The Seven Moral Hazards of Measurements | AccountingWEB

The Seven Moral Hazards of Measurements

Exact measurements of the wrong things can drive out good judgments of the right things.

The illusion of certainty in our measurements creates--to borrow an important concept from the insurance industry--a moral hazard. If people are insured, they may just act carelessly and cause the very thing they are insured against.

Fire insurance causes arson; unemployment insurance allows people to not be as diligent in finding a job; life insurance causes suicide, or worse, murder; auto insurance can cause reckless driving.

Our current cult of calculation, perpetuated by the infamous McKinsey maxim--"What you can measure you can manage"--creates the same type of risk, offering today's business executives the illusion of control and mastery of knowledge.

It allows them to substitute statistics for thinking. It gives them a false sense of security where there should exist more doubt.

The United State's attempt to measure the Soviet Bloc economies during the Cold War was the largest social-science project ever undertaken, yet the various governmental agencies involved consistently overstated the size and growth rate of the communist countries.

In the CIA's Handbook of Economic Statistics 1989, per capita output in 1988 in East Germany--one year before the Berlin Wall was pushed over--was placed at roughly seven-eighths of the West German level.

But as any Berlin taxi driver crossing through Checkpoint Charlie after the fall of the Wall could have told you, the economy of East Germany was manifestly inferior to that of West Germany, yet somehow--due to the moral hazard of measurement--those in the know got it precisely wrong rather than approximately right.

Efficiency is always a measurement, but effectiveness is always a judgment.

Efficiency and effectiveness cannot be "balanced" like tires, because they are entirely different things.

Taking into account the following seven moral hazards of measures may assist executives in avoiding putting efficiency ahead of effectiveness.


The Seven Moral Hazards of Measurements

Moral Hazard 1: We Can Count Consumers, But Not Individuals

Stalin's famous remark that "One death is a tragedy, whereas a million is a statistic" illustrates the danger of lumping individuals into aggregate, amorphous lumps as if they did not have a soul.

Because benefits and costs are inherently personal and subjective, aggregation misses the individual. We can measure the objective temperature in a room at 70 degrees, but any one person may feel either warm or cold, and the differences cannot be used to cancel each other out.

We simply cannot mathematically manipulate people.


Moral Hazard 2: You Change What You Measure

Scientists call it Heisenberg's Uncertainty Principle, which applies to all measures: that the observer in a scientific experiment affects the result.

Central bankers call it Goodhart's law: Any target that is set quickly loses its meaning as it comes to be manipulated.

People will always find ways to make their numerical targets, even if it leads them to ineffective or, sometimes, unethical behavior.

This is why Boyle's Law is so profound:
When you use numbers as the basis for payment, they become irrelevant to the broader objectives of the service.


Moral Hazard 3: Measures Crowd Out Intuition and Insight

Once a measure becomes entrenched as part of the conventional wisdom, it is usually impenetrable to logic, intuition, critical thinking, or better ways to do something.

If you have ever been bribed off an oversold airplane--with a free flight voucher, upgrade, or airline money equivalent--you have economist Julian Simon to thank.

Until 1978, and before the airlines were deregulated, travelers were bumped off overbooked planes rather capriciously (the airlines preferred to bump old people and military personnel on the theory they would be least likely to complain) and this caused enormous amounts of customer complaints and ill will.

This caused the airlines to increase bookings even more to ensure decent load factors, which of course were measured very precisely. But the measures didn't help solving the problem--that took an outsider with a theory.

A flight attendant friend who worked for United Air Lines told Simon of this problem. Simon did not analyze countless numbers and statistics, but used his intuition, grounded by the economist's theory of human behavior being rational, to solve a quite vexing problem.

Daniel Boorstin, librarian of Congress, wrote: "The greatest obstacle to discovery is not ignorance--it is the illusion of knowledge."


Moral Hazard 4: Measures Are Unreliable

A country's per capita gross domestic product increases when a sheep is born but decreases when a child is; and divorce actually increases the GDP since almost two of every commodity must now be purchased rather than just one.

Yet these measures mask the joy of a child and the agony of divorce.

We know how generally accepted accounting principles (GAAP) do a pathetic job of measuring--or even acknowledging--intellectual capital.

