Dramatic slides in housing prices, auto sales, and oil prices have caused—need we point out?—tremendous turmoil over the past year.

We were out in front on all three (click to enlarge):

Auto Sales
 

Oil Prices
 

Housing Prices

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Arguing about performance-based pay is running neck-and-neck with grousing about bonuses, whether they be too big or too small, among popular topics this holiday season. In their upcoming paper, “Give & Take: Incentive Framing in Compensation Contract,” Judi McLean Parks (Washington University in St Louis) and James W. Hesford (Cornell University) test out their hunch that certain compensation packages may be linked to rising fraud, losses from which are currently estimated by the Association of Certified Fraud Examiners to total something like $994 billion annually.

Since compensation packages are considered a central tool in managerial control systems, managerial accounting research has long taken an interest in how compensation packages influence behavior.  A primary foundation of such research is agency theory, a model that assumes agent and principal are self-interested, but in divergent goals, that agents will shirk, “if necessary, [with] guile and deceit,” and that principals will attempt to control agents through monitoring or by aligning the interest of the agents with their own.  In theory, performance-based compensation systems are one way to accomplish the latter.  This may have worked well at GM in the 1980s, when line-workers were put on performance-based pay, so that when GM did well, they did well, but when the agents themselves are reporting the results, such contingency packages may instead encourage financial mismanagement and deceit.

In an effort to supplement empirical studies of performance-based pay, and to include penalty-contingencies, which are actually quite common, McLean Parks and Hesford undertook a controlled study.  Rather than the obvious choice of rats as participants, the authors brought in a random sample of students, paying them for solving anagrams under three compensation packages: flat salary, performance-based bonus, and performance-based penalty.  Each student was given a package with instructions, a “high-quality attractive pen” (keep your eye on these), and self-evaluation forms. Once they turned in the self-scored performance sheets, they threw away their actual work, allowing plenty of opportunity for fraud.

Basic results: those receiving flat salaries were the most honest in their reporting, those on bonus-contingent schedules were less honest, and those on penalty-contingent schedules were the least honest.  Even worse, when no ethics statement was signed, those on penalty-contingent pay were three times as likely as those on salary, and twice as likely as those on bonus-contingent pay, to steal those attractive pens.

The authors unearthed a concern about the use of ethics statements, such as the attestations all CEOs must sign under Sarbanes/Oxley.  Although, overall, 46% of those who did not sign such statements stole their pens, and only 29% of those who did sign statements did not “misappropriate assets,” the details are more complicated.  Those facing performance-based penalties were more likely to misrepresent their performance if they had signed such statements than if they had not. The authors suspect that the existence of the statements themselves suggested to the agents that the principals were weak on apprehending fraud. Why else would they be required to sign such statements?

McLean Parks sums up: “For years we have touted the basic mantra of pay for performance because that's the way you get the best performance. Maybe you get the best performance reported, but what's the underlying performance?"

Not really in the holiday spirit, but you can read the full study, still under review, here:

https://www.business.utah.edu/humis/docs/organization_962_1224879507.pdf

Since we have made it to December, that probably should be February or March, but it’s what Merle Haggard wrote. (A shout out to the handsome Hag as he recuperates in Bakersfield.) It’s hard to keep up with the onslaught of staggeringly bad economic news coming in these days. Not only that, we’re facing the fall-out of Secretary Paulson’s bewildering failure to manage the current crisis, or at least to maintain the all-important appearance that he knows what he is doing, and recently revised data indicates that the job market was in even worse shape than previously thought going into this mess. Nevertheless, like the tentatively hopeful recent lay-off in Haggard’s song, we do see some real opportunities for setting our “real” economy on a more fruitful course in the current turmoil.

