The Challenge Dividend

Bono Still Hasn't Found What He's Looking For

Bono has an open question on Yahoo! Answers this week: "What can we do to make poverty history?"  (Full disclosure: I'm a huge U2 fan).  Here's my pro-competitive answer, which is number 29,276:

"Pleas for more aid, whether financial or food, are a failure of colossal proportions. For decades countries in the West have been shamed to donate, yet the results themselves are shameful. As U2 sings in the song "40": "How long...to sing this song..."

A functioning free market system will make poverty history without wasted billions in aid. The only way to reach "developed" nation status is for the people to build themselves up. But we can help them put these systems in place. Mainly, a change in government is needed in most poor countries.

Corruption must be eliminated so that workers and businesses are free to rise and fall on their own merit, versus by payoffs to bureaucrats or mobsters. Similarly, import taxes and other laws that protect local companies from global competition must also be removed. Only by full, free competition will these countries build working economies that can succeed on their own. Western nations in turn must eliminate subsidies and import protections for poor nations to compete.

Bono, I urge you to move away from pleas for aid and debt forgiveness, and toward encouraging a path of self sufficiency through fair government and free markets. You have a powerful voice, but now it must be aimed at shaming corrupt regimes into setting their people and markets free. Free market systems worked in the West, they worked in Asia, and now it's time for reform in Africa as well.

Let's build a system of fair competition that will help poor nations pull themselves up to the rest of the world. Bono, as U2 finishes "40", will you "sing, sing a new song"?"

To date, I have mixed feelings on Bono's politics.  I love that he is moving beyond music toward a greater goal of improving the world.  But I am not a fan of his calls for more aid and reduction of debts.  These solutions only provide temporary relief at best; at worst they instill a culture of handouts.  Only by reaching self-sufficiency can a nation rise to developed status.

Maybe Bono is tacitly acknowledging that more aid is not the answer, hence his question on Yahoo! Answers.  If only he can keep reading all the way to my post #29,276...

Thanks to Micro Persuasion for the link

The Culture of Cooperation in Free Markets

One of the traditional knocks on our free market system is that it can have a negative impact on our culture.  Some claim that a for-profit mentality turns citizens into cold, selfish calculating economists only looking out for their own good and acquiring things.  Meanwhile, there is a lot of romance around cultures that have less hard core competition, and some picture village utopias where people help each other and have no desire for financial wealth. 

This is the thinking, but is it accurate?  Nope.

In 2002 the Wall Street Journal published an article called "The Civilizing Effect of Market Economies" that told of fascinating research by Joseph Henrich.  Henrich used a simple game to test the altruism of subjects in countries and cultures throughout the world.  In the game, two strangers are brought together.  Player One receives $100 (or local value equivalent) to split with Player Two, and can decide how much to offer.  The only catch is that Player Two can decide to reject the amount such that neither wins anything, which forces Player One to offer something reasonable.  This provides a good consistent test of the altruism and cooperation of societies.

Looking across the results, market-oriented societies are significantly more generous world wide.  For example, people in Hamilton, Missouri offered $48 on average, while nomadic hunter-gatherers in Tanzania offered the equivalent of $33.  This test shows that market-oriented societies are actually more trusting and altruistic.  I believe the reason for this is best summarized by economist Samuel Bowles.  The more trusting and altruistic we are, the better off we all are economically.

"Many people thought markets would make people selfish and amoral. That view is at least too simple, if not just plain wrong.  Markets teach us to behave decently to strangers.  Markets are an arena in which you encounter somebody you've never seen before and engage in mutually beneficial activity."

Other stories and research make a similar case.  Last week I wrote about Pepsi's decision to inform Coke when one of its employees tried to offer trade secrets to Pepsi.  It was surprising to see grizzled cola warriors work together this way.  But it makes sense given the companies' desire to "play fair" and within the rule of law.  Pepsi was signaling to Coke and both of their staffs that even bitter rivals need a code of conduct.  Would this happen in Russia?  Unlikely.

