This most recent year of crisis has provided many opportunities to doubt the capacity of our institutions — our governments, schools, and businesses. Like a receding tide that exposes what was previously hidden, 2020 revealed the apparent fecklessness of institutions we believed to be more competent.
We now know: Governments seem broadly incapable of dealing with crises like the coronavirus pandemic, including its mitigation through efficient distribution of the vaccine. Corporate supply chains have proven surprisingly fragile, with shelves empty of common products that relied until yesterday on hyper-efficient, just-in-time, and far-flung supplier networks. The life spans of corporations are shrinking as they seem unable to innovate in the face of competition. The unprecedented wave of share buybacks by public companies over the last decade is a signal that corporate leaders no longer feel confident in their ability to reinvest profits in innovation to produce market-beating returns. In the US, institutions of higher education are putting assets up for auction or going out of business altogether as students and their families balk at the rising cost of a degree and perceived decline in quality. And in the midst of these institutional breakdowns — when accurate storytelling is more needed than ever — our media seem incapable of regaining the extensive trust they once enjoyed.
Despite the many wonders of our modern age — and there has never been a better time, on average, to be alive — our formerly trustworthy institutions seem broadly unworthy of our trust; they somehow seem less capable than they once were. Examples of current failures stand in stark contrast to well-known stories of institutional effectiveness from the past. Modern instances of institutional success, like the rapid development of the COVID-19 vaccine, feel like surprising and noteworthy exceptions to an otherwise predictable pattern of mediocrity.
The irony is that we know more about the leadership, culture, invention, and growth of organizations than ever before. We understand more about the functional tasks required for effective operation of scaled organizations, including finance, marketing, and accounting, than any previous generation. Over the last century, practitioners and researchers of management science have contributed to a vast body of knowledge. Every year, 100,000 MBA degrees are awarded; the holders of those degrees must be having some positive effect as they apply what they have learned. To argue that our institutions are less effective than before is also to argue that the vast knowledge we have accumulated about organizational excellence is somehow wrong or not applied.
Perhaps it is misdirected. Our institutions, by many measures, are actually better managed and more capable than ever before. The challenge is that they are often focused on the wrong objectives; management knowledge is misdirected. Our institutions are too sterile, too focused on eradication of risk and avoidance of near-term failure, and not oriented enough toward long-term growth, invention, and creation. Because of sticky incentives and inadequate governance structures, leaders of institutions prioritize near-term efficiency over long-term resilience, and that is a problem, perhaps one of the most critical problems of our time. We need our institutions to be trustworthy and effective.
Because of sticky incentives and inadequate governance structures, leaders of institutions prioritize near-term efficiency over long-term resilience, and that is a problem, perhaps one of the most critical problems of our time. We need our institutions to be trustworthy and effective.
The wisdom of controlled burns
Prior to the 1849 Gold Rush in California, 4.5 million acres of forest burned every year in the state. Lightning fires burned for months, and native tribes frequently cleared the land of dead vegetation with fire. For much of the subsequent century, as the state’s population built homes, towns, and parks in rural areas, firefighters worked with fervor to extinguish flames to save property and lives. The efforts were quite successful, and by the 1950s and 1960s, only 250,000 acres burned every year in California.
The near eradication of wildfire was a remarkable achievement of human ingenuity over the natural environment, the result of a determined effort by the residents, governments, and firefighters of western states to reduce the variability and volatility of fires.
Unfortunately, as a direct result of the fire eradication effort, forests in California are now ten times more dense than they would be naturally.
When dry weather and other conditions are right, fires now burn much hotter and faster than they once did. In 2018 a devastating wildfire, known as the Camp Fire, destroyed the town of Paradise, California, where my great-great grandparents once lived and are buried. Although it was particularly destructive in terms of loss of life and property, the Camp Fire’s duration and coverage were not unique compared to other recent fires. Over the last several years, a wave of massive, uncontrolled fires have swept across the western United States. In August and September of 2020 alone, five of the six largest fires in the recorded history of California raged, and the “fire season” stretched well beyond its typical duration.
This unfortunate trend is likely to continue, and in many ways it is the direct result of dramatic institutional effectiveness directed toward what is now, in retrospect, understood to be the wrong objective--fire eradication, not management. We prioritized efficiency and the illusion of near-term safety over long-term resilience, and we are paying the price.
The irony is that there is widespread agreement among experts about what to do to solve the problem of uncontrollable fires. The solution is a persistent strategy of controlled burns to limit the dry vegetation that fuels the spread and intensity of fires. In a controlled burn, a land manager purposely sets alight a defined area of land. When repeated, an effective strategy of controlled burns creates a checkerboard map of burned and unburned areas, limiting the fuel and path a wildfire can travel.
In California between 1999 and 2017, land managers burned on average 13,000 acres per year. They might as well have burned nothing. Many experts believe the state now has a “fire debt” of about 20 million acres. To put that into perspective, it means a space the size of the state of Maine must burn before California can restabilize.
In the last few years, state leaders have passed laws and signed memoranda of understanding to undertake more controlled burning, but little real progress has been made. Everyone knows what to do, but no one seems able to act due to sticky incentives and ineffective governance.
Incentives and vetocracies
If you are a land manager and you start a controlled burn, there is a risk you may lose control of the fire. This form of failure can be extremely expensive, and many people are incentivized to not allow it. Failure is too costly to the individual land manager, and there is no individual upside to compensate for the risk.
