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Adapt Why Success Always Starts with Failure

Tim Harford
June 2011

Too big to fail is a phrase that has entered the lexicon since the financial
crisis. However, failure should be embraced and is an important part of the
road to success, according to bestselling author, broadcaster and economist
Tim Harford, who appeared at Schroders Secular Market Forum recently to
discuss his new book Adapt Why Success Always Starts With Failure.
Harford, a senior columnist at the Financial Times who previously worked at the
World Bank, is known for taking an alternative look at economics in his newspaper
columns and his BBC Radio 4 show More Or Less.

Tim Harford, economist, broadcaster


and author

While his first book The Undercover Economist, which sold more than a million
copies worldwide, looked at the role of economics in every day life, Harfords new
book is a mix of popular economics and psychology which argues in favour of trialand-error as a means to economic and general progress.
Modern life is complex

Harford began with the story of a design student who set himself the task of building a toaster from scratch. After all, at
3.99 a basic toaster costs less than an hours work at the minimum wage, so how hard can it be to make, he asked?
The student found that the toaster consisted of 400 components and sub-components,
including iron, copper, mica and nickel, and soon realised that if he were alone in a
forest and tried to build a toaster from scratch he could spend his whole life trying and
never get close.
Similarly, Harford reflected on a study which found there are an estimated 10 billion
types of products available in an economy like London, many of which are far more
complicated than a toaster. This is compared to around 300 items which would have
existed in a basic hunter-gatherer society many millennia ago.
This all led Harford to believe that although these studies show the incredible
sophistication of the modern economy, he also finds them worrying in that their results
showed him the system is tremendously complex and we dont understand it vey well.
If we want to solve problems and make changes within this complex system then the
sophistication of the toaster is a symbol of the obstacles that lie in wait, he said.

Companies fail all the time - previously successful companies go


bankrupt and fade into obscurity. The economy is not successful despite
these failures; it is successful because of these failures.

Secular Market Forum: Adapt - Why Success Always Starts With Failure

For professional investors and advisers only

Top-down solutions seldom solve problems


Instinctively, according to Harford, when a complicated problem arises, we tend to look to a clever person an expert
to solve it. But Harford says he does not find this default reaction in the face of problems to be plausible.
Research shows that experts forecasts are very, very poor, Harford said. This is not just a dig at economists, but at
all social scientists.
He says that an experts inability to forecast successfully says more about the world than about the experts
themselves. The world is too complex, you dont know what is going to happen and it doesnt matter what intellectual
toolkit you are using, he said.

Lessons from the market


One of the most effective problem-solving mechanisms in existence is the market, according to Harford. He says this is
not because business people are much smarter than politicians, as many would have you believe, but because in the
business world there is more failure.

Research shows that experts forecasts are very, very poor. This is not
just a dig at economists, but at all social scientists.

Companies fail all the time - previously successful companies go bankrupt and fade into obscurity. The economy is not
successful despite these failures; it is successful because of these failures, he said.
He thinks that economic growth is a process of natural selection, in which ideas that are no longer working are
replaced by ideas that are working. He highlights research which has shown that the way companies have risen and
fallen throughout history neatly resembles Darwinian selection. The pattern of bankruptcies which occur during periods
of relative stability correlate although on a different time scale with patterns of extinction from fossil records.
It is through this evolutionary process of trial and error that the market solves problems. However, Harford points out
that institutions themselves are not good at accepting errors.
Loss aversion
Indeed, Harford thinks that people, and institutions as a result, have a deep-rooted
yet irrational psychological fear of small failures and losses.
This loss aversion means that humans have a disproportionate fear of small
losses; most people would care far more about losing 5 than about winning it, for
example
He cited poker and the TV show Deal or No Deal, as examples of situations where
people start making bad, risky decisions when they start chasing their losses.
Similarly, stock investors often hold on to losing positions too long due to their
reluctance to accept losses, whereas they are normally quick to bank a profit
when their stock pick is a winning one.
The main thesis behind Harfords book is that in order to succeed people must
accept that failures are inevitable. Success comes from being able to quickly learn
from failure and adapt accordingly.

Secular Market Forum: Adapt - Why Success Always Starts With Failure

For professional investors and advisers only

Too big to fail


He applies his argument to the world of finance, where in recent years governments have gone to great lengths to
avoid the failure of systemically important banks, causing the phrase too big to fail to enter the lexicon.
Harford thinks the politicians were absolutely right to bail out banks and recapitalise them, given the total ignorance of
what would happen if one of these banks went down. However, he thinks we should aim to build a banking system
where failure is possible.
Currently the interconnections between financial institutions are too great and Harford highlighted a number of
disasters in history which illustrated what can happen when risks are not decoupled.
The dangers of tight-coupling
A financial crisis from the 1980s which had similarities with the
financial crisis of this century was the LMX spiral from the
reinsurance industry. A series of risk-shifting insuring contracts
had been drawn up which left a large number of companies
unaware of the interconnections. When a disaster struck, it
sparked a domino effect among these companies, which had
all reinsured themselves against losses among each other.
However, what really struck a chord with Harford was the
disaster on the Piper Alpha oil rig which sparked the LMX
spiral. Previously unseen flaws in a series of safety
mechanisms led to a catastrophic chain reaction and ultimately
caused the death of 167 men.
One small failure led to a bigger failure, which led to a bigger
failure. The safety systems unravelled and even contributed to
the problem, Harford said.
This domino effect is caused by a tight-coupling of parts within a system, and has also been seen in the nuclear power
industry in incidents such as the Three Mile Island accident of 1979, according to Harford.
Such incidents, where safety systems actually exacerbate a problem, have striking similarities with the financial crisis.
The very concept of Credit Default Swaps (CDS) was introduced as a safety system, yet they caused an added layer of
complexity to the financial system, caused unexpected interconnections between institutions and increased the tightcoupling in the industry.

To learn from your mistakes is such a clich because we find it so


difficult to grasp. We are not built to accept failure, which is a shame
because failure is inevitable.
You are a regional bank in Iowa with reasonable investments, not interested in subprime at all. Then one day you get a
call from a rating agency who say they are downgrading AIG because they wrote CDS on assets you dont hold and
have nothing to do with you. So they are downgrading all the bonds in your portfolio as they dont think AIG can come
good on its CDS.
Suddenly the bank has to sell some assets to meet regulatory requirements and all the other banks try to sell for the
same reason. So the safety system suddenly created interconnections; people who thought they had no connection to
certain parts of the market found out they were all interconnected after all.
Harford also points out that safety systems can encourage risk taking, as was the case in the financial crisis. Banks
such as JP Morgan went to the regulators and asked if they can take more risk now they have the safety cushion of

Secular Market Forum: Adapt - Why Success Always Starts With Failure

For professional investors and advisers only

credit default swaps in place a situation Harford compared to car drivers asking the Department of Transport if they
can now drive drunk because they have improved their airbags.
Harfords conclusion
Harford concluded his presentation by saying he would like to see different decoupling insulation mechanisms which
can break the cycle of leveraged collapses.
I would like to see a diversity of approaches; in diversity you often get robustness, he said.
He said he liked institutions having layers of contingent convertible capital spread through their capital structure, which
would serve as a potential airbag in case of a crash. However, he warned that, if it ended up in banks all holding each
others contingent convertibles, it could trigger a death spiral and a total disaster all over again.
Ultimately he said institutions in the future need to learn from their mistakes.
To learn from your mistakes is such a clich because we find it so difficult to grasp. We are not built to accept failure,
which is a shame because failure is inevitable.

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