I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Friday, May 30, 2014

Deflation and Technical Debt

Technical debt is a useful metaphor for explaining why some code is faster to complete but more expensive to maintain. It is also helpful in explaining design decisions made for sake of expediency, or because of an outright lack of knowledge. Tech debt can be a real burden on development, particularly as it takes away time that would otherwise be directed toward productive investment in new feature development. This makes it tempting to interpret tech debt as a quantifiable economic or financial phenomenon. It is not. If we respect the accounting treatment of it as indirect, and extend the metaphor toward team dynamics and away from financial statements, it also helps us understand our ongoing ability to service tech debt.

Debt and Deflation

Edward Hadas argues that debt is an antiquated form of finance, "unnecessarily distant from economic reality". Fixed interest rates, maturity mismatches (banks borrow short and lend long) and variability in borrower's cash flows create unnecessary risks to borrower and lender alike. Financial institutions create all kinds of provisions and capital structures to underwrite uncertainty and absorb losses. If we set out to create finance today, we wouldn't use such a rigid structure as a primary investment vehicle.

Debt is a wager on future interest rates. The debtor is making an income backwardation play: that inflation will rise faster than the rate reflected in the interest rate, or that their real wages rise over the life of the loan. For example, in simple housing finance, a wage earner takes out a loan to buy a house. If inflation rises faster than expected (per the interest rate on the loan) and their wages keep pace with that higher inflation rate, the debt is easier to service because their income is higher. In this case, they've been inflated out of their debt. In addition, the debtor's wages can rise faster than inflation through salary increases (e.g., due to job promotions). This makes the debtor's real income higher, which also makes it easier to service the debt. The backwardation is that the projected future income at the time of the loan is less than what the spot income turns out to be in the future.

The lender is not entirely betting on the opposite. It is true that the lender comes out ahead if inflation rises more slowly than the rate reflected in the interest rate. But they also stand to gain from the debtor's ability to service a loan. An increase in real wages increases the debtor's ability to service the debt; this is reflected in the borrower's credit worthiness (rating or score). Lower credit risk increases the value of the debt instrument. A lender can sell the loan to somebody else for a higher price, which is their reward for underwriting the risk of the borrower at the time of origination.

For the borrower, deflation increases the real cost of debt. The less money a household earns, the harder it is for that household to service its debt. This is why central banks in highly indebted economies will pull out all the stops to fight deflation. Falling consumer prices reduce revenues. Falling asset prices reduce people's perception of their wealth, which reduces their willingness to spend. Deflation increases the burden of debt and intensifies contractionary forces on an economy. Mature economies - Europe, Japan, US - are debt-financed more than they are equity financed, and there are far more borrowers than lenders. It comes as no surprise that European Central Bank chief Mario Draghi committed to fight low inflation, Shinzo Abe's government in Japan expanded money supply to juice asset prices, and former US Fed Chairman Ben Bernanke committed to Quantitative Easing.

Technical Debt is an Indirect Economic Phenomenon, not a Direct One

In finance, the person using debt to finance an asset purchase is the person who is responsible for the debt. This makes sense in the business of software, because the person paying to acquire and operate software may be "borrowing" against future cash flows in the form of costs to service technical debt. The buyer of a software asset is the person footing the bill for people to service that debt.

But technical debt is an indirect economic phenomenon, not a direct one. That is, technical debt does not necessarily finance a software asset. Technical debt only has economic impact if costs required to service that debt are realized. For example, an asset with a lot of tech debt may not be subject to much maintenance activity, or suffer production instability requiring a lot of attention, or suffer performance problems (directly resulting from that tech debt) requiring additional investment to scale. In each of these cases, a tech-debt-heavy asset may have the potential to be high cost, but those costs may never be realized. If a cost is not realized, it is not a real economic cost. It only becomes an economic phenomenon if excess labor or infrastructure is needed to compensate for its presence.

This brings us to the limits of the tech debt metaphor. There is no bank offering technical debt loans: tech debt is conjured by people during moments of development. One can argue that tech debt borrows against the equity of the asset, but that does not hold up in accounting terms. With or without tech debt, we still carry the asset on the balance sheet at the same economic value: the total capital outlay less accumulated depreciation. The cost of servicing technical debt is a function of people's time, which is an operating cost. The expectation of future payroll costs that may be incurred to service technical debt is not a balance sheet liability that reduces an asset's equity, it's reported in the future period when it is incurred as an operating expense on our income statement and a drag on cash flow. Tech debt may or may not lead to reduced current and future profitability and cash flows; it does not intrinsically reduce the accounting value of an asset.

