The Inverse Skills Problem

THE INVERSE SKILLS PROBLEM

The higher up the corporate ladder, the higher the compensation to the individual. This might be justified, as it makes plenty of sense to pay individuals according to their contributions. However, and in general (provided we exclude risk-bearing entrepreneurs), the higher up the corporate ladder, the lower the evidence of such contribution. I call this the inverse rule.

I will be deriving the point by mere logical arguments. Chapter 2 made the distinction between those skills that are visible (like the abilities of a dentist) and those that present more difficulty in nailing down, especially when the subject belongs to a randomness-laden profession (say, one that includes the occasional practice of Russian roulette). The degree of randomness in such an activity and our ability to isolate the contribution of the individual determine the visibility of the skills content. Accordingly, the cook at the company headquarters or the factory worker will exhibit their direct abilities with minimal uncertainty. These contributions may be modest but they are clearly definable. A patently incompetent professional cook who cannot distinguish salt from sugar or who tends to systematically overcook the meat would be easily caught, provided the diners have functioning taste buds. And if he gets it right by luck once, it also will be hard for him to get it right by sheer chance a second, third, and a thousandth time.

Repetitiveness is key for the revelation of skills because of what I called ergodicity in Chapter 8—the detection of long-term properties, particularly when these exist. If you bang one million dollars at your next visit to Las Vegas at the roulette table in one single shot, you will not be able to ascertain from this single outcome whether the house has the advantage or if you were particularly out of the gods’ favor. If you slice your gamble into a series of one million bets of one dollar each, the amount you recover will systematically show the casino’s advantage. This is the core of sampling theory, traditionally called the law of large numbers.

To view it in another way, consider the difference between judging on process and judging on results. Lower-ranking persons in the enterprise are judged on both process and results—in fact, owing to the repetitive aspect of their efforts, their process converges rapidly to results. But top management is only paid on result—no matter the process. There seems to be no such thing as a foolish decision if it results in profits. “Money talks,” we are often told. The rest is supposed to be philosophy.

Now take a peek inside the chief executive suite. Clearly, the decisions there are not repeatable. CEOs take a small number of large decisions, more like the person walking into the casino with a single million-dollar bet. External factors, such as the environment, play a considerably larger role than with the cook. The link between the skill of the CEO and the results of the company are tenuous. By some argument, the boss of the company may be unskilled labor but one who presents the necessary attributes of charisma and the package that makes for good MBA talk. In other words, he may be subjected to the monkey-on-the-typewriter problem. There are so many companies doing all kinds of things that some of them are bound to make “the right decision.”

It is a very old problem. It is just that, with the acceleration of the power law–style winner-takes-all effects in our environment, such differences in outcomes are more accentuated, more visible, and more offensive to people’s sense of fairness. In the old days, the CEO was getting ten to twenty times what the janitor earned. Today, he can get several thousand times that.

I am excluding entrepreneurs from this discussion for the obvious reason: These are people who stuck their necks out for some idea, and risked belonging to the vast cemetery of those who did not make it. But CEOs are not entrepreneurs. As a matter a fact, they are often empty suits. In the “quant” world, the designation empty suit applies to the category of persons who are good at looking the part but nothing more. More appropriately, what they have is skill in getting promoted within a company rather than pure skills in making optimal decisions—we call that “corporate political skill.” These are people mostly trained at using PowerPoint presentations.

There is an asymmetry, as these executives have almost nothing to lose. Assume that two equally charismatic, empty-suit-style twin brothers manage to climb the corporate ladder to get two different jobs in two different corporations. Assume that they own good-looking suits, that they have MBAs, and that they are tall (the only truly visible predictor of corporate success is to be taller than average). They flip coins in secret and randomly take completely opposite actions, leading to great failure for one and great success for the other. We end up with a mildly wealthy, but fired, executive and his extremely wealthy, and still operating, twin brother. The shareholder bore the risk; the executives got the reward.

The problem is as old as leadership. Our attribution of heroism to those who took crazy decisions but were lucky enough to win shows the aberration—we continue to worship those who won battles and despise those who lost, no matter the reason. I wonder how many historians use luck in their interpretation of success—or how many are conscious of the difference between process and result.

I insist that it is not society’s problem but that of the investors. If shareholders are foolish enough to pay someone $200 million to just wear a good-looking suit and ring a bell, as they did with the New York Stock Exchange’s Richard Grasso in 2003, it is their own money they part with, not yours and mine. It is a corporate governance issue.

The situation is not much better in a bureaucratic economy. Outside the capitalistic system, presumed talent flows to the governmental positions, where the currency is prestige, power, and social rank. There, too, it is distributed disproportionately. The contributions of civil servants might be even more difficult to judge than those of the executives of a corporation—and the scrutiny is smaller. The central banker lowers interest rates, a recovery ensues, but we do not know whether he caused it or if he slowed it down. We can’t even know that he didn’t destabilize the economy by increasing the risk of future inflation. He can always fit a theoretical explanation, but economics is a narrative discipline, and explanations are easy to fit retrospectively.

The problem may not be incurable. It is just that we need to drill into the heads of those who measure the contribution of executives that what they see is not necessarily what is there. Shareholders, in the end, are the ones who are fooled by randomness.