Meanwhile, some fascinating research by Raymond Fisman and Edward Miguel show the negative cultural impact of corrupt governments.  Corruption is a key barrier to economic or market development because it weakens the trust needed for strangers to work together.  In their research, they combed through New York City parking ticket histories to track which countries' diplomats had the most violations.  Diplomatic immunity gave every diplomat a kind of free pass to ignore the law, but those from corrupt, non-market countries racked up the most fines.  For example, 59 violations per Nigerian diplomat, and zero for Ireland.

It seems hard to believe, but the most trusting, altruistic societies are also the most hard-nosed capitalists.  We are kind to strangers, we tip taxi drivers and waiters that we'll never see again, and we offer charity to those less fortunate.  All because we live and work in a more challenging, market-oriented environment. 

The challenge of the free market results in better products and services, along with a better culture and society.

Cola War's "Geneva Convention"

This week news broke of a sting operation in which a Coke employee was caught trying to sell confidential information about a product under development to officials from Pepsi.  What made this newsworthy is that Coke heard about the theft from Pepsi.  And what makes this "Challenge Dividend-worthy" is that it shows that rules are necessary for a good competitive environment.  In this case, a "Geneva Convention for the Cola Wars."

Any good competition relies on established rules to ensure a "level playing field", as well as some means of discovering and punishing those who break the rules.  In battle, agreements like the Geneva Conventions attempt to ensure that combatants are still treated humanely.  In football, the holding penalty helps ensure that good plays can develop.  These rules do not limit the creativity and effectiveness of a battle strategy or offensive play; instead they define a "box" that allows for innovative solutions. 

In business, rules can help encourage a good, fair competition.  For example, anti-trust laws help ensure that one company does not have too much power, and a minimum wage or OSHA standards ensure that a minimum level of worker treatment is maintained. 

This Pepsi/Coke case is an interesting test in that Pepsi could have gotten an "unfair" advantage, probably without law enforcement or Coke's knowledge.  The company could have accepted or ignored the proposal, but it chose to proactively bring it to Coke's attention.  Over at the Freakonomics blog, Steven Levitt claims that Pepsi was acting in its own self interest.  He reasons that if Pepsi were to copy or expose Coke's secret formula it would lead to a price war that would take Pepsi down with it. 

I agree that Pepsi acted in its own self-interest.  But instead of fearing a price war, I believe Pepsi  chose to cooperate with Coke in order to signal that both companies should play fair.  Pepsi signaled that the two cola warriors should follow the Golden Rule and help each other eliminate unfair opportunities, rather than just following the letter of the law.  Meanwhile, the company sends a strong, public signal to potential spies on either side that they will be dealt with harshly.

A couple of things about this story really give me confidence in our free market system.  First, this happened basically without government involvement.  Sure, the FBI came in to operate a sting, but only after Pepsi and Coke got together on their own.  Second, it ensures that the two companies can continue to fight a "fair" war that will be decided by the consumer.  We'll wait for the new Coke product and decide as consumers whether it is a winner.  Coke might benefit from its innovative product, and Pepsi will work to launch one better.  If the secret got out, the two companies might end up spending more time on "spy vs. spy" rather than inventing better drinks.

Good rules and a system of enforcement will ensure that the Cola Wars are decided by the consumer, not by greedy insiders breaking the rules.

The Spoils of Success: Chinese Economy

The Series:
Does lack of challenge lead to poor performance, or in worst case, failure?  I contend that when you look across the field of champions both past and present, they do, in fact, fall when their power is at its height.  From ancient Rome to Enron, defeat is often born in the jaws of victory.  Previous examples covered here include Apple, Google, Starbucks, Republican Party, and The Bill and Melinda Gates Foundation. 

Today's Entry: The Chinese Economy.
The Chinese economy has been an incredible success story in the past decade.  The country is now the third-largest trading nation and its GDP growth has averaged at or above 8% for several years.  The country is the global center of manufacturing, and it will be the center of the sports world in 2008 for the Summer Olympics.  But as this series shows, great success often leads to inevitable arrogance and failure. 

