The BP Oil Spill: Why Slow Is Much Faster

As I read an article in the online Wall Street Journal about the equipment failures leading to the disastrous oil spill in the Gulf of Mexico, I am reminded of a lesson that I teach my laboratory students. It is this: The fastest, cheapest way to get something done is to proceed slowly. Check and recheck each step before proceeding to the next. Don't rush and don't make assumptions. It is counterintuitive advice to give students, who like everyone else, are in a hurry. But, as BP is finding out, assumptions can be costly, time consuming, and deadly.

The Wall Street Journal investigation is the most complete account to date in the media of what went wrong on the Deepwater Horizon. It is a story of rushed procedures and faulty assumptions that appear motivated by schedule and budget considerations. For example:

• BP cut short a procedure designed to detect gas in the well and remove it before it becomes a problem.
• BP skipped a quality test of the cement around the pipe (despite a warning from the cement contractor).
• BP installed fewer centering devices than recommended (6 instead of 21).

The article also reported that on the day (April 20) the Deepwater Horizon exploded and sank, a disagreement broke on the rig over the procedures to be followed. A BP official had a "skirmish" with Transocean officials over how to remove drilling mud. BP prevailed and several hours later 11 people were dead and oil was spewing into the Gulf.

It appears that all involved knew corners were being cut, but a consensus emerged that the process would "most likely work." The cementing contractor Halliburton said that it followed BP's instructions, and that while some "were not consistent with industry best practices," they were "within acceptable industry standards."

But, the problem with complex equipment and procedures is that "most likely" can easily become "very unlikely" when everything has to function. Simply adhering to "acceptable standards" is no guarantee that everything will work.

This is lesson my students usually have to learn the hard way, even though it can be proved mathematically. Suppose you have a 90% confidence in your ability to make electrical connections. You think that if you wire your project without conducting tests, it will have a 90% chance of working. But, if you have 10 connections and each one must work, it is unlikely your project will succeed. The reason is that probabilities for simultaneous events multiply. If two events with a 90% chance of success must occur together, the likelihood of the combined events happening is (0.9) x (0.9), or 0.81, which is 81%. If 10 simultaneous events must occur, the chance becomes (0.9) multiplied by itself 10 times (0.9)¹⁰, or 0.35, which is a 35% chance of success.

A relative high confidence of 90% for a single can connection can be a deceiving number if all of them have to work. Worse still, when it doesn't work, you won't know why. It is difficult and time consuming to track down errors. The only solution is to spend extra time during assembly to test each connection when you make it, before proceeding to the next one.

I see this problem all the time when I teach. Students will follow the assembly instructions but do not perform the tests as they go along. They assume everything is correctly assembled. At the end they will have a beautiful piece of equipment that doesn't work. It is brought to me to figure out why and the students watch in dismay as I dismantle it piece by piece to search for the problem. Sometimes it is a mistake or misunderstanding on the first step, and that forces the students to begin all over again. They learn that time-consuming testing actually saves time.

It's not only students that struggle with this lesson. A friend once asked me for help wiring an external keyboard he purchased for a handheld device. He had followed the instructions, but after making all the connections it didn't work. Frustrated and confused he didn't know what to do next. He took it apart, put it back in the box, and called me.

He came to my office where I spread the parts out on my desk and followed the enclosed wiring instructions. But, after making each connection, I tested it with an electrical meter while twisting and pulling to make sure it was secure. I did this for every connection, because I made no assumptions about reliability based on how it looked or the high probability that almost all the connections I make are secure. When I finished, I turned the device on and it worked.

My friend said: "But, I wired it the same way you did. Why didn't it work?"

"You didn't do the same thing I did. You didn't test each connection when you made it. When it didn't work, you had no good way of finding a single bad connection, which is all that is needed for it to fail. I made sure each connection worked before I continued to the next one."

For highly complex equipment, such as on oil drilling platform, a 99.9% success rate for each step might not be acceptable. Consider a procedure that involves 10 steps with a 99.9 % chance of succeeding. The number 0.99910 is equal to .99, or 99%. A 1% chance of failure sounds safe, but the fact is 1% events happen frequently, about 1% of the time to be exact. If an event with a 1% frequency results in deaths, injuries, environmental and economic devastation, and possible bankrupting of the company, the risk is unacceptably large.

