We seem to be living in perilous times. Parts of the United States government are shut down because the House and Senate can’t agree to either fund or defund Obamacare, whose rollout this month has been an unmitigated disaster. This impasse now threatens the looming deadline to raise the debt limit before the Treasury supposedly runs out of money sometime in the next 48 hours.
Many people around the world fear that the United States might default on its debt if Congress fails to raise the debt limit. The consequences of default would be far-reaching and hard to predict because so much of the world economy is based on the US dollar and the ”full faith and credit” of the US government to honor its debts.
In recent days several friends have asked what I think about this situation. My position is that default is inevitable, but I’d be very surprised if it happened this week. Here’s why:
Most of the Federal budget, nearly 60% of it, is taken up by entitlement programs. People who qualify for these programs, like Social Security and Medicare, are legally entitled to their benefits. The government cannot reduce these benefits without changing the law. About 30% of Federal spending is discretionary, meaning that the government can choose to cut it without violating any laws. And interest on the national debt accounts for less than 7% of the Federal budget.
The problem is that current Federal spending is about 24% of GDP (gross domestic product, i.e. the total value of all goods and services produced by our economy each year), whereas the Federal revenue (taxes) are only about 15% of GDP. So for every dollar the Government collects in taxes, it’s borrowing and spending an additional 60 cents.
That borrowing represents 38% of the Federal government’s funding, which is greater than the 30% of the budget taken up by discretionary spending. So even if we slash discretionary spending to zero, we can’t fund both our current entitlement spending and our interest payments without additional borrowing.
This means we’re in pretty bad shape today, but it’s only the beginning of the story.
In the days before Obamacare became law, the non-partisan National Taxpayers Union issued a report on the unfunded liabilities of then-current entitlement programs. In other words, understanding that we’re going to have greater numbers of older, sicker people in the future and fewer workers funding Medicare and Social Security, how much extra money would the Federal government need to have on hand today in order to deliver all the benefits it has promised under these programs for the next 75 years without raising taxes?
The answer: About $46 trillion. That’s about three times the current United States GDP. And that’s before factoring in the Obamacare subsidies that will theoretically help defray the cost of health insurance for lower-income Americans once the websites stop crashing.
The National Center for Policy Analysis published a similar study 10 years ago, before the Medicare prescription drug benefit (Part D) became law, and the numbers were similar. Authors Jagadeesh Gokhale and Kent Smetters predicted that the fiscal funding gap would be around $50 trillion including Medicare Part D. They calculate that the gap could be closed by a permanent increase in payroll taxes by about 15%, or by raising income tax revenues permanently by about 60%.
This entitlement funding gap is frighteningly large, much larger than the value of the national debt that causes so much political hand-wringing. Each year we’re spending more than 8 times as much on entitlement programs as we are on those interest payments that we’re supposedly going to miss if we don’t raise the debt limit. But we don’t have a meaningful national discussion about entitlement reform.
For all this talk about defaulting on our debt obligations, why aren’t we talking instead about the inevitable default on our unsustainable entitlement spending?
Part of the problem is that this conversation necessarily involves math, and a recent study suggests that less than 10% of US adults are likely proficient enough to understand a question of this complexity.
Beyond ignorance, the obvious answer as to why we don’t talk about entitlement reform is that these programs are untouchable. Any attempt to alter them in a meaningful way is political suicide. This feature was admittedly designed into the programs in the form of payroll taxes. As FDR said:
We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program. Those taxes aren’t a matter of economics, they’re straight politics.
Well done, then. 78 years later and still working as designed.
Medicare, like FDR’s Social Security, is funded through payroll taxes.
Incidentally, some policymakers wanted health insurance as part of the original Social Security Act of 1935, though they feared that including health insurance would jeopardize the entire bill, so it was left out.
In piggybacking Medicare on top of Social Security and using payroll taxes to fund this new entitlement, LBJ guaranteed that Medicare would be just as politically sacrosanct as its forerunner. And 48 years later, Medicare is still as untouchable as ever. It has been amended several times but has always grown in size and scope.
In spite of their shared political knack for creating these fiscal black holes, FDR and LBJ are not the worst villains in this story. That distinction belongs to LBJ’s successor, a man whose infamy seems to have denied him the privilege of a three-letter sobriquet.
Richard Milhous Nixon did not create Social Security or Medicare, but the magnificently reckless monetary policy maneuvers that he undertook to boost his chances of re-election effectively forced central banks around the world to hold the US dollar as their primary reserve asset, making them complicit in anesthetizing the United States to the fiscal pressures of these two entitlement monsters plus profligate discretionary spending, thereby lulling us into a false belief that our government can be exceedingly generous to all without anyone ever having to pick up the check.
When Nixon unilaterally defaulted on our obligations under the Bretton Woods system back in August of 1971, he set us up to run chronic fiscal deficits with no real consequences. And but for a period of fiscal sanity in the late 1990s, we have done just that:
So we find ourselves in the present crisis, stuck between a fiscal rock and a monetary hard place, with massive unfunded entitlement liabilities on one hand and an endlessly-growing national debt on the other. There is no way out but through some kind of default:
- We could default on our bondholders. One of my professors once said that when sovereign debt reaches unsustainable levels, default is inevitable. And a nation can either default quickly through a restructuring, which is a euphemism for “we aren’t going to pay you back” (see Argentina), or do it slowly through deliberate inflation, i.e. paying off an unsustainable debt with cheaper dollars in the future (arguably the Fed’s present and future course of action). A restructuring of US debt is unfathomable at present as we can (at least for now) easily afford our interest payments. And in spite of what seems like partisan gridlock, the Treasury still has a few tricks up its sleeve before it throws in the towel.
- We could default on the old, the poor, and the sick. Restructuring Social Security and Medicare seems like a good idea given more than $46 trillion in unfunded liabilities tied to these programs, in addition to the still-unknown cost of the Obamacare subsidies. But by design any of these reforms will entail a steep political cost, and the proverbial chickens likely won’t come home to roost until today’s politicians have retired or died. It may take a threat of (or even an actual) default on our debt in order to compel the government to undertake meaningful entitlement reform. Some low-risk options for restructuring these programs include significant phased increases in the age of eligibility and financial incentives for families to complete end-of-life planning (advanced directive, living will, medical power of attorney, etc.)
- We could default on taxpayers. Granted, there is no prohibition against raising taxes in the future, but a social contract most definitely exists between taxpayers and the government wherein the government promises fair services in exchange for a fair tax rate. We will likely need some type of tax increase in order to close the entitlement funding gap, and any tax increase will be politically risky. We could theoretically minimize political fallout by increasing taxes on only the so-called “rich”, though this type of default cuts both ways in the tax game and is therefore of limited utility in practice.
We’re in a tough spot, and there is no easy way out. We’re ultimately going to have to restructure both our tax code and our entitlement programs if we want to regain the kind of fiscal and monetary discipline that will allow future security and prosperity. These entitlement and tax defaults will be painful, but they will be much more manageable than a disorderly default on our debt.
The most immediate question, then: Who is in a position to lead us through this transition?
My wife and I teach our three children at home. This is a rather generous assertion on my part, as she does most of the teaching. My primary job is to keep the whole endeavor funded. Beyond that I also teach the sciences, higher math, wood shop, physical education, and occasionally music.
Society calls what we do “homeschooling”, a semantically-ambiguous term that generally refers to families who opt out of both public and private schools and take full personal responsibility for the education of their children. But our reasons for doing so are different from those of the millions of other families who follow a similar path. In fact, there are probably as many reasons to homeschool as there are homeschooling families.
In conversations with friends I regularly find myself answering the question, “What made you decide to homeschool?”
My wife likes to say that we started teaching our children as soon as they were born. We helped our kids learn to roll over, sit up, crawl, stand, walk, and run. We taught them to speak, read, and write. We were among a small minority who did not send our kids away to preschool. Instead, we picked up a homeschool kindergarten math curriculum from Saxon.
We soon found ourselves facing a dilemma: Our oldest daughter was a year ahead in math and several years ahead in her reading and writing by the time she was supposed to be starting kindergarten, not because she is a savant or child prodigy, rather because we taught her those things at an early age when she was ready for them. Should we put her with peers her same age so she could “fit in” socially but be bored academically, or should we put her with peers of similar ability and have her be a social misfit among older kids?
Neither of these was an acceptable option, so we rejected them both. We opted to in-source the teaching and relied on church, music, sports, and other networks for social connections to her peer group.
