Are Blasts from the Past Afoot?

Hyperbole to the contrary notwithstanding, the terrorist attacks on 9/11 did not change everything. Likewise, the Panic of 2008 will not change the fundamental facts of business. It may, however, dramatically change its face. In a topsy-turvy post-panic world your company’s biggest competitor might be a nimble newbie or a lucky small fry in just the right place at just the right time. The successful manager will know, as the Chinese do, that crisis spells opportunity as well as peril.

Some industries, like publishing, may be completely transformed in the next few years. Long on the ropes, newspapers and book publishers face dramatically declining revenues and a slew of new competitors, from bloggers to web videographers, free of traditional publishers’ costly overhead and antiquated distribution systems. Even college textbooks, long among the fattest of cash cows, may come under pressure from radical new business models like that of Flat World Knowledge, which claims it can make an adequate profit by giving textbooks away for free, online, without relying on advertising. Other long sagging and lagging industries, including construction, healthcare, higher education, and real estate, are also ripe for change.

The demise of the big investment banks has the potential to upend corporate finance, returning it to its roots. Startups may stay private longer and then go public via a direct public offering (or “OpenIPO”) facilitated by WR Hambrecht and Company instead of a traditional initial public offering underwritten by a bulge bracket investment bank. Direct public offerings were the norm in the United States before the Civil War and could become so again. Unlike intermediated IPOs where investment bankers set the selling price, modern DPOs use an auction process to discover the price at which all the offered shares will be purchased. The issuer is therefore never stuck holding unwanted shares and first day “pops” in the aftermarket are almost unheard of. DPOs are also considerably cheaper for issuers than IPOs.

Bond issuance and merger finance may also undergo major changes. Private placements have been an important part of corporate finance since the securities regulations of the Great Depression. In coming years they may become even more important because they will be easier for the remaining investment banks, small niche players called boutiques, to arrange than full blown public offerings. Boutiques will continue to offer M&A advice, but corporate law and accounting firms and commercial banks will certainly enter the vacuum created by the exit of the major investment banks.

For bank credit, smaller businesses may find it easier to turn to their local community banks or smaller regionals than to wait for the big boys’ balance sheets to improve. Community banks were largely untouched by the subprime mortgage mess and stand ready to lend to solid local businesses. Also, trade credit will probably make a comeback as businesses sitting on stashes of cash or with access to relatively cheap sources of external finance find it prudent to keep key suppliers or distributors afloat. As in the nineteenth century, credit may again cascade through the channels of trade, from the biggest, best, and oldest companies through their most important customers, clients, and suppliers to the small, weak, and new.

Insuring businesses against risks may also change in the next few years. Insurance companies did not take a direct hit from the subprime debacle – AIG failed due to risks taken at the holding company level, not because of losses at its operating companies. Nevertheless, the panic of 2008 clearly stressed many insurers already facing competition from new alternative risk transfer mechanisms (ARTM), including catastrophe and death bonds. Investors see much value in such bonds because they offer good returns that are not correlated with other financial markets, a clear virtue when almost everything else is down, as at present.

Adam Smith, Profitability, and Efficiency

“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest,” Adam Smith wrote in The Wealth of Nations. “We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” True enough. The self-interest of profit maximization does keep us fed, clothed, sheltered, entertained, and much more besides. But profitability and economic efficiency are not always the same thing, and it is the latter that ultimately aids society. Profits, after all, can stem from sources other than efficiency, like rent seeking or market power, that are social bads.

For the last three decades or so, the general consensus was that markets could do no wrong and governments no right. Increasing numbers of people now realize, however, that some government agencies are economically efficient and some private businesses are not, though they may have been profitable for awhile. What matters, we are coming to realize, is not who owns or runs an organization but rather the structure of the market it operates in (competitive or monopoly at the extremes) and the degree to which internal incentive structures are aligned with the organization’s goals, as in the two by two matrix below.

Stereotypically, businesses inhabit the upper left quadrant, where competition and a high degree of internal incentive alignment ensure efficiency, while government agencies dwell in the lower right quadrant, the inefficient victims of monopoly and incentive misalignments. Some government agencies (and non-profits too), however, compete with other governments and/or private sector firms and have decent internal incentives. Think, for example, of the post office. Stockholder owned investment banks, by contrast, operated in markets that were less than fully competitive and had flawed internal incentives. Due to their market power and incentives they were profitable for a decade or so but ultimately their inefficiencies caught up with them, leaving society with the bill.

