Financial Crisis Raises Fundamental Questions

As regular readers will know, I’ve been meaning to write about this for some time now. One of the reasons it has taken me so long is that I’ve had a lot of difficulty forming an opinion on the merits or otherwise of the Wall Street bailout. On the one hand, I can understand the outrage of the average American taxpayer, in as much as they are in a sense footing the bill for Wall Street’s excesses. On the other hand, I understand the desire to prevent a “freezing up” of the credit market, which would have disastrous knock-on effects for the entire economy—not just in the US, but in the rest of the world too. If the bailout package does in fact achieve this, then I guess it is a necessary evil. But it remains an open question as to whether it actually will help things anyway—indeed, it is possible it may even make things worse. Considering the continued volatility in the stock market since the bill was passed, it certainly doesn’t seem to have had any beneficial effect in the short term. Indeed, the announcement of this package and its bumpy ride through the US house of representatives seems only to have made the stock market even more nervous so far. Perhaps the mere fact that such a bill was announced and considered necessary by the US government has really only served to fuel investor nervousness, whereas if it hadn’t been announced, perhaps the stock market might have recovered on its own. However, the reality of the situation is that we really don’t know—the extreme unpredictability of the stock market is such that we can never be certain what the best course of action is in these matters. And herein lies the problem: the stock market does not seem to obey any sound and consistent rules of logic in its movements, which I think is the crux of the matter here.

Before the stock market, the rules of business were simple and logical: if the profits from the sales of your product or service made more money than you spent producing or delivering them, you made a profit. This meant following simple rules of trying to minimise your costs, while at the same time delivering a product or service that was of sufficient quality and desirability, so that you could sell enough of them to make money. Basically, having a successful business meant giving the customer what they wanted, at a price they were willing to pay, but which still allowed you to make a profit over what it cost to produce or deliver. Even today, many companies have grown into huge, multi-national businesses by staying private and following these basic principles. Perhaps the most famous recent example is Virgin, who expanded into all sorts of new markets from their humble origins as a record label, including starting an international airline, which must be of the most expensive businesses to run of all. They did this largely by giving the customer what they wanted, while cutting out the extras they didn’t, allowing them to deliver a cheaper product and service than their competitors, while still turning a profit. However, the stock market has turned a lot of these rules of business on their head.

For a public company, their primary responsibility is no longer to the customer—it is in fact to the shareholder, which is frequently in conflict with what’s good for their customers. It also means they have to put short term profit for their shareholders ahead of the long term good for their company. Take for example the common practice by public companies of reducing staff. This is one of the few things that is guaranteed to increase their share price, but it very often results in a reduction of service, which is bad for their customers. Even worse, they often end up replacing the staff they got rid of over time anyway, but it is obviously far more expensive to constantly turn staff over than to keep the ones they have, and once again, often results in a reduction of service, as their staff will be less experienced, and will have less well established relationships with their customers. Another example of this sort of thing is restructuring, which pleases shareholders, but often doesn’t produce anything of substance—I’ve lost count of how many public companies I’ve heard of closing branches in certain locations in the name of “streamlining” and “centralisation”, for example, only to open new branches in exactly the same locations later, in the name of “diversification” and “decentralisation”! Public companies partake in these sorts of charades because they know they’re the kinds of things that shareholders like to hear, but of course, this sort of thing only increases costs in the long term. A private company on the other hand simply determines their staffing levels on the basis of demand, and will determine whether to keep a branch open or not simply on the basis of how profitable it is.

But if private companies run so much better than public companies, then why do we even have the stock market in the first place? Of course, the original idea behind the stock market was to allow companies to grow more easily, by allowing anyone to invest in them. However, as examples like Virgin show, you don’t need to be a public company to grow into a huge, multi-national business. Indeed, given the way the stock market works in reality, it may actually be more a of a hindrance to a company’s growth than a benefit much of the time. This is because people (naturally) buy on good news, and sell on bad. But it is during the tough times that a company needs investment, so a lot of the time, when a public company really needs more money to invest in the future, the stock market actually drains it out of them, often running a company with perfectly sound business fundamentals into the ground. Take for example the case of RAMS home loans here in Australia: they were a very successful business as a private company, but they had the misfortune of going public two weeks before the current mortgage crisis started. Although they did have some exposure in this area, it was by all accounts not extensive enough to make them unprofitable. But the general bad sentiment toward home loan companies at the time drove their share price right down, putting this successful private company out of business within weeks of going public! Hence, public companies are under enormous pressure to constantly deliver good news to keep their share price up, even if they are in fact losing massive amounts of money (inevitably leading to such debacles as the Enron collapse).