This period of our lives coincided with my time in graduate school, and I enjoyed applying what I was learning there to the questions we were facing at home regarding education. I understood that our daughter was a statistical outlier among her peer group at the time in terms of her math and reading skills, but those aren’t the only two types of intelligence, and in all likelihood she was below the mean in some other areas. By the law of large numbers, the education system in general (and the classroom setting in particular) caters strictly to the mean. So how could an undifferentiated classroom experience possibly be optimal for anyone who is an outlier, positive or negative, in any dimension?
The answer, of course, is that such an experience is not optimal for any student. And that fact is obvious when you consider the way the system is constructed. Any rational system is designed to economize around its most scarce resource. For example, certain parts of our healthcare system are characterized by big, expensive buildings filled with expensive people and expensive equipment. Why do we build these expensive hospitals and make the patients show up and wait around? Because the doctors and the equipment they use are the most scarce resources in the system. We optimize the system to make sure that those resources are fully utilized, and we waste the more abundant and less-valuable resources, like the patients’ time.
Our education system is similar. We build big expensive buildings and fill them with expensive (unionized) teachers. We make the students come to the buildings and do a lot of sitting around, standing in line, waiting their turn, etc. Why? Because we view the teachers as the most scarce resources. We optimize the entire system around the most efficient use of their time. Individual student outcomes are of vanishingly small importance.
It’s the collective outcomes that matter most to the education system. Public schools in the United States are modeled after the system established in 18th-century Prussia, whose purpose was to instill in its citizens the doctrine of social obedience to the King and to produce a steady supply of qualified labor for the bureaucracy, the military, and emerging industry.
In other words, the education system was not designed to produce excellence (positive outliers), rather a predictable mean and narrow standard deviation. Why? Because people who think the same are easier to govern, easier to lead into war, and easier to manage at work. To these age-old insights I will add a modern one: It’s also much easier to market to a population that has been systematized into thinking the same way.
I have a habit of waxing verbose on these points whenever I am asked why we homeschool. After one such conversation a few weeks ago, a good friend sent me the following illustration of a TED talk given by Sir Kenneth Robinson. It’s worth watching because it conveys these same ideas graphically and much more succinctly than I do:
So I have come to understand that our fundamental reason for homeschooling our children is because we see unique greatness in each of them that we don’t want the system to destroy in its endless quest to reduce variance. We want our children to think in ways that are not strictly correlated with how everyone else thinks.
And in the present environment, the stakes are so high that we cannot afford to outsource this job to anyone else.
That’s why we homeschool.
One percent of Americans now earn a greater share of income than at any time since the 1920s, according to this article posted today. The top 1% of income earners, those who earned more than $394,000 last year, accounted for more than 19% of all income reported to the IRS, while the top 10%, or those who earned more than $114,000, accounted for more than 48% of all income.
I got upset when I read this article. I don’t think it’s fair. And I think something needs to change.
Specifically, I don’t think it’s fair to any of us that the standards of journalism have sunk so low that an AP reporter can get away with publishing a handful of numbers buried in a steaming pile of opinion and pass it off as “news”.
Nassim Taleb rants in his excellent book The Black Swan about how he does not read the news. He relies instead on prices to communicate what’s going on in the world, because prices are purely objective. He ridicules outlets like Bloomberg that try to explain price movements with a narrative that connects them to other events. No doubt you’ve seen the following occur: The market opens lower, and Bloomberg runs a headline “Stocks down on interest rate fears.” And then by lunchtime the market has rallied for some random reason, and Bloomberg changes the headline to “Stocks up on interest rate optimism.”
Of course investors don’t change their mind on interest rates between breakfast and lunch, unless Bernanke happened to make a statement to the press in the meantime. And Bloomberg certainly can’t tap into the thoughts of millions of market participants that quickly with any accuracy. These headlines are absolute rubbish, but we eat them up and come back for more. Taleb attributes this irrational behavior to what he calls the “narrative fallacy”, or our inability to look at facts without trying to come up with a story that ties them together. Everyone seems to want to find a narrative, and every narrative, no matter how far-fetched or even ridiculous it might be, will seem plausible to at least one person.
Let’s apply this lens to the AP article on income inequality. But before we do, I need to rant a bit myself:
I am frustrated with the lack of semantic precision found in most news articles about the economy, particularly the confounding of two concepts that are related but very different: Wealth and income. Too many reporters use these words interchangeably. This lack of discipline (together with lousy education, more on that later) is responsible for spreading a plague of economic and political confusion among the general public.
Wealth is a “stock” variable that describes what you have accumulated. It is expressed in units of money, like dollars. It is your net worth, i.e. the sum of your assets less the sum of your liabilities. It’s the value of your bank accounts, your property, your investments, etc. minus the value of all your debts. It’s the equity on your personal balance sheet. Ideally you want this number to be greater than zero.
Income is a “flow” variable that describes the rate at which you acquire wealth. It’s expressed in units of money per unit of time, like $20/hour or $114,000 per year. Generally speaking, you also want this number to be greater than zero.
But describing personal finance using these two variables is problematic for the popular discourse, because we find it convenient to distill reality, in all of its rich detail, down to a series of false dichotomies in order to simplify the talking points. For example, the terms rich and poor.
What does it mean to be rich? Does it mean high wealth, high income, or both? The answer to this question may seem irrelevant to many Americans considering our labor force participation rate of just 63.3%. There are an awful lot of people who would be happy if they were just a little better off than the status quo. But rich people have high wealth. There isn’t such an easy term for high-income people, so lazy reporters and politicians often call them rich as well. And while high income is correlated with high wealth, it doesn’t necessarily cause high wealth because one can always spend more than he earns.
Even with unambiguous definitions of wealth and income and our best efforts to avoid the narrative fallacy, income statistics can be hard to understand for a number of reasons. So lets go back and walk through that AP article.
We get off to an inauspicious start with the first sentence:
The gulf between the richest 1 percent and the rest of America is the widest it’s been since the Roaring ’20s.
The erroneous use of the word “richest” to describe the concept of income rather than wealth allows the author to foist another subtle lie upon us: That the top income-earners are an exclusive fraternity whose membership has not changed since the Roaring ’20s. You know, a cabal of old rich guys like Charles Montgomery Burns who’ve been waiting for this “Excellent!” opportunity to return to their pre-Depression glory days.
In fact, the composition of the 1% changes dramatically from year to year. In addition to the perennials like Bill Gates, Warren Buffet, and Mr. Burns, the 1% club includes transitory members like the salesperson who had a great year after spending the previous two living on her modest base salary while she built customer relationships in a new territory, and the farmer who had a bumper crop after getting wiped out by drought the previous year, and the entrepreneur who sold a business he had been running on a shoestring budget for several years without taking a salary himself.
These people and many others like them have a lot of lousy-to-mediocre years and a handful of great ones because they take big risks, and sometimes those bets pay off well.
The author continues:
In 2012, the incomes of the top 1 percent rose nearly 20 percent compared with a 1 percent increase for the remaining 99 percent.
The richest Americans were hit hard by the financial crisis. Their incomes fell more than 36 percent in the Great Recession of 2007-09 as stock prices plummeted. Incomes for the bottom 99 percent fell just 11.6 percent, according to the analysis.
But since the recession officially ended in June 2009, the top 1 percent have enjoyed the benefits of rising corporate profits and stock prices: 95 percent of the income gains reported since 2009 have gone to the top 1 percent.
That compares with a 45 percent share for the top 1 percent in the economic expansion of the 1990s and a 65 percent share from the expansion that followed the 2001 recession.
Again, the use of subtle language like “the incomes of the top 1 percent” implies that each member of last year’s top 1 percent got a 20% raise this year. Use of the singular, “the income of the top 1 percent,” would be factually and grammatically correct. We have no way of knowing the average increase for any individuals year-over-year.
The author repeats the same pattern of flawed reasoning and subtle linguistic hints throughout this section, attempting to construct a fictitious narrative of a typical 1%-er during and after the financial crisis using aggregate data, as if, say, the bearish money managers who did well during the crisis were the same people who profited from the market’s recovery in mid-to-late 2009. And to finish this exercise in fallacious reasoning the author compares these imaginary individuals with their younger imaginary selves from 2001 and even the 1990s, apparently to show that if there was such a person who was fortunate enough to have been a member of the 1% club for 23 straight years, he would have done exceptionally well this year by comparison with his measly-but-still-1% performances in past bull markets.
The author goes on to provide a couple of useful numbers that I already included in my introduction, and then comes the following important disclaimer:
The income figures include wages, pension payments, dividends and capital gains from the sale of stocks and other assets. They do not include so-called transfer payments from government programs such as unemployment benefits and Social Security.
In other words, they’ve assumed that the 37% of Americans who have given up looking for work have no income at all, even though we are supporting them with myriad entitlement programs. And these figures also include the 13% of Americans over the age of 65 who are living on Social Security, but we don’t count those payments as income, either. So fully 50% of the population, according to this study, effectively has zero income!
