Archive for the ‘Banking and Credit Crisis’ Category

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Instability in the Global Financal System

May 8, 2012

Instability at the core of the modern financial system is a hot topic, particularly given the electoral shocks in France and Greece these days.  Whatever the color of the new Greek government, the people of Greece have spoken: the sovereign bond deal is dead as a doornail.

This will almost certainly lead to a more extensive default than the one negotiated in March, sending shockwaves through global markets.

But that’s not the only source of instability in the global financial system according to Andrew Haldane, executive director of stability at the Bank of England.

Andrew likened the present world of banking to the Arms Race between the US and Soviets. The desire to increase individual security created greater systemic insecurity. He goes on to give three similar ‘arms races’ in banking and financial markets.

Return Races

The race for returns was a key reason for the financial crisis. There were two aspects to the race on returns, one the return on equity for banks (ROE) and returns for bank CEO’s. Both of which were unprecedented in any historical context in the run up to the crisis.

Return on equity (in UK banks) was at historic highs in 2007, the only parallel is the 1920’s. The behaviors that drove that were similar to an arms race. It was not so much keeping up the Jones, but keeping up the Goldmans. If Goldman posted a ROE of 20%, all the rest had to meet or beat that figure.

The way this was achieved was taking on additional leverage; which pushed the banks and shadow banks into higher risk positions, creating a higher risk industry ‘equilibrium’ that destabilized the system.

Speed Race

Trade execution times:

20 years ago (minutes), 10 years ago (seconds), 5 years ago (milliseconds), Today its microseconds (million’s of a second)

Tomorrow it will be nanoseconds (billion’s of a second); it could well be picoseconds (trillion’ of a second) in short order.

‘High Frequency Trading’ now dominates mainstream financial markets, accounting for somewhere between 50% and 75% of trades by volume today. The average share on the NYSE is held for 11 seconds.

One reason they dominate markets is that they submit HUGE volumes of quotes the vast majority of which are never exercised. The firms cancel the majority of them before their exercised. Today for every order exercised, 60 are cancelled.

What’s going ON here; fake liquidity. Although it looks like they’re lots of quotes in the market, lots of liquidity  – there is actually a mirage of liquidity. Quote ‘stuffing’ is a means of gaming the market. Why, because bandwidth is limited; quote stuffing loads the system slowing down everyone else. Slower traders simply can’t access the board.

Safety Race

The final race is the flip side of the first race; the race for risk aversion is particularly acute in that investors (in banks and other financial institutions) want the safety of collateral. In other words investors in banks are more unwilling to invest in banks on unsecured terms than in the past.

Everyone wants to be senior, everyone wants to be first in line – to have first claim on the assets of the bank. For instance the refinancing of Euro zone banks a few years ago was 60% unsecured, now the unsecured portion is less than 5%.

This race also comes with a price; it leads to bank balance sheets become more encumbered, banks assigning away their assets to investors which can not go on forever. The way it impacts the market is thus: ‘If I’m an unsecured creditor, why would I refinance, why should I let everyone else be ahead of me on the pecking order.

The result is a drying up of the pool of bank capital; a new higher risk equilibrium and destabilized system.

All these ‘races’ are populated with individually rational decisions, the outcome of which is systemically irrational and worse – creating the opposite – systemic instability.

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The Maiden Voyage of Financial Capitalism

April 2, 2012

“Disgruntled Goldman Sachs employee attacks the bank’s ‘toxic’ culture”

“Greek prime minister has warned lawmakers against undermining reforms agreed with the international lenders in an attempt to boost their popularity as the country heads for the polls in May.”

These recent headlines in the Financial Times expose the uncomfortable truth of our present financial reality. How bad is it? Think Titanic; the banking system essentially hit the iceberg at full speed in 2008. We’ve kept her afloat ever since with massive interventions of TARP funds, bank bailouts, zero interest rates and quantitative easing.  But a large gash has been opened in the ship of global Financial Capitalism and the water is rushing in.

I don’t know if you remember the details, but the original Titanic was kept afloat for some time after its tragic accident by the valiant efforts of its crew. In the James Cameron movie we witnessed the heavy bulkhead doors slamming down one after another in an attempt to contain the deadly influx of ocean waters. We have observed much the same in Greece, Ireland, Spain and Italy. The global financial powers have slammed the doors of austerity and debt restructuring on these flooding economies. Unfortunately like the Titanic these chambers are not totally isolatable. In the case of the ship, the water kept rising, eventually overspilling the flooded chambers, filling one after another until the Titanic sank to the bottom of the ocean.