Even worse, all too often stock traders don’t even focus on a company’s profitability, instead just being obsessed with growth. This is because a company that steadily delivers good profits without expanding doesn’t provide many opportunities to buy and sell shares, which is how stock traders make most of their money. They want the company to grow, even if it is at the expense of profits. A great example of this was the “dot.com bubble”—because the then relatively new internet market provided enormous opportunities for growth, stock traders invested heavily in it. Never mind the fact that most of these companies were actually losing money! Of course, this could not go on forever, so it eventually resulted in a stock market crash. When there isn’t enough real money to back up the profits businessmen are making, something eventually has to give. The current financial crisis is a more large scale version of much the same sort of thing: people borrowed amounts of money that were way beyond their actual capacity to repay, to generate profits for businessmen that in reality weren’t backed up by enough real money. And the really tragic thing is that it isn’t just the reckless businessmen themselves who eventually have to pay for this—because of the knock-on effects the share market has on the entire global economy, we all end up having to pay for its excesses. This is what caused the great depression, and is seriously threatening to do exactly the same thing now.

So what can we do about it? It seems to me that—given that the supposed advantages the stock market provides appear to be vastly outweighed by its proven disadvantages—the ideal solution may be to abolish the stock market entirely. But of course, it is difficult to see this happening in practice, and the short term effects for the global economy could be catastrophic (although to a large extent this could depend on how well it is managed). Sadly, it seems the reality is that we are stuck with the stock market for the foreseeable future, so the best we can do is try to control its excesses. Yet it seems to me that the kind of band-aid regulatory measures that are being talked about now will not do a good enough job. I think there needs to be fundamental changes to the laws governing the way public companies are run, and the liability of those companies and the people running them. It is beyond outrageous—indeed, beyond criminal—that business executives can run companies into the ground, then walk away with millions. Tying corporate salaries and payouts to company performance is a good start, but ultimately, I think what is required is that the people running public companies have to have far more personal liability for them. You can be damn sure they would do everything in their power to keep the company sustainably profitable if they knew that—were the company to go under—they would have to pay a large part of the bill themselves. Why should business executives be allowed to walk away from a failed company without having to take much financial responsibility for it, while their customers, employees and shareholders foot the bill?

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well, here in america, our politicians are masters of ‘band-aid’ legislation. we haven’t had a government ‘for the people’ here in a very long time- i suspect because we have had too many folks in positions of power who want to do away with government oversight and just increase government power over the purse strings. leading economists here warned that this particular bailout bill- part 1 and part 2- were essentially useless except to put money in the pockets of the folks who swindled us in the first place. the looming credit crisis hasn’t been touched so far. i have a feeling that there will be another depression- and the unfortunate thing about this go round- we also have global climate change to contend with.

  
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Otis R. Needleman

Otis R. Needleman’s avatar

We’ve already spent WAY too much on bailouts. 700 billion for Wall Street. 85 billion for AIG, most of which they have already used. 25 billion for the car companies, and who knows how much else for the things snuck into the bailout bill. No more. Let things take their course. The sooner we hit bottom the sooner we recover. Another depression? Doubtful. The only way we got out of the Great Depression was through a global war – no, thanks. Hard recession? We’re getting there.

  
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The problem is that too many CEOs get lucrative stock options for how well their companies perform in the current year, and there are too many investors who get huge bonuses based upon how well their portfolios perform in the current year. As a result, people become too obsessed with how well the company is performing from quarter to quarter and not how well it has performed over the past 5 years or how it will perform over the next 5 years. Every decision becomes short term and long range plans are nonexistant.

Corporations need to seek out the long term stock investor, by providing a steady stream of dividends, instead of keeping profits for themselves and trying to force the stock price to go up.

The problem with the $700 billion bailout is that by the time Henry Paulson proposed it, it was already too late to avoid a major credit crisis. Since July, the banks and the foriegn investors were already too scared to lend money and when Lehman Brothers went bust, that sent everyone running for their lives. On top of that the bailout will take a few months to completely set it up so it cannot help the immediate credit crisis. The Fed decided today to start buying commercial paper, which I think will definitely help the US economy.

