean?
Well part of that whole General Ledger thing is what is called a budget. Before the year starts all the income and expenses for the next year are estimated. Then the idea is not necessarily to make income go up and expense go down. It is to hit your budget numbers. (I must say that if you missed your income numbers on the high side and your expense numbers on the low side people would be pretty happy even though technically you missed your numbers.) But part of the process of creating the budget was to guess what would happen, money-wise. So the budget might include money for our piece of computer equipment. And an assumption would be made as to whether it would be bought, rented, or leased. Needless to say, there were separate "buy" "lease", and "rent" General Ledger accounts. So typically one of these budget accounts would have money in it and the others would be empty.
Silly me. I knew that there were separate accounts. But I had heard of money being "reprogrammed" in the federal budget to cover some unexpected event. And I'm a computer guy. I know that all this budget stuff is just numbers in a computer file. It's not that hard to move the numbers around. So I do my analysis. And I figure all I have to say is "if we do it this way we can save a lot of money so we just reprogram the money and everyone's happy". That's when I learned about red money (capital), green money (lease/rent), and blue money (maintenance and other operating costs). Apparently there is no philosopher's stone to turn one color of money into another color.
Now there some good reasons for not changing the color of money. There's fraud. You don't want people just changing things around willy nilly. But it is not hard to put procedures in place so you make sure the changes serve a legitimate purpose (saving money) and not just providing a cover for hanky panky. And there is the issue of "ratios". Most companies operate on borrowed money. And the banks are supposed to make sure that the company can pay the borrowed money back. So they might require a company to maintain a certain "capital ratio". The details don't matter but the result is that a company might not want to make a capital expenditure (buy some expensive piece of equipment) because it will cause the capital ratio to go out of whack. Contrarily, it might be necessary to buy something rather than rent it to keep some other ratio in line. But in my case none of these considerations came into play. Changing the color of money was perfectly feasible. It was just not done.
The Myth of Rationality
The model business people hold up of themselves to the world is that of rationality. They are not swayed by sentiment. "It's just business, mam." They want you to believe that the decisions they make are based on careful analysis and are driven solely by the profit motive. But its not so.
After many years, Boeing seems to have finally gotten the 787 program on track. They are able to build and deliver the planes on schedule and the airlines are able to put the planes in service and keep them there. But a lot of pain, suffering, and money, have been poured down numerous rat holes to get to where we are now. If you listen to management propaganda, then each of the major decisions made at the start of the program was the result of cold rationality applied to careful analysis. Here is a list of the most important and consequential decisions management made:
Taken separately any of these decisions might make sense. But taken together they represented a recipe for disaster. In my opinion, when these decisions were made Boeing management was in poor shape. What is common to all these decisions is that each decision separately would require more and better effort from Boeing management than the alternative "do it the old way" option. This is particularly true of decision #4.
The 787 program has been a fiasco for most of the lifetime of the plane. I thought at the time that Boeing really needed to do #1. But this would be hard to do. So I thought they should focus on it and avoid change elsewhere in the program. Obviously they didn't. The result was chaos everywhere. And chaos is very expensive in the plane building business
There were a number of engineering problems. This delayed things. Then parts came in incompletely or incorrectly assembled. Then the pieces did not fit together very well. And various subcontractors had trouble coming up to speed. In particular, problems in South Carolina were so great that Boeing decided they had to buy the subsidiary responsible for work there so that they could fix management there. Given that early on South Carolina had been a major problem area would you recommend minimizing their responsibilities or doubling down? Boeing decided to double down. In fact, they decided to quadruple down. Not only did they increase the volume of work of the kind originally planned but they also ended up adding in more work. They went so far as to build a full assembly line so they could play South Carolina off against the northwest. And there have been major quality problems with work out of South Carolina as late as as earlier this year. (The current official story is that "everything is good there now".)
There has been similar problems with components made in Italy and other places in the world. And, as a side effect of moving so much expertise and responsibility off shore, we have in effect taught a lot of people around the world a lot about how to build technologically advanced airplanes. This has major impacts from both a civilian perspective (China is in the process of getting a commercial airplane manufacturing capability off the ground, as are a number of other countries) and governmental perspective (the dual use nature of this technology makes it militarily important both for offensive (building better military planes) and a defensive (getting better at shooting down our military planes) perspective). People get wound up about Edward Snowden and not at Boeing. That's because Boeing has a lot of political clout and a good PR operation and Snowden doesn't. But Boeing has done a better job of providing aid and comfort to potential adversaries than Snowden has.