Might that little fact explain why this analysis found such a small increase in the income of this population since 2009? They’re not working!
And now, I present to you the narrative fallacy in all its glory:
The gap between rich and poor narrowed after World War II as unions negotiated better pay and benefits and as the government enacted a minimum wage and other policies to help the poor and middle class.
The top 1 percent’s share of income bottomed out at 7.7 percent in 1973 and has risen steadily since the early 1980s, according to the analysis.
Economists point to several reasons for widening income inequality. In some industries, U.S. workers now compete with low-wage labor in China and other developing countries. Clerical and call-center jobs have been outsourced to countries such as India and the Philippines.
Increasingly, technology is replacing workers in performing routine tasks. And union power has dwindled. The percentage of American workers represented by unions has dropped from 23.3 percent in 1983 to 12.5 percent last year, according to the Labor Department.
The changes have reduced costs for many employers. That is one reason corporate profits hit a record this year as a share of U.S. economic output, even though economic growth is sluggish and unemployment remains at a high 7.2 percent.
Every one of these statements is an opinion with enough facts sprinkled in to make the author sound credible. But there are numerous other plausible narratives that could explain how we got to where we are. Here’s my version:
The distribution of incomes narrowed after World War II as millions of employable men returned home to cities rather than their family farms, swelling the ranks of labor unions as they took private-sector manufacturing jobs that paid better than military service or manual labor on the farm because they created more economic value than these alternative uses for the same labor.
The trend toward urbanization and industrialization continued until the early 1970s, when increased manufacturing automation, information technology, liberalization of trade, and floating currencies forced manufacturing workers to begin competing against machines and cheap offshore labor.
Meanwhile, easy monetary policy began to inflate the prices of financial assets held disproportionately by wealthier Americans and eroded the purchasing power of the working classes due to a politically-rigged Consumer Price Index, which decline in household purchasing power coincided with the rise of feminism to encourage more women to join the workforce.
This increased the supply of labor but not the demand for the same, which further depressed wage growth, which made the two-income household a modern necessity and deprived children of many of the emotional benefits enjoyed by the previous generation, which in turn coincided with the dumbing-down of public education and ultimately condemned a huge segment of the rising generation to chronic under-achievement.
Which is how we arrived where we are today: Greater variance in household incomes than at any time recent memory, and no easy way to fix it.
Especially if we allow such lousy reporting to frame the problem inside a politically-convenient narrative that hints at “solutions”.
Regarding my last post about carving up Microsoft, here’s a Twitter conversation with a good friend that merits some elaboration:
@zmortensen Oh, and spin out Xbox separate from consumer? Crazy talk.
— Jason Sherron (@cheapredwine) September 10, 2013
I believe that Xbox is not immune from the please-your-best-customer plague that afflicts the rest of Microsoft and kills off disruptive innovation. Here’s why:
One of the coolest things that happened during my tenure at Microsoft was the development and launch of the Kinect sensor for Xbox. Using Kinect for the first time — playing a modded version of Forza 3 at the house of a friend who was on the dev team long before the product had a name — was a frighteningly cool experience. It was instantly clear to me that the technology had immense potential to broaden the reach of gaming beyond the traditional target market that skews young, male, and geeky.
My kids were even invited to be Kinect testers before launch. One afternoon we worked our way through a labyrinthine warehouse near the old company store until we found a mocked-up living room. The kids got some snacks and played a pre-release build of Kinect Adventures. They were absolutely mesmerized. The testers were gathering data on the performance of the sensor, and about a week later they called me up and asked me to bring my then-3-year-old back for a second round. “We just fixed a bug that affects only short skinny kids with long hair, and she’s our ideal test case.”
I had high expectations for the product based on these experiences, and the Kinect launch just blew them away. The product was a runaway success, a proud moment for Microsoft when we really needed a hit.
A few months after the launch I got a call from an executive on the Kinect team who wanted to meet to discuss the healthcare market. I paired up with a colleague and we headed over to the side of campus where all the cool kids work.
At the meeting we learned that their phone had started ringing off the hook as soon as the product launched, customers and partners were calling with all sorts of ideas about how to use Kinect in different verticals. Not being a group particularly concerned about customer intimacy, Xbox just told them all “No.” The phone calls soon became frequent enough that the team hired a guy just to answer the phone and tell everyone “No,” which he dutifully did. But being a smart guy, he started keeping a record of who was calling, what industry they were from, and what their idea was before he gave them the obligatory “No.”
After a few months the smart guy found this job pretty depressing. So he created a report for his bosses that showed the distribution of all the people he had said “No” to by industry, to illustrate that maybe they should be paying attention to what these customers were saying. And healthcare was far and away the top industry in his dataset, having 3x more inbound calls than any other vertical.
So the Kinect team had called a meeting with me and my colleague to learn more about what they could do to address the healthcare market.
We took to the whiteboard and started with the forces that are acting on the healthcare system: An aging population, the obesity epidemic, increasing incidence of chronic diseases like diabetes and congestive heart failure, heath reform, business model changes due to the rise of accountable care organizations, population health management, etc.
“We think you should consider that the management of chronic diseases in the elderly is a market that is worth in excess of $100B per year, and it will likely require technology similar to Kinect in order to engage with these patients at home, where caring for them will be least expensive,” we said.
“So… make a game for old sick people?”
“Not a game per se, more like a set of apps that use the Xbox + Kinect hardware to allow healthcare providers and payers to manage expensive chronic conditions at a lower cost.”
“Guys, we’re Xbox. We don’t do old people.”
“It would ruin our brand.”
“What do you mean?”
“Well, our customers are hard-core gamers. You know, young, male…”
“Wouldn’t a set of chronic disease management apps for a different market segment enable you to increase the install base of your platform rather dramatically and then monetize other content, like TV and movies?”
“I think we’re going to make a fitness game for kids who are hard-core gamers.”
“Why is that?”
“Because the kids who play games the most probably need some exercise. And they already know our brand, so we think they’ll buy our fitness game.”
“So your games made these kids fat, and now you’re going to make another game to help them get in shape?”
“Yeah. Pretty cool, isn’t it?”
Well, no, not really. Taking a magnificent technology like Kinect that has the ability to change the world in seriously meaningful ways and offering it only to your best customers within the context of how you make money today is not cool. It’s picking the low-hanging fruit.
My colleague and I left the meeting disappointed that we couldn’t convince these guys to elevate their vision and accomplish anything more than attempting to undo some of the damage that their product has inflicted on a generation of sedentary kids. We were frustrated that they called and asked for our advice when they already seemed to have made up their minds about what they were going to do.
We soon found out why. As we followed up with the Kinect guys a few weeks later, we learned that the exec who led the discussion had been given a nice promotion to lead a new game studio focused on — you guessed it — fitness games for fat kids.
I’m sure it has been a good career move for him, a low-risk way to get to the next level by offering something novel to his best customers. I just regret that he’ll never get measured against the massive value that he could have created if he had been more willing to pursue disruptive rather than sustaining innovation.
So I believe that Xbox has tremendous potential. They have some great technology and some fantastically talented people. They could reinvent the way we experience media in the living room by combining TV, movies, music, gaming, and web content in innovative ways. They could leverage other consumer technology assets in Microsoft’s portfolio and do some great things. And they could go far beyond that if they are willing to think differently about who their best customers might be in the future.
But I think that they are just as risk-averse as the rest of Microsoft when it comes to business model innovation. Odds are that young, male, flabby geeks will continue to occupy the attention of the people running the business in the foreseeable future,. And if Xbox can’t focus beyond their current customers, they would be better off on their own than as part of Microsoft’s broader consumer strategy.
A lot has happened since my last post about Microsoft. There has been rampant speculation about who should be the next CEO. The company acquired the mobility business of Nokia, perhaps signaling that Stephen Elop is the man to beat for the top job.
But an article in today’s New York Times offers a perspective that aligns most closely with my own: That the company is too big to manage, too unwieldy to be agile, that the Nokia acquisition makes this problem worse, and that Microsoft would be able to compete better if it split itself into smaller, more focused companies.
The fact is that Microsoft will not solve any of its problems by growing. More products, more markets, more features: These go-to plays fueled the company’s past growth. To get itself unstuck, the company now needs to do much less: Fewer strategies, fewer products, fewer features, fewer businesses, fewer employees. Microsoft will need to make a difficult pivot in the near future if it wants to remain relevant, and it’s far easier to turn a small ship than a large one.
So I’ll add my voice to those calling for Microsoft to split itself into several smaller companies that will be easier to manage.