In the coming months and years, the government is likely to try to extend its purview, to regulate more aspects of the economy more thoroughly than hitherto. It may also try its hand at mortgage banking (via the remnants of Fannie and Freddie), commercial banking (via the Federal Reserve’s new lending powers), and maybe even automobile production. (If that sounds far-fetched, few before 1970 would have believed that the federal government would operate an extensive passenger railroad system for over three decades.) Rather than outright opposing such endeavors, American businesses would do well to use their expertise to try to move them as close to the upper left quadrant as possible. They would do well to try to move their own businesses in that direction as well, to fight their natural proclivity to create short-sighted incentive schemes and to strive for more market power. What ultimately matters for the economy is not jobs or profits but creating more output from the same input.

Partnering with Regulators

Traditionally, American businesspeople considered regulators a foe to be avoided, co-opted, or, if possible, vanquished. That’s the wrong attitude, especially in the current environment. As Lord Melbourne (William Lamb, 1779-1848) once said, “Those who resist improvements as innovations will soon have to accept innovations that are not improvements.”

Regulators, good ones anyway, curb business’s worst excesses. Where business seeks market power, regulators strive for competition. Where business yearns for high returns, regulators desire systemic safety. Rather than butt heads time again, regulators and the regulated ought to sit down as partners and figure out how both sides can achieve their goals.

Possibilities abound but compensation reform holds supreme promise. From the corner office to the mailroom, people usually do precisely what they are incentivized to do. Tell a pastry chef he can eat his mistakes and you’ll soon have a fat guy in the bakery. Pay workers by the hour and you will have to supervise them much more closely than if you pay them by the piece. Give a CEO stock options and the stock will rise, hopefully due to increased efficiency but quite possibly because of accounting shenanigans.

Companies that get the compensation question right thrive. Consider Guardian Life Insurance Company of America (GLICA), a successful mid-sized mutual life insurer in an industry now dominated by joint stock giants. Although owned by its policyholders, GLICA did not become a stodgy mutual dinosaur because its general agents, firms that sold mostly Guardian products, played the same role that large blockholders play in the governance of stock corporations and basically browbeat Guardian’s management into remaining competitive. GLICA’s managers also devised a long-term incentive program for themselves, which pays off handsomely upon retirement, thus closely aligning their interests with those of their policyholders.

Conversely, business history is littered with the corpses of companies that got the compensation question wrong. Bear Stearns, Merrill Lynch, Lehman Brothers and the other investment banks that stumbled during the financial crisis of 2007-8 are the most recent major examples. Traditionally, investment banks were partnerships. With their all at stake, the partners took small risks while building equity for the long haul. After the investment banks went public, however, managerial incentives changed dramatically. The game then became to earn big returns and gigantic annual bonuses by taking huge risks, stockholders and other long term stakeholders be damned.

It should be an invariable rule of business never to pay anyone until the ultimate consequences of their contribution is clear, when economic profits are actually accrued rather than mere accounting profits booked. Paying mortgage originators full commissions at closing has failed seven straight times in U.S. history. Instead, originators should be paid over a period of five or seven years, and only for mortgages that are not in default. (Analogously, life insurance agents receive their commissions over years to incentivize them to sign up good risks.) Similarly, managers should be incentivized to attain, and then maintain, their stock price target, not merely to puff up the stock for a fleeting moment.

Businesspeople generally concede these points but counter that competitive markets for talent preclude them from deferring much compensation for long. The best people, they claim, would flee to competitors willing to pay up sooner. Here is where a strong partnership with a good regulator can work wonders. Businesses should sit down with their regulators and come up with incentive compatible compensation structure guidelines for every major job category in their respective industries. The regulators should then enforce those guidelines so no company can complain about being at a competitive disadvantage. Where appropriate, the regulators should seek international cooperation. Most importantly, they need to watch out for attempts to find loopholes and changing industry conditions. To ensure that they remain attentive, regulators ought to think long and hard about their own incentive structures.

