I was recently talking to some German friends about their trips to the United States. Apart from the standard touristy things they found memorable about the U.S., they were all greatly impressed that they could go shopping for almost anything in the middle of the night. Even to modern Europeans, the concept of midnight shopping seems fantastic. Imagine their amazement when I explained that, in the U.S., they could go shopping on almost any holiday as well.

Today’s business culture thrives on on performance, success, winning, and constant availability. The world continues on its frenzied trend toward 24×7 services, “five 9’s” of up-time, and six sigma products. The drive to succeed has provided us with all sorts of modern conveniences—and plenty of modern instances.

Perfect.

But I’d like to say a few words in defense of failure, because I believe failure has an important purpose and we can’t simply wish failure away by focusing on success. In my view, systemic failures can be averted simply by introducing some planned imperfections into the systems we build. One of the lessons that should be learned from the current financial crisis is how securities originally thought to be insular from the housing market were proven to be directly on the financial fault line.

Here’s the problem: when a system (such as a computer network, power grid, or financial market) performs steadily for a period of time, it fades into the background and seems as certain as the rising of the sun. Over time, a complex and interdependent mesh of relationships develops. Because these dependencies aren’t explicit, it becomes nearly impossible to predict how the beating of the proverbial butterfly’s wings in one part of the system can wreak havoc in another.

Is there a way to tease out the dependencies in such networks and develop complex distributed systems that fail safely? I think there’s a simple solution: introduce the element of failure. Shoot for 4 9’s instead of 5. Interrupt the broadcast so that we can run the drill before the disaster strikes. Learning to fail on a regular basis could help us deal better with much larger, systemic failures in the future.

Next time you stand in line at an airport, take a moment to reflect on how your driver’s license is more likely to be accurate than the badge displayed by the TSA employees. A front page story in Monday’s USA Today reported on how the United States Office of the Inspector General (OIG) chastised the TSA in an an audit report for improperly managing badges, uniforms, and passes issued to personnel.

The agency overseeing security at the nation’s airports failed for years to track security passes and uniforms of former employees, creating widespread vulnerability to terrorists, says a government watchdog report obtained by USA TODAY.

The Transportation Security Administration lacked centralized controls over the secure passes issued to some of its employees, according to Department of Homeland Security Inspector General Richard Skinner. The passes grant people access to the most sensitive areas of an airport, such as where baggage is screened or planes are parked

Investigators found numerous cases in which former employees retained their passes long after they had left the agency.

The investigation also found that TSA uniforms were frequently not collected when employees left or were transferred.

People using improper badges, IDs or uniforms — particularly in combination — “could significantly increase an airport’s vulnerability to unauthorized access and, potentially, a wide variety of terrorist and criminal acts,” the report said.

For all the effort the Department of Homeland Security has devoted to constructing a nationwide identification system (such as Real ID and New York’s “enhanced driver’s license“), the revelation that even the TSA can’t properly manage identification for its own employees highlights the absurdity relying on identity systems for security. It’s a Catch-22: the more a security system relies on IDs for access, the more valuable the IDs become to attackers. After all, why would a terrorist bother to infiltrate an airport as a mere traveler when it’s easier and more effective to infiltrate as a TSA official?

The TSA responded to the OIG report by claiming the infractions were overstated and that the TSA already has made important changes to its programs. The TSA also points out (rightly, in my opinion) that their security program doesn’t rely entirely on badging but depends heavily on the social trust and social capital (my terms) that exits among coworkers in an airport setting:

While TSA has more than 43,000 security officers in airports nationwide, each airport has teams and shifts of employees working regular shifts who trained to look for threats and things that don’t look right.  If a former employee or someone impersonating an officer showed up at a checkpoint or a sterile area of an airport, they would be subject to the eyes and ears of on-duty officers and random employee screening throughout the airport.

In short, a badging system that aids social processes for trust will be reasonably effective at thwarting attacks; but a badging system that attempts to replace social trust (as I think the Real ID Bill would do) is destined to fail and desimate social capital in the process.

Managing Risk is Not Enough
Late last year, I sat in a meeting in which several bankers were present. During the meeting, one of the bankers said something that in retrospect belongs in the highlight reel of “famous last words.” The comment went something like this: “We’re bankers! We understand risk, because it’s our business. We know how to manage risk. That’s why industry and government are looking to us to solve risk-related problems.”

