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2 lessons Economics should learn from Aerospace

Posted by Harry Seldon on October 30, 2009

Let’s imagine that economy is an airplane. This airplane goes through a severe zone of turbulence, transforming the cruise in an heavily uncomfortable bumpy ride. Passengers start to complain, and feel more and more insecure. One of them finally calls the stewardess and asks: “What are the pilots doing ? Can’t they move us out of this unbearable situation ?” “Well… there is actually no pilot in this plane”, the stewardess answers politely. The passenger now gets really nervous, and says “What ??? Then we should run to the cockpit and try to do something before it is too late !”. The stewardess, feeling really sorry, replies with a “Uh, I’m afraid there is no cockpit in this plane, Mister”. And the story ends there, with the krach of the “economy” airplane.

I had read this little comparison a year ago already in a French newspaper. The author was Jacques Attali, a French economist. As a pilot, I have wanted to blog about this since that time.

To be a little more accurate, an analogy would assimilate companies to airplanes and market to Air Traffic Control (ATC). The problem is the market does not control anything. Imagine air traffic without ATC. Air space would be a mess. Aircrafts would collide all the time and basically nobody would trust air traffic. Finally nobody would take the plane. The air traffic system would be quickly dead. Yet, that is what is happening with the economy. Companies crash and collide because they have secant routes and nobody to help them. Economy is a mess. Most of the time ATC helps pilots by guiding them among the traffic and by giving them slots to take off and land. But sometimes ATC prevents pilots from going too fast to their destination because they would compromise safety of other airplanes. Unfortunately companies have no “market controllers” to talk to, hence the crisis.

Economy should learn 2 lessons from aerospace system engineering:

  • Systems must be controlled.
    An airplane is highly unstable. It can fly because it is very actively piloted. Air traffic is unstable too, it is controlled by ATC. In the same way economy needs guidance, navigation and control. To say it differently economy needs regulation.

  • Systems must be robustified.
    Even once an airplane is controlled and made stable there is still a lot of work to do to ensure that it is robust to all kinds of failures, even some non-anticipated failures.
    Economy needs safety engineers. Currently there is only one safety engineer for the economy. He is Nassim Nicholas Taleb, the author of the Black Swan and Benoit Mandelbrot’s spiritual son. Else financial engineers behave more like terrorists than safety engineers. OK it is a bit harsh.

I began this post by the first point. So let’s develop now the second point.
An airliner has redundancy by design. It has 3 flight computers (and more). It has 3 fly by wire circuits. It has 3 hydraulics circuits. It has 2 wings (just kidding). It has 2 pilots. To design the airplane there is a whole team of engineers whose only role is to evaluate and improve the aircraft safety. They will verify that the airplane is as black swan proof (rare catastrophic event proof) as it can be. For instance, they will check that in the case of an engine explosion the projections won’t cut all the flight control wires. Obviously, propulsion engineer (in engine companies) will make sure an engine does not explode but, all the same, aerospace safety engineers do not take anything for granted. So they study the worst cases and they robustify the system. Moreover, they also robustify the system without any specific case of failure. For instance, the logic behind having several circuits is as simple as “something could happen”. You do not always need to know the exact failure scenario to robustify the system. Obviously, nothing (and no human pilot) being perfect, there are crashes. However, it is still safer to be in an airplane than in a car.

To come back to business, notice that safety by redundancy is the 6th point in the absolutely excellent article ”The Six Mistakes Executives Make in Risk Management” by Taleb. The mistake is “We are taught that efficiency and maximizing shareholder value don’t tolerate redundancy”. (A blogger sums up the six mistakes here).
If you are a manager, don’t leverage too much your department. Don’t think that each competency must be hold by only one person. Don’t make your best to reduce all redundancies. On the contrary identify your key activities and put redundancy on it. On the short term, reducing all redundancy gives you more profits but on the medium term it leaves you exposed to very easy failures (a sick person, an expert who leaves, etc.).

To conclude I will point out that Taleb loves to compare financial analysts to blind drivers. Here is one of his last sentence: “There were so many wise people around, but whom does Obama pick? The same people who were driving a schoolbus blindfolded, who have now been given a bigger bus.” You can find the citation in this article: Black swan now elephant in the room

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Petroleum industry is too profitable, so what?

Posted by Harry Seldon on September 07, 2009

Petroleum is even more profitable than finance. Do you need a proof ? This post is extracted from the longer (too long?) post revenues per employee sum up world’s troubles. First, I give you again the chart of revenues and profits per employee of a few top companies

Revenues_per_employee

But, maybe you do not believe me when I say that oil is more profitable than finance. Indeed if you look closely at the chart, the profits per employee of Goldman Sachs are 380k$/E while it is only “379.18k$/E” for Exxon. That it is about the same, but still, finance wins.
So, to support my point, let me add other data: (from Fortune 2008 and 2009 - though notice that the results do not change much between both years)