But, what is most disturbing is that even if the executives at BP making decisions understood the mathematics of risk it might not have made any difference. The root of cause the Gulf oil spill is the same as the root cause of the financial meltdown two years earlier. The executives take dangerous risks because they realize enormous personal gain when they succeed, while others will pay for the losses when they fail.

Imagine if Tony Hayward, BP's CEO, faced personal financial ruin from an oil spill. What if he had to contemplate having no yacht, no house, no assets, no job, and complete loss of livelihood? After all, those are the circumstances facing thousands of people on the Gulf coast as a result of the oil spill. What if Tony Hayward had to personally operate the equipment on the Deepwater Horizon so that its failure would end his life as it did eleven others? Do you think he would run his company differently? I bet if his life and livelihood were on the line he would make sure careful testing is done to insure safety for all concerned.

Unfortunately, the most likely outcome of this disaster is that nothing will change. There will be calls for tougher regulation, but, just like the financial overhaul working its way through Congress, change will be cosmetic. Opponents of more financial regulation use the same rhetoric as opponents of more oil industry regulation. They denounce increased regulation as an attack on "free markets."

But for "free markets" to work the agents must have a personal stake in the outcomes. Real free markets are composed of the thousand of small business owners and their workers who have a personal financial stake in their successes and failures. It's a sham to say that the executives of banks and oil companies are agents in a free market when they can only reap profits, while everyone else pays for their losses.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Financial Literacy: Maryland's Education Proposal

The Baltimore Sun recently published an op-ed piece by Maryland Comptroller Peter Franchot, supporting proposed legislation in the Maryland General Assembly to require all high school students to complete a stand-alone course on financial literacy before graduation. Franchot argues that educating our children in the basics of financial literacy will help avert future economic downturns. As is typical of many people in the government, he blames the recent economic crisis on bad choices made by consumers. Mr. Franchot writes:

"Thus, in far too many instances, we entered into financial commitments that we couldn't afford, with terms and conditions that we didn't truly understand, in order to buy things that we really didn't need. If more Marylanders had the benefit of sound financial literacy education, fewer of our friends and family members would be facing the loss of homes and life savings today."

I think teaching financial literacy to high school students is a good idea. But, the problems with the financial system go far deeper than a new high school course will fix.

First there is the problem with "stand alone" courses. To understand personal finance, students need to understand more about math, especially arithmetic, than they currently do. Many consumers made bad decisions on loans because they did not understand the basic math behind interest and payment calculations. My own belief is that personal finance education should be woven into current math courses. It would make math more interesting, and therefore relevant. Too many students, and adults view math as a "stand-alone" subject with no connection to their daily lives. If consumers learned just how many dollars their lack of mathematical knowledge costs them in the marketplace, they would see that math is an important subject.

Second there is widespread corporate-government collusion to deceive consumers and then blame them for falling victim to the deception.

I gave a talk on the U. S. mortgage crisis at an international conference on science in society at Cambridge University in the United Kingdom this past summer. In academic jargon the paper I presented was titled: "Quantitative Reasoning Applied to Modern Advertising." The term "quantitative reasoning" just means applying arithmetic to real-world problems. It is a way of thinking that is second nature to scientists, but unknown to most people outside of science.

I argued that if consumers learned some of these quantitative reasoning methods, they could greatly improve their day-to-day financial decision-making. I concluded that the best way to effect economic change is through the market. I said that people selling mortgages act according to their financial interests. In response, consumers need to educate themselves to make choices that are in their best financial interests.

After my presentation, an Australian economist, in a private conversation, disagreed with my conclusion. He said that home pricing, and mortgages are too complex for the average person to understand. It is incumbent on the government to regulate the market. He said that Australian government did not allow the kind of toxic mortgage products that brought down financial institutions in the US and UK, and wiped out millions of homebuyers. As a result, Australia did not have a mortgage crisis.

I admitted that my American bias influenced my conclusion. I told him that in the United States, government and corporate corruption is so institutionalized, that meaningful regulations to safeguard the financial well being of average Americans would never be implemented. From my viewpoint, education is the only realistic way American consumers have to protect themselves.

But, my viewpoint is not meant to excuse corrupt behavior. If you leave your house unlocked and are robbed, you made a bad choice. But, a crime was still committed. If you agreed to a mortgage that you didn't understand, you made a bad choice. But, the lender should have made sure that you understood the mortgage. Instead, lenders created mortgages designed not to be understood.

