Unsolved Business Mysteries

First a shout out to Christof Meyer for putting together and moderating today's presentation of faculty research. Darden's faculty was recently rated #1 for teaching by Princeton Review. I love case discussion at Darden, but I have to say it's a nice change to get out of the classroom and hear professors present on the current research they are working on.

Ron Wilcox (author of Whatever Happened to Thrift and my two-time marketing professor) shares, off the cuff, what interests him academically. Wilcox comes to marketing by way of economics and his interests lay at the intersection of these two fields. For the past two plus years, he's been working on the uplifting topic of the debt cycles of US households.

Rated against the rest of the developing world, the US has the lowest savings rate. He thinks that the current financial crisis is predicated on this. Running up to the crises, many people went out and bought things that they could not afford. But buying things we can't afford is nothing new--Ron says that historically Americans like debt--he cites Thomas Jefferson and GIs coming back from WWII (towns like Leavitt Town were built from Sears Roebuck with their debt).

So why all the problems now? And why can't we save? Two reasons: US is a good place to store money. People from all over the world funnel money to the US, keeping interest rates low, and returns on savings are low (oftentimes below rate of inflation.)

Second, in terms of the psychology of nations--Denmark is the happiest; US is the most optimistic -- we always think tomorrow is going to be better than today. And if you believe it, you don't save much.

Ron's most recent research delves into marketing and psychology of the American consumer. People handle money in strange ways using mental accounting. One of the crazy ways people do mental accounting is, if they've already spent a lot, it's easy to spend a little bit more. Think of the extras you end up shelling out for when you buy a new car, or how much you'll pay for a parking space in the Darden garage after paying thousands for your education.

He also looks at the psychology of debt, and in particular student debt (which with my debt from student loans, is frighteningly personal). In recent years, he says, there have been exponential increases in student debt. I look around the room and people are smiling nervously (I am, too). Wilcox further asks if getting into other forms of debt are easier for us? Credit card debt? Car debt?

To provide an example, albeit a pretty absurd one, Wilcox once played poker with Darden students (it was an item in the Building Goodness in April Auction). He wondered, "Where in the hell are these people coming up with this money--(I can't and) I'm employed!" But he realized that if you are 50G in debt, what's another $100 in a poker game? For a society massively in debt, this has pretty big implications that aren't all worked out yet. This is Ron's unsolved mystery. So he's a marketing teacher by day, and by night tries to think of ways to get people to save money.

Casey Lichtendahl discusses his joint work with another Darden faculty member, Sam Bodily (second year Mgmt Decision Models). He'll be talking about the subject of one of his recent papers, 'Preferences for Consumption Streams.' He gets started pretty quickly and it gets complicated FAST.

According to Casey's presentation, a major objective in life is to increase one's consumption in each year of remaining life. In order to plan, we have to think about preferences for uncertain consumption streams (uncertain because we all die).

Lichtendahl relates expected consumption to NPV. I thought NPV was all about the present value of future cash flows. According to Lichtendahl, it's an additive utility model for income over multiple periods. This explains some of the difference in the way me and Casey think. I believe that Casey thinks, in general, a lot more than I do.

Lichtendahl says that previous work has not researched all additive forms and properties, such as scale of variance. Are you are indifferent betw 50K this year and 50K this year, and $40K this year $63 next year? Let's say you were indifferent, then I scaled both up by 10%. Would you still be indifferent? If firms or individuals use NPV, it should stay the same.

By this time, I would posit that I knew about 10-20% of what Lichtendahl was talking about, but let's keep going. Here's two scenarios -- Scenario A: you get 50K this year, scenario B: there is a 50% chance of 50K+delta and 50% chance of 50K-delta/2. If delta was $10,000 one student from the audience would prefer getting $50K now because of the risk of losing in Scenario B.

Now lets look at same deal. Same scenarios A or B, but you get a guaranteed 40K in year two no matter what you do in year one. If this changes your mind, it means you cannot have separable preferrences, which leads to needing -- a model with multi-variant risk aversion (which I guess is what Lichtendahl is attempting to do in his research).

You thought that was it. It's not, it gets even more complicated. Now you have to choose between two scenarios that each have two distinct probabilities. The expected monetary value is equal between the two, except in one there is a chance that the value you get will be reduced by an unknown amount.

The main result--a multiplicative function allows for the expression of uncertainties (the most common ones: death and taxes). Casey provides an example of one 30-year old's (let's call him John Darden) consumption plans under mortality risk, and shows how the model changes if it incorporates multi-variate risk.

Thankfully, one of my classmates inquired about the practical applications of this research. It aims to help people deal with risk seen later in life, and helps insurance companies advise people on preparing for retirement. Christof points out that current models suggest saving early, while Casey's model puts this into question and suggests that one can consume more earlier in life if one saves at the right time/amount later. As Christof puts it, "so, we get more pleasure with your model. That's great!"

For more multi-variate fun or to make sense of all this, check out: http://faculty.darden.virginia.edu/lichtendahlc/research.htm

Now for something completely different. Sean Carr is one of director of Darden's Batten Institute, currently in the doctoral program at Darden. Carr worked with Bruner on 'Deals from Hell', a book on why some M&A deals failed. This led them to think, what else fails and why? Well, according to Carr, financial systems do (and we all know it's true). Carr's background as journalist covering finance and economy for CNN and ABC News was useful in forming narrative for his more recent joint-effort with Dean Bruner, 'The Panic of 1907,' which provides valuable lessons for anticipating crisis and which I wish more people in Washington read, earlier.

It was really fascinating to listen to the reasons that Carr stipulated were behind the crisis:

Growth. The US was emerging economy, GDP growth 7.4% following waves of consolidation 1800 firms into 94 companies. Hot markets are incubators for crises -- sharp increases in trading, this time it's different attitudes, rising prices leading to over-valuation, etc.

Macro-economic Complexity - In 1907, the financial system was not quaint - it was already fairly complex, and global -- 16,000 financial institutions (~7500 today).

Inflexibility - tight linkages in such a complex system.

Cognitive Biases Are Amplified -- I took this to mean that people are jittery, they don't know what's going and so respond to rumor badly.

Adverse Leadership-- TR was president. As a trust-bsuter, he used words like malefactors and pointed fingers. Carr argues that TR created more uncertainty. Like our current President, he also decided to take a lot of time off around the crisis. He was off somewhere hunting bear when 1907 happened.

Exogenic shock - April 1906, massive earthquake and ensuing fires destroyed SF. They had earthquakes in SF, we had Katrina, tsunamis, and more.

Failure to Organize Collective Action -- JP Morgan was in semi-retirement, and, at first, refused to take control. When he finally did, apart from injecting his personal funds, he compelled heads of other institutions to do something.

Today's crisis, Carr argues, also smacks of an ability to pull together. But ultimately, there is no silver bullet, or one thing to explain how we got in this mess. There needs to be a wider range of explanations, moving parts that on convergance lead to crisis, and while the past does not predict the future, I believe there is a lot we can learn from past crises.