What’s happening in Greece and other affected economies is the fiction of debt resolution. Despite a 100 billion euro default, debt restructuring and the massive support by the ECB the water continues to rise in Greece. The bond friendly resolution has been purchased with the liberty and future of the Greek people. Many young people, all the smart money and anyone else who can walk or run, are leaving Greece at speed while the economy labors under an increasing burden of debt and upwardly ratcheting interest rates. The elections in May are likely to be fought and won by forces deeply opposed to the Euro technocrats that run the government and the financial deal stuck last month. And the water continues to rise; its unstoppable.

In Titanic terms we’re still on the surface, the stars are shinning brightly and the band is playing. However all is not well below the surface; the economic engine room is flooded and water is rising fast on the lower decks. Today the financial press are playing the part of the heroic Titanic orchestra as the situation deteriorates to its dramatic close. It’s a mathematical certainty that the great ship will sink; it’s simply a matter of time. The only unanswered question is: who’ll be in the lifeboats?

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Euro Debt Crisis: No Strategy for Growth

January 13, 2012

Angela Merkel emerged from the European Summit last month with lofty visions, speaking to reporters in flowery terms like ‘European family’, ‘running a marathon’ and preparing Europe for… who knows what? A Prussian dominated European Federal State perhaps?

Missing was a coherent plan to reduce the levels of sovereign debt and, more importantly, a strategy to restore growth to European economies.

Fiscal Policy Integration

Yes there was the “fiscal compact”; a Plan for centrally ‘approved’ national budgets and greater fiscal discipline; all good news to Euro federalists. Meanwhile budget deficits continue to exceed revenues in all European countries.

The Plan, if actually implemented, would place Europe in a death spiral of ever-greater austerity, slowing economic growth and rising debt servicing costs. Europe will simply die on the Bond Market rack.

Addicted to Debt

Meanwhile the debt burden rolls on, and the Euro-Zone nations, like alcoholics on a binge, have, with this Plan, simply stepped to the bar and ordered a couple of cool ones in the morning: ‘hair of the dog’ so to speak.

True to form the IMF seems more than willing to play the role of bootlegger.  There are plans for the International Monetary Fund (“IMF”), to essentially recycle boomerang loans; i.e. IMF is to borrow money from member states and lent it back to Greece, Ireland and other troubled economies. The IMF involvement it seems is necessary for Treaty reasons, but also to lend an air of legitimacy to the process.

The Brits refused to contribute to the Plan and many other member states are hedging their bets. Germany, for instance, has placed its commitment on hold awaiting the formal commitment of others; who indeed are waiting for Germany to commit. The international community (read USA) is also hedging its bets and if they don’t fulfill their commitments soon the Plan could unravel quickly.

Priorities are Twisted

Europe (like the US) is living in a Bond Market induced coma; just more evidence that the ‘financial sector’ has hoodwinked the politicians into believing they’re the center of the economic universe.

According to the ‘gods of finance’, recovery is assured. We need only rescue the banks and embrace the Miracle of Austerity: the wacky idea that you can CUT your way to recovery.

Unfortunately this thinking is dangerous, delusional. This crisis will not be solved by austarity. The cold reality is this: post-industrial economies, including the US, UK and Europe, have changed their ‘engines of growth’. Recovery in the 21st century requires deliberate, informed capital direction, which is not happening.

Direct Capital (immediately) to the Productive Heart of European Economies

According the Organisation for Economic Co-operation and Development (OECD), postindustrial economies (i.e. Western developed economies) are now solidly ‘service’ oriented. The proportion of traditional (i.e. bankable) assets presently being generated in European economies is somewhere in the region of 20% of GDP. In industrializing China the proportion of hard, tangible assets runs about 80% of GDP; similar numbers to J.P. Morgan’s industrializing America a century ago.

According to studies, intangible (asset) investment by U.S. businesses has now risen to $3 trillion per year (2010) dwarfing investment in capital assets.  The new ‘intangible’ economy dominates but is concentrated in small to medium sized businesses that are massively undercapitalized.

Unfortunately, this sector alone is capable of driving growth and employment in the West.

IMF boomerang loans will buy time, but not solve the underlying problem. Hang on to your hats, 2012 could be rough ride.

