Intellectual Hazard

Moral hazard, which basically amounts to a personal incentive to do something unfair to someone else, is a familiar concept in the world of law and economics.

A new paper on the financial crisis explores a parallel concept, "intellectual hazard", which is similar to the concept of "cognitive capture" in administrative law. The people in charge of fixing problems get so used to thinking in the way that is causing the problems that they fail to see what is going wrong and don't take corrective action.

This paper identifies an important but previously unrecognized systemic risk in financial markets: intellectual hazard. Intellectual hazard, as we define it, is the complex organizations. Intellectual hazard impairs the acquisition, analysis, communication and implementation of information within an organization and the communication of such information between an organization and external parties. We argue that intellectual hazard was a cause of the Crisis of 2008 and suggest that this risk may be an important factor in all financial crises. We offer tentative suggestions for reforms that might mitigate intellectual hazard going forward.

Less charitably, intellectual hazard is the tendency of complex organizations to find ways to deceive themselves when knowing the truth would impair their short term profits or disturb the status quo.

Intellectual hazard and cognitive capture go hand in hand. If organizations deceive themselves and regulators fall for the self-deceptions, potential problems develop until they are too out of hand to be prevented.

Did Intellectual Hazard Do In The Automobile Industry?

While economic theory says that investors will shut down companies at the profit maximizing point, this isn't the way that large companies act in practice. For example, when the steel industry died in the United States, most steel companies kept operating at a loss for years and didn't stop sucking up good money after bad until they could no longer make payroll. General Motors and Chrysler did essentially the same thing, operating for several months after they couldn't get further financing from anyone but the government until the government called its bailout loans and forced them into bankruptcy.

In all of these complex organizations, one way to describe what was going on was as intellectual hazard. The companies convinced themselves that they were in the business of making steel or building cars, profits be damned.

The New York Times today, on cue, describes how the "Legendary Bureaucracy" of General Motors that was a key factor in its inability to take the steps needed to make itself responsive and effective enough to avoid financial disaster, is being unraveled, in the post-bankruptcy GM. Ironically, the owners who finally seem to have managed to get GM to cut through its red tape are none other than the governments and unions who are so often blamed for corporate red tape in the first place. A century of ownership by private sector stockholders failed to prevent this ossification of the General Motors bureaucracy.

In the case of Chrysler, similar stories have emerged in which representatives of Italian automaker Fiat that owns the new company together with government and union owners, have similarly cut through many layers of corporate bureacracy.

Is public and union ownership really more efficient than public investor ownership? Probably not, although it also isn't toxic to business efficiency, despite what champions of the publicly held, investor owned company model would have you believe. Honestly, any form of closely held company ownership combined with bankruptcy and new management probably would have done the trick.

One could theorize that the distinction between being publicly held and closely held (as both GM and Chrysler are now) was important in these bureaucracy busting reforms, because classic divide between ownership and management in a publicly held company is largely absent in a closely held company. The problem with this theory is that Chrysler spent many years as a privately held company, first as a subsidiary of Daimler, and then under the management of a private equity firm. So, empirically, this isn't a very good explanation.

A closely held company ownership structure may or may not be necessary for reform of companies like these, but it certainly isn't sufficient.

Three other possibilities make more sense.

One is that the symbolic recognition of failure that came with the respective bankrutpcies was necessary to convince everyone involved in these enterprises that the old way of doing business had failed, so that reform was needed. Before the bankruptcy, too many people had a mindset based on the default assumption of private law that existing arrangements and promises will be honored, long after that became an unrealistic expectation. Half the battle in managing a declining organization is getting those involved in it to genuinely acknowledge that it is in decline so that the steps that need to be taken to reach the best result can be taken.

A second theory is that truly independent new management was necessary to make a clean break from past practices unburdened by associations with the companies' past failures. Perhaps, even if a management team linked or descended from the old management group had proposed the same reforms, these proposals would not have had the legitimacy needed to be meaningfully implemented.

A third theory is that both companies were doomed long ago, and that as a result, there was no incentive for interested parties to change until there was some hope that the effort would pay off. Why fix something that's going to fail anyway? The trouble with theory is that the unions, bondholders and managers involved in these companies took their contract negotiations seriously and acted as if the promises that they were trying to secure from each other really mattered, right up until the very end. Not many of the people inside or deeply involved with the companies really believed that these storied companies which were cornerstones of American capitalism could really fail, even when the companies were forced to resort to government bailouts. After all, Chrysler had experienced multiple near death experiences but survived in the past.

Nothing, of course, prevents more than one theory from being correct. But, the first two, which are species of intellectual hazard seem like the most plausible explanations for what really happened than the third. And, if intellectual hazard can explain the failure to two of the big three carmakers to reform their own bureaucracies, why shouldn't it explain similar failures to make reforms in big financial companies?