During the boom there was a good bit of talk about how as a nation we can do without a strong manufacturing sector. The cliché became, “Michigan is irrelevant,” with abuse heaped on the Great Lakes manufacturing states for being beyond repair. Actually, those same states have made real progress in R&D employment, but it has not been enough to offset job losses in the automotive sector. As we re-evaluate our thinking, it’s clear that we need our manufacturing base: time to go crawling back to the Midwest. Current research suggests that design teams are more productive when they work closely with those building the products, which undermines the idea that the best course is to design things here to be made elsewhere, another reason to invest in domestic manufacturing. And the idea that accompanied waving goodbye to “dirty” manufacturing work, that there’s some sort of financial dark matter we’ve got going for us that could prevent a financial big bang, has really got to go.  It’s a shame that the terms our scientists come up with to describe true mysteries get abused like that, so let’s just say that although the current less awesome/more awful “big bang” wasn’t avoided, it’s surely a contender for great moments in creative destruction.

Multiplication

There is no question that public spending will be re-shuffled as we come to terms with the economic consequences of the slow erosion of our infrastructure, our manufacturing sector, and, in the longer term, our scientific research funding.  We’ve put together some stats on some of the economic benefits of shifting more public investment to these areas; there is reason to be hopeful.

Military spending was 3.8% of GDP in 2000, its lowest level since 1940. It rose to 4.7% in 2004, where it stayed until the end of 2006, then rose to 5.1% in the first quarter of 2008, and spiked to 7.4% in the third.  As this graph shows, our economy would look even rockier without this stimulus.

With the federal budget taking on water and the economy in turmoil, military analysts are certain that big spending on big projects, projects made even bigger by cost overruns and delays, will be curtailed.  Of course, none of this will turn on a dime, but a shift away from defense spending and toward other public projects that were left to languish is a shift toward greater stimulus. Military spending has an over-all economic multiplier of 1.61, which means that for every dollar of direct investment, another 61 cents of economic activity is generated. That’s actually pretty low, about equal to spending in the retail sector. For the broad sectors, the big multipliers are in manufacturing, 2.43, and construction, 2.08. Much of the public money we will spend to avoid a deeper recession will be made in subsectors of these two strong sets with even higher multipliers.  It’s important to remember that we are also coming off the bubble in residential construction, which has among the highest sub-sector multipliers, 2.27. So, what might we expect from some of the projects in President-elect Obama’s quiver?

Rocks and gravel

At their 2008 Annual Conference, American Society of Civil Engineer President D. Wayne Klotz declared this the Year of the Civilization Engineer. (We had hoped for the year of the Indy Financial Writer, but looks like they beat us to the punch.) He probably has a point, at least in terms of revenue.  As a nation we got a D in infrastructure in 2005, our most recent marking period, and ASCE projects that we need to invest $1.6 trillion to get our infrastructure into “good” condition. (For example the EPA estimates there is currently a $540 billion gap between what communities are spending and should be spending on water infrastructure. Disgusting examples of that include parasites traced to faulty pipes in a Colorado town. ASCE estimates that 27% of our bridges are “structurally deficient.” For that we have a tragic example: the collapse of the Mississippi River I-35W bridge in 2007. Those with strong stomachs can read more here: http://www.asce.org/reportcard/2005/index.cfm.)  President-elect Obama has pledged resources to this sector.  State and local government enterprises are labor-intensive (more on that below), and have an overall economic multiplier of 2.22, so the overall stimulus of spending on infrastructure projects is about twice that of spending on defense, and is basically even with residential construction.