That is why I get so angry when I see government officials like Mr. Franchot blaming uneducated consumers for the financial crisis. Education is needed, but it will only go so far in fixing our financial problems. It will not replace trust. All parties to a contract must act in good faith for our financial system to work.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

The Big Snow: Fooled by Variance

No need to visit the gym this week, even if it were possible. I've had plenty of exercise shoveling more snow than I have ever seen at one time in my entire life. More than 4 feet of snow fell in the Baltimore region in just 5 days. As someone who grew up in Albany, New York, and attended schools in Rochester, New York and Madison, Wisconsin, a heavy snowstorm is not a novel event for me. I do not panic the moment flakes start swirling in the air, as many Baltimore-area drivers do. I often question the judgment of school officials, who close the entire system down when an inch or two of the white powder appears. But, 4 feet is an impressive amount of snow by almost any standard. I would not be able to drive anywhere even if I wanted to. Forward motion of my automobile is not physically possible under these conditions.

As snowfall totals go, this event has shattered records. That has kept the media and government people busy tabulating and interpreting numbers. The tabulations are of interest, but the interpretations are mostly silly. Nassim Taleb's wrote a brilliant book on investing titled Fooled by Randomness
. With apologies to Taleb, I've titled this post "Fooled by Variance," which is a condition afflicting a great many of the public statements about the storm.

Variance is a measure of the typical deviation of a measurement from its average value. The usual definition is that it is the range encompassing 95% of the measured values. For example, if we use our rulers to measure human stature instead of snow depth, we would find that the average height of an adult male in the United States is 69 inches. Of course, finding males taller or shorter than 69 inches is common. However, 95% of adult males have a height within 6 inches of the average-between 63 and 75 inches. That range is the variance. However, extreme cases outside of the variance still occur-male heights as short as 30 inches, and as tall as 100 inches have been measured.

In the past week media reports about the storm have referred to it as "a once in a lifetime event," "unprecedented," and "a hundred-year storm." In other words, the storm intensity was far outside the expected variance. But is that claim true? In the 16 years that I've lived in the Baltimore area, this is the third time that I've been snowed-in for an entire week. The week of January 7, 1996 delivered a similar one-two punch with 22.5 inches falling on January 7 and 8, followed by another storm a few days later with more than an additional foot. The blizzard of February 15-18, 2003, with 28.2 inches, remains the record holder for a single storm event. We will never know if the February 5-6, 2010 storm would have topped that number, because the observer, at the official airport weather station, did not follow the proper procedure in recording snowfall measurements.

The established procedure, for determining snow accumulation, is to wipe the snowboard clean every six hours, and then total all of the six-hour measurements. If you wait until the storm ends to measure snow depth, the number will be smaller because the snow will compact under its own weight. If you total more frequent measurements-say every hour-the number will be higher because of reduced compacting. Of course, there is nothing magical about totaling six-hour measurements. It is just an agreed upon protocol to insure that the snowfall amounts were measured under the same conditions, so that a comparison makes sense. But, it also shows that these numbers, and the "records" based on them, are to a certain degree arbitrary.

The 1996, 2003, and 2010 events were all massive paralyzing storms that in each case shut down the city for an entire week. There is not much difference between these three events, which would suggest that the natural occurrence of these kinds of storms is more frequent than "once in a hundred years" or even "once in a lifetime." Not that we would have anyway of knowing the actual intensity of a "hundred-year storm." Snowfall record keeping in Baltimore began in 1883-127 years ago-so we are many centuries away from having enough data to analyze for "hundred-year" or even "once-in-a-lifetime" events.

So should Baltimore be more prepared for large snow events? An article in the Baltimore Sun reports on the amusement of the northern cities. They brag that their streets are clear and their businesses and schools open. But, I lived for five years in one of the snowiest cities in the United States-Rochester, New York-with an average annual snowfall of 92 inches-about 7.5 feet. Actually, 4 feet of snow in 5 days would shutdown Rochester too. The high annual snowfall in Rochester results from lake effect flurries that blanket the city with light snow almost everyday during the winter. My freshman year at the University of Rochester it snowed for 60 consecutive days. It never snowed enough at one time to close the school, but over the course of the entire winter it resulted in an impressive snowfall total. Lake effect flurries mean that snow removal is an ongoing activity during the winter in Rochester. It is not an "event" like it is in Baltimore.