One of the mini-Microsofts might focus exclusively on corporate customers. The winning strategy here is customer intimacy, not product leadership. The company can run a successful business catering to the needs of enterprise IT customers for many years with only modest incremental enhancements to its current set of products, but not if they are undergoing the kind of rapid change necessary to compete effectively in the consumer market. This mini-Microsoft might end up looking a lot like Oracle.
Another mini-Microsoft might focus exclusively on consumers. The goal here needs to be to pursue product leadership, to run faster, to recapture lost mojo, and to establish a thriving developer ecosystem at the low end of the overall software market where customer expectations are relatively low compared to those of enterprise IT. If this mini- is successful, consumers will drag its platform into the enterprise market the way they did with Windows 20 years ago, and they way they are doing with the iOS and Android platforms today. This business will benefit from shedding the Microsoft brand. Its product portfolio might end up looking a lot like that of Apple.
Finally, there will be leftover pieces of the company that will need to be either sold to strategic buyers or spun out on their own. I like the NYT article’s suggestions that Bing would pair well with Facebook and that the Xbox business might make a nice stand-alone company.
There are thousands of ways that a company with hundreds of businesses might be sliced up. What other combinations of Microsoft businesses do you think would stand a chance of success on their own?
It is hard to imagine Microsoft without him. Steve has more energy and passion for the business than anyone else on the planet. He’s a consummate salesman who loves his products so much that he makes other people uncomfortable and doesn’t understand why. He’s plenty smart, but he’s no technologist. And he’s compiled an unenviable track record, having missed every major wave of technology innovation during the past 13 years.
Music. Smartphones. Tablets. App Stores. Search. Advertising. Social. Cloud. Companies that caught these waves have created in excess of a trillion dollars of market capitalization during Ballmer’s tenure while Microsoft has vaporized a third of a trillion of its own value. Ballmer has presided over what may be the most dramatic illustration of the Innovator’s Dilemma that the world has ever seen.
Of course, Microsoft has (or had) a product (or several) in each of these categories that it missed. But the company has been super risk-averse regarding business model innovation. They never had the courage to put their core businesses at risk, to do anything that might disrupt Windows or Office. So these new and potentially-disruptive products never took off because they were over-featured (Excel on a phone, anyone?) and too expensive for all but the most demanding of the company’s current customers. Recent attempts at business model changes (Bing, Azure, Surface) have failed to gain traction as the company repeatedly waited until a competitor had proved a new business model and then attempted a “fast follower” strategy, though too late to prevent the competitor from creating barriers to entry through economies of scale or network externalities.
And so Microsoft under Ballmer became slow, lacking in confidence, and perennially stymied by its competitors. Many talented employees left for greener pastures, which precipitated a vicious cycle of management frustration, more missed opportunities in the marketplace, and more turnover. Yet the core businesses grew at modest rates for a time under Ballmer’s stewardship, playing to the confirmation bias of the executive team that the emperor was in fact wearing his amazing new clothes and the critics were just too stupid to understand anything.
I scored a front-row seat to this show when I joined an internal startup, the Health Solutions Group (HSG), focused on creating new products for the healthcare vertical. My job was to complete the business model for this offering. Given our market, our assets, the value proposition of those assets in the jobs that customers were willing to hire them to do, our channels, partners, cost structure, and commitments to our internal “investor”, what was the optimal way to monetize our offering? How would our assets be packaged and licensed, and how would these packages be priced?
HSG had its own sales force and could go to market any way it wanted, at least for a while. But our presumed destiny was to land somewhere within the bigger Microsoft machine, and for that to happen our packaging and licensing needed to conform to one of a handful of models administered by a group inside the company called World Wide Licensing and Pricing (WWLP).
WWLP is responsible for licensing and pricing a magnificent amount of business, around $30B per year across all the divisions of the company, so it focuses heavily on operational excellence. It can support only a finite number of business models and each of these needs to be applicable across as many products, segments, and geographies as possible. Microsoft therefore prices its Enterprise products by “servers” (physical or virtual machines that run products for many users) and “client access licenses” (or CALs, licenses for each user that touches a product). These pricing models are arcane, highly abstract, and only loosely related to how enterprise software creates value. Naturally, customers hate this way of doing business.
So how do you take a product that by design can do almost anything (the topic of a future article) and monetize it through such a rigid and odious packaging and licensing framework? You can’t. Well, you can try, but it won’t work. We were required to shoehorn a magnificently innovative product that needed a commensurately innovative business model through a set of resources and processes that represent the lowest common denominator in the enterprise software business. The salespeople didn’t understand the result, nor did the customers, and we didn’t sell much of it. The need to conform to an off-the-shelf business model in an organization of Microsoft’s scale was a major contributing factor to our failure to thrive.
As I began to foresee the outcome of the HSG adventure, I wanted desperately to believe that our experience was anomalous, that somehow this ignorance of business model innovation was not a result of the company’s leadership. A group of people this smart and this successful at having disrupted the computing business would not be falling into the Innovator’s Dilemma themselves, would they?
I regret that I did not seize the opportunity to voice these questions to Steve directly. The only times he and I were in the same room, apart from all-hands meetings, was early in the morning at the gym where he was either galumphing on a treadmill or floating in a whirlpool in the locker room.
Once I passed him on the way into the gym at 5:30am on a Wednesday. He was leaving and looked intensely serious. I smiled and said, “Good morning, Steve.” That was all I could muster at the time. “Hey,” he replied.
In retrospect I wish I would have stopped him and said, “Steve, I’m frustrated. We have so many smart people here. We work very hard, and yet we’ve missed every major wave of innovation in the past decade. What’s going on?”
A meeting scheduled a few days after this chance early-morning encounter provided perspective on how Steve would have answered my unasked question. This meeting was part of a “listening tour” organized by our corporate head of HR, who reported directly to Steve. She scheduled a stop in my building and I showed up early to get a good seat so I could ask this question about innovation.
The only problem was that once the meeting got started, someone beat me to the punch. A woman from elsewhere in Microsoft Research asked my question, almost verbatim. Our head of HR was no typical HR person. She was a developer, someone who had run some big businesses at Microsoft before taking on the HR role, and she was one of Ballmer’s inner circle. I awaited her response in eager anticipation with the understanding that she would provide a window into his thinking on the matter.
The answer just about knocked me out of my chair. I didn’t record it, so the following is not a direct quote, but her response went something like this:
Well, you know, that’s a really good question. It is true that we have missed quite a few opportunities over the years. But what you have to understand about this business is that it’s a very large business, and it generates some very nice dividends. And we really like those dividends, so we have to protect the parts of the business that generate the most profit.
Take search, for example. Could we have invented search in, say, 1997? Of course we could have. But that would have taken time and money. It would have taken a substantial amount of money to come up with search, let’s say $100-150 million. And what you have to think about is, how much better off are our core businesses, Windows and Office, because we invested that $150 million in them in 1997? They are much better off today than they would have been if we had spent that money inventing search.
So have we missed opportunities to innovate? Absolutely. And we will probably miss some more in the future. But we’re doing the right thing by continuing to invest in our core businesses.
Now, in general I believe that there are infinitely many wrong answers to any question, just as infinitely many lines can be drawn through a single point on a plane. But sometimes there is one answer that is precisely wrong, just as there is only one line through a given point that is perpendicular to another certain line in the same plane.
And if there was one answer to my question on innovation that was precisely wrong, this executive had just given it. I was mortified. Shell-shocked. Nonplussed. I suddenly realized that I was watching the Innovator’s Dilemma playing out painfully in real time, and that the problem went all the way to the top of the company.
That answer, and the vital decisions made every day regarding strategy and culture that surrounded and enabled it, diverged from everything I know to be true about how to build a business that creates real value for customers and shareholders, one that succeeds in the long run.
Working at Microsoft meant I would either have to deal with the constant stress of these conflicting systems of belief about innovation, or I could capitulate and adopt the company’s way of thinking. Neither of these were acceptable. I had to get out.
I committed to myself that I would do more diligence on my future employers and stay away from companies that have evolved “antibodies” like this to fight innovation. I haven’t perfected this art of due diligence yet, but it’s getting better with each new iteration.
And so, as the Microsoft board commences a search for the next CEO, I humbly offer one bit of advice: Find someone who is a true innovator, one who has walked the walk both as a developer of products and a developer of disruptive business models. Microsoft’s future success will not lie in imitating today’s market leaders any more than Google, Apple, and Facebook disrupted Microsoft by imitating what goes on in Redmond.
We are bombarded with marketing messages every day, at every turn. These messages are carefully crafted, meticulously tested, and precisely delivered in order to maximize their influence on our perception and behavior.
Most of the time consumers don’t stand a chance against marketers. There is great asymmetry in the information available to these two classes. Marketers spend much time and money trying to learn how consumers think, whereas fewer and fewer consumers seem to be capable of thinking at all.
