Dynamic Economic Decision Making
John Mauldin
August 22, 2011

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This week’s Outside the Box is from my good friend John Silvia, the Chief Economist at Wells Fargo and fishing buddy in Maine. He has written a powerhouse book called Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy.

Combining three intellectual disciplines – economics, business, and decision making – that have traditionally been taught separately, Dynamic Economic Decision Making forges a new path that redefines how we view business choices. And that is the main point of the book. So many business leaders and investors make decisions based on static factors, historical patterns, or straight-line assumptions that it is no wonder that all too many bad decisions are made. And worse, we train our MBAs to approach decision making with outmoded tools that have proved themselves worthless in the real world.

Jim McTague of Barron’s wrote:

“For the price of a book you receive the equivalent of a three-credit course from a top MBA program. Silvia, one of the nation’s most astute economists, has written a comprehensive, accessible masterpiece on applied economics. The author is an able teacher: Anyone, novice or expert, will profit from this well-written book.”

I agree. Even though John sent me this book for review, I will download it to my iPad for $40! (note to my editor at Wiley, who published this book: Why can Silvia get $39 for Kindle and I get $12?) I get a lot of reading done as I travel, and this is one I want to get through.

I asked John to write a short piece to give us a flavor of his main points, and I don’t think you’ll be disappointed. You can get the book on Amazon at http://www.amazon.com/Dynamic-Economic-Decision-Making-Strategies (37% off).

Have a great week, and learn to enjoy volatility. And please get the fact that Silvia (and I) keep noting: We are not going back to the old days. We are in a brand new world and we need to deal with it.

Your actually looking forward to the future analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

Dynamic Economic Decision Making

The Great Recession of 2008-10 demonstrated the power that macroeconomic and financial forces have to alter the risks and rewards that frame choices for both private and public sector decision makers. Moreover, these forces completely overwhelmed the complex, micro mathematical strategies that were the rage of many investors. Yet many approaches to decision-making in finance and economics are more like cookbooks—they tell you how to prepare a specific meal, step-by-step, but not the fine art of being the gracious host that leads the guests through a wonderful evening. Too much focus is exclusively on the fine techniques of micro management, while ignoring the reality of the broader set of macro scenarios faced by actual decision-makers involving the many changes in economic growth, finance, and globalization that are ongoing. Is it any wonder that failure and surprise accompany the economic shocks of the day? Our finest financial engineers fail in the face of real world change.

Dealing With Cyclical & Structural Change

“You can’t argue with a hundred years of success.”

–William I. Walsh (The Rise and Decline of the Great Atlantic & Pacific Tea Company, Lyle Stuart, New Jersey, 1986)

Actually you can when the environment changes around you—not knowing that the economic world is changing and the world is always changing. In the early 1950s, A&P, which was then the leading grocery chain in America, ranked only behind General Motors in annual sales. Americans tastes changed. They wanted choices, not the limited availability associated with the Great Depression and World War II periods of thrift. A&P stores did not provide the level of variety, nor cleanliness, expected by the new, growing middle class suburban households that began to emerge after the war. America’s tastes had changed and the offering of A&P did not. (See Jim Collins, Good to Great, Harper Business, 2001, pp. 65-69.)

Three forces interact to drive economic success. First, economic activity provides the overall flow of information and sets the character of surprises and our decision-framework. Yet, in practice, decision makers conduct stress tests, risk assessments and simulations that do not deal with the cyclical nature of economic behavior. This would appear for two reasons.

Second, most business and public policy decision-makers are not trained to deal with or think in terms of the business cycle. Forecasting for most consists of straight-line projections from a spread sheet.

Third, dealing with the business cycle demands a set of assumptions and the interaction of those assumptions that can require scenario building. The results of these scenarios on the outlook for growth, inflation and interest rates, for example, can be more complex than decision-makers have the time or willingness to engage.

