Skin in the Game as a Required Heuristic for Acting Under Uncertainty
papers.ssrn.com
papers.ssrn.com
Small transactional costs stop things from existing at the fetal/growth stage. Evolution destroys them long before the long-term benefits demonstrate themselves as it supports short-term adaptive traits over long-term adaptive traits. If you require skin-in-the-game transactional costs then your transactions will happen far less often, and in the short-term you will get out-competed for resources by those that protect themselves with top-down regulations.
It is often difficult for third-parties to evaluate the authenticity of a cost or regulation, which is why institutional costs exist - they factor out hundreds of checks of hundreds of transactions into a single check of the institution that regulates hundreds of transactions (which itself is often proxied by the social proofing of this institution.) This lowers the transaction cost which causes high growth.
Fetal is really a good analogy here. The womb exists for good reason; scaffolds exist for good reason; decorum on first dates exists for good reason. Without these things early transactional costs defeat growth.
In short, skin-in-the-game evolves out of artificial systems as it is bad for early-growth. However this does not mean that it should; in well-designed/natural systems the entity first exists in a protective bubble during its gestation period and then slowly has its skin placed in the game.
Similarly, a building under construction is incapable of advising someone to buy stocks. And first dates do not usually result in land wars in Afghanistan.
Can you give an example of a process or profession which can be said to willfully expose others to risk, which does deserve this sort of protection when it's just starting out? It seems to me that such responsibilities are nearly the definition of maturity.
Keyword: usually.
Everything has a cost of existence.
I do not think that it is useful to discuss the "cost of acting under uncertainty" when you can discuss the "cost of existence". The former is just a special case of the latter - the existence of conscious actions. When understood in this way, the foetus has a cost of existence, the analogy holds and as it grows older we have more and more cases of its protection against the outside world through its location, tribe, mother, etc (all later forms of gestation period) as we pass through the traditional coming-of-age story arc.
Skin-in-the-game hurts fragility but helps resilience (individual or systemic) become antifragility. At growth stages, resilience is the exception to fragility. At maturity, fragility is the exception to resilience.
The concrete cases that validate this level of abstraction are: (a) entrepreneurs building profitable companies in which many need angel investing in order to survive their operational costs [1]; similarly (b) early-stage deals are extremely fragile to transactional costs, so placing a skin-in-the-game cost on one deal while not on another is extremely likely to cause the other deal to be preferable.
I agree with both yourself and Taleb that in cases in which an actor has the potential to be harmful to others they should be responsible for their actions and have skin-in-the-game. However my point is that no entity is just born like this, they have to slowly place their skin-in-the-game. Lawmakers have the tendency to add regulatory costs to a system that through the process that I've just described stop new entrants from joining and create the perfect opportunity for monopolies to form (which eventually learn to manipulate the presentation of their up-sides and down-sides while avoiding the regulatory down-sides anyway.)
[1] Entrepreneurs are ultra-fragile and therefore the whole startup system that emerges around them helps to offset the operational risks at early stages. Helping individuals to bear risk is how systemic antifragility is grown.
"Skin-in-the-____"
They face rigorous scrutiny for their medical actions.
Startup founders.
Car designers.
Airline pilots.
Of course, all these guys have some skin in the game now. I'd argue that in all these professions, artificially increasing the penalties for failure wouldn't make the world better.
You feel safer if the pilot is in the airplane with you, and has his life at risk as much as yours, than e.g. if he was just remote-controlling the plane from his office
I think a lot of this depends upon whether the task calls for a rational or emotional response. For tasks that require a rational response, having "skin in the game" can cloud your judgment and make you perform worse than if you were a dispassionate observer. For tasks that require an emotional investment, you want the person's risks and incentives to be aligned with yours. (For example, you want a product designer to actually use the products they design, and you want a teacher to care about your kids as much as you care about them.)
A surgeon faces large legal risks for a botched surgery. A lawyer is likewise legally responsible for his actions. Doctors and lawyers are two of the professions with the most skin in the game!
