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Paul Ormerod

Thursday 28 June 2012

Royal Bank of Scotland fiasco shows the power of networks

The last week or so has seen complete mayhem in the Royal Bank of Scotland and its subsidiaries.  A computer glitch has caused their payments systems to collapse.  Monies have not been processed, 17 million customers have been unable to access their accounts and pay their bills.

The impact for RBS has been catastrophic.   So, an incident of this magnitude must surely have been caused by a massive event?  Perhaps the building containing the Bank’s main computers was burned to the ground?  Or the system was the victim of a malevolent cyber attack by a hostile power?  In fact, nothing like this took place at all.  It seems that an inexperienced operative in India accidently wiped information during a routine software upgrade.

In other words, a relatively trivial problem cascaded across the entire network and ‘went global’. 
This is not an issue which is specific to the RBS.  It is a fundamental feature of any system in which networks are important.  The classic example is outages in electricity supply systems, leading to huge blackouts.  Sometimes, there is indeed a major event which causes a major failure, such as a hurricane or ice storm destroying physical links in the system.  But all too often, it is a trivial failure which leads to a cascade across the system.

Most of the time, of course, the impact of small events is confined to their immediate locality and spread no further.  But it is the connected nature of networked systems which means that, in principle, even small events can have consequences on a scale up to and including the network as a whole.  The probability of any single small event causing a dramatic incident is very, very small.  But trivial problems occur on an almost daily basis in almost all systems.  So at any time, there is the potential for catastrophic failure.

In the scientific literature on the fundamental mathematical properties of networks, there is a jargon to describe this inherent property of networked systems.  They are ‘robust yet fragile’, a phrase initially coined by the top Caltech scientist John Doyle, way back (!) in the 1990s.  They are ‘robust’ in that small shocks, small problems, do not usually spread very far in the system.  But at the same time they are ‘fragile’.  A tiny adverse event can in principle bring the whole system down.

We see this principle very clearly in financial markets.  Think back to the banking credit crisis of the late summer of 2007, the harbinger of the major crash just over a year later.  At the end of June in 2007, there were few problems.  Voices were being raised about the problems of debt, but these were still very much in a minority.  The anxieties had not percolated across the network of banks, and their confidence in lending to each other.  Suddenly, this changed, and we had a major liquidity crisis.  Inter-bank lending collapsed, leading, very quickly to the demise of Northern Rock.  Not much had happened.  But negative sentiment suddenly cascaded across the banking network.

Companies must take these fundamental features of networks into account.  The potential problem extends far wider than financial markets.  Adverse comments, often with no basis in reality, about a firm and its products are posted all the time on the internet.  Most of the time, these do not get very far, often no further than the green-ink perpetrator of the comments.  But, very occasionally, a grievance, even one which is completely ill-founded, will get global traction and seriously damage a brand or even a whole company’s reputation.

One of the real cutting edge areas of scientific investigation on networks is how to spot at a very early stage when a comment has the potential to go global.  So defensive strategies are possible, firms are not powerless in our highly connected world.  But it is crucial that both firms and governments start learning the lessons of the networked world of the 21st century.

Friday 1 June 2012

Kahneman and schizophrenia in economics

I was at a fascinating session last night, with Nobel Laureate Daniel Kahneman in conversation with a leading thinker from the advertising world, Rory Sutherland of Ogilvy and Mather.  Kahneman was talking about his book Thinking Fast and Slow, a summary of his life’s work.

I am a great admirer of Kahneman.  Trained as a psychologist, along with his co-Laureate Vernon Smith, he more or less created experimental and applied behavioural economics.  He had the extraordinary idea (!) that instead of theorising a priori about how ‘rational’ people ought to behave, we should observe how people really do behave.

His work shows that, in general, people do not behave as the model of Rational Economic Person says they should.  His Nobel lecture is very accessible, written in English, and is available at    He concludes that ‘people reason poorly and act intuitively’.