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A New Golden Age of Growth

December 20, 2011

As the calendar closes on 2011 panic is spreading through the establishment.  2012 will be a make or break year and a lot of people are very nervous. Personally I believe we’re heading for trouble, probably a bond market crisis. More importantly 2012 will likely be the year that we finally abandon our faith-like allegiance to The Market. Economic stability and growth will not return until we realize that it is not markets that matter but assets, and, considering we’re in the white heat of an asset revolution we’ve all got some work to do. Fortunately it’s all been done before, at the industrial ‘asset’ revolution a little over a century ago. Here’s the story.

J. P. Morgan’s Industrial Asset Revolution

Every schoolboy and girl knows about the Industrial Revolution. It started in in the 19th century and was characterized by some extraordinary innovation: new technologies, mechanized factories, masses of urbanized workers and a new class of wealthy ‘industrialists’. Less well known is the Industrial ‘asset’ Revolution, which post-dated the original technological revolution by several decades. This revolution also involved considerable ‘innovation’, but this time it was not new widgets, but dull, banking, accounting and financial innovations. Although it has gone almost unnoticed by the general public, this revolution was far more important to our general prosperity.

John Pierpont Morgan was king of the industrial bankers. In his day the world literally came to his feet. He was an iconoclastic Victorian giant, complete with top hat, spats, silver tipped cane and giant cigar.  It is a surprise to many to learn that Morgan the banker was also an industry insider, controlling (or owning outright) dozens of 19th century American railroads. Eventually Morgan expanded his banking network beyond railroads and either founded or merged the industrial giants of the 20th Century, participating in such famous businesses as US Steel, International Harvester, General Motors, and AT&T.

Morgan used his insider’s knowledge to build sustainable earnings in railroads and – indirectly – their industrial class assets; newer kinds of assets that the established banks found foreign and offensive. As hard as it is to imagine the great financial houses of the day, merchant bankers all, quietly ran for cover as the industrial era began. For merchant bankers like Barings and Rothschilds, industrial activity was strange and dangerous; railroads in particular were overloaded with fast talking (American) promoters, vicious competition and businesses that had a disturbing tendency to default on bonds and loans.

Morgan saw opportunity where the merchant banks didn’t, and grabbed it solidly.  Morgan realized quickly that leaving the Railroad business to The Market was not a solution. Railroad entrepreneurs were dream merchants; not only were they out of control (irrational, hyper competitive) but they lacked business and financial disciplines which meant they were chronically under-performing as a group. The Wild West free market approach to Railroads led to misdirection of capital and waste, undermining profitability. This was the situation Morgan set out to repair, and repair it he did.

Morgan was one of the first to realize the importance of railroads. He saw that the many factories being built throughout the country needed railroads to get their goods to market. Railroads were the ‘de facto’ national distribution systems for industrially produced goods; so successful railroads were not only valuable in their own right, but the key to profitability of the entire industrial economy.

With the considerable resources of the London bond markets behind him Morgan acquired and merged railroads across the continent. He bullied everyone, including railroad owners until he finally consolidated the industry to the point where it was controlled, quasi-monopolistic and profitable. In doing so Morgan, almost single handedly, established sustainability in the railroads’ assets and, incidentally, in the ‘capital’ assets of a host of associated industries.

He was so successful that the United States government soon intervened with anti-trust legislation to break up the Morgan trusts. However they did so after the pattern had been set, and the asset model solidified so clearly that industry in the 20th century literally exploded on the back of new-fangled (capital) assets that today we take for granted: plant, industrial machinery and inventory.

The industrial ‘asset’ revolution that J. P. Morgan launched in the 19th century, and the new banking model it shaped, accelerated after his death in 1913, driven strongly by a new generation of commercial bankers.

Today the old industrial economy is expiring in the West. The so-called ‘developed’ economies are desperately hanging on to diminishing returns, hoping (praying) that the economy will return to business as usual. It won’t.  According to a recent University of Maryland study intangible (asset) investment by U.S. businesses has now risen to $3 trillion per year (2010) dwarfing investment in capital assets.  Meanwhile J.P. Morgan’s banking business model, based on collateralizing capital assets, is unraveled rapidly.  How have commercial banks responded to these deep-seated changes in the economy? As the proportion of capital assets in the economy diminishes they’ve changed their businesses, abandoned corporate lending (to the commercial paper markets) and become essentially fee generating service organizations. The net effect of these changes in Western banking has been to direct corporate finance to away from ‘asset’ based commercial & industrial banking to a far risker Wall Street investment banking model.