Anyhow, this overload caused by management overreach has resulted in a lot of problems for the 787 program. It seems back on track after many years of delays. A number of analysts think the program will never make back its costs. I think it eventually will, perhaps a decade from now.
The Boeing 787 program is a classic example of the maxim "if they want to do it they will find a way and if they don't want to do it they will find an excuse". I have seen innumerable projects that penciled out just fine. But management didn't want to do them (e.g. retrofit buildings) so they didn't. I have seen innumerable projects that did not pencil out (e.g Boeing moving their headquarters to Chicago) but management found a way. If you ask management they will say that in each case "it was simply a cold hard business decision" but you will be hard pressed to find a business case laid out in detail and that that actually pencils out.
Across the board cuts
Boeing, and lots of other companies have announced (and implemented) "across the board" budget cuts on a number of occasions. This is where you cut the budget of each part of the business by the same percentage. Turn the issue inside out and see what it looks like. If the answer is "across the board cuts" what does the result of the "hard nosed business analysis" have to be to justify this action? It has to be that all parts of the business are exactly as efficient/inefficient or important/unimportant? What are the chances that is actually true? "A snowball's chance in hell" overestimates the likelihood.
What across the board cuts tells you is that management does not understand the business they are supposed to be experts in managing. There should be strong parts of the business and weak ones. There should be parts that are more important and other parts that have less importance. And it is the primary job of management to know exactly which parts those are. Then you cut more heavily in the weak areas and more heavily in the less important areas. It even makes sense to not cut a weak area if it is critical. But you should have been shoring that important but weak area area up long before the need to cut arose. Why weren't you?
Championing across the board cuts is prima fascia evidence of incompetence. Whoever champions this should be fired immediately for cause. The only defense is if the executive in question can prove that he was literally forced to adopt equal cuts by outside forces. And if he received only moderate pressure he should be fired for not finding a way to effectively counter the pressure.
But across the board cuts are common. As are other less obvious signs of incompetence. Every time I see a management decision I ask myself the simple question "does this decision and its rationale demonstrate a deep and honest understanding of the organization"? Frequently it doesn't. As another example, various large financial institutions almost completely crashed the economy of the entire world a few years ago. Executive after executive said "I didn't know my subordinates were engaged in dangerous/unethical/risky practices" or "I had no idea that these procedures could crash the economy (or. perhaps more importantly, destroy my company)". At a minimum these statements demonstrate an ignorance of critical aspects of the business these people are charged with managing (and paid outrageous sums to manage effectively). They should have all been fired for cause for incompetence, I don't care which. I believe that many of them knew that bad behavior was rampant on their watch. But that same bad behavior resulted in them being paid massive amounts of money.
Management Responsibility
In this last example (Wall Street a few years ago) we see a question of where management's responsibility lies. I would like to turn the problem around. I often found myself with a situation where I thought that management should take some action. Frequently they didn't. It took me a long time to figure out what the real problem was. Management certainly does not want subordinates making decisions that management feels are properly in their domain. And they are diligent about asserting themselves in these situations. But what about the situation where assuming responsibility is, shall we say, inconvenient? I have found that management is equally diligent at dodging these "opportunities", usually by inaction. I came up with the following formulation years ago: "it's not a problem if it is not causing management problems".
We see this everywhere. There is a certain amount of work to do. Management doesn't want to pay for all of it to be done. The obvious solution is "off the clock" work by subordinates. If everything gets done and we stay within budget then, viewed from the management perspective, there is no problem. If there is no problem then there is no need for management to do anything. So we see a lot of creativity deployed to create situations where subordinates, for one reason or another, end up doing a lot of work that is uncompensated or undercompensated. You can root around in pretty much any newspaper during pretty much any week and you will find one or more examples of employees doing work that benefits the company but is not fully reflected in those employee's paycheck's. The company and the techniques and the justifications vary from case to case but the result is always the same. That's bad. There is worse.
Boeing was in a dog fight a few years ago over the "military tanker" contract. About fifty years ago Boeing built a bunch of airplanes that were used for in-air refueling. Needless to say, it was long past time to replace these planes with newer ones. But tankers are unsexy. So there was always some other sexier place to spend DOD money. So Boeing was having a hard time getting the government to sign on the dotted line for new planes. To be fair, Boeing tried all the legitimate techniques for getting the business first. But year after year passed by and no signed contract materialized. What's a Boeing manager to do? Well, there's always the illegitimate techniques? But they are at best a public relations problem and at worst are flat out illegal. This is a case where no manager wants their fingerprints visible on anything. What does the actual management playbook (as opposed to the one they teach from in school) say to do in these circumstances? You glower at your subordinate(s) and say "I don't care how this gets done, just do it.". If anyone asks later, you say "well, of course everyone knew that I expected them to behave in a legal and ethical manner at all times. That goes without saying.".
