Risk-adjusted money, cars, supply chains, startups, and why the Internet is killing us all…

Here’s a big insight I want to share with you, something which could change how you think about startups and finance: but all the same, as with my talk on Dangerous Reasons, you probably won’t like it…

For all the obvious reasons, I don’t tend to watch a lot of TV: but Storyville’s “Inside Job” (by Charles Ferguson) a few days ago was irresistable viewing and set me really thinking. The way Ferguson tied a succession of leading “economists” and their universities in deservedly squirmworthy knots was exquisitely masterful: but for me, the star turn of the whole show was the former chief economist (2003-2007) of the International Monetary Fund Raghuram G. Rajan, a man so utterly modest he doesn’t even appear in the Inside Job IMDb credits.

What Rajan presented to an elite conference in September 2005 [timecode 38:30 – 40:40] was a paper called “Has Financial Development Made The World Riskier?” (hint: the answer is ‘yes, it bl**dy has’). His idea was that even though investment bankers were being incentivized to do big deals that increased their companies’ risk exposure, they were not being compensated in risk-adjusted money. Let’s say your company is worth £10m and currently has a 10% chance of failing: you’re now offered a deal that’s worth a further £10m and gives you personally a huge bonus today but increases your company’s risk of failure to 50%… would you take it? It would seem that lots of people on Wall Street basically answered ‘yes’ to this question… all of which led to the overleveraged, hyper-inflative, non-‘AAA’-securitized fake mortgage context for the 2008 Credit Crunch etc. That is, they weren’t making more money while taking less risk, but making more money while taking more risk. If individual agents had been compensated in what Rajan calls “risk-adjusted money” for such insane deals, the bonuses would have flowed in the reverse direction (and 20x greater magnitude, too).

While I was talking with my friend Alan Ferdman yesterday, I was struck by a strong parallel between Rajan’s insight and the car industry. Everyone seems to have a car mechanic story about how fancy-looking car X suddenly developed a computer fault Y and had to be scrapped rather than fixed. That’s an example of fragility: how the risk of electronics failure reduces the effective value of a thing. If roughly 25% of a certain car model will develop a computer fault within 2 years (but you’ll never know in advance until it just happens to happen to you), then that’s an example of an object having a different risk-adjusted value. Alan mentioned how Keith Armstrong had discussed whether a short-lived EMI (electromagnetic interference) fault could have led to Toyota’s “Sudden Unintended Acceleration” problem: fascinating, awful, and terrifically fragile, whatever the actual cause.

Supply chain fragility affects us all too, whether via oil affected by civil war in Libya, hard drive component factories in Thailand destroyed by a tsunami, or a PCB materials factory in North-East Japan hit by a nuclear evacuation. In the MBA-optimized Just-In-Time world we live in, we are so (virtually) close to the producer that the cost of the things we need becomes inherently more volatile: how can we give peas a chance when we don’t know if we’ll still be able to afford them tomorrow? Or eggs? Or beef? Or bread?

Weaving all these strands into a single picture, and I think you’ll find an economics mega-gauntlet being thrown down in front of you. Might it be true – the challenge goes – that for almost all companies, economic development in real terms has now ceased? If a company needs to take on substantially more risk in order to grow, is that company really growing? In risk-adjusted money terms, the answer is that it probably isn’t – it’s merely appearing to grow. It would rather live in more risk than stay as it is: but that way lies chaos, mayhem and disaster.

As financial managers, we are supposed to deal with this by factoring in contingent liabilities, not only real (contractual) ones in our actual accounts but also predicted exposure scenarios in our management accounts. However, for all the supposed rigour of risk management, I think it’s actually almost impossible now to conceive and generate a sufficient number of scenarios to cover all manner of supply chain, finance, channel, and customer fragilities. If the world has apparently become richer while simultaneously becoming more fragile (far beyond merely ecological viewpoints), has it actually become richer, or is it the same, or perhaps even worse?

The whole Just-In-Time thing is simply a way of concentrating, multiplying and sharing fragilities, rather than reducing fragility. Yet that is the channel distribution model the world is increasingly moving towards, in terms of mutualizing the optimized returns on its deployment (in the form of lower customer prices) yet exposing everyone in the chain to more fragility. We save money, but the price of our electricity and petrol is suddenly hugely volatile.

In a lot of ways, it would be useful if we could price up our startups in terms of risk-adjusted money: in many ways, that’s what VCs and lead angels do when they negotiate valuations with entrepreneurs. However, the very ground upon which we build our startup shacks has itself become fragile: one of the first things that happened to my own startup was that the fabless Korean company making the image sensor I planned to use went under – the vast chip foundry making its sensors ran out of money (so the story went), and without any hope of production it folded too. The problem is that if we can’t conceive the ten thousand ways in which the invisible infrastructures we implicitly yet absolutely rely on – water, air, broadband, staples, paper, biros, hard drives, RAM chips, sensors, cables, lead-free solder, whatever – can fail, we can’t possibly price up such pervasive risk. Perhaps this is the real reason startup funding dealflow choked: the inability to price up infrastructural fragility.

Arguably, an even bigger problem is that almost all the social media and digital media startups I see being developed, talked about, and talked up seem to based on an even bigger folly: that there is an infinite amount of ‘juice’ to be squeezed out of the systems around us, by using social hacks, GPS hacks, network hacks, recommendation hacks, gift hacks, etc. But if you stop to think this through this for even a moment, you’ll see that the implicit claim here is that startups can somehow disintermediate the economy out of its dark place: that we can macroeconomically grow by cutting out middlemen (middlewomen too, presumably) or channel owners.

And so I think Internet discourse is killing us: it promotes the idea that we should be applying our ingenuity to shortening and tightening supply chains (i.e. increasing fragility, increasing systemic risk) rather than trying to reduce risk and fragility. We should instead be making everyone rich by reducing fragility, yet the only obviously applicable skills from the MBA smorgasbord seem to increase it. As a design, engineering and finance community, we’ve lost the knack of building worthwhile things – of even trying to judge what is worthwhile and what is merely fragile.

Even though the dismally low-aim Lean Startup community tries to claim that the important question is “Pivot or Persevere?“, I think the only question of real worth is “Worthwhile or Fragile?” Make money, sure, but stop obsessing on optimizing social hacks and instead start building things that make a positive difference – things that make the world less fragile, not more. Do you know how?

(Again, I told you you wouldn’t like it.)

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