Re:Balance -- Jim Peterson

Book Report: Tim Harford -- The Logic of Life

The Logic of Life: The Rational Economics of an Irrational World  By Tim Harford Random House, 213 pages

Economist Tim Harford, in his new book, “The Logic of Life,” has greatly reinforced those who believe that rational decision-making is broadly pervasive in our daily lives.

Remember instinctively agreeing with the question in Mickey Gilley’s 1975 country song, “Don’t all the girls get prettier at closing time”?

Turns out, controlled tests show, that participants in the social meeting ritual of speed dating do indeed adjust their stated preferences for partners based on education, wealth or physical appearance, lowering their standards to the reality of who actually shows up.

If that example may seem unworthy, Harford also finds the same rationality in the choices of young black women to postpone marriage and extend their professional educations, in reaction to a reduced pool of eligible bachelors due to the incarceration rate of their male contemporaries.

In case after intriguing case – ranging from the curtailment of criminal activity by urban juvenile delinquents facing prosecution as adults, to the adoption of safe practices by Mexican prostitutes, to the reliance by over-eaters on improved availability of health care to lessen the effects of their obesity -- Harford outlines the experimental evidence that people know and act on the benefits and risks of their choices, re-calibrating as incentives, rewards and penalties may change.

Harford’s popularizing definition -- that economics amounts to the study of how decisions are made about the allocation of scarce resources – proposes that the resulting insights can support policy adjustments in pursuit of socially desirable goals – whether in the quality of urban schools or the levels of agricultural subsidies.

He brings a wide range of examples -- empirical research into such disparate and seeming irrational areas as the choice of high or low-brow movie rentals, the sexual habits of teenagers and the self-reinforcing concentration in urban centers of both wealth and innovation. From these, Harford teases out the often counter-intuitive evidence that most people, most of the time, perform some assessment of the costs and benefits of their choices.

The cases may at first glance appear to lack a basis in rational evaluation and choices: Some may seem emotional or addictive – to stay hooked on smoking, or gambling. Or selfish – disproportionate executive pay, which as it turns out is primarily motivating for subordinates, or financially effective (if socially unattractive) bigotry in hiring decisions. Or even non-human – laboratory rats quickly adapting their consumption based on the comparative “pricing” of root beer and tonic water.

Harford’s attention to the breadth of rational behavior among large groups of people, generally acting within the scope of their experience and sphere of comfort, does focus attention on the typical – to the exclusion of several important sources of influence:

•    Individuals will act far outside the norms – whether Jérôme Kerviel and his rogue trading at Société Générale, or the young Saudi men whose airplane hijackings changed the world on 9/11.

•    Important decisions are enforced under high stress or in unique and newly-exposed conditions – untested battle leaders and rookie athletes come to mind.

•    And individually rational behaviors can lead to collectively unpleasant results – resistance to voting, if an individual ballot cannot rationally matter, or herdlike safety in numbers – perhaps including the individually rewarding but collectively unsatisfactory performance of most fee-based financial advisers.   

Harford shares two themes with arch-empiricist Nassim Taleb (whose 2007 best-seller, “The Black Swan,” I reviewed -- see here ): insistence on the data, as a source of insight superior to the theorizing of cloistered academics, and the recognition that very small differences in the distribution of advantages yield widely exaggerated effects – whether in neighborhood segregation, comparative country growth rates or authors’ book sales.

A difference is in Taleb’s insistence that however interesting may be the common and every-day events by which our lives are primarily defined, it is precisely the occasional and most highly influential events -- unpredictable but far more common than recognized – that have the most dramatic effects – whether it would be Hurricane Katrina or Virginia Tech, October 1987 or the melt-down of the subprime mortgage market.

Which takes nothing away from Harford’s congenial and accessible explication of a way to rationalize and understand what may otherwise seem puzzling, exotic or intractable. Picking a better date, or renting a better movie, may not be so important. But the same learning can influence serious choices: how to affect urban traffic congestion, or control epidemic diseases, or even prevent the outbreak of warfare. And that matters.   