The $700 Billion bailout may not avoid a deep recession, but I can only hope that it will keep a long recession from being even longer. Of more concern is how will the next President pay for this. Years of tax cuts and war has put the US severely into debt.

  
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Originally Posted By Gotbeer
Of more concern is how will the next President pay for this. Years of tax cuts and war has put the US severely into debt.

I can’t help but wonder if this has something to do with the present situation – at the very least, it sets a very bad example that the US is able to go into astronomical, record debt without having to answer for it. But of course, somebody eventually will have to answer for it, and an economy in so much debt is one that is far less well equipped to handle difficult times, such as we are having now.

  
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Well, here I thought I was going to log in and correct you on the real reason that stock markets crash, but you nailed it!
Grow, grow, grow! That’s what shareholders want. Sustained profitability? How old fashioned! Who cares if a company can pay its bills, pay all its employees (including the owner/CEO) and still have money left to expand operations naturally?
Business leaders think such a business should borrow money and or sell shares so it can grow faster. The MBA way is to leverage every penny you have to try to squeeze as much growth as possible and then borrow more! Much more!
When an individual loads up on maximum debt and has to scramble each month we shake our heads at such irresponsible spending. But a company? That’s just business as usual. When you’re always in panic mode trying to scrape up enough cash each quarter to pay off all the people you owe, you can forget about quality, customer service, or long term stability. And as we’ve seen, one hiccup anywhere in debt being paid and companies start defaulting in a chain-reaction.
How many times have I seen in the news lately about how businesses are having trouble getting credit “just to pay for day-to-day operations”? Excuse me?! What kind of insane company needs loans just to pay for its daily operations? Any sensible company would pay for its day-to-day business with the income from whatever it sells, with a nice “rainy-day” fund set aside in case of slow times.
Anyway, enough rambling, the way business is run today really sets me off.

  
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Thanks Craig – I couldn’t agree more with everything you say!

To be honest, before I wrote this article, I was a little concerned that I may be missing something, as a lot of the minutia of modern business and economics goes right over my head, and quite frankly makes my eyes glaze over! But I don’t think I am missing anything: I think it’s time we all got back to the first principles of how businesses should be responsibly run. We really ought to be applying the same rules of responsibility to business that we do to individuals – it’s just plain common sense.

  
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Actually, it is not unusual for almost every well run business to need a loan to get by on their day to day operations because of the difference in timing from when they manufacture their product to the time they are actually paid for their product.

For example, the market price of corn may be quite good right now, but before a corn farmer can grow his crop, he may need a short term loan from a bank to buy the seeds, the fertilizer, fuel for his tractors, and pay his farm hands. If he can’t get a bank loan, he could use his savings, but that may mean that he may not have enough money to plant all his acres of farmland. Because he planted less, the amount of profit he makes from the sale of his corn will be less and that will make getting by the next year even harder. If a hundreds of other farmers can’t get loans and are planting less, the price of corn will go up which get passed along as higher food prices, and create inflation.

  
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Actually Gotbeer, I don’t think this is the kind of thing Craig is talking about. In a highly seasonal small business such as farming, I think this sort of thing is understandable. But a public company should be big enough to pay its own way, and will almost certainly bring in capital all year round.

  
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Why does Gotbeer’s hypothetical farmer have more land than he can afford to plant? Because he needs to grow, grow, grow as fast as he can, perhaps?
I can see needing a loan to buy the initial acres and the first crop batch. But saying business has issues with timing between when the manufacture and when they sell is the same as me saying I’ll just run up my credit card to pay my bills until payday, I just have timing issues between when my expenses are due and when my paycheck comes. That’s considered recklessly irresponsible when an individual does it, but your farmer gets a pass because otherwise he’s forced to run a smaller farm than he wants to.
The farmer should be saving enough of last year’s proceeds to buy this years expenses (again I understand in the beginning he may need a loan to get started, and it will take a while to pay that off, but he should work diligently to pay it off quickly and get free of debt), its the same thing as me making sure I have more than enough money to pay all my bills before payday.
And why would next year be harder for the farmer? You say he makes a profit (although smaller than he could have). So he has more money to plant more acres next year, and with no loan to pay off he’s actually in better shape than he would have been.