Apparently Rochester has a high average annual snowfall but not much variance. In contrast, Baltimore has a much smaller average annual snowfall-only 18 inches-but a large variance. It is rare, but it does happen that in Baltimore a single storm will dump more than an average annual snowfall. In Rochester it is nearly impossible for a single storm to deliver more than the average annual snowfall. Which means that it makes no sense to have the snow removal capability of Rochester. It would be an under utilized resource, and still not save us in extreme weather events, when the real problem is where to put all the snow that is plowed.

Although, if the climate changes, and monster snowstorms become frequent, then investing in more snow removal equipment would make sense. But a single storm event does not define a climate-a fact that commentators at Fox News are oblivious to. These global warming deniers were quick to claim that the storm "proved" that climate change theories are wrong. It is scary enough when science is politicized. After all, the laws of nature are oblivious to party affiliations. But the inane reasoning of Fox News is laugh out loud funny, a point made in a hilarious spoof on the Daily Show on how to misinterpret data. What is not funny is that Fox News commentators have such a high-profile platform to promote ignorance.



So what can we conclude about this event? The scientific answer is not much. Annual snowfall totals have a great deal of variance, especially in cities such as Baltimore where the annual average is a small number. In those cases, annual snowfall totals will not even form a normal distribution about a mean, because snow accumulations have no upper limit, but a lower limit of zero that cannot be breached. That means that the "average" annual snowfall isn't all that meaningful a number. It is the variance that we should be concerned about.

Cash for Gold Scams: Exploiting Desperation and Ignorance

With the price of gold soaring, while the economy falters, selling little-used gold jewelry has become an attractive means for raising extra cash. In early December of 2009, gold hit a peak of over $1200 per troy ounce, about 3 times the just over $400 per troy ounce it sold for 5 years earlier. As a result the melt value of gold necklaces, rings, and bracelets, has become a valuable asset for many jewelry owners.

That fact has also been noticed by gold dealers, who do a brisk business these days buying up unwanted jewelry in order to extract, and resell the gold content. Commercial TV, and the Internet are awash with ads offering cash for gold. Unfortunately, many of these "cash for gold" operations are scamming their customers. It is easy to fool people, because many jewelry owners have no idea how to estimate the worth of what they own.

The Today Show on Friday January 22, reported that heavily advertised online sites, such as Cash4Gold.com, only pay between 11% to 29% of the value of the gold. The reporter interviewed Ben Popken from the consumer watchdog site consumerist.com that did a study on Internet cash-for-gold offers. According to Popken a pawnshop would pay far more for your gold jewelry than many of these Internet sites. You can see a video of the Today Show report and interview with Ben.

The advice is to always get more than one offer for any gold jewelry that you sell. But, it is actually not that hard to appraise your own gold, and determine if an offer is reasonable or not. I've even created a Web calculator to assist in doing your own appraisal. All you need is a kitchen or postal scale that determines weights in ounces (oz). Place your gold chain on the scale to determine the weight.

Next you need to know the purity, which is expressed in carats. If you have the original packaging, the purity is usually on the label. The most common gold alloy used in jewelry is 14 carat (although 10 carat and 18 carat are also widely used). Pure gold is 24 carat, which means that a 14-carat chain has (14/24) or 0.58333 gold content.

The spot price of gold varies by the day. Updates can be found at many financial and precious metal Websites, such as goldline.com. Today the price is about $1100 per troy ounce. A troy ounce is slightly more than a postal, or food ounce, it is 1.09714 ounce to be exact. That means an ounce measured on a postal scale is (1/1.09714) or 0.91146071 troy ounce.

Those are all the numbers you need to appraise the gold content of your jewelry. Suppose your 14-carat gold chain tips your food scale at 1.5 ounce. You own (14/24) x 1.5, or 0.875 ounce of gold. That is 0.875 x 0.91146071, or 0.7975 troy ounce. The dollar value today would be $1100 x 0.7975, or $877.

Obviously no dealer will offer you that much for your gold chain. The dealer needs to cover costs of overhead, purifying the gold, and reselling it. The dealer will not be in business without a markup. But, if you are offered $250 for the chain, an amount that might seem like a lot, you are getting ripped off. The dealer's services are not worth that much of a difference between the spot price and the offer. A local pawnshop might offer 75% of the value, or $658.

If you want to estimate the value of your gold, get out your food scale and use this calculator.