But every once in a while I find a company that makes a marketing mistake so flagrant and egregious it actually gives me hope that consumers might see right through it. Here is an example:
A recent article on a company blog touts a survey (done by the same company) that claims 80% of doctors surveyed believe that “virtual assistants” will significantly change the way that doctors do their work within five years.
The problem, of course, is that in a healthcare context no one knows what a virtual assistant really is or does. And the world’s best-known virtual assistant is used daily by only 33% of its customers, has sites devoted to its endless gaffes, and has been said to possess the intelligence of a hammer.
So how could 80% of physicians feel so ebulliently optimistic about something that doesn’t yet exist and whose nearest ancestor is barely useful?
There is an Uncertainty Principle at work in marketing that is not well appreciated by most consumers (and apparently some marketers): You can educate your customer about a new product, and you can measure their perception of your new product, but you have to be careful about trying to do both at the same time.
Why? It’s called priming, and it’s one way that marketers manipulate survey results, whether intentionally or through ignorance.
If your customers know nothing about your product before you survey them, then you naturally want to educate them a bit before you ask them what they think. You’ll tell them all about your vision and the great things that your product will eventually do. But in doing so you are priming them. Whatever they tell you next will be strongly influenced by the proximate experience of learning about your vision. If you create a positive learning experience, they will tend to respond positively even if your vision has only a tenuous connection to reality.
The correct way to measure perception is to do it right out of the gate, at the beginning of the survey instrument, before you’ve perturbed the respondent in any way. Otherwise you’re not measuring reality, you’re measuring a survey experience that is likely more ideal (better) than your product.
So if a survey claims that 80% of customers are excited about a product that doesn’t exist, the survey probably has a priming problem.
Let’s assume for a moment the contrary position, that the survey methodology is sound. Now if a company had a crystal ball that accurately predicted future customer preferences, why would they shout its output from the housetops? Wouldn’t they just build that irresistible product and corner the market before competitors could respond?
Of course they would. So this survey obviously couldn’t connect the dots between perception and intent to purchase. Which means this whole exercise is about nothing more than creating the perception of a positive perception about a product that no one really knows about because it doesn’t exist.
Ironically, Google served up the following ad (Google ads on a company blog? Really?) at the bottom of the post in question:
And if Google can deliver such a perfectly relevant ad when it detects unadulterated marketing BS on a company blog, maybe there is some hope for the BS detectors in consumers’ brains after all.
This is the third installment in a series on the gun control issue. In our first episode we examined data that demonstrate a correlation between fewer guns and an increased variance in the homicide rate. In the second we explored game theory as a hypothesis to explain this phenomenon. This time around we’ll look into another hypothesis, one that can explain why past gun control laws have failed to keep guns out of the hands of criminals and what this means for future legislative efforts.
To begin, we have to go back to school. Way back. You’re a four-year old living in the Bay Area in 1972. You are friends with a girl whose dad is a professor at Stanford. His name is Walter Mischel, and you are about to help him understand something that will inform our conversation on this issue.
One day your parents drop you off at Dr. Mischel’s lab for play time. After some opening activities, you find yourself alone with a researcher, sitting at a kid-sized table in an otherwise empty room, staring down a giant marshmallow. You tell the researcher that you like marshmallows very much. She smiles and says that the marshmallow is yours, and you can eat if you want to.
But wait, there’s more: She says she has to leave the room for about 15 minutes, and if you haven’t eaten your marshmallow when she returns, she will give you another one, too! The researcher exits the room and you are left alone with your marshmallow, weighing your options.
You’re a precocious little preschooler, future Stanford material, so you calculate your rate of return on this trade:
- You have one marshmallow
- If you invest that marshmallow for 15 minutes in this grad student’s scheme, you will earn a second marshmallow
- Your return on investment, therefore, is 1 marshmallow/1 marshmallow = 100%
- Your rate of return is 100%/15 minutes, or a whopping (24 - 1) x 100 = 1500% per hour! At that rate you’d score more marshmallows than there are atoms in the observable universe in a little more than three days, assuming you could keep the grad student on the hook that long.
Fifteen minutes later the researcher returns and sees you rubbing your little hands together with glee, marshmallow still on the table. “How about double-or-nothing?” you eagerly ask. You’ve decided that you don’t need Stanford after all. You’re on your way to starting your own hedge fund!
Your less-strategic friends didn’t fare so well in the same study. A few of them ate the marshmallow right away. Others made an effort to delay eating the marshmallow but just couldn’t pull it off: Fewer than 1/3 of the study participants were able to wait the full 15 minutes and earn the second marshmallow.
You can read more about the marshmallow experiment here.
Let’s jump ahead a few decades and play a grown-up version of this game, called Zero-Coupon Bond. It works like this:
I need to raise some money, and you happen to have some money. I promise that I can pay you $100 one year from today, but I can’t pay anything until then. How much money will you lend me today in exchange for $100 one year out?
Let’s leave creditworthiness out of the question, I have plenty of assets for collateral. The real issue for you is the opportunity cost of your money, i.e. the return you could make on the money you lend me if you were to invest it somewhere else.
Let’s say you offer to lend me $90 today in exchange for $100 a year from now. I calculate that the cost of that capital is ($100 – $90) / $90 = $10 / $90 = 11.1% per year.
You admit that the rate is a bit loan-sharky. You blame your experience at Stanford 41 years ago for your unrealistic expected rates of return. We agree to split the difference: You loan me $95 today, I will pay you $100 a year from now. That’s an interest rate of $5 / $95, or 5.26% per year. Not great, but at least I didn’t have to pay an entire universe of marshmallows.
We call this a zero-coupon bond because it is a bond (a promise to pay) that features no coupon payments, regular payments of interest (like you pay on your mortgage) before the bond matures. The principal ($95) is paid back with interest ($5) in a single payment at maturity. And we like zero-coupon bonds because they are really simple instruments that let us experiment on the relationship between present value and future value. They’re the financial equivalents of lab mice.
So here’s a thought experiment: What if you had priced the bond at only $94? Maybe I wouldn’t have sold you my promise to pay. What if I had asked $96? Maybe you wouldn’t have bought it. It turns out that $95 was a very special price for us: You and I were both at least indifferent to $95 today or $100 a year from now, and so the deal was done.
But it’s not $5 that are important, rather the interest rate those dollars represent. This rate, 5.26% per year in our example, helps us establish a relationship between present value and future value. In finance we refer to this as a discount rate, the rate at which we discount future value to bring it back to the present so we can compare what we spend today with what we will earn in the future, or vice-versa. The higher the discount rate, the lower the present value of future cash flows.
And this discount rate has a special place in decision science. In a business the discount rate for future cash flows is the firm’s cost of capital. A business that raises capital at a cost of 12% will not undertake projects that yield future returns of less than 12% per year if its managers are rational. The business is indifferent to projects that yield exactly the discount rate and it will generally consider investing in projects whose yield exceeds the discount rate. Managers sometimes refer to the discount rate as the “hurdle rate”, because it is the rate of return that an investment needs to “clear” in order to be considered.
It turns out that each of us humans is running around with our own individual hurdle rate in our head. We are faced with a constant stream of decisions that trade off future vs. present rewards:
- Do I sleep in, or do I wake up and go to work? Sleeping in pays off now, work pays off later.
- Do I have dessert? That would definitely pay off now, but skipping it generally pays off later.
- Do I smoke the next cigarette? Smoking might pay off now, not smoking pays off later.
- Do I lie, or do I tell the truth? Lying pays off now, telling the truth pays off later.
- Do I contribute to my 401(k) with each paycheck, or do I spend that money on entertainment? You get the idea.
For those decisions that clear your individual hurdle rate, you tend to choose the future reward. For those that don’t clear the hurdle rate, you tend to choose the present reward.
So what is the range of hurdle rates that we encounter in society?
It’s huge. Frighteningly so.
Recall the marshmallow experiment above: A return of the entire universe in 3 days failed to clear the hurdle rate of more than 2/3 of preschoolers. Children in general have incomprehensibly high hurdle rates for future rewards as most parents will attest.
Drug addicts also have high discount rates when compared with the general population. Many acknowledge that they take enormous risks in order to get their next fix, then do it anyway, over and over again.
Persons who are mentally ill exhibit impaired decision-making similar to that of substance abusers.
And these three classes of people are disproportionately represented in the US prison population:
- 56% of inmates in US prisons have been described as mentally ill.
- 85% of inmates are addicts, have previously been addicts, or were under the influence of drugs or alcohol when they committed the crimes for which they were sentenced.
- And “virtually 100%” of incarcerated juveniles charged with capital offenses are “multiply disabled” by the trifecta of neurological impairment, psychiatric illness, and cognitive deficits.