  
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Personally I have some sympathy toward farmers, as they are very much at the mercy of mother nature – and the stock market. If the stock traders decide to drive down the price of whatever it is they’re framing this year, they will lose money. If a big storm wipes out half their crop, they will lose money. If they’re struggling through a drought (as often happens here in Australia), they will lose money. To a point though, drought is so common here that I think our farmers should be much better prepared for it than many of them are, and I think the present “drought” is actually climate change.

None of this applies to public companies though. They are huge entities benefiting from enormous economics of scale, relatively stable revenue, and relatively predicatable costs – one or two parts of the business may lose money for one reason or another, but their sheer size should allow them to absorb that. If the fundamentals of the business are sound that is, and they don’t borrow too heavily – in other words, if they don’t try to grow beyond their means, as is encouraged by the stock market.

  
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I agree with lots of what is being said here, Sachiko, although I think Craig is going a little gaga on poopooing the benefits of economic growth. I can tell he’s obviously never been to a farm, & has no idea of the sheer financial burdens that are required in order to farm these days, especially if you want to produce crops for an actual profit. I disagree that farmers are at the mercy of the stock market, as crops are not stocks, but commodities, where the prices aren’t determined as much by trading and speculating as by the actual supply & demand for the product.

As for the “growth by all means” philosophy of business, I think it is certainly a bad thing, & this was the whole reason the dot com bust occurred, which really initiated the market problems we are having today. I certainly don’t think, however, abolishing the market would be a smart idea, as getting rid of it would create more problems than there are currently with the stock market (regardless of how it’s handled).

I think that it is imperative now to find a way to make corporate execs more financially responsible for their firms. Ultimately, this is all that can and should be done to avoid meltdowns like this in the future.

  
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Originally Posted By Sagredo
I disagree that farmers are at the mercy of the stock market, as crops are not stocks, but commodities, where the prices aren’t determined as much by trading and speculating as by the actual supply & demand for the product.

This is certainly true for the most part, although I do get the feeling sometimes that the price of commodities is very much at the whim of what is fashionable with stock traders at the time, rather than purely supply and demand as it should be (although once I agree that this is the main thing).

I certainly don’t think, however, abolishing the market would be a smart idea, as getting rid of it would create more problems than there are currently with the stock market (regardless of how it’s handled).

I agree with you in practical terms – if we just abolished it overnight, I can’t see how we could avoid a financial catastrophe in the short term. Perhaps somebody who knows a lot more about it than I do could figure out a safe way, but I can’t see any government being brave enough to do it in any case.

I think that it is imperative now to find a way to make corporate execs more financially responsible for their firms. Ultimately, this is all that can and should be done to avoid meltdowns like this in the future.

Do you have any specific suggestions for how?

  
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I certainly appreciate Sachiko’s lucid essay on this topic, and also the wealth of strong political thinking displayed in the replies. This degree of dislocation of public-owned business and its stock-market aspect from reasonable rules of sound individual financial practice is definitely bringing a lot of unpleasantness to the world of the average consumer.

This scenario had a preview in the time of the stock market crash in 1929 (October then, also?!), going into the political dynamics of Franklin Roosevelt’s election to his first term as U.S. President in 1932. In ’32, as now, things became very uncertain as to who the next U. S. President would be amidst the depression venue, and in the face of certain non-U.S. financial influences that had demands they sought to impose. But this time, the lag between the the first major “fall over the edge” and the election date is much shorter. Another thing that differs is that the size of the “Market” (and its abuses) is now much larger, and encompasses manipulation of trillions of dollars of mortgage resources (such as in “derivative” trades) and the concurrent manipulation of exchange rates of the once-sovereign currencies of all the world’s major nation-states. These latter types of speculation have been encouraged by the sham called “Globalization” or “World Free Trade”. Such policies were made possible by a world-wide push for Adam Smith-style economics, with the discouragement of government protections of the banks and consumers justified by the assumption that “natural” supply-and-demand dynamics would automatically lead to a stable (however imperfect) system. Few public figures seemed to realize that between WW2 and today, one John Forbes Nash Jr. (Princeton, early 1950′s) actually succeeded in formally disproving and discrediting Adam Smith with Higher Mathematics. With a radically different and far more attractive economic model therefore in the works, there was really never any excuse for putatively learned government agencies (or reputable leaders of partisan political groups, either) to keep selling “free enterprise” to the public in the manner leading to the present general breakdown.

