Problems of redundancy and systemic failure

Recently I was listening to a series of reports on failures in some key organisations, public and private. All had a common element, the way that costs had been cut to the point that the organisation lost the capacity to respond to the unexpected. The subsequent costs of failure far exceeded the savings made.

Don't get me wrong. The battle against costs is a constant struggle that must be waged on an on-going basis. But would you want to go onto an aeroplane where systems had been cut to the point that there was no redundancy, where a simple system failure might lead to a catastrophic outcome?

To my mind, our constant pursuit of productivity gains has reached the point where the costs exceed the benefits in many cases. Again don't get me wrong. My professional colleagues and I have generated a lot of fees out of productivity improvement advice. However, there is a question of balance.

Today we live in a world of performance agreements, KPIs, performance based contracts. To a degree, our technology defines us. If you look at those agreements etc, you will find that they are all linear. We have translated computer decision rules into a human environment.

We humans don't work this way. We are often messy, disorganised. We are creative. We have dreams. I sometimes feel that there is no place for humans in the current management environment. We would be better off with robots who just do as they are told.

The modern approach works fine in a straight line environment. It can collapse as soon as a challenge emerges from left of field.

My message. Simply, I suppose, cut your staff some slack.

Deposit bases, credit rationing and the Australian banks

Back in December in The Balance of Payments, Australia and the sub-prime crisis I discussed the reasons why a US financial crisis affected Australian domestic liquidity. Since then, the crisis has eased. However, in so doing it has created another interesting set of dynamics.

Reduced access to international liquidity increases the value of domestic liquidity. Financial institutions that can access that liquidity gain relative to those who cannot. In an Australian context, it is the major banks with their big relatively passive domestic customer deposit bases who are the real winners.

Despite the slowing economy, both households and businesses still need to borrow. With reduced availability of funds, the major banks with their control over deposits begin to ration credit and can also increase interest rates. This allows for reduced risks in combination with increased margins.

Of course, if the economy really slows even the big banks will be affected by the overall reduction in the demand for funds. But at this stage in the cycle, the immediate flow-on effect of the sub-prime crisis is increased bank profitability.

Funding Australia's private schools

Note to readers: I began this post in January, but then got swamped. However, it seemed sensible to finish it despite the passage of time.

Neil has already beaten me to this one, the problems associated with the way the Australian Government funds private schools. However, I thought that I might make a brief comment on the economics involved.

For the benefit of international readers, education is technically a state responsibility. However, over recent decades the Commonwealth Government has assumed greater funding responsibility. Now in the school sector it is the main funder of private education, leaving the states with public education. Herein lies a problem.

In funding private education, the Commonwealth Government uses as a funding benchmark the average cost per pupil in the state system. On the surface, this seems quite reasonable. Yet it is now creating real difficulties.

In recent years there has been a major drift of kids from the state systems to private education. Some parents are now paying up to 50 per cent of their net family income to have their children educated in private schools.

Pretty obviously, many parents believe that there are major problems in the state systems. The reasons for this are complex and beyond the scope of this post. My concern is the impact on the funding of private schools.

As children move out of the state systems, the average cost per pupil in the state systems rises. This happens for two reasons.

First, it reduces the ability of the state systems to capture economies of scale. The state systems still have to provide universal education available to all across large and varied geographic areas with dispersed populations. As children move, they lose some of the advantages offered by network economics, the fact that the cost of teaching an extra child is much lower than the average cost per child.

Secondly, and linked, it leaves the state systems with a greater proportion of higher cost pupils, higher cost schools. Higher cost pupils because problem children who require more attention tend to remain in the state systems. Higher cost schools because the state systems have to maintain schools in areas that the private system will not address because the number of pupils is to small to be economic.

As the average cost per pupil in the state systems rise, so does funding to non-state schools. This extra funding allows private schools to do new things, attracting new students from the state systems. Market disciplines are further reduced, because the proportion of costs covered by fees is further reduced.

In all, it is actually something of a crazy funding model.

Why markets are not always better

Well, it was a longer break than I had intended! Still, a lot has been happening while I was off-line. I have been jotting down notes in my spare time to provide a base for future stories.

I had to laugh today.

Eldest is doing economics at the University of New South Wales. Her latest assignment was to prepare one side in a debate. There were meant to be two of them in the team, but her partner dropped out of the course so she had to go alone.

Why did I laugh? The topic they were given read "the market always gives better results than Government action." Helen had to argue the negative.

How could she not win? Because of the use of the word always, she had only to provide one example to prove her case. The results of the sub-prime collapse are all around us. Of itself, that was sufficient for her to win.

However, while I laughed I was left with a feeling of unease. Irrational exuberance has always been with us. To illustrate her point, Helen gave tulip mania as an example. She could equally as well have taken the south sea bubble.

There have been many crashes. Today, or so it seems to me, we are especially vulnerable because of the sheer size of financial markets relative to physical markets.

Leverage is central to financial markets. If you are making widgets or mining iron ore, then what you do is subject to physical as well as financial constraints. In the financial world, you can leverage transactions far beyond the real value of the underlying assets.

We call this financial engineering. This is a misleading term because it implies a degree of precision, of safety, that is simply not there.

When a small number of institutions operating in a relatively small market by global standards can leverage to the point that they threaten the whole global financial system, then we have a problem.

In Australia where our major financial institutions are generally secure, we still have something of a funding drought because of the flow on effects. This hurts everyone.