Similarly, the benefits of a controlled burn will only accrue over the long term, if at all. The number of years between significant fires is likely greater than any one land manager’s tenure. If a fire comes, the chances are good it will come on someone else’s watch.
Compounding the difficulty, rules make controlled burns hard to execute. In California, purposeful burns have to comply with the Clean Air Act, unbelievably, which limits emissions from human-caused events. Of course, air quality impacts from prescribed burns are tiny compared to the damage months of widespread fires can do to the air. (2020 images of San Francisco bathed in an eerie orange glow from smoke are testament to this.)
Rules, incentives, and governance — too many people who can say “no” — make it difficult for individuals to act within the confines of the existing system, and so nothing gets done. Forests continue to become more dense, and large fires rage out of control, with greater intensity and frequency.
For the last 100 years, land managers have become very effective at putting fires out immediately when they happen. The systems are optimized for it. Governments have invested in the equipment and regulations to enable it. What they have not optimized for, due to sticky incentives, is the art of the controlled burn.
Inputs and outputs
Organizations produce the results they are designed to produce. The question to ask of any institution we belong to, support, or depend on is this: What is the institution optimized for? Fire eradication? Or prevention? Near-term safety, or long-term resilience? If a primary product of an institution is bureaucratic deadlock we should wonder whether such stasis is a feature or a bug; chances are the organization is performing exactly as designed, and the design may be optimized for preservation of the status quo. One must consider the outcomes to determine what the organization is optimized to produce, and also consider whether those outcomes, if they are not the stated objectives, are the implicit objectives of the organization’s design, including its governance, systems, and incentives.
Forest management practices in California reduced total acres burned dramatically, and suppressed the damage to life and property for a long time. These same practices, however, rendered the forests very fragile, resulting in a terrifying fire debt that has yet to be paid. Everyone knows what must be done — careful controlled burns — yet no one is able to act.
Similarly, many of our large institutions — our governments, schools, and especially our corporations — are like these very dense forests. Decades of avoidance of “small fires”, as evidenced by a relentless focus in corporations on capital efficiency, renders institutions extremely fragile in the face of inevitable shocks. When the “fire” comes, it burns quickly and with intensity. And although we cannot predict the timing, we know the fire will inevitably come. As long as Return on Invested Capital (ROIC) remains the primary metric by which we measure corporate success, we should expect corporate failures to become increasingly swift and painful, with widespread impact — the financial equivalent of the Camp Fire.
Jack Welch, former CEO of GE, once proclaimed, “Variation is evil.” Through management practices like Six Sigma, Welch and many others sought to eradicate risk entirely from the operations of their companies, just like land managers in California who learned over decades how to put out every small fire.
Although Welch was an incredible leader and full of wisdom, in this regard he was extraordinarily wrong. The idea that variability, or volatility, must be removed from companies for effective operation is unsound because it constrains ingenuity; it seeks to turn people into machines. It relies on a command and control system and hierarchy that cannot work over the long term. Capital efficiency is useful, and decades of management practices are geared toward it; companies need to be efficient, but efficiency can be taken too far.
The growing mountains of capital we see on corporate balance sheets are evidence of this decades long march toward capital efficiency. Everyone knows a company needs to innovate — CEOs feel compelled to provide evidence of innovation activity in their annual reports and speeches — yet very little of the activity seems to produce meaningful results. Innovation becomes theater, like the land managers in California burning 13,000 acres a year in the face of a 20-million-acre fire debt.
Contrast Welch’s approach with the management philosophy of Reed Hastings, founder and CEO of Netflix, who declared in a recent podcast interview, “Most companies over optimize for efficiency...The non-intuitive thing is that it is better to be managing chaotically if it’s productive and fertile. Think of the standard model as clear, efficiency, sanitary, sterile. Our model is messy, chaotic, and fertile. In the long term, fertile will beat sterile.”
The non-intuitive thing is that it is better to be managing chaotically if it’s productive and fertile. Think of the standard model as clear, efficiency, sanitary, sterile. Our model is messy, chaotic, and fertile.
The solution for corporations is the same for land managers seeking to prevent uncontrollable fires: adoption of a strategy of “controlled burns”, a willingness to tolerate some inefficiency and bounded risk in the near term in exchange for long-term resilience. If innovation is the result of learning, of systematic conversion of assumptions to knowledge, then it must be, by definition, capital inefficient in the near term.
In innovation and investing, like in fire management, magnitude of correctness matters more than frequency. The secret to resilience therefore lies in creating the systems that enable large magnitude, but not necessarily frequent, correctness. In an uncertain environment, where many different futures are possible, the best strategy for maximizing returns and minimizing risk is to run as many experiments as possible, at the lowest possible cost per experiment. Innovation for long-term resilience requires comfort with controlled mistakes, with a strategy of rapid and cheap experimentation, or “controlled burns.” It is folly to repurpose the governance, processes, incentives, and talent a scaled enterprise successfully deploys to minimize variability and eradicate risk; it is impossible to redirect those elements toward experimentation and “controlled burns.”
In future articles, we will examine the requirements for controlled burns in corporations, including the incentives, funding structures, talent, processes, and systems optimized for experimentation. There is much that scaled organizations can learn from startups — learning machines optimized for speed, disruption, and value creation in chaotic environments. At High Alpha Innovation, we believe startups are the economy’s equivalent of “controlled burns” and scaled enterprises can benefit from and leverage startups’ strengths and capabilities to build resilience.
Institutional leaders: It’s time to start some fires.