Auditor Concentration, Choice and Competition -- the GAO Takes a Pass

In the logging camps north of my little home village, lumberjacks teaming up on a two-man crosscut saw would admonish each other, “Either push or pull – just don’t drag your feet.”

Which on first glance would apply to last week’s report from the US Government Accountability Office, on the continued tight concentration in the market for audit services (here).

Despite re-affirming what has long been obvious -- namely, that almost all large public companies are audited by one of the Big Four firms, that audit fees have risen significantly in recent years, and that for global-scale companies, the option to choose among auditors is all but non-existent -- the GAO’s phlegmatic conclusion is that no compelling need for immediate action appears to exist.

So how well-deserved in the criticism of Comptroller General David Walker, head of the GAO – ranging from Paul Boyle, head of the UK’s accountancy regulators (here) to blogger Francine McKenna (here)? Can Walker really be expected to resolve the absence of client choice among the Big Four tetrapoly? Or to re-write fee levels, or to eliminate the threat to audit firm survival from ruinous litigation?

The concerns about large-firm fragility and performance do not lack for substance. The GAO’s sanguine view that audit quality has improved is already under challenge in the rapidly-growing population of subprime-driven litigations – a courthouse rush of new lawsuits marking a return to Enron-era levels (here), that to date sweeps in at least three of the Big Four along with clients of them all.

But to criticize Walker for foot-dragging is to mis-analyze the reasons for his diffidence.

The GAO makes a common but crippling error in its view of the impact of another large firm failure, on which more shortly. But its passivity is based in reality: it has available no achievable solutions, so its rational acknowledgement at least deserves recognition as credible.

That is because the critics of the current regulatory paralysis have no effective rebuttal to the GAO’s recital of the impediments to new entrants to the large-audit market:

First, the smaller accounting networks, suffering shortfalls in capacity, expertise and qualified personnel, lack either the interest or the risk appetite to take on audits at the Fortune 1000 level.

Second, proposed changes to allow outside investors in the accounting firms, with fresh capital to supplant the limitations of the private partnership model, cannot be shown either effective or beneficial. The firms don’t need, don’t want and couldn’t use the money, even if the bankers were prepared to take the risk, which they aren’t.

And, third, while the private market participants show their indifference to any initiative to help the auditors’ plight, beyond their own whining about limited choice, the menu of possible government actions is no more appealing.

That is, proposed official actions such as breaking up or spinning off parts of the Big Four, or requiring mandatory auditor rotation, or placing caps on auditor liability in hope of assuring their survivability, are all politically infeasible and potentially pernicious in their own unknown and unpredictable effects.

With the prevailing American political zeitgeist defined by populist cries for change, there is no chance of traction for either legislative or market-based relief in favor of a small cadre of high six-figure audit partners.

If the GAO stopped there, with its reputation behind an admitted inability to alter current conditions in any managed way, its shoulder-shrugging would at least advance the public discourse.

But its failure goes deeper – the same recurring flaw that runs through officialdom worldwide -- in the erroneous claim that the impact of another large-firm failure would be ameliorated by the relevant federal agencies. All three -- the SEC, the Public Companies Accounting Oversight Board and the Department of Justice -- are said by the GAO to be prepared to take various actions to help minimize the disruption to the market.

Walker and the GAO are wrong. There are no such preparations. The agencies are impotent. Out-going PCAOB chairman William McDonough admitted it in September 2005: “none of us has a clue what to do if another of the Big Four failed.” Unless there is a double-secret codicil to the GAO report, concealed somewhere in a bunker in a Washington file drawer, the same remains true today.

So the Comptroller General is merely acting out the bureaucrat’s classic rationalization of inactivity, in accordance with his basic genetic make-up: if nothing can be done, selling inaction as the best course becomes the strategy.

Or as baseball philosopher Yogi Berra would have put it, if the accounting regulators don’t want to solve the problems of large firm concentration and survival, nobody’s going to stop them.