Debit Card Deceits: When Zero Isn't The Floor

Debit cards have become a popular alternative to credit cards because they have many of the conveniences of credit cards without actual debt. I have come to rely more and more on my debit card because I don't have to carry a checkbook and hold up checkout lines with identification hassles every time I write a check. I simply swipe the card and go on my way. Money is deducted directly from my checking account, just as if I wrote a check. Once I deplete my checking account balance, the card stays in my wallet until the next payday. It appears to be a full proof system for staying out of debt.

However, appearances can be deceiving because the belief that you can't get into debt using a debit card is based on a false assumption. Account holders naturally assume that once the balance is zero, transactions will be declined. The reality is banks will process the transaction even if the money is not in the account and then assess hefty overdraft fees. The account holder becomes liable for the purchase, the overdraft fee, and any additional fees that the bank dreams up.

My teenage daughter had a recent run-in with debit card fees. She does not have a credit card, but she has a checking account at M &T Bank with a debit/ATM card, and a job with direct deposit for her paychecks. Like many consumers, she believed that a debit card protected her from ever spending more than the balance in her account. However, a couple of small purchases during a night out with friends unleashed a cascading series of bank charges put the balance on her account hopelessly below zero.

At a local eatery she bought a sandwich for $8 and then moved across the street to the local coffee shop where she made a $4 purchase. She thought her checking account balance was low, but each transaction on her debit card was approved. What she didn't realize is that because she did not have the money to cover either purchase, each transaction triggered a $35 overdraft fee. Checking her account online the next day, revealed that she was now more than $70 below zero. She thought the problem would be solved in a few days when her paycheck for $90 would be posted.

However, that was another false assumption. M&T's fee structure imposed a $10 charge everyday that the account remained below zero. By the time the $90 arrived she was more than $100 in the red and counting. Her paycheck vanished and the $10 daily charges continued. The next $90 paycheck would be in two weeks. It had become mathematically impossible for her get out of debt.

After learning all this, I understand why payday loan operations continue to thrive despite their exorbitant fees. In some circumstances, a payday loan is a much better deal compared to a bank. For low-income people with small balances, a simple math error made while shopping can cause unrecoverable financial harm if a bank is involved.

Because my daughter wanted to be responsible for her own finances, she avoided telling me what was happening. I found out by accident, when coincidentally, another problem occurred with her account that prompted the bank to call, and I answered the phone. Someone had obtained access to her debit card number and was making fraudulent purchases. These transactions, totaling hundreds of dollars for purchases in places outside the United States, had not been declined either. But the bank's monitoring systems had flagged them as suspicious and called to verify their authenticity.

We had to visit the bank and fill out paperwork certifying that the transactions were indeed fraudulent so that the charges could be reversed. By the time we arrived, the fraudulent purchases, multiple overdraft fees, and daily charges had resulted in a checking account balance that was close to $1500 below zero.

I asked the M&T bank manager: "At what point does the balance get so far below zero that transactions are declined?" Interestingly, he did not have an exact answer to that question. He indicated that there are limits, but that the limits are not hard and fast. From his point-of-view, the bank was doing a favor by allowing purchases to go through even if no money was in the account to cover them. Of course, it is an unasked favor, for which the bank is charging fees that are often far greater than the purchase amounts in question.

On reflection, I found the bank's priorities deeply unsettling. After all, M&T had asked us to come in, but it was the suspicious pattern of activity that triggered the phone call, not the negative balance. A $4 purchase at a local coffee shop that resulted in hundreds of dollars in fees is part of the bank's business model. A $300 purchase for tickets to a Canadian amusement park that my daughter couldn't possibly have made, is a threat to the bank's business model. The latter event triggered a phone call from the bank; the former event did not concern them. The bank had no moral qualms about appropriating my daughter's entire paycheck for a $4 coffee purchase, but acted outraged by someone taking money from the bank.

After reversing all the fraud, we still had the negative balanced caused by the fees associated with the legitimate purchases. I managed to negotiate reversals for all but the first overdraft fee. That restored her account balance to a positive number and eliminated the daily $10 charges.

However, I found agreeing to even one overdraft fee a distasteful compromise given that my daughter never agreed to overdraft protection in the first place. In fact, not only do banks provide an expensive service that is not always wanted, but they also deceive customers further by re-ordering transactions to maximize fees. Suppose you went shopping with $100 in your account and made purchases of $4, $6, $8, and $102 in that order. You might think that the $102 purchase at the end would trigger a $35 overdraft fee because you had a large enough balance to cover the first three purchases. But, at the end of the day the bank would assess $140 in fees by re-ordering the purchases. It would process the largest purchase first as an overdraft, followed by the other three small purchases all as overdrafts.