It seems safe to assume that that the discount rate among those who end up incarcerated is quite high, meaning that criminals likely to choose present rewards over future rewards, every time.
Here’s an illustrative example:
Going back to our robbery vignette from episode 2, let’s consider that you have $100 in your pocket and I have nothing in mine. I can choose to rob you and get $100 right now. I know that I have a pretty good chance of getting your money even if you put up a fight or try to flee.
I also know that if I commit a robbery, I run the risk of getting caught and going to jail for, say, a year. For the sake of easy math, I’m going to value my freedom at $100,000 per year, or the opportunity cost of all the fun I could have during that time as a free man.
So assuming I pull off the robbery and get caught, my payout would look like this:
I get $100 today and lose $100,000 over the next year. Pretty lousy deal at face value, isn’t it? Things don’t even look very good in present-value terms for a rational person whose discount rate is, say, 10%:
The opportunity cost of the first year of future incarceration is discounted by 10% (divided by 1 + 10% = 1.1) to arrive at a present value of -$90,909. The “net present value” or NPV is the sum of what I get immediately ($100) and the discounted future value of what that decision costs me over time ($90,909). So the NPV of a decision to rob you is $100 + -$90,909 = -$90,809. If I think like most adults, there’s no way I’m going to risk the robbery. Getting caught would be just too expensive.
But let’s use this model to ask a rather interesting question: How high would my discount rate need to be to justify the robbery? In other words, how much would I have to discount the future punishment in order to make robbing you today seem like a good idea?
It turns out that if my discount rate was 99,900% per year, I’d be indifferent to robbing you given the payouts above. That rate seems astronomically high, doesn’t it? If a person with that kind of discount rate was your lender in the Zero Coupon Bond game above, they’d insist on lending you only $0.10 today in exchange for a $100 payment one year from now. If a business used that discount rate to allocate capital, it would invest only if it could double its money in about a month.
But a rate of 99,900% per year equates to about 2% per day, or 750 times less than the discount rate of most preschoolers as measured in the Stanford marshmallow experiment. The disturbing conclusion is that this simple crime could very well pay off in NPV terms for someone with the discount rate of a child, or a drug addict, or one who is mentally ill. In other words, for precisely the classes of people who tend to end up in prison in the United States.
We who consider ourselves to be rational adults struggle to understand this fact, but that doesn’t stop it from scaring us. And we respond like we’re dealing with rational adults: If 1 year in prison for robbery doesn’t deter the crime, let’s make it 2 years.
But how does a criminal view another year in prison? We’ll keep the other terms (amount of money stolen, opportunity cost of a year in jail, discount rate) of the deal the same:
Wait a minute, what happened here? The NPV is now $100 + -$100 + $0 = $0, and the perpetrator is still indifferent to the crime!
Perhaps we “rational” adults forgot that discount rates, like other interest rates, compound exponentially over time. We discount the Year 1 punishment back to present value by dividing by 1 + the discount rate, or 1 + 99,900% = 1000. We calculate the PV of the second year of prison by dividing its opportunity cost by 1 + the discount rate squared, or 1,000,000. And for the third year we will divide by 1 + the discount rate cubed, or 1,000,000,000, etc.
So if the perp’s discount rate wasn’t big enough to discourage the crime given a 1-year sentence, adding more years isn’t going to make a bit of difference. You could threaten him with an automatic life sentence, and the crime would still pay off in NPV terms.
The threat of additional incarceration does nothing to dissuade those who are already predisposed to view crime as a good investment. This idea is counter-intuitive for those of us who have reasonable discount rates and are therefore motivated to stay out of jail, we naturally view obeying the law as a better investment. Incarceration thus becomes a means of removing the high-discount-rate persons from society. And there sure seem to be a lot of them lately:
What’s causing this? And what can be done to change the status quo?
First, we need to recognize that even those with the highest discount rates for future consequences cannot discount immediate ones. Consider the internet café armed robbery video we discussed in the last episode: The bad guys viewed robbing the café and its patrons as a good investment in spite of the high likelihood that they would be incarcerated. However, they quickly (and dramatically) changed their minds when faced with the threat of immediate death. Their discount rate didn’t change, but the consequences were moved out of the future and into the present where the discount rate is irrelevant. Criminals respond better to immediate consequences than to future ones.
Second, we need to recognize and begin to address the futility of the growing mountain of new laws that are aimed exclusively at people who have no intention of obeying existing ones. These legislative actions seem to be popular and therefore help our officials justify their bids for re-election, but do they do any real good? And how do we calculate the cost of already-law-abiding people having to navigate an endless web of rules?
Finally, we can go back to the Stanford marshmallow experiment and internalize a few of its findings from follow-up studies of the same participants:
- Having a low discount rate in preschool (i.e. tending to choose future rather than present rewards) was correlated with being described by parents and peers as more competent ten years later.
- Choosing future rewards in preschool was correlated with achieving a higher SAT score in high school.
- A 2011 study of the same participants indicates that the ability to choose future rewards over present ones remains with a person for life. Brain imaging showed key differences between the marshmallow-eaters and non-eaters in areas linked to decision-making and addictions.
Most importantly, a similar study in 2012 found an underlying factor that significantly affected the subjects’ ability to choose the future reward: The participants were divided into two groups, one that was primed with a broken promise before being presented with the first marshmallow (the unreliable tester group), and one that was primed with a fulfilled promise (the reliable tester group). Subjects in the reliable tester group went four times longer before eating the marshmallow as compared with subjects in the unreliable tester group.
Whoa there, pardner.
Are you saying that the way a preschooler makes decisions is correlated with the way he will make decisions as an adult?
And are you saying that these behaviors in preschool ultimately predict the way his adult brain will work at the cellular level?
And you’re saying that, while he’s still in preschool and this behavior is not yet hard-wired into his neurons, this tendency to choose future rewards — that will make him more competent, more successful, and even keep him out of jail — can be increased by something as simple as keeping your promises to him?
That’s exactly right.
But none of these facts will help anyone get re-elected. And so this time around we’ll get a new set of gun control laws, which will be obeyed by the law-abiding citizens and completely disregarded by the criminals. All perfectly rational, of course.
In my last post we undertook a cursory analysis of data related to firearm ownership and homicide rates across various jurisdictions. We concluded that strict gun-control laws and reduced firearm ownership are correlated with increased variance in the total homicide rate:
In other words, the worst-case scenarios are worse under strict gun-control laws and lower rates of firearm ownership.
Mere correlation, however, does not necessarily imply causation. We need a hypothesis that explains how gun control can enable more murders to be committed, then we need to test that hypothesis empirically before we reject it or fail to reject it.
But first, you and I need to rob a bank. For educational purposes.
You suggest that we knock off a local branch of an unnamed bailed-out bank holding company that recently froze the accounts of a legal firearms manufacturer. I insist that no weapons or threats of violence are needed to rob a bank these days, we’re peaceful, enlightened criminals who have no need for such things. You go inside, walk up to the teller, demand money, and leave. I drive the getaway car. Electric, of course. We stash the loot in an abandoned building in Detroit and lay low in our hideout until the whole thing blows over.
We’re up late one night watching Current TV. Suddenly, sirens wail! We look at each other in a panic, aware that the jig may be up. We reaffirm our loyalty to one another, we pinky-swear that we will never confess to our crime or implicate one another, no matter what the cost. You start to cry. I steel my resolve and pick up a pointy stick, ready for battle.
The cops burst through the door. I raise my weapon and ask to see a warrant. They taser me. You chortle a bit when you see me flailing about on the floor. I can’t feel my legs. You get handcuffed, I get hog-tied. This is the last time we see each other. They put us into separate cars and haul us off to the Graybar Hotel. We’re booked and held separately overnight.
Late the next morning a jail officer leads me to a drab, windowless room and motions for me to sit in a rather flimsy and uncomfortable chair. The jailer exits and another man who looks like Barney Frank waddles through the door and plops his corpulence into the chair across from me. He leans forward and squints for a moment through thick glasses.
“We know everything,” he intones somewhat nasally, his fetid breath inducing a wave of nausea. I gag and try to cover it by clearing my throat.
“Of course!” he retorts sharply. “Your partner sang like a canary.” He manages a wry smile.
I put on my very best poker face. I’ve been practicing regularly in anticipation of a moment like this. After an awkward silence, Barney’s doppelganger turns a bit redder in the face, inhales sharply and bellows:
“You have two options! Confess everything, and you’ll get five years. Or keep quiet, and you’ll get twenty years. Either way, we own you!”