Bankers today do not realize how rapidly intrinsic value is migrating and how dangerous this is to their profitability. In addition they have become complacent, over-focused on earnings (effects) while ignoring causes (solid, well managed assets). They cannot, or will not, do the hard work necessary to learn the intricacies of the new knowledge-based intangible assets. Like the merchant banks of old they will lose ground steadily as the revolution proceeds; before it’s all over many established banks will collapse in spectacular fashion.

The unpleasant reality is this: the western ‘industrial’ economy is sinking, while the assets of our lifeboat, our new ‘creative’ economy, are still too immature, too small to carry the societal load. The secret to making a successful transition, however, will be found in a formula that J. P. Morgan would recognize instantly.

Like the Morgan of old, successful commercial bankers in future will need to become pro-active. Modern banking needs innovators, specialists in the creative world of intellectual property and technology commercialization. The new banking order will be initiated by hard working insiders who having learnt the secrets of the new economy and who are prepared to work with businesses to bring order and sustainability to this new class of assets. It will be new, but once again rooted in assets, not simply (derivative) earnings. Success will breed success and a new much more productive economy will emerge that will lead to another Golden Age of Growth.

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New Assets, Bankers Still Don’t Get it

October 26, 2011

I had a conversation recently with a banker friend of mine, who’s skeptical about the ‘new’ economy (“there is nothing new about the new economy”, he claims). While I’m ranting on about great opportunities and how the new assets are essentially ‘invisible’ he interrupted and said: “But Robert we can’t bank that stuff, there‘s no intrinsic value there. Its not real like land, or plant and machinery.”

After that, I had to stop and catch my breath for a moment. Apart from the horror of absorbing this shocking statement, I was beginning to see how difficult it is for many knowledge-rich businesses today to get banking facilities – they might just as well be talking to a brick wall.

David and Goliath

After I recovered my composure, I said, “Matthew, let me tell you a little story about how attitudes just like yours almost destroyed the most powerful company in the world.”

I don’t know of you remember at all, but during the ’60s and ‘70s IBM owned the computer business. It was the biggest and most powerful technology business on the planet. IBM began its life in the 1880’s as International Business Machines, and had grown up during the 20th century as a machine-maker ‘extraordinaire’. By the late ’70s, IBM was unsurpassed in terms of technology development, but was even more dominate in reputation, in the power of its brand. It was often said in those far away days “nobody was ever fired for buying IBM.” In other words they were, and were perceived to be, the best in the business. They owned the computer market by virtue of their brand reputation and the excellence of their hardware, selling frighteningly expensive mainframe computers.

With success came a kind of arrogance and complacency, a fatal flaw very evident in their negotiations with start-up software pioneer Bill Gates. Bill was so young and Microsoft so small in the late ‘70s that neither registered on IBM’s radar screen. Good fortune, however, was just around the corner. Early in 1981 Microsoft was approached by IBM to produce some operating software for IBM’s ground breaking, soon to be released PC, the Personal Computer.

As it happened Bill and Microsoft didn’t have a ready operating system to sell to IBM, so they went out and purchased a basic operating system from software developer Tim Paterson for $50,000 and adapted it. The renamed version eventually became IBM’s PC-DOS.

New Approach to Software

Developing software and selling it outright to customers was standard operating procedure in the software world of that day. Remarkably, in Microsoft’s case, something quite amazing happened. Bill recognized that his simple operating system was more than a toss away service for IBM’s hardware; his software had great utility and value. Bill Gates pondered on how best to sell his operating system to IBM, but also retain the right to sell it to other customers as well.

Bill Gates launched Microsoft and (almost accidentally) created the modern software industry by ring-fencing his computer code with a legal agreement and licensing its use to IBM instead of selling it outright. Under the agreement Microsoft retained the right to independently develop and market its own version of PC-DOS under the brand name MS-DOS. Signing this agreement was a colossal blunder for IBM, a mistake that in very short order catapulted this titan of industry to the point of ruin; meanwhile Microsoft, a global superstar, was born.

The lesson for bankers today is this. The launch of Microsoft might never have happened if IBM had not brought an antiquated industrial mind-set to the negotiating table.

IBM, of course, played by the existing rules of business; they KNEW that only ‘real‘ tangible assets were important.  For IBM, software was unimportant; it was simply an expendable service. As a result of this blindness IBM didn’t see the opportunity or the danger and therefore did not object to the licensing arrangement.

Microsoft KO’s IBM

In the stoke of a pen, IBM abandoned two of the most valuable (if non-traditional) assets of the 20th century; simply left them on the boardroom table. And (bankers take note) what were these assets: the MS-DOS software assets, and more importantly a relationship-based customer equity asset that would dominate the world of computing for the next quarter century.

