Wanting the Downturn to be Over

Like all of you, I want this downturn to end soon. Everyone who owns property or investments for retirement has seen their net worth plunge this year.

Many people are saying we are at the bottom and that now is a good time to invest again. I hope they are right, but I am not sure yet.

With the stock market down about 50% worldwide, this ought to be the bottom, compared to previous recessions. However, I wonder if we might not see a a second stage of this sell off in the next 3 - 6 months. I have no crystal ball to predict next year's headlines, but if they are as grim as what we have seen in recent months, it could mean more bad news for the markets. Furthermore, governments have reduced interest rates to virtually zero and maximized monetary and fiscal measures. If this huge amount of stimulus fails to break the downward pattern, we could be facing a long economic winter.

But even if my pessimism proves wrong about the stock markets, that would not automatically mean that that the broader economy will turn around quickly. On the contrary, I expect unemployment to rise for several years. I expect retail sales and manufacturing activity to decline for 1 - 2 years, if not more.

Obviously, I hope my gloomy assessment proves to be wrong. But many years ago I learned the error of assuming what I want to happen will be what actually occurs. My favorite sports teams and politicians win occasionally, but lose more often. I find it helpful to retain dispassionate objectivity even when I am sick and tired of watching disasters unfold.

So I am not buying into a recovery yet.

Obama’s One-Time Opportunity: to Restructure the American Economy

With worldwide equity markets down by 40 – 50%, it seems virtually certain that we are already falling into a depression. Hopefully it will be far smaller than the Great Depression of the 1930’s where the economic contraction was 40%. But a 10% or a 20% contraction of GDP is a realistic scenario in this dire situation. Already in March the Gallup Poll found 60% of Americans said a Depression is likely; today I suspect most Americans would admit we are already there.

President Obama is right to offer hope for the long term and to show compassion to those most injured by this storm. However, unless he tells Americans soon how terrible the economy is already, he will certainly get blamed for the inevitable continuing catastrophe. The American people can handle a candid assessment and will sacrifice to make the changes needed for an eventual recovery. But minimizing the challenge now will soon shift the blame to Obama, who didn’t create this regrettable state of affairs.

It is customary for a new CEO when taking over the management of a company in distress to clean house and to lower short-term expectations. This involves examining the books and disclosing hidden losses. It allows a more realistic set of goals to be pursued without useless baggage from the past, which should be thrown overboard.

The plunging financial markets have signaled severe economic deficiencies. Some people naively believe that our main challenge is how to restore the stock market and the housing market back to their former levels. But the precipitous stock market decline is due to a very sick American economy, not just an isolated problem in the financial sector.

What we are witnessing is not only the failure of some of the largest American banks and corporations, but also the financial disintegration of the government. Conventional wisdom says that the government must use every fiscal and monetary measure available to restore confidence and to increase consumer spending to help avoid world recession. But I see it differently.

Let me explain why. My international banking career has trained me in credit assessment of both corporations and of national governments. What has become abundantly clear to me throughout my 35 year financial career is that size alone is insufficient to protect any bank, any corporation, or even an entire nation from financial collapse.

So restoring economic growth alone will not restore our fortunes. In fact, too rapid growth – in house construction, in stock prices and in energy consumption – has caused the present problem. The US (and world) economy is entering into a time of intense contraction. This is a necessary antidote to the haphazard growth.

By every normal measurement, the US government’s financial health is poor and deteriorating rapidly. Let me put some numbers to this by comparing the United States and China, which are respectively the most profligate and most disciplined major economies in our world.

Although China’s economy is half our size, it has been growing 6 times faster. That rapid growth comes from having a three times higher national investment and savings rate.

China consumes 6.93 million barrels of oil per day, compared to America’s 20.8 million barrels of oil per day, despite having a four times greater population. That is the main reason that China enjoys a $300 billion trade surplus compared to our $900 billion trade deficit. It is also the reason we are the largest debtor nation and they are our largest creditor.

Consequently, our national debt is $14 trillion, 34 times as great as China’s debt. What is more, China’s treasury holds $1.5 trillion in gold and foreign currencies, while we have only $71 billion. Our financial cupboard is bare!

Putting the United States on a path to recovery of its financial health is an immense undertaking, but let me sketch out the top priorities.

• Guard the federal treasury against quick depletion. The titanic struggle to regain economic health will take years, if not a full decade. Every dollar of government resources is precious and should be used frugally. The government doesn’t have an endless well of financial resources.
  