Many decision-makers feel more comfortable on focusing on the business, where they feel comfortable, and not of forecasting. Even more misleading, over time the model of the economy does not fundamentally change and, thus retaining its original framework. In addition, many simulations are defined in terms of allowing one factor, for example economic growth, to fluctuate. This is done to simplify the analysis but with the knowledge that other key variables are likely to change at the same time.

There is a tradeoff here between simplicity and reality. Often, the comfort of simplicity leads to a misrepresentation of the outlook. Better to deal with the complexity and get a sense of the issues than fall back on simplicity and misrepresent the future outlook. These simulations and ignore the reality that other drivers, such as inflation, interest rates, profits and exchange rates, also move along with changes in growth. Over the last fifty years, the economy does has not ever returned to its prior “normal” but a new framework has always emerged with each business cycle, always different than previous frameworks, sometimes in significant ways. The original equilibrium was never restored. Creating economic models as if it did will not make it so.

Decision-traps limit the leader’s ability to deal with cyclical but especially longer-term changes. Decision-makers tend to anchor their expectations about the future in the past and to think in terms of their historical investments in their career and in their firm. Their career is their memory of events and decisions tend to be framed in terms of our experience. Decisions about the future of the firm tend to reflect the firm’s existing structure. Seldom do firms break out of character and set a new course. This causes them not to examine the marginal costs and benefits of moving to a new future. In addition, public policy makers are slow to recognize the changing character of competitiveness in industries (autos, textiles, and consumer electronics) and thereby subsidize such industries for far too long. This is not only a U.S. tendency but very much the general case as evidenced by the United Kingdom in the post-World War II period until Prime Minister Margaret Thatcher took office in 1980 and introduced a market-driven approach regarding subsidization of industries.

Finally, decisions on the future of the institution reflect the influence of past decisions (path dependent) and which sets the parameters for success regarding future decisions. In some cases, decisions today cut off options tomorrow while other decisions today open up options for the future. A student who decides to go to one college cuts off the opportunity to go to another college. An athlete decides to play baseball and give up playing soccer. A business firm decides to pursue project A and set aside project B. Once we decide on one path, generally we cut off other options and decisions today will reflect our decisions in the past. Business decisions also have this tendency for path dependence as will be shown in several cases in this chapter.

Four Biases in Decision-making

(For a great read on decision-making biases see Michael Roberto, Know What You Don’t Know: How Great Leaders Prevent Problems before They Happen.)

Two aspects of successful decision-making in a changing economic world are evident so far. First, a strategy is needed that recognizes the reality of fluctuations in economic growth as well as in the four other economic drivers. Second, this strategy should prevent economic shocks or change from causing business failures. If they use the three techniques to identify change, decision makers now have observations that suggest the future direction of economic change. But what mental barriers prevent decision makers from accepting such change?

Normalization of Deviance

Our first decision-making challenge is the normalization of deviance. In this situation we normalize, learn to live with, small deviations in the normal run of affairs. We learn to live with a dripping faucet, a toilet that runs a bit longer, a door that sticks. Diane Vaughan, sociology professor at Columbia, made a study of the Challenger space shuttle disaster of 1986. (The Challenger Launch Decision: Risky Technology, Culture and Deviance at NASA. Chicago: University of Chicago Press, 1996.) Vaughan’s study focused on the gradual development of a set of beliefs that small deviations from the norm in the behavior of the O-rings under cold temperatures were acceptable since no major problems had occurred. Since most flights had occurred with temperatures in a normal range the overwhelming evidence was that there was no problem. The small amount of erosion that did occur in some flights was considered an anomaly. Over time, these anomalies became the accepted course, much like the sticky door, and so they were taken for granted as the normal course of action. Deviations from the normal became accepted as part of the acceptable risks of any flight. At the time of the flight in 1986 the temperatures at launch were much colder than normal and disaster soon followed.

