Strategies for a discontinuous future.

Friday, May 12, 2006
On Risk

Higher Learning in France Clings to Its Old Ways - New York Times
I was doing some more thinking after commenting upon Umair's earlier post on the idea of at-will employment when I came across this article. While the article focuses on the ills of the French education system, it also illustrates one of my key theses on wealth creation.

Conventional wisdom holds that deployment of capital and labour create wealth. However, this misses the critical role of risk taking and management. It is the embrace of change against all fears and acting out of conviction in the face of active opposition - indeed, as a contrarian - that leads to creation of wealth.

This is as true of individuals as it is of societies and corporations. Quite frequently, people arguing against capitalism and free markets pose me this hypothetical : would you call it a fair system if two equally intelligent people born into similar backgrounds with similar qualifications and work ethic end up being vastly different in terms of their financial well-being? In other words, shouldn't a fair society be the one where equally qualified people end up more or less equally wealthy?

On the face of it, this is a seductive line of logic, but my answer is always the same: how do their attitudes to risk compare? Do they embrace change equally and pursue the same opportunities? If not, then the answer is no. A fair society is one where only equality of access and opportunities are guaranteed, not the equality of outcome because at the end of the day, how far you go in life depends upon what you make of the opportunities that come your way and, even more importantly, how many opportunities you create yourself. Consider two equally talented and qualified people John and Jane Doe. If John Doe works for the government all his life and retires after working for 30 years with a pension while Jane Doe lives on four different continents, changes three industries and seven companies, tries to create a business of her own a few times, fails and goes bankrupt but still keeps trying until she succeeds spectacularly then clearly John and Jane will differ significantly in how rich they are when they turn 60.

What are the societal implications? First of all, on aggregate, the entrepreneurial population will be richer on average but within that group, there will be vast differences in wealth. There will be a few that succeed spectacularly, many who are moderately successful and a few who would have failed. Compared to this, the non-entrepreneurial group trades off stability and security for less wealth so on aggregate they will be poorer but the income levels will be more uniform, i.e., the standard deviation will be less. Therefore, the degree of inequality of wealth distribution would be significantly correlated with the overall change embracement and entrepreneurial attitude of the population. This is the familiar boogeyman created by socialists who see the gap between the rich and poor as, ipso facto, the evidence of the unfairness of the capitalist system. Of course, this is retarded : it's much better to live in a society with a few Bill Gates's and Larry Elison's who themselves may be multibillionares, but who create thousands of millionaires among their employees, allow hundreds of thousands of risk averse non-entrepreneurial people to trade off instability for steady income and middle-class lifestyle, and generate billions of dollars of wealth for the society at large which gets further redistributed through taxes and pension funds.

It is obvious that a society needs successful entrepreneurs for the economic well-being of its people. Successful entrepreneurs make it possible for the majority of risk-averse population to trade off labour for steady income and, more importantly, risk reduction. This is a critical point : entrepreneurs are not only income creators for the society but also risk-reducers fore the masses. I don't think this is fully appreciated by most economists. Entrepreneurs not only create wealth but they also mitigate economic risks for the non-entrepreneurial segment of the population.

In effect, the society gets not only a share of the wealth created by the entrepreneur, but it also gets a free subsidy in the form of risk reduction and mitigation from the creation of a successful enterprise. Furthermore, successful enterprises create a portfolio effect at te societal level as risk is distributed across many segments of the economy. I don't think we value or appreciate this portfolio effect, but it is critical to the resilience of an economy. One result of this portfolio effect is that it allows re-deployment of capital and labour to the most productive segments of the economy. For example, a lot of the redundant personnel from forestry and manufacturing industry in Canada are moving to Alberta and finding jobs in the oilfields. Similarly, a lot of dot-commers and telecommers are now working in non-tech industries.