Ownership of the MS-DOS software platform soon paid handsome profits for Microsoft. With its unique capabilities MS-DOS helped launch IBM clones, competitors to IBM in (clone pioneer) Columbia Data Products, Eagle Computer, Compaq and others. This however was only the beginning, soon MS-DOS became Microsoft Windows and the world had a ubiquitous new software operating system for a generation of personal computer users. Microsoft’s ownership of this non-traditional asset, one of the most profitable assets of the 20th century, was – ironically – only made possible through ignorance and neglect: software-as-asset being a contradiction in terms for IBM.

But MS-DOS was not the biggest asset IBM left on the table that day. Customer equity, the magic ingredient that catches customers’ desires, that informs the ‘Why of the Buy’ for computer purchases soon passed from IBM’s hardware to customers’ familiarity with the Window’s operating system. PC buyers were loyal to Window’s (and to a lesser degree Apple’s) operating system, not the hardware platform. Armies of computer buyers flocked to Microsoft based computers regardless of the hardware platform. (Note to Microsoft, today customer equity is moving to Apple’s platform, beware!).  This customer equity asset was, until recently, the most valuable asset in the history of computing – more than anything else it created the myth of Microsoft and almost cratered IBM as a viable business.

So, Matthew, there is something new about the new economy, value is driven in new ways, from unfamiliar, intangible sources that most bankers don’t understand. How can bankers hope to keep pace with all these changes? I don’t know but burying your head in the sand and pretending that nothing has changed won’t help, that’s for sure. “

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Bank of America, The New Lehman?

August 12, 2011

This is my last negative post, from now on I’m going to be focused on solutions to reinvigorate capitalism; presenting ways of unleashing the full potential of the most talented, connected and creative generation in the history of the human race. That we’re reduced to trembling in fear, talking about a double dip recession or another Great Depression is a disgrace.

Having said that the problems we face in the aftermath of the Financial Crisis are not going away. Apart from the unsustainable debts of almost everyone, municipalities, individuals, sovereign governments etc., there are unresolved liabilities emanating from the 2008 mortgage mess that are about to break through our defensive perimeters. Think Titanic; the banking system essentially hit the iceberg at full speed in 2008. We’ve kept her afloat ever since, but at the moment the economic engine room is flooded and water is rising fast on the lower decks. It’s a mathematical certainty that we’ll sink; it’s simply a matter of time.

Why single out the Bank of America? Well there are a couple of reasons. First of all their behavior was and continuous to be deplorable.  To say banking standards were compromised in the past decade is like saying Bonny and Clyde were good kids out to have some fun; the reality is bankers were overwhelmed by greed, recklessness and incompetency. How many banks foreclose upon a home that the owners paid cash for, and don’t have a mortgage? Bank of America did. But that level of incompetency is only the tip of the iceberg; there is a growing army of Attorney Generals lining up to sue Bank of America for illegal foreclosures in their States. Wisconsin is only the latest. Attempts by the bank to settle this matter are unraveling fast.

Even that paragon of virtue, AIG is suing BofA (for $10 billion) over a variety of abuses. But they’re only one of a long (and growing) line of litigants seeking to recover losses on hundreds of billions of dollars of mortgage-backed securities, claiming that Bank of America, its Merrill Lynch and Countryside Financial divisions knowingly misrepresented the quality of mortgages placed in securities and sold to investors.

Bank of America is not alone in having these problems, many banks share them, but unfortunately for shareholders, BofA is the weakest in the herd. With a share price in the single digits there is a growing sense of unreality at the senior management level. Although it remains the largest bank in the United States by assets, the BofA has dangerously weak capital ratios. But as CEO Moynihan said recently: “We simply could not continue… diluting our shareholders to raise capital.”

The banking industry has been sleepwalking through the crisis ever since TARP program was announced.  And complacency reigns; when the banking industry has gotten in trouble in the past (i.e. after the Enron fiasco) they’ve received only a slap on the wrist and a bank friendly settlement acknowledging no wrongdoing or liability. How do the banks do it? The banks have important cards to play; they can rightly claim that they are central to the material well-being of the nation – not just too big to fail, but too important to be held accountable for wrongdoing.