I don't want to re-litigate the whole tanker incident. Frankly, it was a few years ago and I remember only some of the details. And it represents an extreme example. The details ended up in the public domain. And important people were fired. Other important people went to jail. But "I don't care how, just do it" is a common strategy for providing management with plausible deniability.
Usually, what's involved is pretty mundane. My ex-boss used to work a horrific number of hours because management provided inadequate resources and he felt a responsibility to get the job done and done well. My cousin was talking about her company being too cheap to buy her a color printer. She had to jump through a bunch of unnecessary hoops to get what should have been a simple job done. Besides the "just do it" component the other point of commonality in all these cases is this. The job got done. It got done in a way that was invisible to General Ledger. The fact that it got done and that there were no visible negative consequences meant that from management's perspective there was no problem,
I spent years trying to bring my now ex-boss around to my point of view on this. He finally saw the light a couple of years after I retired. He no longer works horrible hours. And the company seems to get along ok now that his efforts are no longer heroic. Once management sees something that affects them negatively then they have a reason to take action. But the other thing I told my manager is that this sort of thing is dangerous. If you can turn your problem into management's problem without leaving any of your fingerprints visible then you're fine. But it is often impossible to do that. So the manager knows (or should know) what's going on. At that point he may decide you are not a "team player" or you are a "troublemaker". In other words, he can work things so in effect his problem becomes your problem. But the thing to remember is he could have done that anyhow.
Conclusion
You have no doubt correctly concluded that I think senior management of large companies is wildly overpaid. So let me conclude with a quick note about how this came to be. How would like it if your friends and family and softball buddies set your pay? And, oh by the way. you are the one who gets to pick the specific set of friends, family and buddies that serve on your "compensation committee". That's how it works in these large companies. Senior executives and members of the board of your company decide how much you as CEO get paid. You have come up through the ranks with the senior executives so you probably like and respect each other. As CEO you have more say than anyone else as to who serves on the Board of Directors of your company. So who do you pick as board members? Friends, possibly some members of your executive team, and CEOs (or senior executives) of other companies that you are friendly with. Everyone knows it's a "you scratch my back - I scratch yours" situation. If everybody decide that these positions should pay extremely well then everybody (or at least everybody we care about) does extremely well. But wait, there's more.
The possibility exists that this might look bad. Luckily someone came up with a great way to deal with this a few decades ago. Companies that specialized in determining "appropriate" compensation for senior executives were invented. Officially they are expert in impartially determining what a "fair" compensation package looks like. So they provide complete cover. "We hired this highly respected company to figure all this out then we did exactly what they recommended." Problem solved. It's just another one of those "hard nosed business" situations. But guess who picks out which "compensation specialist" company gets the job? The CEO. And no one has to tell anyone anything for these companies to figure out that their job is twofold. First, they come up with an astronomical number, the more astronomical the better. Second, they come up with a bunch of really high quality BS to justify the number. This second part is where they really earn their money.
And any "compensation specialist" company that does a really superior job deserves to be paid accordingly, right. It's only fair, after all. So, once a company is able to develop a bit of a reputation, it does really well. In the real world, the group made up of your friends, family, etc. would do a poor job compared to the job these companies do. Your friends would not come up with a figure that was nearly high enough. And the fact that these "compensation specialist" companies are so expert at coming up with an astronomical number and then papering the whole thing over with truly awesome BS is why they get paid the big bucks, baby.
My academic credentials are nearly nonexistent on this subject. I took a single one semester class on Business Law in High School. I took some American Institute of Banking classes decades ago when I worked for a Bank. What you are getting is a worm's eye view of the situation, what things looked like from the other end of the organization chart. Like many, I have repeatedly asked myself "why did they do that?" when some particularly spectacular piece of management stupidity surfaced either at work or in the news. The same kinds of things kept happening over and over so there had to be some underlying method to the apparent madness. It took me a long time to extract the method as the "usual suspects" were of no use. None of what I am about to reveal is to be found in any MBA curriculum, academic publication, or in the prodigious output of the "business press" (Forbes, CNBC, etc.). But these are iron clad principles that have the force of law in actual business practice.
But first, how could this be one of my posts without a digression? So let me digress, but only for a very short time, and ask "how do CEOs justify their large compensation packages"? Their answer is that "they work hard and they are smart". And by "smart" they really mean something more along the lines of skillful. They have to be very smart to understand the complex problems they wrestle with on a day to day basis. But they also have to apply the very best judgment to solving these problems. So more than just raw "smarts" are required. So, in their eyes, they really are very special. Let me first address the "hard work" issue as it can be easily dispensed with.