As ridiculous as this statement now seems (especially to those of us whose retirement funds have been decimated) I’d argue that the statement holds true—even in a grizzly market. Yes, good bankers do know how to manage risk—their own risk. Which is why the best investment bankers view a recession more like a sabbatical, while the rest of us have to figure out how to keep food on the table. And even as the government is coming to the rescue, the Fed won’t be doing the risk management part: they’re paying bankers to figure out how to get out of the mess they’ve created. Talk about a win-win!

Not that these guys aren’t suffering. Here’s a bit of anecdotal evidence of how bad things have gotten:

This is a finance guy making a ton of money and he was trying to decide whether he should sell the country home in Connecticut, the apartment here in the city or the 8,000-square-foot dream home in Oregon that he just finished…  (from “End of an Era on Wall Street: Goodbye to All That“)

A dilemma for sure, but global financial crises demand desperate measures.

Markets Transfer Risk, Not Trust

The foundation of modern financial markets is seeped in the mathematics of probability. Over the years, rules and regulations have been piled on to promote competition and reduce overall risks. The results are compelling. And something in the human psyche tells us that since these guys are so much better at managing their own risk—and they obviously are, since they have several luxury houses at their disposal—then maybe we should trust them to manage our risk too. A market allows us to transfer our assets to someone who can navigate a risky terrain better than we might ourselves.

But risk management in itself doesn’t guarantee collaborative outcomes—that is, outcomes in which gains and losses are shared proportionally—nor does risk management inexorably produce social trust.

Clearly, the current crisis is as much about a breakdown in social trust and a loss of social capital as it is about debt ratios and credit freezes. We’ve already seen how even an injection of more than a trillion dollars won’t allay lenders’ anxieties. If you’re not an actuary, the reason is obvious: anxiety isn’t a risk equation, it’s a human emotion. Anxiety is symptomatic of a collapse of trust.

The problem with words like “anxiety” and “trust” of course is that they’re mystical to the mathematical mind. How’s a actuary to calculate the value of trust futures? or social trust default swaps?

Restoring Social Trust

What the world needs now is a renewed social trust. Until recently, social trust seemed like an intangible commodity with a will of its own; it couldn’t be systematically cultivated, measured, forecasted, or valued. But a growing canon of research into successful resolutions of social dilemmas demonstrates that collaborative arrangements are more likely to emerge when certain conditions are met. It’s time to develop mechanisms that foster pro-social behaviors by supporting natural processes of recognition, reciprocity, and community awareness. Most of the fundamental research is available to build such a system, so it’s more a matter of applying these ideas to real world relations, institutions, and markets.

Laws of Relation Revisited: Codifying Pathways to Trust

A few years ago, I challenged the software industry to take ideas about trust from various branches of science (such as game theory, social science, evolutionary biology, and psychology) and produce a system that greatly improved the likelihood of collaborative outcomes and improvement in social trust. The system could then be applied to trust-related problems on the Internet, such as spam, identity theft, and credit fraud. If such a “trust leavening” could be invented, it might even be applicable to a wider range of problems, including stronger trust in financial markets.

To design a trust system, there needs to be some workable theory on trust that explains how it’s created, how it’s maintained, and how it’s used. The theory needs to be intellectually accessible to a wide range of professionals. Just to get the conversation started, I offered three “Laws of Relation” (which are really more like postulates at this point). They are:

Law of Relational Symmetry

The party in control of the terms of a relationship controls the relationship and, in the absence of symmetrical countervailing controls, will eventually exploit the other participants.

Law of Relational Risk

Contribution to the relationship that is not met proportionally by the other participants is a loss to the contributor.

Law of Relational Projection

Any party with more than an informational interest in a relationship is a participant in the relationship.

As it turns out, financial markets illustrate these laws rather well.

The first law says that exploitation will occur in asymmetrical relations. Who controls the playing field in financial markets? The SEC? The Fed? It seems in many cases, the large investment banks who continually added exotic financial instruments, pushed for rule changes, and lobbied for reduction in government oversight. The prevailing belief in Washington was that these are smart guys who know how to manage risk. As it turns out, they were easily the smartest guys in the room and they were exceptional at managing their own risk, but not motivated at all to think of market risk. The average investor has almost no say in matters regarding market rules, so the relation was systematically slanted in favor of the rule makers.