The Justice Department, true to form, is concluding its inquiries into bank malfeasance without filing any serious charges. Banks are hoping and expecting that they’ll receive a politically brokered ‘free pass’ when the dust settles. Unfortunately, neither banks nor officialdom will be able to withstand the public backlash that’s coming when the economy takes another steep nosedive. The public, already plenty angry, will be out for blood and the politicians will simply throw the rotten bankers to the mob to save themselves.

Like Lehman the fall of Bank of America will be very much greater in perception than in reality. It will have a knock on effect that staggers the imagination. Batten down the hatches, and man the lifeboats.

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‘Servicing’ the Economy

May 17, 2011

The Irish property boom and subsequent bust is a portent reminder of the hazards of the Wall Street version of banking, which over several decades has managed to turn the most conservative institutions in our economy into Las Vegas like gambling casinos.

Bankers have traditionally been the guardians of assets, its why it they were so dour; their job and role was to protect the value in assets, and thereby protect their depositor’s principle and the integrity of the capital system. In Wall Street’s version of the game, traditional banking is a bit of a dog; much better to turn boring (low return) mortgage assets into a stream of high value ‘services’ that generate multiple sources of immediate fees (earnings and personal bonuses).

The ‘sub-prime’ mortgage scandal demonstrated clearly that under this regime, NOBODY in the system is focused on stability. Every player in the property game these days, mortgage ‘originators’, servicers, securitization specialists, banks and their and sophisticated investment advisors, even credit rating agencies are focused entirely on fees, no one is watching the asset. In changing the focus of attention and misaligning the incentives in the system, the quality of mortgage assets was degraded – to devastating effect.

Assets matter, for instance, with a solid housing market individuals are able to leverage their homes to raise funds for, perhaps, sending their children to school, for investing in their businesses or expensive life-savings operations. Businesses are able to leverage their commercial property for a variety of purposes, including managing cash flow. Banks holding solid mortgage assets are able to leverage these assets to provide liquidity for the local business community, while national governments are able to leverage the housing stock to support currency values and central banking liquidity to the benefit of the economy as a whole.

As the Irish are discovering today to their dismay, blindly following Wall Street model of ‘servicing’ an economy creates instability; for the Irish it created a kind of economic whiplash.

Assets, and their sustainable value are the underpinnings of the capitalist system and all nations value and in many ways ‘rest’ upon their asset foundations. Turning assets into fee generating ‘services’ is the reverse of what a sensible economy should be doing. Unfortunately the game today is all about finding new and exciting ways of converting assets into services; this means that capital stability is sacrificed for expediency.

‘Servicing’ the economy not only degrades an economy’s strength but also reduces leverage and growth potential. Not that leverage disappears in this new Wall Street system, banks, naturally, publically traded, are able to leverage their new ‘mortgage’ related earning steams – good for them. Unfortunately this is very bad for the rest of us.

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Rise of the Service Economy

March 19, 2011

According the Organisation for Economic Co-operation and Development (OECD), post industrial economies (i.e. Western developed economies) are now solidly ‘service’ oriented. By some estimates over 75% of US GDP is composed of services, the UK comes in at 71.6%, Switzerland at 72.1%, and Luxembourg at 79.4%.

Unfortunately this transformation of economies from industrial to service presents a series of problems. Economists, being economists, describe it in terms of productivity. For instance, according to the UK Treasury:“The service sector is at least one third less productive than manufacturing.” In some sectors, services reach only 50% of the productivity per head of old line manufacturing. Many believe that services processes have not been designed with the ‘rigor’ applied to such activities as engineering.

But, of course, that’s not all. The old industrial economy was underpinned by tangible assets, which had a number of advantages. First of all tangible assets are given formalized treatment by management and important social institutions. For instance, there are reliable valuation standards for these assets, they qualify under GAAP (Generally Accepted Accounting Practices) which means these assets appear on company balance sheets and are accepted by banks, securities regulators, investors and others as legitimate value. More importantly, businesses can leverage an asset, something that is NOT possible with a service.

With upwards of 80% of our economy now in ‘services’ our economic leverage is vanishing, and with it our ability to reliably finance growth.

Banks (which leverage assets on a 10-1 basis) are desperately trying to increase their asset bases to meet the demands of regulators and shareholders; however many are trying to do so with thinly disguised ‘services’ which at present don’t have the collateral value of older class assets. Public companies are able to leverage their service businesses through their multipliers, most importantly their price to earnings multiples in the stock market. However for the 90% of knowledge-rich small to medium sized companies today there is no financial leverage and therefore these businesses are swimming against the tide – many underperform or simply fail.