I have frequented several sandwich shops over the years. The ones I frequent (and here I am specifically talking about the non-chain shops, e.g. Subway) have been run in many cases by Korean women of a certain age. I have no idea how many hours they put in but its a lot. They are there from dawn till dusk. In one shop I now frequent all the pastries are baked on site every day. So the proprietor is there from before sunup until the shop closes late in the day. These ladies put in an unbelievable number of hours. And this applies to many small businesses. I have frequented establishments run by both sexes and all ethnicities. Many small businesses depend heavily on the proprietor. And they depend on that person putting in long hours every day and having the flexibility and skill to perform multiple duties. I would stack up the range of skills and the work ethic of these proprietors against any "ten million dollar man" (and they are nearly all men) helming one of these corporate behemoths.
The rest of this post will address the intelligence and judgment components.
General Ledger
Ok. I was not altogether honest. Because I need another digression. The term or art for the corporate books is General Ledger. Some of you may be familiar with Quick Books, an inexpensive software package designed for use by small businesses. And a thorough discussion of General Ledger systems would span several weighty volumes. But there are only a few things you need to understand. And those things can be covered quickly.
General Ledger systems have what's called a "chart of accounts". This is a list of buckets (e.g. accounts) into which items of income or expense are placed. There is a separate chart of accounts for each department. Each account for a department is "rolled up" to create a division total. These totals are rolled up through larger and larger portions of the corporation until you finally get to the top. Then all the top accounts are rolled together to figure out how the corporation as a whole is doing.
General Ledger systems fulfill several roles. So it is useful to have lots of separate accounts. In a store there can be an account in the "shoe" department for "men's shoes" and another for "women's shoes" and one for "socks" and so on. So each time a pair of men's shoes is sold the amount is added into the correct account. In a similar manner the sale of a pair of women's shoes goes into its account. And so on. And we can have an account for "sales tax" and other accounts for other things. So in order to find out how the department is doing you can add all these accounts together. But you can also add the accounts for "men's shoes" together from all the shoe departments in all the stores to see how "men's shoes" are doing over all. This should give you the flavor of how General Ledger works and why most General Ledger systems have lots of separate accounts.
And so far, I have talked about income accounts. There are also expense accounts. The shoe department might have a "salary" account. But, in the same way it was useful to have lots of income accounts, it might be useful to have an "overtime" account and a "bonus" account (shoe sales people might get an extra "bonus" for selling a particularly large amount of shoes). And there might be a "lighting" account and an "advertising" account and so on.
So that gives you a flavor of how General Ledger works at its most basic level. And I demonstrated how it might be useful to add the accounts up in different ways. Corporations of any size add the accounts up in at least three different ways. (1) They add them up one way to calculate their Income Tax bill. (2) They add them up a second way to produce the "Annual Statement" for stock holders. And (3) they add them up a third way to assist management in running the company. Why do they do this? Because each "way" serves a different purpose. In the first case the idea is so show the least profit so the Income Tax bill will be as low as possible. In the second case the idea is to show the most profit so the stock holders will be happy. In the third the idea is to shed light on what parts of the business are doing well or badly and which managers are doing a good or a bad job.
As an example of this, Boeing is one of several companies that is not profitable, at least when the accounts are added up in the proper way. How do we know? Because they have not paid any Income Tax in years. However, if we add things up in the "Annual Statement" way, Boeing is very profitable. So it is only fair that their senior executives should be paid millions. And, as far as I can tell, Boeing does a terrible job properly adding things up in the third way, the way that allows them to make good management decisions. Because they have made a lot of really boneheaded decisions over the past couple of decades. With that digression complete let me get back to the main line of analysis. My first issue of management stupidity is:
General Ledger Visibility
What do I mean? Well, a few years ago Boeing was going through hard times. This resulted in a laser focus on expenses. This in turn resulted in an edict from the top echelons of the company to trim the use of office supplies and to cut travel expenses. What? Boeing is a multibillion dollar company. In this environment accountants have a term for things like office supplies and travel expenses. It is "not material", as in "this will not have a material effect on the financial situation". So why did Boeing management highlight these two tiny expense categories even though completely zeroing out all expenses in these specific categories would not have affected Boeing's profitability in a noticeable way? It is because small though they are they are "visible" in General Ledger. Each department has a General Ledger account for each. If the amount of expense in either or both of these accounts goes down the reduction will directly increase profit. But, you say, what about doing something that would make a big difference like say making Boeing engineers more efficient?
