On Innovation

Innovation is stifled in two ways: poor communication culture and grade inflation. Economics is the study of incentives and both grade inflation and poor communication are products of perverse incentives. As we will see, in the course of this discussion, perverse incentives can take many forms and yield some interesting results.

Companies run more efficiently when executives cooperate with each other; instead of merely trying to protect their turf and keep from getting “beat up” in meetings. I am a consultant and at my last client, there was no incentive for one department to talk to the other, because they just wanted to protect their turf. In organizations that lack a free and open communication culture, where executives keep things secret at the top, innovation is stifled. People don't want to take risks as they are afraid of being punished or what I term "thrown under the bus." Thus, the whole enterprise suffers.

We can take the metaphor of a house in which the CEO is the patriarch and the departmental heads are the children. If a lamp is broken, people start protecting their terf, instead of together to figure out how to fix the problem (i.e. sharing info), the result is a modus operandi of constant crisis. Things are constantly operated in "crisis mode" and the goal of each chief is to put out fires so that their ass doesn't get burnt.

Naturally, in this reactive management style, there is no management of anything except crises. It is better for executives to manage things proactively, as things run more efficiently. The challenge that I see is how to convert an organization that is reacting to crises to one that proactively addresses issues in which cross-functional specialists collaborate on how to fix core business problems. This would have the result of increasing innovation, allowing people to take calculated risks, and more operational efficiency.

If the variable pay of executives were tied to how well they communicated with other departments (although evaluating this would be the challenge, given its subjective nature), then the incentive would exist for departments to collaborate and a firm could move from a reactive management style to one that is proactive. Communication is the key to planning. Companies are built off of information and when information stops flowing, progress is stifled. Companies don't plan correctly and this is why they hire consultants to come in and tell them they are stupid.

The command and control concept comes from how the military runs. Management Science wasn't even a discipline prior to WW-2, when the US military needed to optimize its logistics for the war. In general, fragmentation of your troops, units, and divisions is bad news. In military operations, one needs central planning of the war so as to maximize the efficiency by effective resource allocation across the battles.

We can see the results of misallocation of resources as far back as the Civil War. During the Civil War, the regiments of the South were fragmented. Soldiers thought of themselves first as Virginians and second as members of the Confederacy. There was very little central planning. However, this weakness in their operations was offset by the Southern man's “will to fight”; if you see your house burnt down by a Yankee, you don't care about anything except killing Yankees. In the North, the soldiers really didn't care about the war as much as the Southerner. To them, it was just a steady paycheck.

The Civil War wasn't about slavery. Only the elite, which constituted 15% of Southerners (i.e. the landed upper-class) could even afford to own slaves. Of the other 85% of Southerners, who couldn't even afford to own a slave, a good portion of them didn't agree with the practice.

The fact is that the war was about states’ rights. When you boil that down, you can see a clash of two economies: agriculture and industrial. Each had its own set of values and priorities, which determined their position on what was "morally right." After the Civil War, states lost their rights and we became more federal; power became concentrated in the Federal Government.

One could plausibly argue that slaves were healthier as slaves, than when they were free because the plantation owner had an incentive to keep them healthy. There the pesky economics goes again, rearing its ugly head. Sharecropping was just another iteration of slavery, but people had the illusion of freedom. Slavery was destined to die off, though; the rest of the world was already moving in that direction.

Ultimately, the Civil War settled a dispute over the Constitution. The South really lost the war in the definitive Battle of Gettysburg, when Lee told one of his top officers (i.e. Pickett) to take a hill on which the Union was positioned. It was a gross waste of resources, because "Pickett’s Charge" cost Lee 15,000 men over the course of two battles. If I could go back in time just once, I would go to Lee that day and whisper in his ear "never try to take a hill from a downward position; you are at a disadvantage."

Another stifling factor for innovation and a primary cause of the housing boom has been grade inflation. You may raise your eyebrows at this thought, but just hear me out. There is a correlation. I believe the housing boom has been fed by two factors: excess global liquidity and diminished confidence in capital markets.

We can expect interest rates across the board to increase over the near term to address the excess liquidity and equilibrate capital demand with supply. The reason that there is excess capital is because people are putting their eggs in tangible assets and staying away from equity investments. They were burned in the Internet bubble of the early 00's and so they are staying away from equity investments. This fear is feeding the current housing bubble. People are moving their nest egg into real estate, which has historically returned 5% per year, adjusted for inflation.

This is part of the problem in 3rd world countries, where people lack confidence in capital markets. So, they buy something tangible such as land. However, land alone is unproductive. So, you have capital being invested in land, but not being made available for the capital markets, because there is a problem of transparency.

This problem stifles innovation, because people with ideas need capital to invest in R & D, which then causes the overall quality of life for the market in question to improve. This is what we mean, when we talk of "dead capital" in the 3rd world. Capital assets should be generating income; they should be put to use bringing the ideas on which capitalism is based to life through investment in R & D.

We in the US have our own problems with capital markets. In the US, people have lost confidence in capital markets as a suitable place for their nest egg. We can thank the accounting scandals for this. Why did we have the accounting scandals? I posit that the CPA's don't know how to audit anymore. Thus, they weren’t smelling rats, when they should have. This goes to grade and test score inflation. People are passing the CPA exam, who should not be, because they lack the necessary auditing skills to hold companies accountable to their financial statements, which is the primary information that investors use to base their decisions.

Now why do we have grade and test score inflation, you scratch your noggin? I posit that the reason these menaces exist is two pronged: a shift in the approach to education and the nature of the education business. The philosophy of education has transformed from one where an average grade was a "C" to one where the grades are inflated. There have been more perfect scores on the SAT in recent years than at any other time in history. Now, either we can give props to Darwin insofar as we are witnessing natural selection at work and our gene pool is flushing out the idiots, while keeping the geniuses, or the test itself is getting easier. There has been a shift in the approach to education. The education system has been moving toward enhancing student self-esteem. However, I think there is a larger problem at play.

When companies hire newly minted graduates, they hire those with the most A's. Businesses view schools that produce many students with high grades as providing a quality product. So, they have an incentive to “shop” there for skilled labor. In this context, the school has an incentive to inflate grades so that its graduates get top jobs or go to top graduate schools, which it can subsequently advertise to prospective students as the return that they will earn for choosing their school. The machine feeds off of itself.