It is a fact that civilizations rest upon their asset foundations, solid assets allow them to mobilize their human networks to all kinds of productive purposes, investment in new business opportunities, building systems of education, health and or security. The growth of the service economy is very exciting and it is delivering an economic benefit, generating its fair share of GDP. But presently constituted services are not building solid dependable assets which individuals, companies and society can leverage efficiently to build a sustainable future.

Things to Think About

1.  We all need to take a leaf out of Bill Gates book. In the early days of Microsoft Bill converted his MS-DOS operating software from a ‘service’ to an asset by treating it differently than other software developers. Bill ring-fenced his software with a license agreement and leased it to IBM and others instead of selling it outright. This allowed Microsoft to gain both earnings from the sale of software but also to gain from the accumulating asset value of this valuable source of wealth.

2.  Its time for leaders to look very closely at their businesses and try and understand the sources of value more clearly. And then act to build real asset disciplines, value, and leverage in their non-traditional assets.

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ENTERING THE FINANCIAL STARVATION ZONE

July 1, 2010

Climbers face many challenges, particularly in extreme zones like the summit of Everest. Apart from being physically demanding, the highest peaks are oxygen depleted, which means at the very moment when you require extra energy, you are deprived of the sustenance you need to perform effectively. Climbers call this is the Starvation Zone, and many excellent low altitude climbers are simply incapable of managing the physical and mental challenges of high altitudes.   

Credit is the oxygen of business; it courses through the system feeding the body and animating the limbs of commerce. Over the past decade we’ve been operating at low altitude, a credit rich environment but business leaders beware, you’re about to enter a Starvation Zone of your own.

The extraordinary period of Keynesian stimulus ended at the Toronto G20 summit. In future governments have agreed to rein in their stimulus spending and are obligated to half their operating deficits by 2013.

It was also agreed that banks must significantly increase the quality and quantity of their capital assets. Capital requirements act as a kind speed-limit for banks, increasing capital levels has a real cost as it makes credit both more expensive and less available. Every extra dollar a bank holds in capital equates to at least $15 that it is unable to lend.  

If that weren’t enough, The Bank for International Settlements warned on Monday that central banks must raise interest rates even before their respective economies are clearly in recovery.

All this of course is sensible and prudent economic management from the macro level, but for business in the short to medium term it spells falling demand and a rapid contraction of credit at a time when the global economy is far from healthy. It’s as if, having almost broken our backs getting to base camp, we decide to push on to the summit of Everest in poor health and lacking oxygen – good luck.

Things to Think About

  1. The past is NOT a reliable guide for the future; going forward you’ll need MUCH better teaming and what we call a High Altitude Mind Set to succeed in this difficult environment.  
  2. Successful High Altitude climbers manage the Starvation Zone by preparing in advance, acclimatizing their bodies, adjusting their pace, strengthening their internal fortitude. Its time for businesses to do the same. Begin now to condition your organization for far more challenging times than you’re experienced to date. (for details on how to accomplish this see (www.heroichearts.ca)
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THINGS ECONOMISTS CAN’T TELL US, and WHY

June 9, 2010

Many not so casual observers, including Queen Elizabeth II, have wondered why economists did not anticipate the recent Financial Crisis. The reality is most economists were stunned when the Crisis arrived, panicked at its blinding speed and can only recommend ‘the same old, same old’ going forward. There’s two principal reasons they didn’t see it coming. One, economists weren’t looking broadly enough at the economy to see the problems developing in the first place, and second, what evidence was available (and there was plenty) tended to be discounted or ignored for ideological reasons.

The Dismal Science

Economists, despite being highly respected and sophisticated scientists, have been on the defensive for centuries. Truthfully, the study of economics was in difficulty even before Thomas Carlyle leveled his famous ‘dismal science’ charge in 1850. Perhaps the one nagging criticism  that stings most strongly these days is the charge that economists are so infatuated with the wonder of their theory that they ignore practical reality.  

Why should the rest of us care? It’s a serious issue because economics matters. The management of a modern economy, the decisions and actions undertaken by politicians, senior policy advisors, Chairmen of the Federal Reserve Bank, business leaders, Wall Street investment bankers and others, are derived from an underlying body of economic thought; today those underpinnings rest largely on the shoulders of neoclassical economics, the foundation stone of modern capitalism.

Neoclassical Economics

Although neoclassical economics is a foundation, it is by no means a unified body of theory. However modern economists working within the neoclassical paradigm tend to agree on both a quantitative approach to economic analysis and a field of study centered on the exchange process. Neoclassicism is a mathematical system of thought concerned with market related phenomena, particularly the determination of prices, outputs, and income distributions.