There are lots of engineers. They have relatively high salaries (not senior management salaries but definitely not janitor salaries either). If you were to say increase the efficiency of engineers by 1% wouldn't that save lots more money than you would by dinging the office supply and travel accounts? It turns out surprisingly the answer is no? The thinking goes that Engineers are on salary. If you increase their efficiency by 1% their payroll cost does not change at all. They just end up sitting on their hands for a few minutes over the course of a week. So no number in General Ledger changes so there is no savings. Is this right? It doesn't matter. Management thinks it is right. So since, to management's way of thinking, reducing office supply costs and travel costs changes the numbers in General Ledger, albeit by a small amount, it is better to do that than to try to increase the efficiency of Engineers because the latter change will not show up in the General Ledger numbers.
This General Ledger Visibility problem raises its ugly head in even more perverse ways. One way to restate the problem is "General Ledger is more real than reality". In the early days of the space program there was a process called "ground truthing". NASA people would look at satellite pictures or other measurements. Then they would go out and actually look at what was on the ground, the ground truth. They wanted to understand how much of what the satellite said was really real. Then they could figure out how far to trust the satellite data. In many cases the satellite data gave a better picture of what was going on than you could get from the ground. In other cases there were various fixes and adjustments that were necessary to get the satellite data to align with reality. And in still other cases the satellite data was misleading and could not be trusted.
General Ledger systems are like satellite data. Sometimes they tell you what is going on better than any other method. Other times they can be trusted after the appropriate adjustments and fixes have been applied. And other times they just plain mislead you. Many executives, however, are true believers when it comes to the numbers General Ledger systems spit out.
Manageable versus Unmanageable Costs
Let me be clear what I am talking about here. If an executive believes that actions he takes can affect a cost then that cost is manageable. Otherwise, it is unmanageable. Let me give you an example, in this case an example that has nothing to do with Boeing. A company I worked for used a lot of natural gas. Now this cost was visible in General Ledger. It had its own little line in the chart of accounts in a particular department. And the amount was large, millions of dollars per year. So that was not the problem. The problem was that the company had almost no control over the cost of natural gas. So to a great extent the cost was unmanageable. Now they did what they could. They put a great deal of effort into using the gas efficiently so they used as little as possible. They also tried to be smart about how they bought gas. If the thought the price trend was up they would sign up for a long term contract at a fixed price. If they thought the price trend was down they would avoid long term contracts and buy on the "spot" market.
Now the above example is a set of specific circumstances. So I'm going to move on to a more general situation. (I don't know if it applies to Boeing but likely it does.) Companies occupy buildings. In some cases they own the buildings but the trend is toward leasing. These buildings involve operating costs, specifically power for heating, lighting, air conditioning and other machinery, etc. The prime consideration that goes into how most buildings are built is construction cost. They are typically built as cheaply as possible and no thought is given to whether this will result in high operating costs. So typically these buildings are very inefficient to operate. In the last decade or so a lot of effort has gone into studying this. And it turns out that a lot of ways have been identified to reduce operating costs, particularly costs associated with energy use. And some of these ways turn out to have very good cost/benefit ratios. I have a brother who has studied this area thoroughly. He says that a lot of these "retrofits" pay for themselves by reducing operating costs dramatically. A typical payoff period is 18 months. That is a fantastically quick return on investment.
But in spite of this it is very rare to see buildings retrofitted. Why? Well, let me trot out a very lame excuse first. Many building leases are "all in". The price of the lease requires the landlord to pay operating costs like energy bills. So if the building is retrofitted it will be disruptive to the company using the building and, since the rent is fixed, there will be no cost savings. This is lame. If the retrofit is done and the rent is reduced but by less than the savings both sides benefit. The land lord has more money left over after his operating costs have been deducted from the rent check and the tenant sees cost savings because the rent is now lower. So why doesn't this happen? Because management sees rent as an unmanageable cost. It doesn't matter how high it is. It's unmanageable so efforts are turned to reducing costs in other areas. Is management correct? No!
Red money, Green money, and Blue money
If you think at all about the color of money you probably think it's all green. A nickname for U.S. currency is "greenback" because that's the predominant color of our currency. I used to also believe that all money was the same color too. This led to a lot of frustration.
In a previous job (not at Boeing) I was responsible for selecting and procuring computer equipment. This was back in the old days when a nice computer ran several million dollars. So we are talking decisions that involved very high levels of management because the equipment was very costly. (The company was far smaller than Boeing so a million dollars was a very big deal.) I am going to skip over all the "do we really need to do this" part of the discussion. Let's assume that everyone has agreed that the investment needed to be made and we were just trying to figure out how the acquisition should be structured.