I don't know enough about 9/11 dispatchers to say if they face liability.
On the other hand doctors have, compared to their patients, no skin in the game. If the patients health gets worse or the patient dies the doctor stays unharmed. This is partially the reason for overtreatment in medicine (the other one being the asymmetry between the rewards for positive/negative effects of treatment vs. no-treatment.)
Then what about driving ? By the same logic, car accidents should be much less. Flights are much safer due to the amount of research done in air-travel safety, in general, and also after every accident. And also because in roads you have too many cars interacting together at the same time, where any one person's small mistake can cause an accident, which is not the case with aeroplanes.
Yes, of course. But why? Why is the amount of safety research so much higher after a plane crashes compared to when a patient dies? Why are simple checklists common practice for pilotes but not for doctors even though they could save many lives [1].
As for car travel. It seems to be inherently more dangerous for the reasons you mention. But lets introduce a principal-agent problem [2] for car driving. Assume that for example taxi drivers would steer the vehicle from a save place say as a drone. Would you want to drive with such a taxi?
[1] Gigerenzer: Risk Savvy - How to make good decisions. [2] https://en.wikipedia.org/wiki/Principal–agent_problem
I don't think it's bad to require some skin in the game, but require too much and many risks that are quite beneficial to society as a whole just won't happen.
Made me think of this: http://www.youtube.com/watch?v=pM-igYjn6E4
The corporation sheilds from financial risk, thus enabeling an actual risk. When latter is missing the problem of lack of skin may appear.
By contrast, one of the functions of modern corporations is that culpability does not pass-through to the decision-makers. This is an actual removal of risk, not re-distribution, as there are consequences that a corporation is not capable of facing.
Creditors tend to be established firms and bankrupt companies tend to be new, small enterprises, so it seems that limited liability promotes socially beneficial risk-taking by offloading bad outcomes on those who are best able to absorb them. ... "From each according to his ability, ..."
One could imagine company law creating a same-again limitation on liability. If you invest a million dollars, you have two reasons to watch the management you appoint, first they could lose your investment. Second if they screw up and do a lot of damage the investors are on the hook for the same again; potentially another million dollars.
It is quite a tricky proposal to analyze. Consider the common practice of supplying goods on 30 days credit. It is slightly risky. The purchaser might go bust without paying. Under current once-only limitation of liability it is common for suppliers to lose out, which can cause a ripple effect as one company goes bust, causes its suppliers to fail causing their suppliers to fail...
Under same-again limited liability the ripples go in a different direction as investors liquidate assets to meet "second" liabilities.
"The skin in the game heuristic is best viewed as a rule of thumb that places a pragmatic constraint on normative theories. Whatever the best moral theory (consequentialism, deontology, contractualism, virtue ethics, particularism etc.) or political ideology (socialism, capitalism, libertarianism) might be, the 'rule' tells us that we should be suspicious of people who appeal to it to justify actions that pass the cost of any risk-taking to another party whilst keeping the benefits for themselves."
Designers who wouldn't drive a car they designed. Doctors who wouldn't get treated in their own hospitals. That sort of thing.
The problem, to my mind, is how you'd motivate that sort of risk taking for people who are more powerful than those they're advising, or have different goals, or are in positions where they can't prove that they've skin in the game. I think most of us would, as a matter of course, get people to put their money where their mouth is if we could practically pin people down to it on a day to day basis. But, in reality, I might not choose to be treated in the hospital I work at because I can afford better care, or because I think some of the people there have it in for me, even if I'm an excellent doctor. I might not choose to drive a car I designed because I can afford a better one, or have different tastes.
etc etc.
And that's even in the case that I can show that I've skin in the game. I've worked jobs before where having any interests in the problem that might tempt you to fudge the results was grounds for not being employed.
It's very difficult to apply such a heuristic when I'm not necessarily playing the same game as you for the same prizes.
