Formal education is a funny thing. When you are young, a good education seems extraordinarily important, admittedly to no small extent because everyone tells you that. But it also seems important in and of itself at the time because it is during the formal part of your education that you are learning in a very deliberate fashion, complete with exams and grading to tell you how well or badly you are doing at it. You are learning for the sake of learning, and you and others are measuring your progress.
Once you have demonstrated enough capability in your selected field of study, they give you a degree or some other sort of certification, and you are off to start a career. And for the first few years of that career, it is often just the nuggets of knowledge that you managed to retain from your formal education that anchors you sufficiently to begin to be able to stand fast in the face of the whirlwind of demands placed upon you by whatever role it is that you have chosen.
But after a very few years, a funny thing happens. The on-the-job experiences and learning that you have accumulated become far more relevant to your ability to contribute and lead in your chosen work. And twenty years out, it is rare if ever that one consciously retrieves anything that they learned in their years of formal education in any kind of instrumental fashion to execute or even frame your thoughts about, well, anything, which is why it is both surprising and heartening when that does happen.
My wife is a Social Worker who worked for the Children’s Aid Society for over 30 years. My daughter is A Ph. D. candidate at U of T in Social Work as well, so it is not surprising that Child Welfare is a more common topic for family discussions than Structured Finance. As you can imagine, I am at a severe disadvantage in terms of the requisite educational qualification to have anything of value to say in discussions around Child Welfare policy, but I do my best not to let that dissuade me from participating. And just the other day, I recalled a nugget of learning from my first year MBA courses of nearly 40 years ago that was very helpful in framing the challenges that confound any society in establishing sound Child Welfare policy.
It was, of all things, something that I recalled from the inventory management module of my Operations Management course, the part about optimizing “Stock Out” risk. Stock out risk is the risk that a vendor loses a sale because of insufficient inventory. When the topic is first raised with first year MBAs, the initial thought is that you simply devise a model for demand based on historical sales figures for a particular product and ensure that the business maintains sufficient inventory so that in all of the modeled scenarios there is never a “Stock Out”. However, young MBAs are quickly taught that it is not so simple. It is profitability that managers are seeking to maximize, not sales. Unsold inventory represents an investment of capital, and capital has a cost, either in the form of an interest rate for borrowed capital or a required return in case of equity capital. It is entirely possible, and indeed most likely, that the inventory level required to ensure zero Stock Out risk is not the profitability-maximizing strategy given the cost of capital. Optimizing inventory management in order to maximize profitability will almost invariably require accepting some level of Stock Out risk and thereby foregoing potential sales to avoid over-stocking.
So why was I thinking about Stock Out risk in a discussion of Child Welfare policy? Because the topic was the historical high rates of apprehension of children at risk that separates them from birth families, both temporarily and too often permanently, that is increasingly recognized as having devastating long term impacts on birth families and apprehended children. And how are apprehension polices determined? To a large extent by applying a zero-tolerance standard with respect to the likelihood of serious harm to or even death of a child left in the care of challenged caregiver. We understandably impose a standard that lowers “Stock Out” risk with respect to any single child to zero, ignoring the social cost to thousands of children and families of disrupting family relationships, however fraught they might be.
It is of course a much different consideration to countenance a lost sale than it is to losing even one child. But it is important to understand what it is we are doing in the context of Child Welfare policies. Zero risk tolerance policies provide protection against the risk of a small number of catastrophic outcomes in return for the certainty of very large number of disrupted families and personal traumas. Sadly, there is no simple formula for optimizing this trade-off; there is no social accounting “bottom line” calculation that we can point to. But at the very least all engaged in the debate must acknowledge and accept the trade-off, even if we cannot quantify offsetting social costs as easily as we can the cost of capital in over-stocking a business’ inventory.
I now await a no less appropriate Social Work theory-based perspective on residential mortgage expected loss-given-default calculations from my wife and daughter.