Yet despite his scientific standing, economic theory has so far made very little use of his results.  Theoretical journals are still replete with articles full of calculus, in which agents (economist-speak for ‘people’) are reasoning very well, and taking the ‘optimal’ decision.

So there is a schizophrenia in the profession of economics.  Nobel prizes are awarded to people whose work shows empirically that in general people do not optimise.  Theoretical work carries on in the same old way, assuming that they do.

Why is this?  Perhaps Kahneman’s own work gives us an insight.  He distinguishes between System 1 and System 2 thinking.  System 1 is when the brain is almost on autopilot.  He illustrated this in his talk last night.  ‘If I mention the word “vomit”, your brain reacts.  If I ask “what is 2 plus 2?”, the answer comes in your mind automatically’.  System 2 thinking requires much more effort – most people, he said, cannot multiply 24 and 17 whilst at the same time negotiating a right turn in heavy traffic.

Actually, I guess that most economists could do this.  Many of them could even carry out the maths required to optimise a particular function at the same time!  In other words, economists are so steeped in calculus, they have performed these mathematical operations so many time, that for them, the maths of calculus has become System 1 thinking.

So when economists approach a problem it has become second nature to write down some functions and to maximise (or minimise) them.  It is as instinctive as adding 2 and 2 is for more normal people.
But Kahneman’s empirical insights require hard System 2 thinking.  You are trying to understand a particular problem.  Well, exactly how do agents behave in this situation?  What rules are they following, how do we translate them into maths, can we solve the resulting equations or do we need numerical solutions?

In short, it is much harder to do Kahneman-inspired theory than it is to maximise a utility function.  In economic theory, System 1 thinking rules!

Tuesday 22 May 2012

Political map of London is like America: strong geographic segregation

Thomas Schelling is a brilliant American polymath, who deservedly won the Nobel Prize in economics in 2005.  One of his most remarkable insights is about segregation in cities, which he published as long ago as 1971.

The residential pattern of American cities tends to be pretty sharply divided on ethnic grounds.  The population of many areas is often overwhelmingly drawn from a single ethnic group.  There are white neighbourhoods, black neighbourhoods, as so forth, in which there are very few members of other ethnic groups.

An obvious implication of this seems to be that there is strong racial prejudice in the US, that many people actively prefer to live amongst people of their own ethnicity.

Schelling showed that strong segregation at the level of the city as a whole can arise even when individuals have only a very weak preference in favour of being surrounded by people of their own ethnic group.  There is a big, often highly mathematical, scientific literature on this in the four decades since Schelling made his discovery.  But his basic finding still remains valid.  Very weak individual preferences often translate into apparently very strong ones at the city-wide level.

His work was all the more remarkable given that personal computers had not been invented. Schelling obtained his results using coins on graph paper.  He placed pennies and nickels in different patterns on the "board" and then moving them one by one if they were in an "unhappy" situation.

Source: Guardian newspaper

The first preferences in the 2012 London Mayoral election are a remarkable example of city-wide segregation. They give the impression of a city which is sharply divided in its political allegiances and outlook.

Of course, many factors determine electoral outcomes. And the chart is not implying that people select their place of residence according to its political preferences. But, certainly, there is a self-reinforcing aspect to this process, which Schelling did not incorporate into his original model. The underlying maths of these models came much later.

The overall culture of a locality is an important determinant of an individual’s political preference. Many wealthy left-wingers, for example, choose to live in the Labour areas immediately north of the river in the centre of the city. They do so because of the local culture, which in turn reinforces their own opinions and voting habits. So we have a Schelling-type process underpinning the electoral map, overlaid with the kind of self-reinforcing feedbacks which pervade modern life.

A very American outcome in Europe’s leading city!

Tuesday 8 May 2012

Compulsion or Co-operation: Curbing Executive Pay

Andrew Moss, who has been in charge of Aviva since 2007, has become the third chief executive to quit amid increasing shareholder discontent in recent weeks, following David Brennan at AstraZeneca and Trinity Mirror’s Sly Bailey. Just what is going on with the public limited company, one of the great inventions of capitalism?