One potential advantage is that having "skin in the game" has a more positive connotation than betting on outcomes, to the general public at least. Regardless, Hanson at least deserves a mention.
From a stylistic point of view I'm not a big fan of the appeals to authority (e.g., "the ancients were fully aware" ) either.
From a startup perspective it's worth mentioning that mentorship or advice is also generally more confusing and less useful when the mentor lacks "skin in the game". Hence mentor "whiplash".
In other words, when comparing an ancient society to one descended from it, I'd expect the "successful" adaptations of the ancestor culture to be disproportionately present in the descendant. The converse need not be true.
In Taleb's example Taleb of the builder, those ancient heuristics became our tort law (and will be a part of our reputation networks in the future). He doesn't mention all the cultural adaptations we've since dropped...
So it's obvious at best, and an appeal to authority at worst.
I don't care whether a bank earns a financial gain or a loss. I care how big the gain or loss is. One hundred years of small profits can be wiped out in one bad quarter.
I do not believe Taleb is proposing punishing all risk taking. He's advocated aggressively taking risks where the downside is known.
The problem we face is that many are now in a position to get a limited, positive upside if things go well, but they face no downside. And the potential harm in such situations has no upper bound.
Skin in the game ought to be proportional to harm. Many comments mention medicine as a profession that should not have skin in the game.
Rubbish. Doctors are very liable if things go wrong. But it depends how wrong. We don't hold doctors accountable for small errors, or random errors.
We hold them accountable for big errors. The bigger the error, the worse the punishment.
As they point out in the paper, there are some cases where risk is intentionally removed, such as through bankruptcy for businesses to protect entrepreneurs. I think that can have positive effects.
I'm not fully convinced that "academic economists, quantitative modellers, and policy wonks"..."have no disincentive and are never penalized by their errors." I believe their reputation is at stake. The authors may mean they have no financial risk, but their reputation is tied to their future earnings. I'm not sure that's a bad thing as long as it's considered.
Overall I'd say there's nothing surprising in this paper, nor any specific proposals (as I hoped) but mostly a philosophical argument made in reaction to the current financial and political environment. I do agree with their premise. As a political view, I think "Skin in the Game" would make a pretty good slogan.
It would be interesting to implement distributed trust networks around this concept. If there are clear failure/success signals, you could have nodes present a bond which is destroyed on success and paid out on failure. Automated damages collection, I suppose.
Examples:
Thomas Friedman supported the Iraq war. http://www.youtube.com/watch?v=ZwFaSpca_3Q
Joseph Stiglitze and Peter Orzag predicted Fannie Mae and Freddie Mac faced near zero risk.
Stiglitz later claimed credit for predicting the financial crisis(!) and Orzag had a prominent position in Obama's administration
http://www.pierrelemieux.org/stiglitzrisk.pdf
What commentator can you think of that's lost his job for a bad prediction?
Pundit's have perverse incentives. They can point to correct predictions to boost their career, and they are penalized very little for wrong ones.
They have an incentive to make many predictions, and retrospectively choose to highlight only those that panned out.
It is not as if Stiglitz was in control of the institution or encouraged that they engage in these more risky behaviors.
It is more like a doctor performing a check-up on a patient, which represents a mere snapshot in time, saying they're in good health. And then the patient decides it's okay to start smoking, eating fastfood for every meal, and giving up exercise. Are you going to blame the doctor for not warning this could happen?
I would say the stronger lesson is that continued checks and oversight are critical to the health of any institution or business. Though I do also agree and think people who make sloppy predictions should also be held accountable for their behavior.
Perhaps the point is that the risk is not removed in those cases, but reduced. Entrepreneurs clearly do have skin in the game, and bad decisions will affect them. At the same time, having a "safety net" that ensures bad decisions will not completely destroy an entrepreneur's life is clearly beneficial because it allows more people to try their hand at it.
Though I don't know how serious I can take this when the guy uses the word 'wonks' in reference to those he disagrees with.