What I mean by "structured" is "buy, rent, or lease" and "new or used". The idea was to pick among the various possibilities. Now naïve old me, I cranked up the spread sheet and starting calculating the cost of the various options. My assumption was "all things being equal" (and I wrangled all the technical issues to make sure that all things in fact were equal) we just wanted to structure the deal to result in the lowest overall cost. This is where I learned the hard way about red money, green money, and blue money. What do I mean?
Well part of that whole General Ledger thing is what is called a budget. Before the year starts all the income and expenses for the next year are estimated. Then the idea is not necessarily to make income go up and expense go down. It is to hit your budget numbers. (I must say that if you missed your income numbers on the high side and your expense numbers on the low side people would be pretty happy even though technically you missed your numbers.) But part of the process of creating the budget was to guess what would happen, money-wise. So the budget might include money for our piece of computer equipment. And an assumption would be made as to whether it would be bought, rented, or leased. Needless to say, there were separate "buy" "lease", and "rent" General Ledger accounts. So typically one of these budget accounts would have money in it and the others would be empty.
Silly me. I knew that there were separate accounts. But I had heard of money being "reprogrammed" in the federal budget to cover some unexpected event. And I'm a computer guy. I know that all this budget stuff is just numbers in a computer file. It's not that hard to move the numbers around. So I do my analysis. And I figure all I have to say is "if we do it this way we can save a lot of money so we just reprogram the money and everyone's happy". That's when I learned about red money (capital), green money (lease/rent), and blue money (maintenance and other operating costs). Apparently there is no philosopher's stone to turn one color of money into another color.
Now there some good reasons for not changing the color of money. There's fraud. You don't want people just changing things around willy nilly. But it is not hard to put procedures in place so you make sure the changes serve a legitimate purpose (saving money) and not just providing a cover for hanky panky. And there is the issue of "ratios". Most companies operate on borrowed money. And the banks are supposed to make sure that the company can pay the borrowed money back. So they might require a company to maintain a certain "capital ratio". The details don't matter but the result is that a company might not want to make a capital expenditure (buy some expensive piece of equipment) because it will cause the capital ratio to go out of whack. Contrarily, it might be necessary to buy something rather than rent it to keep some other ratio in line. But in my case none of these considerations came into play. Changing the color of money was perfectly feasible. It was just not done.
The Myth of Rationality
The model business people hold up of themselves to the world is that of rationality. They are not swayed by sentiment. "It's just business, mam." They want you to believe that the decisions they make are based on careful analysis and are driven solely by the profit motive. But its not so.
After many years, Boeing seems to have finally gotten the 787 program on track. They are able to build and deliver the planes on schedule and the airlines are able to put the planes in service and keep them there. But a lot of pain, suffering, and money, have been poured down numerous rat holes to get to where we are now. If you listen to management propaganda, then each of the major decisions made at the start of the program was the result of cold rationality applied to careful analysis. Here is a list of the most important and consequential decisions management made:
- They would move from a plane made primarily out of aluminum to one made in large part out of carbon fiber.
- They would transition from a "send a lot of small parts from subcontractors to a Boeing plant for final assembly" to a "send large pre-assembled pieces of the plane to a Boeing plant where they will be snapped together" construction method.
- Instead of Boeing doing all the design and "integration" (making sure all the parts fit together) work a lot of the design and integration work will be done by contractors with Boeing supervising.
- Instead of almost all of the plane being built in the U.S. large parts of the plane would be farmed out to foreign countries.
Taken separately any of these decisions might make sense. But taken together they represented a recipe for disaster. In my opinion, when these decisions were made Boeing management was in poor shape. What is common to all these decisions is that each decision separately would require more and better effort from Boeing management than the alternative "do it the old way" option. This is particularly true of decision #4.
The 787 program has been a fiasco for most of the lifetime of the plane. I thought at the time that Boeing really needed to do #1. But this would be hard to do. So I thought they should focus on it and avoid change elsewhere in the program. Obviously they didn't. The result was chaos everywhere. And chaos is very expensive in the plane building business
There were a number of engineering problems. This delayed things. Then parts came in incompletely or incorrectly assembled. Then the pieces did not fit together very well. And various subcontractors had trouble coming up to speed. In particular, problems in South Carolina were so great that Boeing decided they had to buy the subsidiary responsible for work there so that they could fix management there. Given that early on South Carolina had been a major problem area would you recommend minimizing their responsibilities or doubling down? Boeing decided to double down. In fact, they decided to quadruple down. Not only did they increase the volume of work of the kind originally planned but they also ended up adding in more work. They went so far as to build a full assembly line so they could play South Carolina off against the northwest. And there have been major quality problems with work out of South Carolina as late as as earlier this year. (The current official story is that "everything is good there now".)