The Law of Relational Risk predicts that collaborative outcomes are more likely when all parties experience a loss proportionally. The losses on Wall Street have been catastrophic, but not for everyone. Many of the people directly involved in creating this mess won’t suffer from the crisis the way some of the shareholders or general public will.

And the Law of Relational Projection distinguishes participants from on-lookers. One thing that has been a surprise to everyone is how interrelated and interdependent we’ve all become. Interdependency can be a vital pro-collaborative element to relations (per the Law of Relational Risk). In fact, it’s our agreement on a shared conflict, our mutually assured financial destruction–that has formed the basis for cooperation in congress and among world banks. But the strategy only works well when these relations are explicit. Instead, as our home loans have been sold, resold, hedged, and bet on through derivatives of derivatives, it’s no longer clear to anyone who is a participant and who’s a bystander. So what’s happened is that people who were believed to be bystanders have brought the house down with little or no accountability.

Designing Pro-Collaborative Systems
Few of society’s existing institutions are set up to support collaborative outcomes, and so exploitation is inexorable. With an informed understanding of elements that promote collaboration and trust, we can greatly improve our institutions, including financial institutions. I’ll continue to present my ideas on how to do this in follow-on posts, but I hope that professionals from a wide range of disciplines will contribute their ideas as well.

Today, there was some interesting discussion in the New York Times on human instincts for punishment and forgiveness. According to the article, researchers have found that within a population, some percentage of people (between 10 and 40%) are attuned to following their “referee instincts” by ensuring evil-doers get their due. This instinct has clearly come into play during the wide-spread financial crisis:

The public urge for punishment that helped delay the passage of Washington’s economic rescue plan is more than a simple case of Wall Street loathing, according to scientists who study the psychology of forgiveness and retaliation. The fury is based in instincts that have had a protective and often stabilizing effect on communities throughout human history. Small, integrated groups in particular often contain members who will stand up and — often at significant risk to themselves — punish cheaters, liars and freeloaders.

But allowing such impulses to play out on a grand scale can also exacerbate a crisis. The article continues:

Some experts believe that Japan’s disastrous delay in bailing out its banks in the early 1990s was caused in part by a collective urge to punish corrupt bankers, and they fear a similar outcome today.

Game theory suggests alternative approaches to resolving social dilemmas. In running various gaming scenarios in which participants respond to each others’ uncooperative behaviors, the best outcomes for all players are achieved when players follow simple tit-for-tat strategies and allow for forgiveness. On this subject, the article states:

Fortunately for the economy, researchers say, a strong countervailing psychological force is also at work: the instinct to forgive, and to cooperate…. Running thousands of computer variations … scientists have found that the strategies that pay off the most are tipped toward cooperation.

Agreed. But we’re not in a laboratory, so the quaint models of game theory aren’t so readily applicable. In real life things are so much messier, if only for the phenomenal scale on which the current crisis is playing out. It’s not even clear how the average person can actively participate in responding to the crisis. I imagine most just want to board up their windows, live off of food storage, and wait for the hurricane to pass. I imagine the average person won’t be quick to take advice from financial advisers or government officials, because so much trust has been lost in these relationships. If so, the result would be an even worse situation for everyone.

The financial crisis highlights our need for greater social trust. Humanity has learned to stitch societies into a globally integrated economy, but our natural pathways to trust have languished. The explosions in the size of the organizations and communities we associate with, the amount of information we need to process, and the complexity of the system of trade we must rely on for our well being have overwhelmed our native, instinctual ability to form relationships based on trust. How to construct a basis for trust in the modern era is, in my mind, the most important issue of our time.

Yesterday, Olivia Judson published a piece in the New York Times about how human beings are almost incapable of being objective, particularly when it comes to the subject of themselves. This creates severe difficulties for studying humans as individuals, cultures, and civilizations. She points out:

The literature from psychology shows that, as individuals, we are good at seeing other people clearly, but poor at seeing ourselves. Most people, for example, describe themselves as being better drivers than average, and consider themselves better looking than other people consider them.

It seems the observer’s paradox applies also to self-observation. Who knew?