Franklin Roosevelt and those that served with him found that imposing and strengthening certain government protections began to work toward a cure for the evolving breakdown crisis… not that everything they did and said was perfect, or would work exactly the same way today. Some think John Maynard Keynes was the great economist of those times, but the stuff he actually pushed was mostly not applied — Roosevelt TOLERATED Keynes, who, in retrospect, really must have worked for people that had no appreciation for the constitutional governments that were trying to get a start in the new world order (eg, Mexico, Brazil, and the U.S. itself, to name a few).

How would we do it today? We certainly need new treaties among the major nations of the world RIGHT AWAY — and China, India, Russia, and Brazil have already come forward with proposals for an emergency stabilization of international monetary exchange rates, actually inviting the U.S. to go along. That is shame (for the current administration especially), that the U.S. wasn’t much more of a leader in getting on top of this sickness, instead of first becoming such a victim of it, before any “Rooseveltian” remedies were considered. (In the case of exchange-rate treaties, that would be a new “Bretton Woods” agreement.) What we’ve seen so far are pitiful attempts to maintain the trappings of “business as usual”. Now, it looks like the U.S. needs to pitch in and trade a large number of double-, triple-, and quadruple-breasted suits for the proverbial tar and feathers. Certain perpetrators are likely to exposed, and should go behind bars (not the kind where drinks are served, nor those in the elite parlance of lawyers).

All the while, the media (mostly under the control of elitist financial oligarchs) is lying to the general public all over the world — the$700B bailout not only is NOT showing signs of working, but is also only a trial balloon for the real world-wide public swindle that is intended. For the U.S. alone, we are looking at a demand for immediate tribute about seven times greater than Paulson’s bailout. The tack taken by the Treasury should be just opposite: they have loosened up credit for the “big guys” with low interest rates on “Fed” disbursements, allegedly to “stimulate the economy”. They speak of 1-1.5% interest, when the EU demands 5%, imposed on cash flow rates in trillions of dollars per year. Same planet, same system, folks…what does that mean for the U.S. dollar value, not to mention this thing called “general welfare” that the Constitution is supposed to protect? Different kinds of loans should bear appropriate rates, also. The LOW U.S. rate should only apply to INFRASTRUCTURE investments for the U.S. itself, which it needs to put people back to work on repairing, rebuilding, enhancing, and expanding the REAL property and REAL economy of the U.S. (And other nations would be thereby encouraged to do likewise, sometimes in collaboration with the U.S. for special projects.) And the HIGH rate? Any sort of speculators should have to pay (personally) VERY substantial and competetive interest rates to gamble with public funds in ANY country.

In 2007 many State and local government entities in the U.S. signed onto a draft of a “Bankers’ and Homeowners’ Protection Act” (or something like that). At the high levels of the U.S. Federal Government, such voices have seemed to fall on deaf ears so far. But the proposed “pre-bill” has an international following, and is very clear about certain protections and general welfare concerns. One priority would be to freeze all mortgage foreclosures (or even evictions?) immediately, while the government would take as much time as necessary to organize a systematic auditing procedure, and establish appropriate long-term property and financial asset evaluations with fair tax and repayment liabilities. (This might even require new currencies to be designed and printed.) Thus, there would be an emergency action prescribed, now overdue, followed by a long-term mathematical study and application, which would put think-tank people to work on something useful, once again, rather than chronically money-hungry bureaucratic manipulations.

We could go on and on from here, breaking the above suggestions down into a lot of particulars. But I would mostly hope our descendants will carry this ball more successfully, perhaps in spite of the ragged mess it has become in the hands of my age-class.

  
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Thanks for your comments Alcove6409 – you certainly seem to know a lot more about economics than I do! I was wondering why they don’t put a temporary freeze on mortgage foreclosures as well – it seems that the logical way to deal with this crisis is from the bottom up, rather than the top down. The “Bankers’ and Homeowners’ Protection Act” you mention sounds like a good starting point: help the people struggling with their mortgages, and it should in theory have positive flow-on effects for the whole economy. Then you’ll be helping the people who are the victims of this crisis, rather than effectively rewarding those who have profited from it (I certainly agree about the interest rates too).

  
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If you want to see some of the lies involved in the current basket of bailout initiatives and other nonsense, read back a few months on these sites:

http://market-ticker.denninger.net/
http://globaleconomicanalysis.blogspot.com/

What you hear on the TV news and read in mainstream business or investing news or websites is less than half the truth. The much discussed $700 Billion bailout bill is the most misunderstood issue today, and the other things going on under its smokescreen are far more important in the long run.

  
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