There are many ways that China, too, could decline.  Political crackdowns and rising labor costs that result from its success, for example, could turn the world against it.  A recent BusinessWeek story shows that the flood of dollars from its hot export market can itself lead to problems:

"First-quarter growth hit a torrid 10.3% and industrial production in May surged by nearly 18%, the fastest rate in two years. China's global trade surplus, meanwhile, hit $13 billion for the month, up from $9 billion a year earlier, and exports climbed 25%. When those export earnings are converted into yuan, they produce a tidal wave of excess cash that feeds ultraloose bank lending. That in turn leads to real estate bubbles and too many new factories, office buildings, and highways."

What the article misses is that this is exactly what happened to Japan in the late 80s.  At the time, Japan was on an incredible hot streak, and the U.S. was in relative decline.  But a real estate bubble soon began, and surplus cash from exports were funneled into many unwise loans.  The result was a stagnant economy with a trillion dollars in bad debt.  Japan has been relatively stagnant for the past 16 years.

There may not be a good solution in China.  In fact, some say that China simply must go through periods of rapid growth and retrenchment as its economy catches up to the rest of the world.  It may need to go through the same steps and learn the same lessons as Japan, Germany and the U.S.  On the other hand, perhaps the tighter government control of the country and economy will lead to rules that put a brake on excess spending.

Overall, China has an opportunity to read about the failures and lessons of other nations that industrialized rapidly and joined the "first world."  Lessons abound in the history of these nations,  from the Great Depression to environmental protection to Social Security reform.  By studying history and avoiding our errors, China can become even more competitive and improve further.

UPDATE: Last Friday the Bank of Japan increased interest rates from 0.0% to 0.25%.  For years, the country kept interest rates at zero in hopes of encouraging its stagnant economy to move.  Not only did this not work, but it encouraged more bad loans.  Without a cost (a "challenge") to borrow, there was less pressure to reward good businesses or punish bad ones.  This move was done as a response to Japan's improving economy, but it might pay extra (challenge) dividends by encouraging better lending decisions in the end.

Challenge of Public Exposure: AOL

My highlight from catching up on blog reading over the long 4th weekend is this story of Vincent Ferrari trying to cancel his AOL account.  You have to see and listen for yourself here:

• The actual audio recording
• The New York Times piece
• Marketing guru Joseph Jaffe
• The Today Show segment:

There's two interesting takes on applying the "Challenge Dividend" model here.  First, it shows how things can go wrong when a challenge is set.  Obviously, AOL is giving its customer service reps a bonus when they manage to turn a cancellation around; supposedly they are able to keep 50% of those who originally call to cancel.  This incentive is a kind of positive challenge that ultimately leads to higher sales; and some customers might even be happy that they were presented with a more appropriate service (e.g. high speed). 

But the negative is that a bonus for retention can run counter to the additional goal of customer satisfaction, and ultimately brand equity.  This kind of high pressure sales result is well known at car dealerships, for example, where extreme commission pay can lead to intimidation.  I've heard stories of salesmen holding onto customers' keys until they buy a car. 

The good news is in this second lesson: the evolution of media and the Internet means that experiences like this are increasingly publicly available.  This means a huge amount of pressure that will force companies like AOL to either generate positive customer service on each occasion, or pay the price in the public eye.  This one rep, "John", led to crushing stories in the New York Times and the Today Show.  Who knows how many more people will cancel, but chances are there will be some overtime in the AOL call center this week.

This kind of public exposure pressure is pretty tough.  It's hard enough to ensure consistently strong customer service by every employee at a small company, but imagine a business like AOL with tens of thousands of people around the world touching customers.  But this kind of pressure will continue to ensure that the companies that get this right win our dollars and loyalty, while those who anger even a handful will be exposed to millions. 

The Spoils of Success: Gates Foundation?

The Series:
Does lack of challenge lead to poor performance, or in worst case, failure?  I contend that when you look across the field of champions both past and present, they do, in fact, fall when their power is at its height.  From ancient Rome to Enron, defeat is often born in the jaws of victory.  Previous examples covered here include Apple, Google, Starbucks, and the Republican Party.  While I was planning to end the series last week, this topic and my next on China were too hard to pass up...

Today's Entry: The Bill and Melinda Gates Foundation.
Warren Buffett's decision to give the bulk of his fortune to the already rich Bill and Melinda Gates Foundation is big news.  Pundits are mainly positive. Most say that this could lead to a breakthrough in cures for everything from major diseases to global poverty; and it could spur others to give more.  I think it's a bold and smart move by Buffett.  Instead of spending his time building a new foundation and finding the right investments, Buffett is turning the responsibility over to his trusted bridge partner and successful business mind, Bill Gates. 

On the other hand, when I heard of the enormous size of the foundation's resulting budget, my "Spoils of Success" radar went up.  As this series of posts shows, an excess of power and resources often leads to spectacular failure and waste.  In Venezuela, for example, we see that a soaring price of oil is funding huge public giveaways in order to keep a dictator in favor and power.  A similar phenomenon happened in the Internet Bubble of the late 90s.  Too many bad ideas got funding and the result was a lot bad businesses, SuperBowl commercials, and Aeron chairs.

My fear is that this huge fortune will simply result in a spending free-for-all.  After all, the nature of charity itself is giving away money.  And when money is given, rather than hard-earned, there is already a bias away from the benefits of challenge.  On the other hand, Gates is arguably the best business manager in history; if anyone can crack the code, it's probably Bill.  Here's where I think the possibilities lie:

Why it Could Work:

• The Gates Foundation is already "results oriented".  Building on a recent trend, Gates has worked to ensured that his donations are proving an ROI.  (See this previous post for more).
• Now that Gates is retiring from Microsoft and focusing on his foundation, there could be a big burst from his focus.  At only 50-years-old he is still in his prime.
• Adding Buffett to the team brings the best investor in the history of business.  He will be pressuring Gates for results just as he does with the CEOs of the companies he invests in.

Why it Could Fail:

• Tax rules require that 5% of a family foundation's assets must be distributed each year.  At $60 billion, that means a stunning $3 billion each year will go hunting for worthy causes.  Some believe it might be too hard to find that many results-oriented projects.  Think Net Bubble for Charities.
• The Gates Foundation is specifically targeting poverty and disease in developing nations.  However the biggest, ongoing barrier to improving these decades-long issues is corruption in the target nations.  A chunk of any gift is regularly siphoned off by government bureaucrats.
• Already the results of the Gates Foundation's work is mixed.  BusinessWeek recently showed that its efforts to improve public schools in the U.S. is earning low grades. 

Suggestions: In order to maximize the potential of these gifts, I believe Gates should use tactics that encourage challenge, and thus improvement.  For example:

• Challenge Grants. Set up "X-Prizes" for those organizations that find solutions to major problems.  Say $5 billion to the inventor of the first affordable AIDS vaccine.  This would create a market and spur many additional investments and alternative approaches.
• Pay-for-Performance.  Today, charities spend too much time and resources on pursuing the next dollar from donors.  Instead, the Gates Foundation could "guarantee" them an annual budget as long as they hit results targets.  This, again, provides a market-based incentive and challenge.  And it puts more staff in the field driving results, versus dialing for dollars and dining with donors.
• Challenge Corruption.  As stated above, government corruption in many target nations is hurting every charity.  Perhaps it is time for Bill Gates to publicly "out" the governments and individuals that are blocking or siphoning dollars.  In addition to reducing corruption today, a proper government is the only thing that will allow self-sustainability long term.

Although I remain somewhat doubtful of this new charity and its massive resources, I am warmed by Bill and Warren's gift and attempt to improve society.  It will be an interesting chapter in both their lives and the development of the world.  I'll be rooting for them.

Final Note: As is obvious from their charitable gifts, as well as their public statements, both Bill Gates and Warren Buffett are in favor of the "death tax" that Congress has fought hard to phase out for years.  See here and here for my previous posts on the topic.

Update: The July 10, 2006 Fortune magazine has a cover story about Warren Buffett's decision to give his $40 billion fortune away.  Once again he uses the space to talk about the importance NOT giving a fortune away to your children.  His quote:

"Certainly neither Susie or I ever thought we should pass huge amounts of money along to our children.  But I would argue that when you kids have all the advantages anyway, in terms of how they grow up and the opportunities they have for education, including what they learn at home - I would say it's neither riht nor rational to be flooding them with money.  In effect, they've had a gigantic headstart in a society that aspires to be a meritocracy.  Dynastic mega-wealth would further tilt the playing field that we ought to be trying instead to level."