Why would we want to put so much faith in these numbers? Picasso once said, "Art is a lie that tells the truth." It seems in some instances, measurements are truths that tell lies.

Another example of the unreliability of measures is illustrated by the consulting firm Bain & Company's home page on its Web site, where it proudly proclaims: "Our clients outperform the market 4 to 1," shown over a graph from 1980 to 2009 depicting the S&P 500 Index and Bain clients.

This is the equivalent of the rooster taking credit for the sunrise because he crows every morning. One expects this type of unscientific hyperbole from politicians, not management consultants.

I would be willing to bet that Bain's clients perform better than the S&P 500, thus have more money to spend on consultants.


Moral Hazard 5: The More We Measure the Less We Can Compare

Engage in this gedanken: You (or a loved one) need(s) heart surgery. You talk to nurses, friends, and other people you trust and respect, and two surgeons are consistently recommended to you.

You go online to do some research on these two practitioners and discover their mortality rates (i.e., the risk of dying from surgery): surgeon A = 65 percent; surgeon B = 25 percent. Which surgeon would you choose?

I have conducted this gedanken in seminars attended by various educated professionals--who certainly have taken a statistic class or two--and, astonishingly, the overwhelming majority select surgeon B.

But wouldn't you want to know what type of patients the two doctors serve? What if surgeon A takes a disproportionate share of hard cases and thus has a higher failure rate? He or she just may be the better surgeon.

The point is, we simply do not know without gathering more information, both quantitative and qualitative, and making further judgments based on our own risk profile.

Seeing the two numbers side by side seems, though, to give people a false sense of precision and, in this case, could lead to a deadly decision.

This is the major problem with benchmarking studies and best practice reports--you are studying the results of a process, not the process itself.

It tends to confuse cause and effect, and we are back to man trying to fly by strapping on wings and jumping off of cliffs rather than studying the theory of aerodynamics.

We simply cannot compare two doctors, two universities, or two hospitals based on measures alone. It takes subjective evaluation, discernment, and intuition.

History is the science of human biography, not measures, and we can no more compare two countries' cultures by examining their GDPs than we can compare two people by the size of their bank accounts.

Moral Hazard 6: The More Intellectual the Capital, the Less You Can Measure It

Ideas only come from sentient beings, not inanimate objects or pets.

Since 75 percent of any country's wealth-creating capacity resides in its human capital, how could it be otherwise?

To complicate matters, a lot of that knowledge is tacit, which is hard to capture in spreadsheets and pie charts.

We may be able to count the physical assets of a Google or a Microsoft, but traditional accounting pays no attention to its human capital, what has been labeled the "invisible balance sheet."

Traditional book value accounting--assets minus liabilities equals equity--can only explain about one-sixth of the value of the market capitalization on the nation's stock markets.

Accountants call the difference between market value and book value goodwill; but that is just a label for their ignorance.

Data, reason, and calculation can only produce conclusions; they do not inspire action. Good numbers are not the result of managing numbers.

Dr. Martin Luther King did not deliver the "I have quarterly objectives" speech.


Moral Hazard 7: Measures Are Lagging

Imagine driving your car with your dashboard gauges informing you of last month's speed, fuel level, temperature, oil pressure, RPMs, and the rest.

This is precisely the status of accounting information: it is like walking into the future backward. It is a lagging indicator--or at best coincident, assuming real-time accounting takes place.

This type of information can only tell us where we have been, never where we are going.

Enron and the other spate of accounting scandals from the early 2000s were not so much about fraud, malfeasance, misfeasance, or other crimes, but rather the increasing irrelevance of the traditional accounting reporting model.

Enron's legerdemain is not what caused it to fail. Its financial deception allowed it to remain in business for longer than an otherwise similar firm engaged in accurate financial disclosures, but this is a question of timing alone and not causality.


The Future Cannot be Measured

The Danish philosopher Søren Kierkegaard wrote: "Life is lived forward but understood backward."

Certainly measures help us reflect on past events and aid us in improving our theories.

But they can never take the place of dreams, imagination, passion, and the spirit of enterprise where entrepreneurs toil and struggle to create our future.

No measure is capable of capturing the richness of free minds operating in free markets dreaming of better ways to improve our future, and it is folly to believe otherwise.

It may even lead us into moral hazards, or a world where we are so preoccupied about measuring past performance we do not take the time to dream about the future.







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