It has provided a flexible legal framework for dynamic activity and innovation for centuries. The structure really took hold and boomed in the late 19th century, when the first truly global, multi-national enterprises emerged. And it continues to be by far the most important building block of the Western economic system, which has delivered prosperity beyond the wildest dreams of previous generations.

For most of its existence, the joint stock company has operated without its validity being queried in the wider political economy domain. In the decades of rapid growth which followed the Second World War, for example, executives were well remunerated. But there was a general feeling that everyone was benefiting from the rise in prosperity.

But since the 1980s, there has been growing criticism of the way in which the corporate system operates. Many readers will recall the public vilification of one Cedric Brown, the hapless chief executive of the newly privatised British Gas. His ‘crime’ was to be paid the unheard of sum of £400,000 a year. Today, even allowing for inflation, most chief executives appear to require many times this amount simply to get out of bed.

The present crisis of public confidence in the institution of the public limited liability company was of course triggered by the financial collapse of the late 2000s. It is not just that confidence has been eroded. Outright rage has risen dramatically, with the protests often taking the form of demonstrations against capitalism itself.

The public appears to accept huge rewards when they appear merited. Footballers, film stars, rock musicians, the founders of Facebook and Google – very few seem to begrudge them what the Labour Party’s old Clause Four used to call, in its quaint way, ‘the full fruits of their industry’.

The real concern is of course what appear to be massive rewards for failure, combined with hostility to the enormous gap which has emerged between the rewards of the board and the remuneration of the rest of the workforce.

One response to the problem is what by now has become the knee jerk reaction of what we might call the interventionist class. The politicians and public sector bureaucrats who believe that rules can be devised to solve any problem. And preferably rules which are administered by themselves or by their peers in specially created agencies, replete with ever-rising numbers of support staff and gold plated pensions.

The alternative relies on a view of the world which is the complete antithesis of that of the would-be central planner. Just like the natural world, our social and economic systems are at heart evolutionary. They do not stand still. Behaviour changes, often in unpredictable ways, and at unexpected speed.

Much of our behaviour is increasingly driven not by the calculations of Economic Person, rationally weighing up the pros and cons of all the alternatives, pondering in splendid isolation. Instead, we act by copying, by imitating the behaviour of our peers. The principle is very familiar in the world of popular fashion. Remember Crocs? Shoes with holes in. Suitable perhaps for Arizona or Adelaide, but hardly for rainy Seattle or Scotland. Yet they swept the market. Once they became fashionable, people wanted them simply because others had them.

Copying or imitation exists at far more elevated levels. In the 1990s, it became fashionable to have an independent central bank. Yet it is hard to argue that the Bank of England, granted independence by Gordon Brown and Ed Balls, has covered itself in glory. And the European Central Bank was not exactly on the qui vive both before and during the financial crisis. The choice was hardly justifiable on so-called rational criteria.

We have seen exactly the same principle of copying operating in the shareholder revolts against what is often pure looting of the company by senior executives. James Caynes, for example, the chairman and chief executive of Bear Stearns, was paid $40 million cash between 2004 and 2006 and made millions more by selling his shares. He presided over the destruction of virtually the whole value of the shares in the bank during 2007. Many more have followed in his wake.

Yet it is only now that shareholders are exercising their power and calling companies to account. Their actions show the basic, fundamental strength of capitalism, its endless capacity to renew and recreate itself. But they also show the inherent unpredictability of the modern economy, the great difficulty of predicting the tipping point, when the consensus moves decisively in a new direction, almost regardless of ‘objective’ reality.

We have passed the tipping point. The fashion is for shareholders to become even more active, to devise new ways of holding executives to account for their performance and remuneration. More regulation, more red tape is the last thing that we need right now.

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Saturday 24 March 2012

Why do films flop?