In business, normalization of deviance was apparent in the credit standards involved in subprime lending yet borrowers continued to pay, or enough of them paid, so that the entire enterprise was profitable, at least in the short run. The rise in housing prices over the last twenty years provided the underlying rational of the housing mortgage market. Credit standards were continually eased, often for political purposes, by government-supported enterprises such as Fannie Mae and Freddie Mac. At the same time, capital gains taxes were lowered on housing taxes on income in general were rising and interest rate deductions were eliminated for consumer credit and auto loans. Thus, to meet their desire for consumption, households increasingly took equity from their homes through home equity loans, which reduced the capital cushion of ownership. Easier credit standards, meanwhile, meant that the purchaser of the home had “less skin in the game,” that is the buyer of the home has less invested in the home and therefore less interest in paying off the mortgage if events turned bad (which they did as house prices fell) and therefore the real credit risk in lending was rising. This ultimately proved to be the undoing of the market. Lower credit standards meant more buyers could qualify. Rising demand for housing initially drove up prices. Eventually, supply caught up. Housing prices slowed and the carrying costs of the mortgage could not be justified. Many buyers, walked away now.

In recent years, the normalization of deviance was evident in the housing market bust of 2008-2009 and the deterioration of credit standards that came to be accepted. Mortgage standards eased by 2005 and 2006 such that 60 day plus delinquencies were rising earlier in the life of adjustable rate mortgages (ARMs) suggesting that the risk profile of the borrowers had risen and likely this rise was faster than investors in these loans had expected. The rapid rise of delinquencies in 2006 suggested that indeed the housing problem was much greater than many had expected. In short the mortgage market framework changed and many failed to notice. The fact that home prices were rising justified the increasing deviance of lending standards—until home prices no longer could rise and started to fall dramatically. In fact, in the history of markets, it often takes a substantial change in prices to reveal the underlying deviance of traded prices from their fundamentals. Success was defined in terms of rising home ownership even though the underlying credit quality of the borrower and the appraisal/market value of the house were increasingly suspect. The markets normalized the deviance in credit standards as long as home ownership rates went up.

Change as a process not an event

A second barrier to effective decision-making is the failure to recognize change as a process and not an event. Decision-makers want to identify one event as the “cause” of a significant change. Yet, the lessons of the pre-World War I period is that an entire sequence of decisions lead to the outbreak of the conflagration and not a single cause such as the shooting of Archduke Ferdinand. (Barbara Tuchman, The Guns of August, Ballantine Book, 1962.) Since 1956, three firms have dropped out of the Dow Jones index, Bethlehem Steel, General Motors and Woolworth. Yet there is not a single event in each of these company histories that caused the companies’ relative decline. Instead, changes in the overall economy led to an increasing disconnect between the economy and the framework of decision-making in each company. (Jim Collins, Good to Great, provides an interesting view on Bethlehem Steel. James O’Toole, in Leading Change, provides a view on the decline of General Motors.) Catastrophic failures such as Johns Manville (Asbestos litigation led to bankruptcy filing in 1982.) and Enron (irregular accounting concerns led to bankruptcy in 2001) can be attributed to singular failures over a short period of time.

For business firms the trend growth in the globalization of trade signifies the process of rising competition that characterizes the economic framework today. Recent years have also produced a trend of lower inflation and lower interest rates. Lower inflation, on average, suggests a reduction in pricing power with products and services increasingly being perceived by customers as commodities—perfect substitutes in a perfectly competitive market place. The challenge for businesses is to create the impression, if not the reality, of product differentiation—imperfect substitutes in a monopolistically competitive environment. For example, in financial services, are the services offered significantly different to justify a pricing for service model or are all the benefits of a financial service firm generated at the back-end by reducing back office recordkeeping costs?

The Illusory Correlation

A third decision-making stumbling block is the illusory correlation. This idea, which is particularly popular when many decision-makers are scrambling for simplistic explanations in a very complex environment, is the leap from observing one economic trend and then using that trend as an explanation of another trend without any intervening theory. Certainly odd events happen and there is a tendency to ascribe cause-effect to situations where no real link exists. This illusion is particularly prevalent among financial commentators.