There has been similar problems with components made in Italy and other places in the world. And, as a side effect of moving so much expertise and responsibility off shore, we have in effect taught a lot of people around the world a lot about how to build technologically advanced airplanes. This has major impacts from both a civilian perspective (China is in the process of getting a commercial airplane manufacturing capability off the ground, as are a number of other countries) and governmental perspective (the dual use nature of this technology makes it militarily important both for offensive (building better military planes) and a defensive (getting better at shooting down our military planes) perspective). People get wound up about Edward Snowden and not at Boeing. That's because Boeing has a lot of political clout and a good PR operation and Snowden doesn't. But Boeing has done a better job of providing aid and comfort to potential adversaries than Snowden has.
Anyhow, this overload caused by management overreach has resulted in a lot of problems for the 787 program. It seems back on track after many years of delays. A number of analysts think the program will never make back its costs. I think it eventually will, perhaps a decade from now.
The Boeing 787 program is a classic example of the maxim "if they want to do it they will find a way and if they don't want to do it they will find an excuse". I have seen innumerable projects that penciled out just fine. But management didn't want to do them (e.g. retrofit buildings) so they didn't. I have seen innumerable projects that did not pencil out (e.g Boeing moving their headquarters to Chicago) but management found a way. If you ask management they will say that in each case "it was simply a cold hard business decision" but you will be hard pressed to find a business case laid out in detail and that that actually pencils out.
Across the board cuts
Boeing, and lots of other companies have announced (and implemented) "across the board" budget cuts on a number of occasions. This is where you cut the budget of each part of the business by the same percentage. Turn the issue inside out and see what it looks like. If the answer is "across the board cuts" what does the result of the "hard nosed business analysis" have to be to justify this action? It has to be that all parts of the business are exactly as efficient/inefficient or important/unimportant? What are the chances that is actually true? "A snowball's chance in hell" overestimates the likelihood.
What across the board cuts tells you is that management does not understand the business they are supposed to be experts in managing. There should be strong parts of the business and weak ones. There should be parts that are more important and other parts that have less importance. And it is the primary job of management to know exactly which parts those are. Then you cut more heavily in the weak areas and more heavily in the less important areas. It even makes sense to not cut a weak area if it is critical. But you should have been shoring that important but weak area area up long before the need to cut arose. Why weren't you?
Championing across the board cuts is prima fascia evidence of incompetence. Whoever champions this should be fired immediately for cause. The only defense is if the executive in question can prove that he was literally forced to adopt equal cuts by outside forces. And if he received only moderate pressure he should be fired for not finding a way to effectively counter the pressure.
But across the board cuts are common. As are other less obvious signs of incompetence. Every time I see a management decision I ask myself the simple question "does this decision and its rationale demonstrate a deep and honest understanding of the organization"? Frequently it doesn't. As another example, various large financial institutions almost completely crashed the economy of the entire world a few years ago. Executive after executive said "I didn't know my subordinates were engaged in dangerous/unethical/risky practices" or "I had no idea that these procedures could crash the economy (or. perhaps more importantly, destroy my company)". At a minimum these statements demonstrate an ignorance of critical aspects of the business these people are charged with managing (and paid outrageous sums to manage effectively). They should have all been fired for cause for incompetence, I don't care which. I believe that many of them knew that bad behavior was rampant on their watch. But that same bad behavior resulted in them being paid massive amounts of money.
Management Responsibility
In this last example (Wall Street a few years ago) we see a question of where management's responsibility lies. I would like to turn the problem around. I often found myself with a situation where I thought that management should take some action. Frequently they didn't. It took me a long time to figure out what the real problem was. Management certainly does not want subordinates making decisions that management feels are properly in their domain. And they are diligent about asserting themselves in these situations. But what about the situation where assuming responsibility is, shall we say, inconvenient? I have found that management is equally diligent at dodging these "opportunities", usually by inaction. I came up with the following formulation years ago: "it's not a problem if it is not causing management problems".
We see this everywhere. There is a certain amount of work to do. Management doesn't want to pay for all of it to be done. The obvious solution is "off the clock" work by subordinates. If everything gets done and we stay within budget then, viewed from the management perspective, there is no problem. If there is no problem then there is no need for management to do anything. So we see a lot of creativity deployed to create situations where subordinates, for one reason or another, end up doing a lot of work that is uncompensated or undercompensated. You can root around in pretty much any newspaper during pretty much any week and you will find one or more examples of employees doing work that benefits the company but is not fully reflected in those employee's paycheck's. The company and the techniques and the justifications vary from case to case but the result is always the same. That's bad. There is worse.