Therefore, it is critical for a society to develop deep pools of risk absorption capacity, and nurture its entrepreneurs. How can this be done? At the aggregate level, one way to look at this is the risk-taking capacity of the society as a whole as manifested by its enablement of individuals to survive the conequences of risk taking. Are there policies and mechanisms in place that make it easier for people to take risks? Some of this are: easy availability of risk capital, venture-friendly tax regimes, availability of deep skills pool, large domestic markets, mechanisms to transfer learnings from successful entrepreneurs to newbies, social safety net and so on. Mechanisms such as universal healthcare and unemployment insurance in Canada should be evaluated not only for their compassion value but also how much they help in increasing te risk-taking capacity of individuals : social safety net goes far in increasing the risk-taking capability of the society as individuals are assured that two of their fundamental needs - basic survival and healthcare - will be taken care of even if they fail.

Similarly, at-will employment laws should also be seen as contributors to business risk mitigation as I argued in the other thread. Imagine what would happen in the absence of at-will employment : not only would businesses not hire as much, the workers themselves would not have as much incentive to seek active change. They would continue working for dying industries and/or companies for far longer than would be economically efficient. However, ease of layoff ensures that they quickly figure out what to do next, which usually leads to them finding a job that is economically more robust and/or to re-education and re-training for new skills that are in demand which usually comes from new and growing segments of the economy.

I think there're economies of scope and learning in this as well : the more a society learns how to do this, the larger the fraction of its population that gets better at it.

Other factors are socio-cultural: attitude of consumers to new products and services, social stigma attached to failures, the prevailing mythos in the society, social network & capital and so on. For example, note the quote from the NYTImes article:

"We are caught in a world of limits where there's no such thing as the self-made man," said Claire de la Vigne, a graduate of Nanterre who is now doing graduate work at the much more prestigious Institut d'�tudes Politiques de Paris. "We are never taught the idea of the American dream, where everything is possible. Our guide is fear."

Compare this mythos with the US where pursuit of wealth is a passion and where instituions from Babson College to incubators in Silicon Valley have deeply ingrained mythos of optimism and chasing the American dream.

As I argued in my previous posts, this is a key competitive advantage that the US has. It occurred to me that another evidence of this is the formation of new industry clusters as studied by Micheal Porter. I think Porter understood the role of economic factors such as economies of scope and learning in the formation of clusters, but I don't think he's accounted for the cultural factors. To me, the fact that outside the US the biggest clusters have taken root in Israel, India and China are the evidence that these socio-cultural factors matter just as much as the economic factors, if not more. In fact, the rise of clusters in India and China is concomitant with the dramatic change in their national mythos where suddenly the entrepreneur has gone from being a blood-sucking buccaneer to the world-conquering hero.

Contrast this with EuropeFrance where free enterprise is now a dirty word and suddenly it becomes obvious why Europe France will experience secular decline in its economic fortunes for the foreseeable future. It is sad to see that the national mythos appears to be one of fear, change-aversion and risk-avoidance. There's something terribly wrong with a country whose best and brightest can only aspire to become government bureaucrats. Is it any wonder that they are so far behind in terms of embracing people from other cultures within their midst or globalization in general?

-- Mahashunyam // 6:54 AM //


Good post!--James Scott's Moral Economny of the Peasant stands out among the academic work on risk taking and management (eg survival guarantees). He studied peasants' risk-reward calculations for choosing which subsistence giving crop to cultivate (steady, lower-yeilding vs riskier, higher-yeilding) and pooling risk.
// Anderson // 8:15 AM

Very good post indeed. However I suggest being more cautious when concluding that �Europe is destined to a secular decline�. Europe is many countries, many cities and many different ways of thinking and approaching life.
// macaia // 7:45 PM

Your discussion of risk as a critical success factor at the individual level is brilliant.

Connecting the risk profile issue to at-will employment is entirely false - you have no argument there. Risk is a free-will issue; at-will is a legal mandate.

Do we understand you correcly that you disagree with Umair that the US workplace is dysfunctional? It appears that you are predicting the decay of all global worplaces that don't map to the US way of doing things.???

Again - I suggest you research at-will, particularly its (grandfathered in) origins and the (legitimite) arguments on either side of the issue - your opinion on at-will appears to be those of an outsider looking in on this one - are you employed in the US?
// David G // 9:13 PM

Taking Their Business Elsewhere
"Foreign companies are spurning U.S. exchanges. Regulation isn't the only reason."

// Dimitar Vesselinov // 1:46 AM
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