  • List of the industries generating most revenues per employee
  • List of the 10 highest paid CEOs Ok the first one is from a finance company (Blackstone), the second one is from a software company (Oracle) but, be seated, “The next seven highest paid CEOs all helm energy companies: Ray Irani of Occidental Petroleum (OXY, Fortune 500), John Hess of Hess Corp (HES, Fortune 500), Michael Watford of Ultra Petroleum (UPL), Aubrey McClendon of Chesapeake Energy (CHK, Fortune 500), Bob Simpson of XTO Energy (XTO, Fortune 500), Mark Papa of EOG Resources (EOG, Fortune 500) and Eugene Isenberg of Nabors Industries (NBR).” (CNNMoney) Shouldn’t we feel sorry for traders who are not working in the oil industry?
  • 25 top-paying companies First one is a law firm (Bingham McCutchen), second one is a Medical Doctor firm (Lehigh Valley Hospital & Health Network), interestingly, the 3rd, 4th, and 5th company are also law firms (Orrick Herrington & Sutcliffe, Alston & Bird, and Perkins Coie). And the 6th one at last is an oil company: Devon Energy “The largest independent oil and natural gas producer in the U.S., Devon pumps half a million barrels of oil a day” (CNNMoney). One word about lawyers and MD: I am really not shocked to see them first because a lawyer or a MD has much more responsibility than an engineer. So even if their job may be in some cases less complex (does not mean easy obviously) than engineering, it is definitely worth more money per person. Back to our subject, Goldman Sachs is only 11th, behind, another oil firm (EOG Resources) and behind sofware companies (among other Adobe Systems).
  • Best big companies to work for The first one is… an oil company: Valero Energy the Largest oil refiner in North America! And the second one is nothing else than Goldman Sachs! However, notice that the ranking puts a high weight on the size of the company because else in the ranking of the best companies to work for Goldman Sachs is before Valero and that the first company is Google (2007).

Petroleum industry is way too profitable, so what?
Petroleum industry is the most profitable because oil is the most useful thing around. Oil is energy and the world needs energy. There is a high demand for energy so energy should be expensive. OK but this does not explain why oil companies revenues per employee (and wages) and profits are so high.
In fact, wages and profits should be greatly lowered by the expected high cost for unextracted crude oil. Cost of crude oil should appear in the balance sheet of an oil drilling company, and then in all the supply chain. Well, crude oil costs do appear in terms of concessions. But they are way undervalued. As an approximation you can neglect these costs. You can think that current cost of unextracted crude oil is ZERO$. That exactly means that nobody owns it and that reserves are unlimited. In my opinion everybody owns it, just like every natural resource, and it is limited. The market of natural resources (oil among others) should take into account in its pricing process all the natural reserves and not only the extracted reserves.
And to pronounce a taboo word : taxes. Profits from petroleum companies should be more taxed because these profits are not merited. They are not justified by an extraordinary complexity or by an extraordinary innovation. The useful innovation would be to find substitutes to petroleum.
Maybe if, like many, you really hate taxes, one other solution would be to force petroleum companies to highly invest in fundamental research for new energies.

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Money is energy and energy is money

Posted by Harry Seldon on August 30, 2009

When I made the short study about finance and petroleum industries, my main point was to insist on the fact that regulation is much needed for this world. But it appeared that this study was bringing much evidence that money is energy. So I am going to make a shorter post on this particular subject out of the previous post.
Behind the answer ”money is energy”, the question is naturally ”what is money?

A common answer is “time is money”. But, are you able to buy a travel in time with money? Are you able to buy more lifetime when you have a deadly disease? Not really. When speaking about “time is money”, one thinks that he can buy someone’s work to do his work, so that he has more free time. Or one can buy someone’s work to do more work and earn more money. Good, but what is bought here, is work and work is energy. Besides that, notice that the dimension of energy is proportional to the inverse of the square of time ([E=ML²/T²]). So even if I do not think that time is the best definition of money it is clear that energy, time and money are linked.

In fact, nowadays, people think about money as a mean to exchange goods. This mean is controlled by the government who decides of the value of money. This is called fiat money. But this does not sound to be the best definition of money. The best one - at least from my point of view - is the definition that was used during most of the short man kind history, that-is-to-say “money is price of gold”. In this case, money is called Commodity money.
We know that energy is mass (thanks Albert, E=mc²). So saying money is energy, or gold (mass) or oil (mass) is about the same. Moreover, money, like energy, can be exchanged, converted and transformed. Therefore, defining money as energy includes both definitions: money is something that can be exchanged for products, and the intrinsic value of money is gold.
If you look at the chart in the post about about profits in finance or petroleum industries, fiat money is represented by finance, whereas commodity money is represented by oil industry. The chart shows that oil industry is the biggest money generating industry. Seen the way the economy is working, the closer you are from money the more money you make. In this sense, the chart proves that the best definition of money is its definition as a commodity, and further in the analogy, as energy.
There was commodity money, there was fiat money, now is the time of “energy money”. And today, the best representation for (energy) money is petroleum. So, when a company is pumping free petroleum, it is exactly as if they were pumping free cash. Because petroleum exists in a limited quantity on Earth, because Earth belongs to all people, this cash belongs to all people, else why not make pay for oxygen while we are at it. So there are a bunch of people that are being stolen. I would not say the same about solar energy because it is not limited (at least the limit has not the same order of magnitude as for oil). So if one makes huge profits from selling solar energy, I would not call that stealing.
That being said, this asks the question of how to integrate the internal value of resources in the law of supply and demand? Well, I have no easy answer but if you have a decent proposal I would love to hear from you. And in this case you are probably a good candidate for a next Nobel Prize.

Remember, money is energy and equivalently, energy is money. With this in mind it is clear that in order to bring back order in this world governments need to regulate finance and energy. But essentially finance and energy are one and the same. Governments would not be able to regulate one without regulating the other. For instance the speculation on oil is made by the finance industry (and also by the petroleum companies themselves). So, to forbid speculation on petroleum, governments must act both on the finance industry and the petroleum industry.

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