A Bet You Won't Forget

I just sent the following to the Letters to the Editor section of the Wall Street Journal. I doubt the editors there have the fortitude, testicular or otherwise, to publish it so I post it here. I am quite serious about the wager. Yes, the national debt is a problem but the notion of the United States dissolving in the next few years I find ludicrous.

Igor Panarin thinks there is a 50 percent chance that the United States will dissolve in 2010 (Wall Street Journal, 29 December 2008, A1). In the spirit of the late Maryland University economist Julian Simon, I'd like to wager an ounce of gold (presumably Mr. Panarin is not daft enough to accept a dollar denominated bet) that the United States will substantially retain its current borders through 2010. Even money of course.

Depending on the odds offered, I might also like to make additional bets that Mr. Panarin's "Texas Republic" and "Central North American Republic" would annex Mexico and Canada, respectively, before falling under their sway.

Why is the Federal Reserve contemplating issuing bonds?

When I first saw a little news squib that America's current central bank, the Federal Reserve, wanted Congress to grant it the power to issue bonds (long term IOUs), I thought it was a piece from The Onion, the hilarious king of print news satire. Had the story been real, I told myself, it would be plastered on every front page of every self-respecting business periodical in the country and CNN would soon have 15 to 20 talking heads babbling about what the news means for the nation and its teetering economy.

Well, it appears the story is real but hardly anyone noticed it or gave a thought to its implications. The Fed already issues debt, zero-interest debt, in the form of Federal Reserve notes. (You know, the money you used to carry around in your purse or wallet before the September crash.) It also issues deposits called bank reserves, on which it now pays a little interest but completely controls. It puts those liabilities or "sources of funds" to work on the asset side of its balance sheet, which includes interest-bearing Treasury bonds and loans to banks (and now non-banks too), gold, and some other physical assets. It's quite a lucrative business.

If the Fed wants to issue interest-bearing bonds, as the Treasury does, it must think that the demand for dollars (at 0% interest) is weakening or will weaken.* (Why issue debt at > 0% when you can issue at 0%?) But who would want dollars in the future if they don't even want dollars today? As Peter Schiff recently noted: "Perhaps the Fed feels this [paying interest] will make holding its notes more appealing. However, since the interest will be paid in more of its own script, I do not believe this con will work."

So what is going on? One possibility is that the Fed is preparing to issue bonds denominated in one or more foreign currencies. It can/will do so more quietly and privately than the Treasury can and will use its vaunted "independence" to hide the fact as long as possible. Or, perhaps, it will issue bonds that will be denominated in dollars but pay interest in a foreign currency or in gold or some other commodity. Or maybe the bonds will be collateralized by specific sets of its assets. The bonds it wants to issue, in other words, will have to be "sweetened" in some way in order to get people (firms, other nations' central banks) to hold them.

Another possibility is that this is just a ruse to keep the bailout from showing up in the national debt, which by convention includes only the Treasury's bonds. That was why the GSEs were spun off from the government in the late 1960s, btw, to get their debt off the Treasury's books. What I suggest is that we don't fall for the ruse and count any interest bearing bonds issued by any federal agency as part of the national debt.

Needless to say, we've been down this road before. Check out One Nation Under Debt for details.

Happy Holidays! It may be the last normal one for a long time.

*This is not as crazy as it sounds. During the Great Depression, Mexican pesos circulated in the border areas of the United States. Mexican pesos! See Amity Shlaes, The Forgotten Man, 138. Also, in the late 1970s the U.S. Treasury resorted to selling bonds, called Carter bonds, denominated in German marks. See this article for details.

Save the Economy: End Prohibition

At the end of the First Great Depression (1929-1933), the U.S. federal government ended the so-called Noble Experiment, known by most today as Prohibition. It was a shrewd move. Banning the manufacture, sale, and transportation of alcohol did not end the consumption of alcohol in the United States, not by a long shot, but it did decrease the quality and increase the cost of what alcohol was consumed (after existing stocks were depleted). Worse, the policy was a boon to organized crime and wasted huge amounts of police resources. Ending Prohibition freed up human capital to engage in more productive pursuits and stimulated investment in legal alcohol production and distribution.

