Tuesday, October 7, 2008

What to do?

Decision makers at every level are perplexed by the turbulence created by the current financial crisis. Everyone is acting under great uncertainty -- business owners, state governors, the Department of the Treasury, the presidential candidates, and university officials. And yet today's actions may have enormous effects on the business, the non-profit organization, the family, or the state tomorrow. Liquidity drought, variations in cash flow, the availability of credit for major capital projects, the possibility of bankruptcy of major and essential business partners such as contractors, the possibility of further major job losses in various regions, abrupt decline in demand for houses and cars, and a plummeting stock market make for an environment of choice in which every action can have seriously bad consequences.

I'm thinking here particularly of decision makers who are responsible for large, complex organizations -- organizations that deliver services or products, that depend on staff and facilities to fulfill their mission, that need to make medium-term plans about investments of resources for future use, and that depend on assumptions about revenues in the future to satisfy the cash-flow needs of the enterprise to stay financially viable. What is noteworthy about this situation of choice is that it necessarily involves plans and projections about the future. And it involves the temporally extended coordination of activities of people and expenditures of resources over a prolonged period of time. This means that it isn't possible to achieve success through a purely opportunistic and moment-by-moment response to events. You can't fly a complex organization by the seat of your pants.

So how do we plan for the best outcomes in the current circumstances of turbulence and uncertainty? The normal assumption of continuity -- assume that most circumstances won't change much between today and tomorrow -- is distinctly inappropriate. Today's economic and financial environment has many moving parts -- and they interact in surprising ways. And unfortunately, it appears that there is no reliable science to guide us here. Experts disagree about the mechanisms and the potential remedies of the current crisis. Navigating this environment is akin to trying to catch a pingpong ball in a crowded wind tunnel.

So what is to be done? I mean to pose this question in the most pragmatic way possible. Given deep uncertainty about the changes that may occur tomorrow, and given a fairly deep ignorance of the fundamental mechanisms that are affecting this storm, how can prudent stewards of institutions and businesses do the best job possible to preserve the fundamental interests of their stakeholders and carry out the missions of their organizations?

There are a couple of rational-choice answers to this question, falling generally under the topic of "decision making under risk and uncertainty." One prescription is the expected utility rule: identify the possible actions and their various outcomes; assign a probability and utility to each outcome; and choose the action with the greatest expected utility (sum of the products of probability and utility for the outcomes). Or we might consider the more risk-averse rule, the minimax principle: choose that action with the least bad worst possible outcome.

Unfortunately, neither of these decision procedures is of much help in current circumstances. We don't know what the range of possible outcomes is for a given action or policy (because we don't understand the mechanisms); we can't assign likelihoods to outcomes; and it's not feasible to measure the utility of a given outcome, all things considered. So expected utility decision-making doesn't seem very helpful in current circumstances.

Another approach depends on what we might call "locally rational decision-making" or heuristic decision-making. We don't know what the consequences of an extended liquidity crisis are, but we may reason that more reserves are always useful; so we may choose to curtail spending today to increase reserves. Or we may observe that an additional debt burden for the business is likely to be a handicap in the future, so we may postpone important capital projects. Or we may defer hiring additional staff in order to preserve more budget flexibility in the future. But notice that there are rules of thumb that point in the opposite direction: "A business should take bold moves in times of crisis, to leave it in a stronger position when recovery begins." This advice would encourage investment rather than curtailing it. So the problem with rules of thumb is that they often come into conflict with each other -- leaving the decision maker in a quandary.

In fact, if the range of uncertainty is great enough, it is impossible to be prudent. Prudence involves taking steps today that are most likely to leave you in a satisfactory position tomorrow. But if we are uncertain about even the most basic truisms -- if we are in a position where the most basic assumptions of continuity are defeated -- then we can't begin to weigh possible outcomes or design prudent strategies. It's hard to see how a pilot could fly "prudently" in the dark and without instruments.

It would seem that today's financial crisis doesn't create quite this degree of radical uncertainty, however. It is a fair bet that the world economy and financial system will survive and will recover within a few years. It is likely enough that cash reserves will be very useful for organizations and businesses in the next few years. It is likely that risky decisions have a greater potential for enterprise ruin than in normal times -- "high risk, high reward" is probably a bad rule to follow in current circumstances. And these assumptions add up to a counsel of conservation of resources, flexibility of activities, cost discipline, and preservation of accessible reserves.


Siyuan Song said...

Basically a financial system has only one function: exchanging financial resources to satisfy every trader. But this activity involves time and then risk follows.

Risk actually comes from what we cannot understand, predict, or control. The biggest risk in our minds is usually losing life. Therefore, comparatively financial risk is not taken seriously enough, especially because it is also an invisible risk and it is shared by institutions while not individuals.

A strong financial system relies on a strong production system, which relies on technology and natural resources. On the other hand, a strong financial system could motivate the production system to move too far.

If we investigate a society from the perspective of control theory. We could see that when the positive feedback cycle of a society goes too far, the negative feedback cycle will begin to work. Wall street companies have moved our society beyond normal growth too far, too risky, too volatile. Now we are coming back to stable by throwing away the excessive movement. Whatever the excessive movement is, that is the waste of our social resources.

contango said...

an intelligent and interesting article. thank you