It is also true among decision makers at firms or in state governments who ascribe changes to individual decisions. In fact national or global trends are the real culprits. U.S. presidents and corporate head are credited or blamed for every advance or decline on their watch while trends occur totally outside their control.

In the early years of the post World War II period, some analysts asserted that the economic success of the Soviet Union validated their economic model. In fact, the correlation of economic growth and with the Soviet model was purely coincidence. The Soviet Union was living off the resource transfers from other nations and countries that it had conquered with little regard to the long run consequences. It had the incentives within its economic framework that would insure continued success over the long run. In economic studies, the appearance of success in the short-run may hide underlying problems and those countries, states and companies may be living off past success with little provision for the future. Flash-in-the pan success in the short-run, may give the appearance of a new economic model but often that success is illusory unless supported by long-run oriented policies.

In economic or business comparisons, Americans are hampered by their anchoring bias dating back to the early post-World War II period. Japan and Germany had been destroyed by war. China, India, and Russia were not trading partners. Brazil and Mexico were run by military juntas. The U.S. had a largely closed economy and little global competition. Yet current public policy makers continue to speak in terms of America’s leadership in many industries—textiles, furniture and consumer electronics—that have become global. In fact, the post-World War II period was an exception in economic leadership with one country—America—holding such a dominant position. The reality is that change is constant and memories of the past are a prescription to failure in most cases.

Sunk Costs

Finally, decision makers’ ability to react to cyclical and structural change is hampered by their attachment to sunk costs, which are the costs already put into a project that are past and irreversible and are not altered by the decision to continue ahead or to stop the project. Richard Brealey (Professor at the London Business School) and Stewart Myers (professor at MIT) point out the decision in 1971 whether to continue with Lockheed’s development of the TriStar airplane after $1 billion had already been spent. Lockheed had already spent one billion dollars and was not recoverable whether Lockheed went ahead or not with the project. (Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, third edition, McGraw-Hill, 1988, p. 95.) In 1981 Lockheed announced it would stop production of its money-losing L-1011 jetliner. Eventually Lockheed dropped out entirely from commercial airline production. (John Greenwald, Jerry Hannifin/Washington, Joseph J. Kane/Burbank, Catch a Falling TriStar, Time magazine, December 21, 1981.) Overly committed to certain activities, decision makers stick with investments that are quickly losing their value. They are unable to let go of the past and move on to new opportunities. As a result, these investments lose value. Cyclical and secular change, by its nature, means that old investments become sunk costs, and barriers to innovation.

In fact, in many cases decision makers escalate their commitment believing that just a bit more investment will allow them to achieve their goal. (For a real-world example of the sunk cost effect with tragic consequences see Krakauer, J. Into Thin Air: A Personal Account of the Mount Everest Disaster. New York: Anchor Books, 1997.) In public policy, this can be seen in the commitment to retain the scale of many industries through protectionism and subsidies beyond any economic justification. While many U.S. firms in the textile, furniture, steel, auto and consumer electronics industries are globally competitive, government subsidizes these industries on a scale that allows weak companies to persist. They then can sell products at low prices and thereby hamper the ability of competitive firms to earn a profit and reinvest so as to remain globally competitive. Policy focuses on preserving jobs with little regard to workers and their skills. As a result, there are too many workers in old technology fields when these workers must to move into fields where they have a competitive future.

Example abound for both private and public policy decision-makers today. Credit standards are an obvious example of the normalization of deviance whereby credit standards that were questionable in the past now serve as good credit today. As for the illusory correlation, every investor can recite numerous examples of one-time wonders in forecasting the future of stock prices. Sunk costs are exemplified in both the public and private sectors by those continuously failing projects that continue to somehow get financing without ever becoming successful.

As for the current cycle/structural evolution of the economy, each of these decision biases is well represented. For successful investors, the challenge is to recognize our own biases and to better adapt to the constant evolution of the economy. Change in the economy is a process, not an event, and the bias to recognize the old blinds us to what is new.

Source: JohnMauldin.com (http://s.tt/136nu)

Category: Think Tank

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