Here at the beginning of the Second Great Depression (2007-??) the government ought to end its long, expensive War on Drugs. We simply can't afford to continue the fight, no matter how noble some think it. Like prohibition of alcohol, prohibition of marijuana and other controlled substances has decreased their quality and increased their price without coming close to ending their consumption. Legalization would free up a non-trivial amount of police resources and stimulate investment in the production and distribution of hash, cocaine, and so forth. It might not be enough to save the economy, but at least we can get high safely and legally until it improves.

Who is the bigger scammer, Extreme Acai Berry or Target National Bank?

The financial system continues to crumble and 4Q 08 GDP may plummet 6 to 8 percent and I have to deal with this bull-oney. My wife, God bless her (because I won't), fell for the Extreme Acai Berry scam. This website sells a trial sized package of acai berry pills for, like, $3.95. It has a little disclaimer that says if you don't cancel within the 14-day trial period it will automatically ship a slightly bigger bottle for $89 and some change. In even smaller type (at least on the day I looked at the site), it said that the trial period began immediately, not upon receipt of the product, which, in our case anyway, was 12 days after purchase! Customers who call the number to cancel are greeted with a message saying that they should call back due to high call volumes. So it is basically impossible to cancel even if you figure out that the "trial period" is not a "trial period" in any meaningful sense of the word.

For additional details, see these sites:
http://www.sybervision.com/reviews/Extreme-Acai-Berry.php
http://www.ultimatefatburner.com/extreme-acai-berry-review.html
http://www.ripoffreport.com/reports/0/372/RipOff0372878.htm

This is what really peeves me, though: the credit card issuer that my wife used to make the purchase, Target National Bank, will not credit us the $89 and is continuing to do business with the scammers! There is no way that the government can police all of cyberspace but it certainly can ensure that Visa, Mastercard, Discover, and other transaction service companies are punished if they co-operate with known scam artists. These companies should regulate themselves before the government does. As soon as people start calling in to complain about the scam, they need to alert the offending firms to make good. If they don't, they need to cut them off. Otherwise, the transaction service companies are enabling the scam artists. They are accomplices, if you will. Suing some fly-by-night isn't worth it but suing Target National Bank could be lucrative. Until it goes bankrupt that is. Any class action lawyers out there who want a piece of the action?

In the meantime, I cannot stand doing business with companies that don't even understand their own interest so I've severed our relationship with Target National Bank and urge everyone else with a target on their credit card to do likewise. You shouldn't be charging much in this environment anyway.

The Housing Bubble and the American Revolution

The New York Times today (30 November 2008) ran a very nice piece (The Housing Bubble and the American Revolution, WK5) by Tim Arango about the book Ron Michener and I have been working on (Yale University Press, forthcoming) regarding New York's colonial money system and the financial crisis of the 1760s. It is nicely balanced, with obligatory retorts by Gordon Wood and Edward Countryman. Of course these folks have had nothing to say about One Nation Under Debt because it is unassailable. The next book will be even more formidable so I'm glad they got their shots in now, when it is cheap to do so.

Irresponsible Reporting at CNN and the Wall Street Journal: Don't Believe Everything You See or Read

The financial crisis exposed Wall Street's weaknesses in visible and dramatic fashion. It has also exposed the weaknesses of the media, but in a way that is much more difficult for the public to discern. Members of the media sometimes report on their own industry's problems but more often they don't, largely because they are blind to them. (Btw, no cracks about professors being blind to the problems with higher education. I've written a book on the subject of how much we suck and hope one day to find a publisher with the testicular fortitude to publish it.) I've done quite a bit of media since Lehman Brothers and AIG bit it and what I've seen is enough to make me question the efficacy of the so-called fourth estate. Thank goodness for bloggers ... I mean real bloggers and not traditional media types with blogs.

Here is a case in point. On Tuesday past (25 November 2008), Wall Street Journal columnist Dennis K. Berman published a column called "One Cure for Financial Mistrust: Create New Banks." This is the type of piece that makes my blood boil as it is nothing more than an op-ed dressed up like news. The argument was that the government ought to put up $10 billion, solicit private subscriptions for another $50 billion or so, and start a new bank or banks because the old ones can't be "trusted" anymore. In support, Berman made some allusions to the first (1791-1811) and second (1816-1836) Bank of the United States but got some of the facts wrong. Worse, the piece was premised on the mistaken belief that the financial system is based on "trust." The biggest blunder was that Americans create scores of new banks, called de novo banks, every year and are in the process of creating more community banks as we eat the bird today. (Most community banks, by the way, have weathered the crisis beautifully.) Finally, while it would be an exaggeration to say that government money is retarded, it is safe to say that most people do not believe that government money is smart money, so government participation in an IPO would likely backfire.