Also I think that the lack of 'skin in the game' encourages risk, which counteracts a natural tendency for large groups to be more conservative (look at big business vs small). If you made decision makers have skin in the game, you'd have even less innovation and new ideas in large institutions. This is taking into account factors beyond his thesis, but leads to interesting thoughts when it comes to practical application of his ideas.
This is a pretty mild epithet coming from NNT. He has described the same group in much less complimentary terms.
For example: http://www.washingtonpost.com/blogs/wonkblog/
source: extensive reading of political blogs + newspapers circa 2006-2008.
The same as those people that were counting bananas or such after the Fukushima incident should have been given incentives (including financial ones) to move close to the affected area, with their families and kids. You either trust your words and computations or you're not.
Doesn't Taleb mean that the 'skin in the game' heuristic will prevent uncertainty, randomness and volatility in the system rather than bring benefit? Within examples such as the 07-08 financial crisis, which he must be referring to indirectly, 'skin in the game' would have meant less risk-taking, therefore reducing volatility. But I can't see how the system would have actually benefited from volatility.
In other words, if you want a system to evolve robustness, you probably want to expose it to a diverse array of inputs.
(sarcasm aside, I do think there should be stronger professional repercussions in economics for advocating idiotic policies. It's one thing to found a startup and fail, and then start again; it's another to cause a deep recession in a country and then say "oh well, let's try again")
If the advice goes badly, the author also suffers. Such recommendations are more reliable than those from authors without 'skin in the game'.
If the banks writing bum mortgages had to take the loss instead selling all the losers to Fannie and Freddie, many bum loans would have never been made.
The execs at Lehman and Bear had skin in the game. Sure some of the senior-most folks got away with small fortunes, but everyone last money. Some people lost their life savings.
Conceptually this makes sense (similar to requiring all derivatives trades to have margin requirements to limit leverage) but does it really fix what went wrong?
Compared to driving a car with a ton of metal and five airbags around you, riding a bike means that you literally have skin in the game.
On the other hand driving a car you basically have no skin in the game. You jump a red light or drive too fast and as long as the cops don't catch you it's alright.
Now imagine that these two roles usually exist in the same person, to varying degree.
As long as there are areas with very high reward (investment banking, drug dealing, human trafficking, startups), and enterprising individuals with the connections to organize them (either through experience and leadership progression, or by using opportunities to undermine former leaders / acquire resources), people will rise to these opportunities.
Once an operation reaches a certain size however, many leaders become disconnected - intentionally or otherwise - from the day-to-day business of their organization.
Given the typical attitudes on HN, I'd expect that most founders here would be genuinely mortified to find out if their software had caused real-life problems - most would take a lot of care to ensure good user experience and correct results; these make good business sense too. However I think many would eventually aim to become distanced from the business too - the dream of reliable passive income.
Meanwhile, we imagine - and it's not hard to imagine - that many bank executives, criminal leaders, and others - actively enjoy their life in distance and immunity while feeling little remorse for the damage they do, and certainly not taking any intrinsic risk for it.
We expect that the rule of law will deal with these problems when they occur - that's what optimistic films and positive fiction tell us - but the reality is that a good-enough combination of wealth, influence, leverage over others, and wits can let people stay at arms-length from (but in control of) nefarious affairs even if they are aware that they are causing harm.
In some ways I think this expresses itself even in the trend for honest businesses to avoid liability where possible -- if we take liability for what we do, we also have to do the best we can and take genuine care of our customers.
Somehow a fear of litigation, genuine exploitation of litigation (c.f. ambulance-chasers), and fear of decreased business efficiency have reached the level where companies do prefer to distance themselves. Often it is via lacklustre or even laughable attempts, such as using oft-ignored in-store signage, disclaimers, or automated customer interactions.
Retreating from each other for fear of risk isn't healthy as a general trend, and neither is our inability to reach and re-integrate those who expressly intend to maintain their distance to avoid risk to themselves.