These practices might be changing because Congress is debating new legislation that would require banks to get your permission before setting up your account with expensive overdraft protection. Consumers are also fighting back. Eileen Ambrose reported in The Baltimore Sun that Maxine Given of Baltimore County, sued M&T Bank, claiming the bank's overdraft program violates Maryland's consumer protection laws. And, as Bob Sullivan reported in his Red Tape Chronicles, consumers are leveraging the power of social media online to publicly embarrass and shame the shady practices of many banks. Let's hope Congress gets the message and enacts meaningful consumer protections.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

The Public Option for Healthcare: Logical Flaws in the Argument Against

I am mystified by the arguments presented by opponents of the “public option” for health insurance. Their line of reasoning has a rather obvious logical flaw. The gist of the argument against the public option is that it would lead to a government take over of the entire health care system because private insurers couldn’t compete with the government. Opponents of the public option say that would be a bad outcome because government-run-health care would not be able to provide the kind of health care services people want and need. Their underlying assumption is that any health care plan run by the government would be an inferior product compared to private health insurance.

But, that assumption is the source of the logical flaw. Since when is it a competitive advantage to offer an inferior undesirable product? If public health care were really as bad as opponents claim, why would anyone choose it? It seems that the real fear opponents of the public option have is that many people might find it an attractive choice. But, if it’s an attractive choice, why is that a problem?

Actually the market place is full of examples where private, for-profit companies compete successfully against government-run or non-profit entities.

My job at a private college is not threatened by the existence of cheaper public schools.

Rural electric cooperatives are not a threat to for-profit electric companies because those companies do not find it profitable to serve the rural market.

Package delivery services provided by private companies such as UPS and FedEx compete successfully against the “public option” of the U. S. Postal Service.

The existence of member-run credit unions did not put private banks out of business.

In fact the banks managed to fail by themselves; no outside competition was needed. That fact calls into question the entire assumption that privately-owned equals competent and efficient while government-run equals inept and wasteful. To borrow the title of a recent book on the collapse of Lehman Brothers, “a colossal failure of common sense ” permeates the management of many privately run companies.

No organization, public or private, is immune from ineptness and mismanagement. But, if I worked for an organization that I perceived as incompetent, I would work to fix the problems or find another job. I would not contribute to the problems just to prove my point that the organization is dysfunctional. Unfortunately, many members of Congress work for the government solely to prove that government doesn't work.

Actually, private and non-profit health insurers already compete head-to-head in the marketplace. My health plan through my employer is with a non-profit company. Its existence hasn’t put the private for-profit health insurers in my state out of business. I fail to see how public health insurance for people not currently served can be a threat to the existing private insurance system.

No one has suggested that private insurance and private health care be outlawed. This being America, I have no doubt that those who have the jobs and income that provide adequate health care will continue to receive the kind of care to which they are accustomed. The issue is how do we as a nation provide care for the tens of millions of fellow citizens who are not served by the current system. Many of the uninsured have zero options available. Every other developed nation in the Western world takes care of its citizens. How can the richest nation of them all, claim it cannot afford to?

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

UK Trip Part I: Executive Compensation

I just returned from a trip to the UK where I spent four days touring London and then four days at Cambridge University where I gave a talk about the mortgage crisis in the United States. It struck me perusing the London media just how many of the banking problems in the UK mirror those in the US and even more striking, how the rhetoric matches word-for-word.

A British tabloid-style newspaper—The Independent—ran a headline on August 4: ‘Big bonuses? It would be wrong to stop paying them.’ Beneath it ran the subheading: "Barclays’ £50m-a-year boss delivers a defiant rebuff to critics who say bankers are overpaid." Quotes in the article could have been lifted from the financial section of any newspaper in the US. Here is a sampling:

“performance-related bonus payments were vital given the bank's "obligation to run a client-first business”

“It is pay for performance and it is based on principles we have followed for a while now.”

“It would be wrong for the bank not to pay out ‘if we had really good performance.’”