Only if the software itself is truly impaired - for example, owing to poor design decisions, our software doesn't scale beyond a single user and a significant portion of the asset is written off - is technical debt a direct economic phenomenon. However, in that case, "debt" is the wrong moniker: the asset is well and truly impaired, not merely leveraged by debt. If a business takes out a usurious loan to buy a truck, the truck isn't impaired by the loan or the high interest payments. If the truck is severely damaged in an accident, it is impaired and written down. Because of the optics, impaired software is more likely to receive additional investment than it is to be written off.

Since tech debt is an indirect economic phenomenon, we have to look at our principal actors differently. In technology, the people who are responsible for servicing the asset (e.g., the code) are the people who are responsible for tech debt. Remember, in finance, we don't borrow against an asset. We borrow against future cash flows of a household or company, using an asset as collateral should the borrower not have the cash to service the debt. In tech, our code may be the asset against which we have borrowed, but we're really borrowing against the time of the team (e.g analogous to future cash flows) responsible for it to service that debt. Tech debt is a call option on people's time at some point in the future, not the asset itself.

Thinking about it this way allows us to extend the debt metaphor a bit further.

Capability Deflation Increases The Cost of Servicing Technical Debt

We saw earlier that deflation impairs people's ability to service debt. The same applies to tech debt. The inflationary or deflationary forces that impact our ability to service tech debt are related to our capability. We "inflate" our capability - and thus reduce our burden of servicing tech debt - through skill development and productivity enhancement. Our skills improve through study and experience. Our productivity improves with knowledge, tools and process. Holding our tech debt static - that is, assuming our tech debt merely rolls over - our ability to service that debt improves with the inflation of our skills and productivity. Capability "inflation" is the same as a household seeing real wages increase. The stronger our capability, the less impact that tech debt has on a team, the more "value" it can produce.

The converse is also true: capability deflation increases the real cost of servicing tech debt. An erosion of skills, loss of situational knowledge, and reduction in productivity all contribute to capability deflation which increases the burden of technical debt. Again, holding our technical debt static, our ability to service it declines with the deflation of our skills and productivity. Just as deflation intensifies contractionary forces on an economy, so, too, does deflation intensify contractionary forces on a team: the greater the deflation, the greater the burden of servicing tech debt, the less "value" produced by a team (the equivalent of economic contraction). In extreme cases, as happens in financial markets, debt servicing "crowds out" our ability to invest in our business through software creation.

Whip Deflation Now?

In 1974, fighting what would become runaway inflation in the post-Bretton-Woods currency world, the United States launched a grassroots campaign encouraging all citizens to curtail consumption - and share their ideas for doing so - as a way to contain inflation. The campaign was entitled "Whip Inflation Now", or "WIN". In the immortal words of Alan Greenspan, "this [campaign] is unbelievably stupid".

Leaders of any tech organization are in a constant battle against capability deflation. People will quit and work somewhere else, taking their skills and situational knowledge with them. People's skills will erode as they become content maintaining a "software annuity" that pays them a high salary for low-effort maintenance work. Organizational memory erodes as people leave, and those who remain forget why specific design decisions were made. Demand outpaces supply for skilled software engineers, forcing firms to hire less skilled developers if they are to have developers at all. New technology obsoletes old technology, and old software becomes trapped in legacy infrastructure. As evolution gives rise to pure maintenance, the work becomes less and less engaging and attractive. All of these things are deflationary forces on team capability.

To keep capability deflation in check, we have to burn the candle from both ends: refresh skills, and refresh assets. Have "refactoring" hack nights to attack tech debt, run spikes to introduce new technologies into legacy code, and rotate people through different teams to disseminate situational knowledge. We can also make investment cases to retire legacy software assets, which we can help by drawing attention to the "tech currency" of the software assets in our production portfolio. We can also use the strangler pattern to incrementally retire legacy systems, reducing the economic cost - and uncertainty - of replacement.

There will always be tech debt, if for no other reason than one person's engineering masterpiece is another's code hairball. And there will always be the threat of capability deflation. We can fight capability deflation - we have no choice, we have to fight it - but we'll never defeat it. To keep it in check, have a corporate culture that values knowledge acquisition and collaboration, and an investment strategy that constantly reinvents the software that runs the business.