He produces a cassette tape player and hits the record button. I am momentarily startled by the reappearance of such an ancient technological artifact, then I close my eyes to concentrate and mentally draw the following matrix:
As a result of some serendipitous timing and your convincing work at the bank, we made off with a total of $1 million that we have agreed to split 50-50. So if you and I cooperate by honoring our pinky-sworn agreement to not rat each other out, each of us will receive $500,000 once the prosecutor realizes he doesn’t have enough evidence to convict us.
But if I honor our agreement and you defect, I go to jail for 20 years (for the purposes of the exercise, I value my freedom at $100,000 per year) and you probably get to cut a deal with the prosecutor to walk away with only probation after you testify against me. You’ll say the whole thing was my idea, that I hid the money and you have no idea where it is. And once I go to jail, you’ll pick up the $1 million payout at that abandoned building in Detroit. Given the way you laughed at me last night while I was being shocked into oblivion, how do I know that this wasn’t your plan all along? You sly devil!
It’s clear that you’re better off if you defect, and I now realize that if you do, I’m much worse off if I don’t defect. We both go to jail for five years and the bank will get its money back, but that’s preferable to me doing twenty while you live it up with all that cheddar.
You’re probably being put through this same ordeal in the room next door. We’re locked in a distributed Battle of the Wits. I bet your interrogator looks more like Princess Buttercup than mine does.
This little anecdote represents a specific instance of a game that economists call Prisoner’s Dilemma. Generally, you and I would both be better off if we cooperated, but we each have an incentive to cheat. And if there is an incentive for you to cheat, the rational thing for me to do is defect, and vice versa. We call this rationally-optimal state a Nash equilibrium (named after the mathematician, not the point guard).
It turns out that Prisoner’s Dilemma can help us model all sorts of interactions in which the players have a choice to either collaborate or defect: Advertising, the use of performance-enhancing drugs in sports, OPEC oil production quotas, etc.
One of the most famous applications of game theory was the military doctrine of strategy known as mutually assured destruction that defined how the Cold War was carried out. The United States and the Soviet Union each had enough nuclear-armed missiles to destroy the other several times over. We cooperated by not firing them at each other. If we had defected by launching our missiles at the Soviets, they also would have defected by launching their missiles at us. We’d both be annihilated, which is the worst possible state, so neither of us launched the first strike.
But if we had disarmed unilaterally, mutual destruction would no longer be assured. There would be no reciprocal penalty for the Soviets should they defect and launch the first strike, and vice-versa. The ironic reality is that two nuclear-armed superpower rivals are safer than one nuclear-armed superpower who could strike with impunity with no threat of reciprocal strikes.
Let’s use game theory to test gun control scenarios.
You are walking down the street with $100 in your pocket. I am sitting on the corner with nothing in my pocket. As you approach, I have a strategic decision to make:
- I can cooperate by letting you pass, or
- I can defect by attempting to rob you of your $100.
Being a rational thug, I quickly create the following payout matrix in my mind:
If I choose to cooperate, you keep the $100 and I get nothing, which seems like a pretty good deal for you but a lousy deal for me. If I defect and decide to rob you and you cooperate, I get the $100, and you keep nothing. If I attempt the robbery, you could decide to defect by running away or putting up a fight. I size you up and figure that I have a 90% chance of winning either a fight or a foot race, which makes my expected payoff 90% x $100 = $90. Therefore you have a 10% chance of keeping the $100 plus a 90% chance of me breaking your nose and sending you to the ER, which makes your expected payoff 10% x $100 + 90% x -$1000 = -$890 if you decide to defect.
My worst-case scenario if I defect is that I get $90. My best-case scenario if I cooperate is that I get nothing. So, rationally, I step up and demand that you hand over your money. When I do, you instantly calculate the same payoff matrix and decide that while $0 is worse than $100, -$890 is a lot worse than $0. So you cooperate. The Nash equilibrium here is that I defect and you cooperate, and as a thug this equilibrium pleases me immensely.
But I have a problem: There are people who I can’t intimidate into cooperating. I can segment my “market” and target only the easy prey: Women, smaller men, people walking alone at night. But these targets get wise to my strategy and start changing their behavior to reduce their vulnerability. They walk in groups to improve their odds of escape or winning a fight against me. They cross the street when they see me up ahead. They don’t go out after dark when it’s harder to see me and there are fewer Good Samaritans to rescue them.
I need to change my strategy to adapt. I could partner with a few of my friends to improve the odds of success against stronger victims or groups of people, but we’d be a bit conspicuous sitting around waiting for someone to rob. And I’d have to split the loot among the group, which I don’t like. And being thugs like me, they can’t be trusted.
Here’s a thought: I could use a weapon. I could present the weapon as I make my demands. People are conditioned to fear weapons, almost every time they see one in the media it is associated with something bad happening to a good person. And if I’m armed, I’ll be able to take on stronger individuals and even small groups of people, increasing the size of my target market, my expected profit per transaction, and my win rate! Here is the updated payout matrix:
Let’s assume you have a 1% chance of being brave/stupid/fast enough to run from someone who is able to threaten you with a deadly weapon. And while I have no intention of actually using the weapon on you, it’s important that you understand that you don’t know what my intentions are. All you know is that if I use the weapon on you, your very negative payout represents a reasonable risk of immediate death.
Clearly, the armed-robbery business is much better than the unarmed-robbery business. For the thug, at least. And things don’t have to stop at mere robbery. A few early successes can induce grandiose delusions or narcissism as the thug realizes the power he wields over his victims. The thrill of power may lead him to act out other, more perverse fantasies to increase his “payout” at the expense of his victim, who is rationally willing to settle for any outcome marginally better than death.
But let’s say that you, the victim-in-waiting, have studied game theory a bit as well. You understand that the Nash equilibrium above is bad news for you. It sets you up to be either a victim or a hermit, and neither of those is any way to pursue life, liberty, and property, not to mention happiness.
What would happen if you exercised your natural right to defend yourself? You happen to live in one of the 49 states that issue concealed carry permits (the one holdout, Illinois, was recently ordered by a Federal court to come up with a concealed-carry permit program within 6 months), so you obtain one and carry a firearm legally. Here’s how the payout matrix changes:
This changes everything. The thug knows that if he attempts to rob you, armed or otherwise, you are entitled to defend yourself. If he picks the wrong target, he’ll get two rounds to his center-of-mass and one between the eyes. That’s a very bad ending for any rational being, even a thug. So in a scenario where there is a chance that the victim may be armed, the Nash equilibrium is for both parties to cooperate (the upper-left cell).
That’s a lot of words to illustrate what happens in this short video. Two armed tough guys attempt to knock off an internet café in Florida. They begin rounding up the patrons to separate them from the possessions (and who knows what else), when an armed 70-year-old rains (lead) on their parade. Spoiler alert: People get shot (though you wouldn’t know it from the video), nobody dies, and you may laugh out loud when you see the replay of Thug 1 running over Thug 2 as both cowards try to squeeze through the exit door at precisely the same moment:
If you think all this game-theory nonsense is the result of me twisting microeconomics to fit a uniquely modern problem with crime and violence, you’re wrong. Take a look at this excerpt from Cesare Beccaria’s Essay on Crimes and Punishments, as quoted in Thomas Jefferson’s “Legal Commonplace Book”:
Laws that forbid the carrying of arms…disarm only those who are neither inclined nor determined to commit crimes. Such laws make things worse for the assaulted and better for the assailants; they serve rather to encourage than prevent homicides, for an unarmed man may be attacked with greater confidence than an armed one.
So, can correlation imply causation? Yes indeed, provided there is a hypothesis that can be tested and validated empirically. I think the game-theory hypothesis is quite compelling. Based on the evidence I’ve studied, I even think it’s correct. But I can’t in good conscience recommend that we carry out a randomized double-blind controlled study when the lives of innocent people are at stake. We need to look at the variance that already exists in crime rates and firearm ownership, there is a mountain of evidence that we can use if we are willing to do the science rather than acquiesce to political demagoguery.
Articles like this one began to appear soon after last month’s tragic massacre in Connecticut. The logic embodied in them is straightforward: Guns are designed to kill people, and more guns mean more dead people, therefore fewer guns mean fewer dead people.
The reasoning is so patently obvious, in fact, that anyone who argues against common-sense gun control like a ban on assault weapons and high-capacity magazines is either an idiot or a murderer-in-waiting, and we can’t afford to let either of these join the conversation. We just don’t have time.
I mean, come on, people! How many more innocent children have to die before we figure this out?
Before we jump any deeper into an emotionally-charged conversation, let’s take our own look at the data. And let’s commit to intellectual honesty. No fudging the facts or conveniently excluding data that do not support our thesis.