This is quite a change from the past. A century ago the great Alfred Marshall could say of economics: “Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man.” These days you’ll find a much less ambitious definition for economics, generally along the following lines: “Economics is the social science that examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.” …a dismal science indeed.

So, where did it all go wrong?

It all happened a long time ago, in the horse and buggy days of the Victorian era. Mid-Victorian capitalism was facing a mountain of trouble. Marxism and the rising working class movement were galloping forward on the left; on the right there was a looming – cataclysmic – breakdown of laissez faire, which eventually launched an era of vicious protectionism and hyper aggressive imperialism. According to economic historian Eric (Lord) Roll, in these confusing times there was a strong desire among classically minded economists to produce a more scientific study of economics and – ideally – find a way to side-step the theoretical challenge of Marxism once and for all.

The Marginalist Revolution of the 1870’s provided just such an opportunity. The marginal utility theories of Jevons, Manger and Walras revolutionized economic thought and with it the entirety of economic study.  Neoclassical economic theory, which emerged as a consequence of the Marginalist Revolution, introduced important new concepts into the economic lexicon, particularly a theoretical perspective that the value of goods is determined subjectively “in use” by the end-user (classical economics had assumed that goods had a hard, objective value, which was equal to the amount of labor applied in its development – the so called labor theory of value).

However, neoclassicism also introduced fundamental changes in the study of economics; its explicitly scientific approach introduced a mathematical bias into economics, which has grown significantly over the course of the past century. Unfortunately, mathematical precision has come with a hefty price tag: the Marginalist Revolution reduced the scope of modern economic analysis considerably. By drawing a ring-fence around the exchange process – forevermore the ‘legitimate’ area of economic inquiry – neoclassical economics retreated into a narrow, quantifiable definition of economics, where the larger (messy) questions were simply ‘out of bounds’. And although economists gained much greater mathematical certainty and logical consistency in adopting neoclassical principles, the Marginalist Revolution placed significant limits on the boundaries of economic study, stifling inquiry of those economic inputs that lay outside the narrow confines of the exchange process.

It was this reduction in scope, this retreat from the larger study of political economy, undertaken over a century ago that created the ‘boundary’, the theoretical wall that defines the limits of economic analysis; the presence of which leaves economists as mere spectators in critical elements of the economy. It is one of the reasons why so many of them didn’t see the storm clouds gathering in the first place and still can’t.

Economist’s counter these charges by pointing out that their market focus is reasonable, given that every meaningful economic activity that takes place outside the boundary eventually winds up in an exchange transaction, which they believe, essentially, brings the outside world to them on their (quantitative) terms.

Yes, economists do consider ‘out of boundary’ inputs, but lumber them into a broad undifferentiated category they call externalities. The practical consequences of this approach, however, distance economic analysis from the primary sources of economic activity. For instance most economics are unconcerned (and presumably unaware) of the nature of new asset classes in an emerging knowledge  economy or more importantly, just how these new assets impact economic risk assessment over time. In other words, economists are left to examine only the derivative (quantitative) effects of economic phenomena rather than their primary causes.

The Ideological Force of Monetarism

Unfortunately, this confusion between cause and effect has been greatly magnified by the late 20th century rise of Monetarism. Like many theoretical considerations in economics, monetarism was controversial and applied carefully within the profession; while outside in the world of finance and business it was swallowed whole, hook, line and sinker. Unfortunately monetarism became more than a new set of economic principals, it morphed into an ideology, a faith like belief in the purity of markets. The practical effect of market purism has been to undermine traditional checks and balances perfected over the ages to preserve the integrity of capital. As a result capital management practices collapsed across the board when it became popular to believe that markets purified the economy of all risk. This ideological sedative infected all aspects of economic decision making, undermining the culture of banking, accounting, credit rating, management and economic policy making.

Modern Economic Thought

Modern economics, despite being an important theoretical advance on the past limits economic thought in several ways. Firstly its dedicated mathematical approach limits the very process of economic analysis, for it implies strongly that anything that is not quantifiable simply doesn’t count. Secondly its constricted focus means it looks at the economy through a microscope rather than a telescope – in other words its missing the capitalist forest for the statistical trees. These reductive forces contribute to the fatal combination that blinded many economists in the run up to the Financial Crisis and are, even now, limiting our ability to put the economy back on a sound footing.

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