The Disney sci-fi flick John Carter has become one of the biggest flops in movie history. The studio has announced that the film's theatrical run will lose $200million.

There has been a huge amount of comment in the media about why this happened. On Yahoo!, for example, several reasons were put forward. For example: the advertising campaign was bland; Taylor Kitsch is not a leading man; the title was wrong; the reviews were bad.

Other huge loss makers have figured in the discussion. In 2011, Mars Needs Moms lost $110million. Sahara in 2005 and Green Lantern in 2011 both had strong lead actors, and both grossed takings well in excess of $100million. But the costs far exceeded this, and both lost over $100million.

There is a long list of massive failures going back many years. Ex post, once the film has failed, many reasons are put forward to explain why it happened. Ex ante, however, in every single case, the producers believed the film would make a profit and not a huge loss. And commentators who seem so erudite in explaining failure after it has happened rarely, if ever, succeed in making a successful prediction of the failure.

There will be specific reasons associated with each failure. But there is a much more fundamental reason, deeply rooted in how popular culture evolves. ‘Popular culture’, incidentally, does not refer simply to films, music, or television shows. Performances of Wagner’s Ring Cycle at Bayreuth have on occasions been very badly received by the highbrow audience.

Even though the people at this festival by definition are devotees of Wagner, even though they adore Götterdämmerung as an opera, until they have seen this particular performance, they do not know whether they will like it or not.

More fundamentally, their opinions are shaped not just by their own personal evaluation, but by the reactions of others in the audience. Someone may feel the performance was rather good, but he or she can observed directly the reactions of others immediately around them, and can hear the general reactions across the audience as a whole.

In the same way, people react to films, spreading their opinions by word of mouth and by blogs.

Positive feedback, the response to how everyone else is reacting, creates massive inequalities of outcomes in film successes and failures. And this may be only tenuously related to the objective attributes of the film, such as the presence of stars or whether it has a good story.

The American economists Arthur De Vany and W. David Wallis published an article in the Economic Journal in November 1996, using a formal mathematical model to account for success or failure in the American cinema and testing it by comparing its properties with those of the weekly data provided by Variety’s Top 50 films in America. The principle of positive feedback operates with devastating effect. During the nine months which they analysed, the top four films took over 20 per cent of all box office revenues, and the bottom four less than one hundredth of one per cent.

But the process of the evolution of preferences to a popular culture offer such as a film involved inherent, massive uncertainty, which no amount of pre-planning can overcome. People do not have fixed tastes and preferences, as economic theory assumes. They evolve over time, and they do so in part in response to the choices and decisions of others.