And my favorite quote described seven-figure bonuses as:

“essential if we want people to work in our industry”

When I returned home, the first headline I saw in my local paper, the Baltimore Sun read: “CEOs paid more even as profits fall” followed by the subheading: “Debate swirls as most of the area's 10 top-earning CEOs receive higher compensation during a recession that has dragged down many companies' stock prices and profits.”

The reporters analyzed the compensation for 20 Baltimore-area companies that paid their CEO at least $1 million and found that 17 received compensation increases even though in most cases company profits fell. The reporters obtain their compensation figures from documents filed with the SEC. The company spokepersons who responded to questions couldn’t give the usual “pay for performance” justification without sounding completely out of touch with reality. Instead elaborate mathematical manipulations were offered to convince everyone that the figures for executive pay on SEC-required filings were misleading because of SEC-enforced rules. The spokespersons insisted that the pay the CEOs actually received was much lower. I don’t know if I should take comfort in the argument that federal law requires that SEC documents misrepresent actual pay.

It occurred to me as I read the articles in Baltimore and London that no matter what order of magnitude is attached to compensation figures, spokespersons for the industry will argue that it must be at that level. As the recession squeezes budgets, teachers with 5-figure incomes warn public education will suffer if salaries are cut, medical doctors making 6-figure incomes warn that public health will suffer if government-run healthcare puts limits on their income, and here we have bankers with 7-figure incomes arguing that banks will fail to function if CEO compensation is limited. It appears that compensation is like closet space, no matter how much you have, expenses will expand to require all of it. Any reduction in income then becomes unimaginable.

However, I find the logic for executive compensation interesting on many different levels. First it would be interesting to know if independent studies have found cause and effect relationships between executive pay and company performance. Recently I came across a study on the relationship between the cost of executive homes and company performance.

Two business professors, Crocker H. Liu and David Yermack, conducted a study reported in a paper titled: "Where are the Shareholders Mansions? CEOs Home Purchases, Stock Sales, and Subsequent Company Performance." The study found an inverse relationship between company performance and CEO stock sales to finance large real estate purchases. In other words the bigger the CEO’s home the worse the company performs. The authors concluded that, “regardless of the source of finance, future company performance deteriorates when CEOs acquire extremely large or costly mansions and estates.” It is wrong to generalize from a single study but it does suggest that the justifications for high executive compensation might not hold up when the facts are examined.

A large part of the problem as Jay Hancock pointed out in a recent column is that CEO pay is not negotiated with the company owners. Boards of directors determine CEO pay, not the shareholders who actually own the company. As a result market forces don’t work, an observation made by the father of free-market capitalist principles Adam Smith more than two centuries ago. It is worth reading the entire section below from Smith’s treatise The Wealth of Nations because it describes exactly the problems with executive pay today.

“The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. The trading stock of the South Sea Company, at one time, amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds. The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.”

Adam Smith understood that “negligence and profusion” would always prevail in the management of publicly traded companies because the directors are not the owners. Of course newspapers like to report on the excesses of high-living executives and print their self-serving explanations because of the public outrage stirred. There is an obvious “two-headed quarter” in play that angers people. Executives profit handsomely when performance is good and profit handsomely when performance is bad.

However, I see an attitude that is even more deeply troubling. Beyond the conflicts of interest Adam Smith described, the idea that seven-figure salaries are essential or there would be no executives might be a more revealing testament to the cause of dysfunction in corporate America.

For most people pay is a necessary condition to work but not sufficient. Motivating people to do a job well usually requires more than money. For many people work is an opportunity to perform a social good and contribute to a cause larger than oneself. Teachers teach and doctors practice for reasons beyond money.

But, the apologists for high executive pay, talk about compensation and performance only in monetary terms. This is an attitude that does a disservice to the majority of their own employees. When I go into my bank the people who work there seem genuine in wanting to help me. It is a social transaction, not just financial.

I am well aware that in any industry, compensation is determined by market forces that have more to do with scarcity than the value of the work to society. It is for those reasons major league baseball players will always make orders of magnitude more than teachers. But success in teaching and sports is usually defined in non-financial terms. To do the work requires a desire for more than just money.

The evaluation of executives needs to include more than just financial measures. There needs to be ethical and societal dimensions when evaluating the performance of executives because the decisions they make have impacts far beyond the company stock price. The underlying assumption behind performance evaluation—rising stock price equals good; falling stock price equals bad—is overly simplistic. When large companies fail many more people than the shareholders lose.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy