Why valuation economics are messing up the Internet, Inequality, and Productivity debates

How much is the Internet worth?  How bad is income inequality in advanced economies?  What is causing the productivity slowdown?

These three questions are related, but I doubt few people know why. The reason is that all three problems are misinterpreted based on the standard microeconomic measure of income and value. I’m going to make this brief, but keep in mind this is just an introduction to a series of work I’m planning to blow up the policy discussion economists have been having.

To begin, I live in Silicon Valley, literally in a Stanford apartment on Sand Hill Road. I’m not one of the tech geniuses building the future, but I do watch them from a front row seat, and I really believe the value creation here is vastly under appreciated in Washington, not to mention European capitals and most editorial pages. Even my friend Tyler Cowen seems to be missing the big picture:

The results are mixed, but again I don’t see a strong case for a disproportionately high consumer surplus from these [Internet] services, if anything the contrary. (from his blog, May 2015)

The productivity slowdown is too big in scale, relative to the size of the tech sector, to be plausibly compensated for by tech progress. (from his March 4, 2016 NYT column, “Silicon Valley Has Not Saved Us From a Productivity Slowdown”)

The mistake economists have been making is to ignore value above the demand curve. Classic economics dating back to Adam Smith recognized a dual paradox of value, with one type of value high in utility (e.g., water, food, tools, clothing) and a more economic type of value signaled by prices in exchange (e.g., diamonds, gold, and other conspicuous goods). My theory is that the paradox is actually a trinity, and the classic dichotomy ignored value in consumption (or maybe a better word is desire). A forthcoming essay in COMMENTARY will make a more detailed case, but it will not include this figure which contrasts a Demand curve (Willingness to Pay, a.k.a. WTP) with something you won’t see in textbooks, yet:

PPT Value Theory for HooverThe first objection I’ve heard to this theory is that the WTA-WTP gap has already been explained by the endowment effect, and not only that, but the pioneers of behavioral economics were already awarded a Nobel Prize. Sorry, but no, the endowment effect has been overinterpreted, and it is NOT fully fleshed out.  For starters, the effect often disappears for commodities and appears elsewhere when people are not even endowed. It presumes that there is an objective value to a good (the exchange price) which is distorted by irrational subjective attachment. I think this “irrational primates” explanation goes too far. It makes more sense to appreciate a desire for something above the demand curve, to wit: a penniless bum is budget constrained and cannot afford an icy-cold can of Coca-cola (so his WTP is zero), but if he were given a can of soda, his consumption would far exceed zero. Indeed, there is a rich literature on contingent valuation that recognizes the WTA of many things approaches infinity (e.g., the value of an extra decade of life).

Why does this matter to Tyler and the techno-skeptics?  Simply put, the WTA value of modern things is vastly higher than older, more tangible, more commoditized goods. I have conducted some preliminary, not-ready-for-peer-review research and discovered a huge gap differential:Slide4

I also tested two theories, again just preliminary. My first theory is that consumption valuation increases with time. The endowment effect should be linear — if you take a teddy bear away from a kid for seven days instead of one, he should be seven times as displeased. But I expect displeasure to be nonlinear, namely increasing exponentially. It is. Here’s my question of nearly 50 colleagues at the Hoover Institution about the WTA of pizza over three time periods. Slide2

My second theory is that valuation increases with rarity. Commodities that are easy to exchange should yield a WTP-WTA gap that is no larger than the friction of exchange. (And for the endowment nerds out there, I suspect this is most of what the canonical “college mug” experiments of Kahneman were picking up). But what if you were asked to sell a ticket to the concert of your favorite entertainer?  What if it was their last concert ever? The way I framed the question to colleagues was by using three different types of tickets to a favorite sports team: a regular season ticket, a playoff ticket, and lastly a ticket to the championship game. The nonlinear valuations were confirmed.  To be fair, these were not per-review quality studies, but I have no doubt those will show the same result.Slide3

Now let’s connect the dots back to Tyler. Is it true demand for Internet access on airline flights is low? Yes, but that’s explained by the short duration.  People are willing to accept loss of something at a low value when the time is brief. I bet the value of a year of Internet is worth millions of dollars to Tyler Cowen, even though he can easily do without it on every flight. And it’s worth more than access to a library because there is no substitute for the Internet. It is unique, not a commodity.

If we did a better job as economists of measuring consumption values, we could chart the exponential increase in progress that has been missing from traditional output & productivity measures. The productivity slowdown masks a consumptivity explosion. And further to the point, even the poorest people in modern economies are enjoying the boom. Lower mortality, cleaner air, better parks, and free wifi are all real trends and really invaluable.

The Paradox of Value

After two centuries of development, economics still lacks a good understanding of how to value things. To be honest, I never realized the gaping hole in the field until recently, despite earning a Ph.D. in economics and teaching Econ 101 to hundreds of students over the years. Adam Smith mentions the “paradox of value” in the Wealth of Nations, but the idea was not original to him. Indeed, the diamond-water paradox was something Smith himself heard in lectures and can be traced back to the ancient Greeks, namely one of Plato’s earliest Socratic dialogues.

First, let’s review the diamond-water paradox, which is a staple of introductory econ lectures (indeed, I remember being fascinated by it as a college freshman, too). Why is a bucket filled with diamonds more valuable in monetary terms than a bucket filled with water? Water is necessary for life itself whereas diamonds are useless ornaments. Why does water cost so little and diamond cost so much?

The answer is that there are two different meanings of value, and that economics is dedicated to studying the monetary value of things. More accurately, the field of economics evolved to focus on market valuations, and as I have discovered, never resolved the other meaning. Adam Smith phrased it this way:

“The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called ‘value in use ;’ the other, ‘value in exchange.’ The things which have the greatest value in use have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.”

A nice blog post on the diamond-water paradox by Timothy Taylor pointed me to a 2002 economic history paper by Michael White. White offers a nice history, but contends that it’s a myth that Smith could not resolve the paradox. This folklore emerged during the marginal revolution and was codified in Paul Samuelson’s 1948 textbook.

The standard lecture uses the paradox to highlight the radical power of market prices allocating resources through the power of supply and demand. Water is one of the most abundant substances, what with oceans covering two-thirds of the surface of the planet. This essentially endless supply makes water nearly free. Fresh water literally falls from the sky. Only in a dessert would a man dying of thirst (a locally constrained supply situation) be able to appreciate water’s great value. I don’t have a problem with Samuelson’s fable (in White’s words “Until 1871, the explanation for the discrepancy between the value in use and value in exchange remained a mystery because classical economists were incapable of resolving it.”) because to me the fable works in appreciating the explanatory power of the marginal analysis of utility, marginal cost, surplus, and all the rest. Sure, I accept that Smith understood the essence of the paradox. Smith understood that scarcity involved an interdependence of supply and demand, though he seems to denigrate conspicuous consumption of “baubles and trinkets.” Despite all this, I think everyone failed to resolve the deeper puzzle of cardinal utility and it remains unresolved by Smith as well as Marshall and Samuelson.

The second half of Smith’s explanation seems, to me, flawed still. Do you agree that things “which have the greatest value in exchange have frequently little or no value in use”? I don’t.

Diamonds in 1776 arguably had no industrial utility like today, but that’s not the point. Smith is defining “use” too narrowly. A century afterwards, economists engaged in a raging debate over the idea of utility, and the emerging consensus was that utility could not be quantified, but that pleasure and pain were important concepts that Smith neglected as a type of value. Recall the notion of ‘utils’ that you experience when consuming greater quantities of normal goods. Most understood utils to be useful as an explanatory device only. Other scholars believed further in a theory of cardinal utility, meaning that utils could be measured and quantified, but it seems that none could figure out how.

Despite that, we should not neglect Smith’s mixing up of use and utility. A diamond has sentimental value, or psychological value if you prefer, that is altogether distinct from its market value and its use value.

Here, I imagine I have lost most of my fellow economists. They are thinking of consumer surplus: the fact that a diamond consumer might purchase the item at a market price that is a fraction of what she would be willing to pay. The difference is what we call surplus, which some teachers (including me, back in the day) mistakenly call utility. But no, that surplus is itself a fraction of the satisfaction I mean to explain. Willingness to pay (WTP in the vernacular) is constrained by one’s budget, income, wealth, etc. However, unlike WTP, utility is not budget constrained. Consider the poor farmer girl whose fiance is a poor farmer boy; neither can afford a diamond ring now or ever. They are married, live, and die happily without ever owning a diamond or having any bearing on the demand curve for diamonds. Yet would this lass not value a diamond?

It is this sentimental sense of value that is not recognized by the market price (value in exchange) nor the demand curve’s surplus. It is a concept of value in utility – cardinal utility – that I want to understand. White reminds the reader that John Locke did establish this notion as “intrinsic” wants of mankind in the 17th century, and also that other 18th century scholars made the “use-exchange” distinction in books that Adam Smith had in his library. To repeat, Smith never claimed this insight to be original.

The Origins of the Paradox of Value

Thousands of years before Adam Smith was born, Plato wrote about the paradox of value in Euthydemus (Greek: Εὐθύδημος, Euthydemos), written around 384 BCE, one of his earlier Socratic dialogues. This history is delightful and, to me, just as important as what Plato actually wrote. As you may remember, the great philosopher Socrates never wrote any poems or books or anything at all. He is remembered only because his students, especially the brilliant Plato, wrote about him in their own plays and dialogues. This fact is an historical challenge exists – the Socratic Problem – about the impossibility of knowing “the ideas of the original Socrates as distinct from his literary representations.” A dominant view is that Plato’s earlier works are the truest homage, and that latter dialogues such as The Republic utilize the great man as a fictionalized character to represent Plato’s own ideas.

Euthydemus is a dialogue in which Socrates describes two rhetoricians, known as sophists, whose skillful and pugilistic wordplay is sarcastically praised. Socrates explains his long and playful conversation with the brothers to his friend, Crito. And after a lengthy description, finishes his tale by telling Crito that he (Socrates) expressed his admiration to the brothers but admonished them not show off their rhetorical skills to wide audiences, despite the acclaim and applause they often got. And here’s why:

“If you are wise, you will also bid your disciples discourse with no man but you and themselves. For only what is rare is valuable; and ‘water,’ which, as Pindar says, is the ‘best of all things,’ is also the cheapest.”

This is the advice of Socrates. the teacher, founder of the Academy where select groups of students paid to learn from his methods. What perfection! He says keep your discourses private among your disciples, for that will enhance the value of your words. Here we have Socrates not only touching on the value of scarcity, but explaining why he left no books. Books were not a source of revenue, in his view.

The passage begs the question, who was Pindar? He was famous in his time as a great lyric poet in Thebes. Pindar would have been an old man when Socrates was a young Athenian soldier. I have no idea if they met, but the passage indicates that Socrates had read Pindar’s famous first ode to the Olympics, which opens with the words, “Water is best” for survival, gold is best for wealth, in leading up to the glorification of victory in the games as best for one’s spirit.

Life, wealth, meaning.

Use, exchange, utility.

This may seem to be an esoteric issue, but take care to notice the many casual assumptions about value in newspaper and magazine stories. For example, the wry aside that teenagers “waste time” on Facebook which equals X million dollars per year. Time on books, social networks, video games, television, sports — these have no use but great utility. Notice the difficulty of measuring inequality in 2010 versus 1910. Notice how hard it is to measure inflation because consumption basket change dramatically. Notice how we talk about valuing public goods, national parks, and the environment. It’s a challenge. Finally, notice how government policy is distorted by assumptions that work and income should be taxed while uncompensated activity should not. Who produces value, after all?

The thread of value is woven into all things, and our search for its true meaning is far from over.


The “China Shock” is Short-Sighted

There is a new academic paper by David Autor, David Dorn and Gordon Hanson that challenges one of the bedrock beliefs of economics: free trade is good. Titled “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade,” the paper shows how workers in sectors more exposed to imports from China are suffering relative to other workers. This is not a new perspective at all. Indeed, the bedrock of economics is more like fresh cement compared to the ancient instinct to fear outsiders.

China Shock offers new insights, really tremendous coverage of many issues, and deserves to be taken seriously. It should not, however, be oversold (which I think Noah Smith does a bit here claiming that free trade with China wasn’t such a good idea). Even so, I think the China Shock is flawed, or more accurately, it is short-sighted. Here’s what it is missing, in my opinion:

First, theories against trade need a lot more than anecdotal, short-term empirics. And yes, when it comes to opening trade to 1/6 of the world’s population, there will be a shock before the system restabilizes that will take longer than 15 years to settle. Fifteen years is long enough to ask questions, but not to answer them.

In the parlance of econ 101, a phrase I actually dislike, there will be “winners and losers” from trade. Autor et al. are saying they found more than the expected negative impact on the losers. Nevertheless, my first impression is that their analysis of China’s integration via the WTO to the world economy is just one story, barely half told, and far too early to draw definitive conclusions. We are talking about a core principle based on centuries of history and hundreds of more compelling stories. In short, the anti-trade view tends to be short-sighted.

Second, the ultimate story that substantiates the value of free trade is the historical experience of the United States, specifically the internal growth dynamics after 1789 when the adoption of the U.S. Constitution expressly forbid trade barriers among the states themselves. “No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports…” says Article 1, Section 10, Clause 2. This is widely seen as one of the reasons the U.S. is the world’s richest large economy and has been so for over a century. Eugene Melder has a nice paper, published in 1940, on this.  More recently, there’s this passage from the 1985 Economic Report of the President:

The power of free trade is amply demonstrated in history, including the early history of the United States. Under the Articles of Confederation, protectionist interests in individual States moved quickly to restrict the flow of competing products from other States. The debilitating effects of this protectionism on the States’ economies convinced the framers of the U.S. Constitution to forbid individual States from levying tariffs (and the Federal Government from levying export duties). Federal courts have guarded the integrity of this prohibition, ruling as recently as 1981, for example, that a Louisiana tax on natural gas passing through the State was unconstitutional. The constitutional ban on State tariffs was crucial to the development of the U.S. economy not only because it established a free-trade area
among the 13 original States, but also because it ensured that the free-trade area would expand automatically as new States joined the Union.

Would Autor et al. expect to find outsize winners if trade between California and the other 49 states were given a trade restricting policy shock? I am confident that a negative California shock would be rather harmful to workers in Arizona, Michigan, Ohio, and the rest. Indeed, until a scholar can convince the public that a single city should declare autarky for its own net benefit, I will look at the debate over trade with real bemusement.

Third, any general analysis of a trade shock has to consider consumption impact, not just production. Not to knock the supply side, but it’s a one-eyed view. The suppression of inflation during this recovery has been an absolute puzzle for the Federal Reserve. I find it hard to believe how the China Shock effect on pricing has been overlooked, not in this paper, just as a general observation. The natural question to ask is how the wage effect balances against the price effect for net well-being. It’s fair to counter that the authors examine real wages, which by definition are inflation adjusted, but is that good enough?

Real wages neglect the broad consumption gains from trade, especially in this era of rapid technological change, and are based on what many economists think is a flawed measure of inflation. The inability of prices to measure quality of life improvements, new products, and more is a major controversy.

Let’s not forget the timeline: 1978, China begins to adopt property rights & free markets. 1977-95, the personal computer is invented/developed/mass-marketed. 2000, China enters the WTO. 2007, the iPhone is invented. China is the manufacturing location for a great deal of modern tech hardware, including the iPhone which is ubiquitous among U.S. consumers of all incomes and did not exist previously.

Fourth, what role does America’s labor rigidity play in all this? The authors note that a standard economics textbook would have predicted a certain kind of labor market response to a trade shock, but that theory has not been realized:

“Labor-market adjustment to trade shocks is stunningly slow, with local labor-force participation rates remaining depressed and local unemployment rates remaining elevated for a full decade or more after a shock commences.”

My second reaction to the paper was not to blame the shock for the slow labor adjustment, rather it was to blame federal and state labor market regulations that hinder flexibility. Increased trade adjustment assistant (TAA) surely slows the adjustment, just like unemployment compensation slows the search for work while causing skills to atrophy. The insight that free foreign trade is incompatible with controlled markets domestically is well documented, and the U.S. case in recent years only confirms that challenge. I think what this paper shows is the weakness of U.S. labor regulations, which were exposed by the size of the shock.

The bottom line is that Autor, Dorn, and Hanson have written a brilliant paper, and it is one that I will be reading more closely and pondering for a long time. But I do want to make it clear that the paper does not change my priors. Free Trade is Good. No exceptions, no limits.



The choice: higher minimum wage or more jobs?

The Congressional Budget Office was asked to estimate the effects of $10.10 national minimum wage, and it reported the impact of a $2.85 increase over the current $7.15 would be (1) higher incomes for millions of lower-income workers and (2) the total loss of income for 500,000 Americans. Policymakers and voters should understand that mandating higher wages is not costless, and one cost in forcing employers to give raises to the lowest-paid workers will destroy some jobs. That’s just reality.

To make the math simpler, the CBO estimates means this: Every penny increase to the federal minimum wage costs 1754 jobs.

Of course, the effect is not so simple, but the CBO number is a fair starting point. A more realistic model would note that each penny increase will be more harmful than the last. Why? Because a higher minimum effects (1) more people (2) more deeply.  At the margin, almost every job involves a labor-capital tradeoff. Capital investments to replace suddenly more expensive labor (that prices it above its marginal value) will not occur immediately. But the timing of capital addition to displace labor will correspond to the size of the cost differential. In short, a $1 increase will cause a shallower and slower job loss than a $2 increase.

So what to make of the notion of a $15 minimum? Set aside the completely destructive approach of encroaching on local sovereignty and local conditions — seriously, why can’t Ohio set its own minimum wage? Or not. Let Ohio be Ohio, and trust the people of Ohio to manage their own wage setting.  But, I mean it, set aside the illogic of a national wage. Can we model the job losses of a $15 versus $12 versus $10.10?

Based on the simple CBO penny cost above, I calculate the $15 minimum wage will destroy 1.36 million jobs nationally.  But, importantly, I know it will be far worse.  The impact is exponentially higher for every penny.  If one assumes that each dollar increase has a 50% larger impact – an exponent of 1.5 – then the $15 minimum will cost 2.2 million jobs.  If the impact is 100% larger for each dollar increase, then the loss is 3.7 million jobs.

This is not a choice I would recommend. In fact, I would recommend allowing any adult the freedom to work at any wage they want. How is it moral to deny a person their choice of a job? If a person prefers a lower paying job that is a short walk from home, in a location they love, doing work they enjoy — there are just too many factors to be fairly managed by a one-size-fits all wage floor.

The Presidential Tax Plans (and the Fiscal Sandwich)

I was asked to talk about presidential candidates’ tax plans today on Trish Regan‘s FoxBiz show. As usual, I prepared more content than the video medium allows, so let me share some thoughts with you here. Disclaimer: I am not advising any candidate. I speak for myself here, not for Glenn, or anyone else.

Now the way media invites go for a guest is that I will get a call or email asking if I would be able to talk about topic X at time Z. I usually take those for TV if I have something to say. Often I decline when the topic is outside my range of economics, national security, or (hoping someday) superhero movies and how to be an awesome dad/husband/dog owner/soccer coach/Spurs fan/garage organizer. This time the producer said the topic was “presidential candidates’ tax plans.” Cool!

Since I am in DC on a work trip, this was an opportunity to appear in studio, or at least in the FoxBiz side studio. Cool. I said yes, did about an hour of homework to study up on who has said what lately, and off we go.  I arrived early so got made up by the team there, then waited in the “green room.”  Being early, I switched channels from FOX to FOX Business so I could see what others are seeing for the ten minutes before I appear.

Trish is a great host, and my bet is that she will become a bigger star in the years ahead. But this was my first time talking with her, and I knew it would be wise to get a gist of what was happening now and what was on her mind. Good tip: always do this preview if you can. Some green rooms are less organized. I’ve been in major network green rooms where the remote TV control is broken. Anyway, on this day, Trish says right before the commercial break something to the effect, “When we come back, we will talk electionomics and what the Trump tax plan is all about.”

Uh oh.

There is no Donald Trump tax plan. There’s some bravado about how he knows the tax code better than anyone and how he’s going to go after hedge fund guys. That’s it. Pitchfork populism and the fact that he knows how to abuse loopholes in the tax code. Those seem like disqualifiers in my opinion, but, I really had nothing in the tank if Trish wants to ask follow-up questions.

Thank God for the iPhone. Thank God for mobile Google searches. And thank God for Miss Collins who taught me to read quickly in 5th grade at Prarie Lincoln Elementary.

Two minutes later, I am in the studio. Earpiece in, Mic on the lapel. Smile and think about talking to my sisters about policy issues. (That’s how I get ready for any media talk. My sisters are brilliant, but they are not swimming in the econ literature nor are they up to speed on policy wonk world. So I figure if I can explain to them, especially with a splash of humor, that should work for everyone in the USA).

What I WANTED to say is that Marco Rubio, Jeb Bush, and Rand Paul have put out serious, important, and substantive tax plans (Check Dan Mitchell’s analysis here and this superb dynamic candidate plan overview at the Tax Foundation). Nobody else has put out real policy plans, although a few candidates such as Ben Carson have established important principles. I was going to say, “Well, Trish, Electionomics is much more about establishing what your principles are rather than serious policy plans. So when a candidate like Jeb puts out a serious plan, it opens him up to attack, and we should respect the political courage it takes to be serious. So give credit to Rubio, to Bush, and to Paul.”

I anticipated some questions about how those plans have been estimated to create bigger deficits. Critics say Jeb’s plan will cost 1.2 trillion dollars of lost tax revenue over ten years. Paul’s will cost $3T, and Rubio’s will cost $4T.

We should all challenge the premise here. Saying any tax plan will “cost” something is false. Every cost means more Americans keep their money instead of Uncle Sam. More importantly, why the 10 year benchmark? A good tax plan will dramatically increase GDP growth, not to mention personal incomes. Beyond ten years, a good tax plan should narrow the deficit path.

I WANTED to say something else, that needs to be said, which is:

It is a mistake to link fundamental tax reform to budget deficits in isolation. Look at what President Obama has done. Obama increased tax rates, tax revenues, and tax complexity. The man is 3 for 3 on increasing the tax burden, year after year. Yet the six largest deficits in US history have all occurred with Obama in the White House. The annual deficit during Obama’s first term was over One Trillion Dollars each year. Even though CBO reports the deficits in the current year to be a third of the peak, they also project that Obama fiscal structure will cause deficits to rise toward One Trillion Dollars per year within ten years. That is a terrible legacy being left by this White House to the American people.

I should end the blog post there, because that structural deficit legacy is so important, but let’s think about why. Higher deficits seem to correlate with higher tax complexity. That is because tax policy is only half of the fiscal sandwich. (Yes, I really wanted to say fiscal sandwich on live TV. I know it is stupid, but it sounds like a nice blend of wonky good point and something that the sisters would laugh at. One can hope.) The other half of the fiscal sandwich is federal spending. And if a candidate – a serious candidate – has a plan to slow the growth rate of federal spending, then you’ve got yourself a president.

In the end, Trish gave me a lot of air time. I tried to introduce some reality to the Trump TV bubble. But there was much left unsaid. As for things unsaid on tax plans, Hillary and Bernie are offering even less substance than Trump. That’s electionomics for you!

The Refugee Crisis is Just Beginning

The surge of Syrian refugees into Europe is a crisis with many fracture lines. I’ve been asked to comment on it multiple times given my role in working on immigration issues as the editor of PEREGRINE, even though our focus at Hoover is on immigration to the United States.

The civil war in Syria is to blame, not Europe or the “West” as some have claimed. Syria had a population of 22 million people, and best estimates are that 4 million have fled the country and nearly 8 million are internally displaced. Although the focus of media coverage has been on refugees flooding into the European Union, keep these numbers in perspective. Turkey has taken in 1.8 million, and the tiny country of Lebanon has taken in 1.2 million. And Europe?  Germany says it anticipates taking in 800,000 refugees and asylees this year which is 4x normal (asylum is a refugee status for someone already in-country). The Economist has a useful graphic contrasting different European refugee acceptance numbers and per capita rates. Some countries such as Poland are willing to accept only Christian refugees (roughly 1/10 of the Syrian population). In contrast, some states in the Gulf region are taking in zero refugees.

Images of dead refugees carry great moral impact, but I am not so quick to judge. I may believe it is right for America to be more open to immigrants than any other nation, even proud of our historic openness, but I respect the sovereignty of other countries to be closed. Japan and Australia, as two examples, are ethically and culturally distinct in their regions. A nation has no moral obligation to welcome foreigners as fellow citizens. But does it have an obligation to protect refugees during a war?

The challenge for Europe is this: will welcoming refugees now lead to an acceleration of even more refugees in 2016. It is naive to think there is no feedback loop. Almost every one of the 18 million people that remain in Syria would be better off anywhere else. And what of the people of Africa’s civil wars?

Let’s not pretend there are easy answers.

As for the U.S., the President establishes an annual cap on the number of refugees admitted. Currently that cap is 70,000 people per year (see this fact sheet from immigrationpolicy.org). I would like to see that set higher. However, I think our focus should be on refugees for nations nearer to home, notably in Central America. The U.S. has already contributed $4 billion to aid international and NGO efforts to help the refugees.

The other policy dimension to this, in my eyes, is the wages of pacifism. By allowing Syria to fester, by not engaging early on and ousting the Assad regime in 2011, by precipitously withdrawing U.S. troops from Iraq, the White House pursued a pacifist fantasy that was a central causal factor in today’s crisis.

There are sins of omission in foreign affairs.

What Shape is Talent?

I’ve been thinking about talent in the U.S. military. Talent management is impossible without talent evaluation, and for most organizations that means performance evaluation. Much as I would like to point to the science of performance management, my research in recent years suggests that there’s more art than science at this stage, certainly in the private sector. Although General Electric is famous as a leadership factory that successfully uses forced ranking to identify its top (and bottom) people, that model has proven to be disastrous at Microsoft and possibly at Yahoo! In sharp contrast, the new fad is for firms to eschew performance evaluations entirely, a model that Adobe announced to great fanfare last year. With wild variance in practices, it is impossible to advise “best practices” to the Pentagon or any of the services. However, it is more than possible to advise pragmatic, well-grounded principles.

The very best performance evaluation system may, in fact, be deployed by the U.S. military right now. Because the services are free to operate their own PE model, there are 4 (or 5 if we count the Coast Guard) different models in operation. Based on what I’ve seen, two are world class.

Let’s focus here on what the real world tells us about the shape of the distribution of talent. A forced rank method assumes that units have a “normal” or bell-shaped talent distribution. A forced ranking system, to be effective, should afford raters the correctly sized buckets to match the shape of their team’s performance distribution. For example, if a commander has 10% of his people clearly in the bottom, but is required to identify 20% in the bottom, everyone loses. The team loses, the boss loses, and the larger organization loses. If those numbers are reversed (20% bad, but 10% bucket), the outcome is also destructive to the higher goal of managing people effectively. The key moral of this story is that an effective PE system should have the flexibility to let the rater fit his evaluations to the the shape of his talent.

Imagine that talent is not normally distributed. A provocative academic paper published in 2012 (O’Boyle and Aguinis)1 found that talent is distributed more similar to a Paretian distribution, i.e. pyramid shaped, than to a normal distribution. They identified a consistent “superstar” phenomenon in five different fields, from professional basketball to academic research. This is an important point, and basically a valid point, yet a careful examination of the data reveals that the O’Boyle-Aguinis case is overstated.

Talent in the NBA

Consider, by way of explanation, performance of pro basketball players. As a random case study, I pulled all player statistics for the 1981-82 NBA season, a total of 373 player records including Dr. J and Moses Malone. Larry Bird and Magic Johnson were in their early prime, and neither was among the top 10 scorers. A histogram of total points scored by each player reveals a distinct Paretian distribution (figure 1 here).


Three players were in a class by themselves that season. George Gervin set the maximum at 2551, followed closely by Moses Malone and Adrian Dantley. Breaking points into 20 bins over 5% ranges between 0-2551, you can see that only two other players were within the top quartile bins.  However, the problem is that total points is not actually how coaches assess basketball players, right?  We know that other factors matter just as much, even if we focus on offense. Assists. Rebounds. But it turns out that every quantifiable aspect of talent also follows a Paretian distribution. Consider total rebounds.


Most NBA players get 1/3 of the rebounds that the superstars get, and a full quarter of players get 1/10 of the max. That’s Paretian. A slam-dunk for the O’Boyle-Aguinis thesis, if you will.

However, this is not how coaches evaluate talent. Rather, coaches consider how efficient players are in terms of their shooting percentage, and they also are sensitive to how much performance is achieved per minute or per game. Is it fair to label someone as a bottom talent if they only get to play 1 or 2 games in an 82 game season? No, and if we convert the above data into output per minute, then we see a very different distribution. A normal distribution.


That should give HR executives some relief that their models are not completely miscalibrated. But a look at rebounds per minute should still concern us, because it is not normal at all.


A performance evaluation system that uses any number of bins will not fairly assess NBA rebounders. Keep in mind, this is over a fairly large population of players. Most organizational units look more like teams, with maybe a dozen members. There’s no way a typical team will be able to (1) identify the right talent to measure, then (2) measure talent correctly, and finally (3) fairly rate people according to any neat distribution.

Take the U.S. Army for example, which uses a 3-bin rating: Above-Center-Below Mass. De Facto, only Above and Center are used, with no more than 50% of rated individuals in a unit allowed to have the Above rating (“ACOM”).  How is that fair if the talent distribution is normal?

My final step in considering NBA talent merged three performance metrics into a single score, what I label the PlayerScore. It works like this: each metric is transformed into a 0-1 score. For example, the top points/minute score is a 1.0, and other scores cascade below it from 0.97 to 0.83 to 0.00. There are many ties. I included rebounds per minute and assists per minute as well, then took the average of those three. The theoretical maximum is 1.0 for a player that gets a 1.0 in all three areas. In 1981-82 NBA, the top player had a 0.643, he played for the Los Angeles Lakers, and his name was Earvin Johnson. Right behind him was a guy named Larry Bird with a 0.621 score. But that’s just looking at three measures, and you could easily weight them differently or use a half dozen other measures such as steals, shooting percentage, foul shots taken and made, and so on.


The point is that talent is approximately normal, but only under extremely favorable assumptions, on average, over large populations. In the real world, team talent is abnormally distributed. And it will change shape from one season to the next. All these observations about the real world affirm the lesson:

An effective PE system should have the flexibility to let the rater fit his evaluations to the shape of his talent.