Boeing was in a dog fight a few years ago over the "military tanker" contract. About fifty years ago Boeing built a bunch of airplanes that were used for in-air refueling. Needless to say, it was long past time to replace these planes with newer ones. But tankers are unsexy. So there was always some other sexier place to spend DOD money. So Boeing was having a hard time getting the government to sign on the dotted line for new planes. To be fair, Boeing tried all the legitimate techniques for getting the business first. But year after year passed by and no signed contract materialized. What's a Boeing manager to do? Well, there's always the illegitimate techniques? But they are at best a public relations problem and at worst are flat out illegal. This is a case where no manager wants their fingerprints visible on anything. What does the actual management playbook (as opposed to the one they teach from in school) say to do in these circumstances? You glower at your subordinate(s) and say "I don't care how this gets done, just do it.". If anyone asks later, you say "well, of course everyone knew that I expected them to behave in a legal and ethical manner at all times. That goes without saying.".
I don't want to re-litigate the whole tanker incident. Frankly, it was a few years ago and I remember only some of the details. And it represents an extreme example. The details ended up in the public domain. And important people were fired. Other important people went to jail. But "I don't care how, just do it" is a common strategy for providing management with plausible deniability.
Usually, what's involved is pretty mundane. My ex-boss used to work a horrific number of hours because management provided inadequate resources and he felt a responsibility to get the job done and done well. My cousin was talking about her company being too cheap to buy her a color printer. She had to jump through a bunch of unnecessary hoops to get what should have been a simple job done. Besides the "just do it" component the other point of commonality in all these cases is this. The job got done. It got done in a way that was invisible to General Ledger. The fact that it got done and that there were no visible negative consequences meant that from management's perspective there was no problem,
I spent years trying to bring my now ex-boss around to my point of view on this. He finally saw the light a couple of years after I retired. He no longer works horrible hours. And the company seems to get along ok now that his efforts are no longer heroic. Once management sees something that affects them negatively then they have a reason to take action. But the other thing I told my manager is that this sort of thing is dangerous. If you can turn your problem into management's problem without leaving any of your fingerprints visible then you're fine. But it is often impossible to do that. So the manager knows (or should know) what's going on. At that point he may decide you are not a "team player" or you are a "troublemaker". In other words, he can work things so in effect his problem becomes your problem. But the thing to remember is he could have done that anyhow.
Conclusion
You have no doubt correctly concluded that I think senior management of large companies is wildly overpaid. So let me conclude with a quick note about how this came to be. How would like it if your friends and family and softball buddies set your pay? And, oh by the way. you are the one who gets to pick the specific set of friends, family and buddies that serve on your "compensation committee". That's how it works in these large companies. Senior executives and members of the board of your company decide how much you as CEO get paid. You have come up through the ranks with the senior executives so you probably like and respect each other. As CEO you have more say than anyone else as to who serves on the Board of Directors of your company. So who do you pick as board members? Friends, possibly some members of your executive team, and CEOs (or senior executives) of other companies that you are friendly with. Everyone knows it's a "you scratch my back - I scratch yours" situation. If everybody decide that these positions should pay extremely well then everybody (or at least everybody we care about) does extremely well. But wait, there's more.
The possibility exists that this might look bad. Luckily someone came up with a great way to deal with this a few decades ago. Companies that specialized in determining "appropriate" compensation for senior executives were invented. Officially they are expert in impartially determining what a "fair" compensation package looks like. So they provide complete cover. "We hired this highly respected company to figure all this out then we did exactly what they recommended." Problem solved. It's just another one of those "hard nosed business" situations. But guess who picks out which "compensation specialist" company gets the job? The CEO. And no one has to tell anyone anything for these companies to figure out that their job is twofold. First, they come up with an astronomical number, the more astronomical the better. Second, they come up with a bunch of really high quality BS to justify the number. This second part is where they really earn their money.
And any "compensation specialist" company that does a really superior job deserves to be paid accordingly, right. It's only fair, after all. So, once a company is able to develop a bit of a reputation, it does really well. In the real world, the group made up of your friends, family, etc. would do a poor job compared to the job these companies do. Your friends would not come up with a figure that was nearly high enough. And the fact that these "compensation specialist" companies are so expert at coming up with an astronomical number and then papering the whole thing over with truly awesome BS is why they get paid the big bucks, baby.
Subscribe to:
Posts (Atom)