Imagine my delight, therefore, when CNN's Situation Room contacted me to go on the show to discuss the piece. I demurred as I was at home grading but they begged and we compromised and I ran into Philly to tape the segment. I patiently explained that Andrew Jackson did not create the second Bank of the United States but rather killed it by not renewing its charter, that community banks stand ready to lend to people and businesses with good applications, that scores of new banks form in the U.S. every year, and that while the chartering process could be sped up and streamlined we do not want to let just anyone have a bank. I invoked Tony Soprano (The Sopranos boss) and Avon Barksdale (a drug kingpin on The Wire) on that one. And I also explained that government participation in an IPO would not necessarily be a buy signal to private investors. (In a developing country it would because of the expectation of graft but here that is less likely. In the early nation government participation in the Bank of the United States was a buy signal because the great Alexander Hamilton was behind the project.) Most importantly, I debunked the myth that the financial system runs on trust. Rather, it runs on collateral and contracts and, in some cases, a repeated prisoners' dilemma. After all that, after dragging me away from grading on their urgent behest to set the record straight, CNN didn't run the interview. Not one second of it according to the transcripts. In retrospect, they were looking for a yes man, for someone to say, oh gee Berman is so smart why didn't we think of that, duh!

After taping, I stayed in the city in order to do a live appearance later for Fox News. This, too, was disastrous. They plugged my book but they owed me that from an earlier appearance where they promised it but did not deliver. That one would have paid off big in terms of sales -- I was literally bombarded with requests for my presentation -- but it appears I got nary a sale from my very brief live appearance this week. The opportunity costs were enormous: forty minutes of makeup for like 2 minutes on the air and an abrupt cut off. And why? Because the host didn't like where I was going, which was to argue that at this point the Fed ought to be using Hamilton's nee Bagehot's rule and lending to everyone with sufficient collateral to put at a penalty rate. Once again, I suspect Fox thought I was going to say something different than I did. When I flummoxed them they cut away and didn't even say thanks. I should have known as this was the same outfit that claimed in a voice over that I called financiers "witch doctors." I never did that. Alchemists maybe, but never witch doctors. ;-)

The takeaway from all this is Americans need to read substanstive documents if they want to have a deep understanding of the current crisis. TV and the WSJ are not enough and in fact a case could be made that the pablum they shovel out in censored measured doses actually infantilizes the audience.

There are some exceptions, of course, like the article "The Housing Bubble and the American Revolution" in this Sunday's New York Times "Week in Review" section about the financial crisis of the 1760s. Of course even The Times got my name wrong, replacing my middle initial E with a W!

Another Modest Proposal

This is my first post in November because I've been very busy prepping my Money and Banking textbook for publication with Flat World Knowledge, among other things.

My brother, the state of Oregon and its Death with Dignity Act, and The Economist, however, have given me an idea for "Another Modest Proposal" that I feel compelled to share. The original modest proposal was a satire in which wit Jonathan Swift argued that the way to solve the world's problems was to eat Irish babies. This last week, The Economist had "a modest proposal" for the inhabitants of islands being swallowed by the ocean due to global warming. My brother suggested that, with the imminent demise of his 401K, his retirement plan will be a .357 magnum and a bullet.

See where I am going with this? Our personal and public finances would be greatly simplified if we knew when we were going to die, or rather had an upper bound on our death date. Instead of going out in agony, at the cost of millions, we should be able to choose our exit date well in advance and plan for it both financially and medically. (We should be able to "no code" ourselves starting x time before our respective exit dates. Why suffer heart surgery if we plan to die the next week, month, year, etc. anyway?) Social Security benefits would be based on two ages, age at retirement and age at planned death. If the exit date comes and the person wants to continue living, s/he can opt to do so, but will be "dead" to the state and will stop receiving S.S. and other entitlements and will also lose the right to vote. If s/he opts to die, there should be some better method available than a bullet or one of those suicide booths from Futurama.