Retrofitting: Make mine green

Obama has also promised to exert major efforts in retrofitting and other public projects aimed at a more fuel-efficient economy.  This is good news for our workers since a larger percentage of project capital is spent on labor in such projects than in new construction, where materials and underlying real estate eat up more money.  Robert Pollin of the Political Economy Research Institute at UMass, Amherst, and Bracken Hendricks of the Center for American Progress have researched the economic benefits of a $100 billion package, to be spent over the next two years, aimed at creating jobs laying the foundations for a low-carbon economy.  (For those with over-taxed memories, the stimulus checks sent to households beginning in April cost about $100 billion.) $50 billion would be allocated to tax credits to help businesses and homeowners finance retrofits and investments in renewable-energy systems, like geo-thermal.  This is important as it encourages private investment that will create jobs now, offset by lower fuel costs in the future. Direct government spending of $46 billion would be devoted to retrofitting, an expansion of freight rail and mass transit, and building smart electrical grids.  Of this, $26 billion would be devoted to retrofitting 20-billion square feet of public buildings, resulting in an estimated energy savings of $5 billion a year. The remaining $4 billion would be set aside for federal loan guarantees to underwrite private credit for investments in renewable energy and building retrofits. Using the Bureau of Economic Analysis’s input-output tables, Pollin computes that every million spent on public infrastructure creates about 17 jobs, and on green investments 16.7 jobs, which compares to 14 jobs for tax cuts for household consumption, and 11 jobs for military spending. Putting it all together he believes at the very least the program he describes would replace the 800,000 construction jobs we have lost in the last two years, and is more likely to create about 2 million jobs, bringing the unemployment rate back into the low-5% range. (More here: http://www.peri.umass.edu/fileadmin/pdf/other_publication_types/peri_report.pdf; Map of some working projects available here: http://apolloalliance.org/apollo-14 )

Michigan, Ohio, Indiana: we can’t make it without them

We have been asked our opinion on the wisdom of advancing bridge loans, in addition to the $25 billion set aside to enable the retooling necessary for producing more fuel-efficient cars, to the Detroit 3. It’s unfortunate that this question is devolving into a battle between Democrats and Republicans; there’s a lot at stake.  Auto-manufacturing has the highest overall economic multiplier of any subsector (2.87) and job multipliers between 5 and 6.5 for each primary assembly job. In a report that received wide attention, the Center for Automotive Research suggested that a failure of any one of the Detroit 3 could set off cascading job losses up to 2.5 million in the first year, as well as heavy hits to state and federal revenues. Some have argued that CAR’s numbers are too high. Well, OK then, let’s say job losses of 1 million; that’s still awfully high. Although it may be true that many of the D3 workers would eventually be picked up by the transplants, throwing the region—MI, OH and IN have a combined population of about 28 million, or 9.3% of the U.S. total—into that kind of turmoil is too risky right now.

Some are suggesting bankruptcy is the better way, but we’d suggest three major risks to that. First, an auto made by a bankrupt company would be a hard sell.  Second, restricting funds for new products that may be truly successful, like the Chevy Volt, is throwing in the towel prematurely. And, third, bankruptcy is a unpredictable process and can quickly move to liquidation, which would likely be the end of our domestic automotive industry. Some think that’s a good idea. We don’t. If we are serious about rebuilding our manufacturing sector, a clear lesson from the current meltdown, we need our domestic auto industry to be whole again.

Looking forward, it’s worth noting that the automotive industry ranks sixth in R&D spending, with annual outlays of about $18 billion.  Recently built shiny R&D centers in the Midwestern manufacturing states may be at odds with the popular stereotype of the Rust Belt, but they’re there, and it’s a smart decision to build on what we have, and develop the synergy between R&D and manufacturing that will support innovation in transportation systems. [More here: http://www.nsf.gov/statistics/seind08/c4/c4s3.htm]

The original plan was to ask for $50 billion, but the request was halved, according to one industry analyst, because the full amount sounded unrealistic.  He added, back in October, that the $50 billion now looked like chump change, and he was referencing Secretary Paulson’s $700 billion bailout, not the $7.4 trillion currently set aside by the Fed for assorted bucket work.  With somewhere between 1 and 3 million good-paying jobs at stake, a relatively modest $25 billion spent heading off yet another crisis sounds pretty good, especially since there is nothing in the TARP legislation that would prohibit this. But we need a real plan from management, and should allow no excuses from anyone. It’s alarming to hear elected officials suggest we can’t make these loans because the auto chiefs will just go back to doing what they have always done. We wouldn’t accept such ineffectual reasoning from our own children, would we?  And we need to allow for the possibility that the importance of product innovation has finally been embraced at the top levels. (http://www.cargroup.org/documents/InnovateorDie_clean.pdf)