Wednesday 21 March 2012

Corporate structure, Darwinism and Random Selection

The corporate world exhibits a wide variety of structures. Co-operatives and partnerships have been around for a long time and have some well known examples. The Co-op, for example, was founded in Rochdale as long ago as 1844 and now is represented worldwide. Goldman Sachs was a partnership for most of its existence. There are more exotic forms of the corporate beast, such as companies limited by guarantee, industrial and provident societies, friendly societies and, recently made possible by legislation in the UK, community interest companies.
But by far the dominant form of corporate organisation is that of the joint stock company with limited liability. In other words, companies ultimately controlled by shareholders. These can range from one person bands to the world’s largest firms such as Google.
Although the concept had been around for a long time, the shareholder company came into dominance in the corporate world in the late 19th century. It remains by far the single most important form of corporate structure, even if we count the frequencies of the various structures on a simple head count rather than by value or turnover.
Companies run by managers on behalf of shareholders are coming in for increasing criticism. In the financial crisis, the value of the equity of many banks collapsed and shareholders were sometimes left with nothing at all. But in the process, the managers had enriched themselves. The issue of the pay of senior executives in such companies remains a very live and sensitive political issue.
Is it time to call a day on this form of organisation, and if so how is it to be done?
A lot depends on why we think this particular structure came to exercise such dominance in what we might think of as the ecology of corporate organisation. Many different forms of organisation compete to be adopted by entrepreneurs setting up in business. But it is the shareholder company which is by far the most frequent choice.
If we do a simple plot of the relative frequencies with which the different types of structure are observed – even on a simple head count – we observe a highly skewed outcome. Huge numbers of shareholder based companies, a lot of partnerships, but far fewer than the number of the ‘market leader’, some co-ops, then fewer and fewer until we get down to recent innovations such as the community interest company, with very few examples.
Pure Darwinism would lead us to believe that the shareholder company is dominant because it is better suited to the environment, to the ecology of corporate structure. It is somehow fitter than its rivals. Selection by fitness, however, does not by itself account for the relative frequencies with which we observe the different corporate forms.
A quite different theory also comes from biology, to account for the frequencies with which different species are observed in any given ecology. Stephen Hubbell, based at the University of California at Los Angeles, came up with the so-called ‘neutral’ theory, which generates results which conform to the outcome which we observe empirically in ecological systems. A few species have lots of members, most species have very few. Exactly what we see with corporate forms.
A plausible hypothesis is that, in any given system, rare species are rare because, for whatever reason, they have not adapted well to their environment. Similarly, abundant species must have particular attributes which enable them to flourish. But the word ‘neutral’ in this context means that no species has any special qualities or characteristics which make it more or less suitable to operate in its given environment. Their relative success or failure is ‘neutral’ to their attributes. In other words, how a species behaves, what it can and cannot do, is irrelevant to whether or not at any point in time its numbers are small or large. The outcomes which we observe are the result of purely random processes.
It is a disturbing theory, which appears to defy common sense. But common sense tells us that it is the Sun which goes round the Earth and not vice versa. We see the Sun move, but we seem to stay still. It has the great strength that it fits the facts. Yes, evolution takes place, but the eventual outcome and the eventual ‘winner’ are determined much more at random than by inherent fitness.
The policy implications of this are important. If we think the neutral theory applies in any serious way to corporate structures, the way to remove the dominance of the shareholder company is to allow more innovation, to allow different forms to come forward, one of which will eventually replace the dominant species.

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Monday 13 February 2012

Co-operation and Competition

Ed Mayo, ex-head of the New Economics Foundation and now of Co-ops UK, has an interesting blog (here) on the importance of co-operation in our economic system rather than competition. This is a really challenging and difficult topic.
Co-operation is extremely important to the successful functioning of the market-oriented economies of the West. But this is not because of co-operation as an organisational structure. The dominant form of corporate structure for over 100 years has been the shareholder-based joint stock company, and not organisations based on co-operative lines. But nevertheless, co-operation between firms is essential.
The most important reason for this is very simple. Complex economic systems contain many linkages between the different component parts. In an evolutionary context, we can think of a competitive relationship between two firms being expressed by a negative connection between them. If one does well, the other is likely to lose out, and its fitness is reduced. In contrast, a co=-operative relationship is positive. If one does well, the fitness of the other is increased, and vice versa.
Economic theory focuses exclusively on the competitive links. But these are dominated by the co-oerative ones. The structure of production is the reason why. Most economic activity does not involve the final consumer, the individual. It is business to business. So if a firm learns to produce something more efficiently, or if it innovates successfully, the companies to which it supplies benefit.
More generally, co-operation is needed to agree institutional structures in which economic activity can take place. And it is the basis of most contractual agreements. It is impossible to specify in complete detail most business-to-business contractual relationships – look at the massive difficulties caused by Brownite thinking on this in terms of the relationships between regulators and the regulated in the relevant sectors of the UK economy. A strong element of trust is required.
But all this co-operation, which pervades successful capitalist economies, has nothing to do with the organisational form of companies. It can, and indeed has, shown itself in a system dominated not by co-operative but by joint stock firms.
I have been interested in this for some time, and here is a very technical paper which examines what happens in an evolutionary system when most of the linkages are competitive and not co-operative.