Let’s zoom out and consider the issue more broadly than others usually do: Murder of an innocent person in any form is evil, and guns certainly aren’t the only way that bad guys kill. They also use knives, swords, baseball bats, crowbars, rocks, pointy sticks, ropes, lead pipes, candlesticks, automobiles, bombs, poison, fire, water, and even their bare hands, among other things too numerous and too gruesome to list. So why analyze only firearm-related murders?
To the murdered innocent and those who love him the precise manner of his demise is of secondary concern, subordinate only to the principal fact that he is dead, that he has been unjustly deprived of life and this evil deed cannot be undone.
Well, this is troubling. It looks like there are 20 or so countries that have significantly lower firearm ownership rates and homicide rates that are at least as high as that of the United States, as if a higher firearm ownership rate was correlated with a lower overall homicide rate.
How could there be so many murders in those countries with so few guns? Puzzling. The model is probably skewed by all those Spanish-sounding names in the upper left quadrant.
Since we’ve committed to be intellectually honest, we can’t simply exclude these “outliers” and compare the United States against, say, Northern Europe – which is buried in that cluster of blue points in the lower-left quadrant of the graph with practically no guns and practically no murders – even though doing so would clearly support our thesis that fewer guns would make us safer. No, we’ll take the high road and try to find another dataset that controls for factors like living in a narco-state vs. a Scandinavian socialist utopia.
Here is Graph 2, in which we compare Homicide Rate vs. Firearm Ownership Rate by State. The firearm ownership data come from a 2001 survey of 201,881 households by the Behavioral Risk Factor Surveillance System (whose name sounds very safe and trustworthy in spite of containing the word surveillance) and are paired with the 2001 intentional homicide rates by state (compiled from various sources):
This whole exercise is starting to get frustrating. This graph exhibits the same troublesome negative correlation between the firearm ownership rate and the homicide rate as the previous graph, but the best-fit regression line is logarithmic, which means that there might be indirect effects for the first few armed households, i.e. their guns may be indirectly protecting more households than one. The R-square indicates that 35% of the variance in the homicide rate is explained by the firearm ownership rate, which is significant even though the factor’s coefficient contradicts our thesis. Regardless, 65% of the variance in the homicide rate across jurisdictions is explained only by factors other than firearm ownership, which doesn’t bode well for our idea that we just need fewer guns to make our society safer.
But most disturbing of all, three of the four jurisdictions with the most-restrictive gun laws and the lowest firearms ownership rates (Washington DC, US Virgin Islands, Puerto Rico) have murder rates that are 2-3x higher than those of the states with the next three highest murder rates (Louisiana, Alabama, Mississippi), all of which have much-less-restrictive gun laws and rates of gun ownership that are 8-10x higher than the more-restrictive states. And this particular cohort pairing shares a number of otherwise blameworthy factors (high poverty rates, high unemployment, poor public education systems, etc.). Not good at all.
Could the United States really be that similar to the rest of the world? These household firearm ownership statistics are probably comparable to the rest-of-world firearm ownership numbers, as they may control for the fact that the US, due to high per-capita GDP, likely has many more households with multiple firearms than does any other country.
Enter Graph 3, in which we compare Homicide Rate vs. Firearm Ownership Rate for the US (by state/territory/district) and the Rest of World:
Controlling for US households that own multiple firearms, then, it looks like the distribution of household firearm ownership by state is well within that of the rest of the world. And the same inverse relationship between the firearm ownership rate and the homicide rate seems to hold.
There are exceptions, notably Hawaii and the cluster of blue points that surround it, all of whose names have been invoked by the media with great reverence as examples of the success of strict gun-control laws, but we cannot ignore the reality that more-restrictive gun laws and a reduced firearm-ownership rate can be associated with a significant increase in the homicide rate, both in the United States and the rest of the world.
To say that this observation is counter-intuitive would be a gross understatement.
But really, how bad could it be if we enacted sweeping gun-control legislation at the national level? Let’s assume what looks like the worst-case scenario, with the entire United States adopting the position of Washington, DC:
There would be 3.8 households out of 100 that own firearms (down from a national average of 31.7 per 100, Senator Feinstein would be pleased) and there would be 40.3 homicides per 100,000 people (up from a national average of 4.7 per 100,000 in 2011).
That’s an 8.5x increase in the national homicide rate.
That’s 125,840 homicides per year.
That’s more than 12 Sandy Hook massacres every day.
Perhaps the data do not necessarily support the easy, ”intuitive” arguments for gun control after all. It seems that disarming a population is correlated with increasing the variance in the expected homicide rate. There are good outcomes, make no mistake about that. But there are also some very bad outcomes, on the order of 10x worse than the status quo.
But we can still ban those scary-looking assault rifles, right? And those big high-capacity magazines like the terrorists use. There’s clearly no point in having those if you aren’t planning on killing lots of people. They’re no good for hunting, and you don’t need that kind of firepower to defend yourself against a mugger or a rapist or a burglar in the middle of the night.
Wrong. Dead wrong.
It turns out that Washington, DC is far from the worst-case scenario for homicide. And it turns out that gun violence, or violence of any type, is far from the most efficient way to massacre innocent people.
The most efficient weapon in the history of the world is forced starvation, and the Ukrainian language has a word for it: Holodomor (literally hunger-extermination).
The Holodomor was Stalin’s answer to the problem posed by the kulaks, relatively prosperous farmers who owned their land and had resisted collectivization following the Bolshevik revolution. When Soviet economic policies that favored trading grain for farm machinery caused food to become scarce, the government responded in August, 1932 declaring that all food was property of the state and mere possession of food was evidence of a crime. Crops were seized from the kulaks and redistributed to party loyalists under a quota system, while the kulaks and more-affluent peasants were left to starve. By the most conservative estimates the Holodomor killed 3 million people in Ukraine during the following 12 months and 6-7 million during that same time period across all of the Soviet Union.
One of those victims was my wife’s great-great-grandfather, who died in August, 1933 under forced labor on what had previously been his family farm. He had sent two of his sons to the United States prior to the Bolshevik revolution, and today our family is fortunate to have a collection of his letters to those sons, letters that document in excruciating detail the tightening grip of the tyranny that ultimately took his life.
Can you fathom the loss of 3 million lives in one year? How about 3 million out of a total population of 29 million?
That’s a homicide rate of 10,345 per 100,000.
In the United States today, that would be 32.5 million people in a year.
That would be more than 3,300 Sandy Hook massacres every day. For a year.
Here is Graph 4, in which we compare the Holodomor to the overall homicide rates in the rest of the world. The scale of the vertical axis is now logarithmic to accommodate the magnitude of this atrocity. The Holodomor was 100x worse than the homicide rate of modern-day Honduras, currently the world’s most violent country. You will note from the graph that there was no legal firearm ownership in Ukraine in 1932, the Soviets had outlawed firearms in 1929 after years of kulak resistance to collectivization:
The actual food confiscation of the Holodomor was carried out not by bureaucrats but by urban thugs loyal to and armed by the regime. They raided farms, built watchtowers over the fields to ensure the peasants weren’t “stealing” grain (the penalty was summary execution), abused the peasants going to and from work, and amused themselves by raping the women who lived alone in the countryside. These mobs had been half-starved themselves and brainwashed by propaganda into thinking they were doing their civic duty, and there was nothing that the disarmed kulaks could do to stop them.
Think this type of massacre couldn’t happen today? You’re wrong. One is brewing right now: Venezuela has long had a strict permit process for firearm ownership. Last year Hugo Chávez enacted sweeping new gun-control measures, banning all retail sales of firearms and ammunition. And just today, his heir-apparent vowed to crack down on “hoarding” and sent troops to take control of food distribution networks. Who will protect the disarmed producers when the loyalist paramilitary mobs come for their food?
Remember the Los Angeles riots of 1992? 53 dead, 2000+ injured, billions of dollars of property damage. 6 days before the National Guard and the Marines were able to restore order to the city. 45% of property damage was inflicted on Korean-owned businesses even though Koreatown was far from the epicenter of the rioting. The business owners had no one to protect them, their families, and their livelihoods — no one except themselves and their neighbors. One gentleman reported firing more than 500 rounds from his rifle — into the ground and into the air — to defend against the mobs of looters after the police had abandoned his block and before the National Guard arrived days later.
This is precisely why law-abiding citizens must never be banned from owning powerful weapons that are designed to defend against large numbers of armed, violent people when tyranny rises.
Sandy Hook was a tragedy, and we should learn from it and do better in the future. We need to look beyond legal firearm ownership as the cause of murder, since the data show that jurisdictions with stricter gun laws and fewer firearms per capita can have significantly higher murder rates compared to states with more firearms.
And as we try to learn from Sandy Hook, let us never forget the 32.5 million reasons why we have the Second Amendment.