Emergent phenomena

Since we’re talking about shuffling funds, we want to make our standard plea for public funding of scientific research at levels adequate to maintain our international leadership. A most galling development in recent years is the assertion that the US would naturally hold the lead, coupled with dwindling public funding of the crucial research behind that leadership.

Here’s one example: Throughout the 20th century, the United States held the undisputed lead in Condensed-matter and materials physics (CMMP). CMMP, the largest physics subfield, comprises both pure and applied research into complex phenomena born of simple things. Although decades often pass between the humble advances in our understanding of those simple things (rocks, ice, snow, water) and the dazzling inventions that rock our world, it is widely accepted within the scientific community that long-ranging CMMP research leads the technological revolution.

Early in the 20th century parent companies invested in their long-term futures by encouraging high-risk long-range research in their industrial labs. GE founded their labs in 1900, Bell in 1925; and IBM’s TJ Watson in 1945. The results were stunning: X-ray tubes, transistors, lasers, the integrated circuit, and the discovery of cosmic micro­wave background radiation matching just what a team of astrophysicists at nearby Princeton had calculated would linger from the Big Bang, were all products of these privately funded labs.

Although private institutions currently provide two-thirds of overall R&D funding, the rush to market pushes them to focus on incremental improvements to already existing products; they often concentrate on the D while neglecting the R, and funding of longer-range research has dropped to just 10% of the industrial investment budget. (The NAS cites the research models in many of the new venture-capital funded start-ups as a big contributor to this mindset.) The federal government remains the largest supporter of CMMP research itself: current funding levels are $600 million a year, roughly flat over the last decade in inflation-adjusted dollars. But the likelihood that a CMMP grant application will National Science Foundation funding has dropped from 38% to 22% in the last five years; new investigators face a bleaker 12% chance, down from 28%. And our CMMP PhD awards have fallen 25% over the same period. At the same time other countries are rapidly increasing funding. In the last decade the number of articles published by U.S. authors in two international scientific journals has just held steady, causing the percentage of articles published by U.S. authors to fall from 31% to 24%.  If part of the plan is to maintain our lead in the international scientific community, as well it should be, we can’t continue to accept a crippling lack of funding. But we can end with some encouraging news.

Bucky paper: That’s what we’re talking about!

In October, an international team at Florida State University announced they have made significant progress in developing manufacturing techniques that may soon make bucky paper competitive with top composite materials currently on the market. We’ll guess that when many web-surfers clicked on the link only to see that the thin sheet of aggregated carbon nanotubes is virtually indistinguishable from a small sheet of origami paper they quickly moved on.

But bucky paper has the requisite characteristics of a true materials break-through:

1. Its development is moving at a snail’s pace; 2. It is an unexpected side product of a different quest. (In 1985 researchers at Rice University set out to create the same conditions that exists in carbon-creating stars. One “extra character” showed up out of left field: the buckyball, AKA the third form of pure carbon we have discovered.  While fooling around with buckyballs, researchers stumbled upon their tendency to stick together and, by filtering them through a fine mesh, produced bucky-paper);  3. Its physical properties are hard to fathom—one tenth as heavy but potentially 500 times stronger than steel, conducts electricity like copper and disperses heat like brass (unlike other composites), and made from carbon molecules 1/50,000 the width of a human hair; and,  4. It’s a true international collaboration. Lockheed Martin Missiles chief technologist Les Kramer suggests bucky paper will be a radical technology for aerospace, others possibly a Holy Grail. (More here: http://www.hpmi.net/)

What’s not to like? Let’s make sure there’s more to come.