  
  
• Reduce energy consumption drastically
  
  
  
• Balance imports and exports
  
  
  
• Reduce foreign borrowing
  
  
  
• Increase domestic savings and investment
  
  
  
• Discourage debt-based consumer spending
  
  
  
• Reduce military spending
  
  

These priorities would help restore America to an economic superpower once again. Here are a few specific suggestions:

1) Introduce gas tax measures to reduce energy consumption by half. While we should improve domestic oil production and develop new energy sources, these alone will never offset enormous energy imports. Why not follow Europe and most of the world by taxing energy much more? Their energy conservation plan has been proven highly effective for decades. Japan consumes 38% less oil per capita and Germany uses 53% less than Americans. That gives them an enormous economic advantage.

I suggest raising retail gasoline prices to the level of the rest of the world. Higher taxes should also apply to industrial energy consumption. This is a bitter pill, but the only alternative is continuous financial decline until this oil-import haemorrhage stops. The lessening oil consumption will do immense good for the environment. The tax revenue from this program could fund further tax cuts or new social programs.

2) Avoid huge bailouts to GM and other bankrupt companies. GM (together with GMAC LLC) has total liabilities of over $200 billion against $5 billion of operating cash flow during its best recent year, before the massive losses began. Even if GM recovered miraculously to its previous earnings in 2005, it has $150 billion more in debt than its cash flow could ever service. GM needs rescue, but after it goes though the bankruptcy courts. Why should the Federal Treasury shoulder an unnecessary further $200 billion for GM alone, which will only result in extraordinary gains for shareholders and creditors?

The current request by the three large automakers is disingenuous, to say the least. GM alone is losing $5 billion per month. Once the government steps in, the market will expect a continuous financial lifeline, which is in fact an implicit government guarantee. This would ultimately cost several hundreds of billions in the long term, like with Freddie Mac and Fannie Mae.

Airlines have demonstrated repeatedly that the bankruptcy mechanism rarely grounds planes permanently. They provide for an orderly restructuring. GM and the other car companies should be drastically restructured before tax payers help out. The priority of keeping a vigorous American car industry is worthwhile, but not at such a high cost.

3) Reduce consumer debt costs, particularly among the poorest citizens. Historically, American states restricted interest rates to 6%, 10% or 12%, but gradually this was raised to over 30%, and now there is no limit whatsoever on consumer interest rates and other excessive fees for debt. Why not limit consumer interest rates to 15% or 20% by federal law? This would discourage the spiraling growth of credit card debt and other consumer debt, which cripples low wage earners.

4) Provide much larger incentives for saving & investment. The United States has had the lowest personal savings rate among major nations for decades. Recently the savings rate has been about zero, when personal borrowing is netted against savings. Most of the leading economies apart from the USA have had high savings rates: Japan, China, Germany, and most of Europe. This is what pays for industrial investment.

Repairing the Damage — After the Global Firestorm

(This blog was previously published at The Huffington Post on October 30, 2008)

My father often told me the story of going into Tessmer’s General Store in Hartville, Ohio one day in1929, when he was 23 years old. Old Mr. Tessmer looked up at him from reading the financial pages of the newspaper and said: “Young man, you don’t understand yet what this stock market collapse means. But next year you will understand it.”

The jury is still out on how big the current financial firestorm will become. Is it a prelude to a deep recession? Is it the onslaught of an actual depression? With the unpredictable swings in the stock market, some people think that a recovery may already be starting.

I don’t have a crystal ball, even though I anticipated this crisis in various blog posts . On March 8, 2007, I wrote:

“Sooner or later, we will see fierce worldwide economic storms that make the Indonesian Tsunami and Hurricane Katrina seem like small local incidents. At some point in the coming years or decades, stock markets will likely plunge around the world in dismaying amounts. Potentially we could see 20%, 40% or even 60% of equity values wiped out in a very short time.”

I became increasingly apprehensive that soaring market exuberance would give way to severe financial disintegration. Opinions vary whether this was an inevitable long cycle wave as opposed to just poor management by government combined with new heights of corporate greed, or perhaps both.

It started out seemingly as an American crisis, but the infection is now truly global. The 35% drop in American stock prices is not as severe as the plunge in Europe and Asia. Foreign currencies have taken a battering not seen in 70 years. We are beyond doubt in global financial chaos.

Global commodity markets have participated in this pandemonium. After a market run-up larger than any seen in 50 years, we are now seeing a colossal commodity slump. Energy, metals, agricultural products, building and industrial supplies are now in massive oversupply.

What started in the financial sector has broadened quickly to most other industries, particularly automotive. Early indicators show consumers are dramatically curtailing purchases of nonessentials.

We are in a tailspin of historic proportions which cannot be sorted out with a few global meetings of world leaders. Regrettably, Humpty Dumpty cannot be put back together again by “all the king’s horses and all the king’s men”.

Hopefully, we will elect President Obama, not President McCain. But even Obama will not be able to fix this mess any time soon. Perhaps Joe Biden was politically naïve in acknowledging an inevitable crisis of confidence – but I for one agree with every word he said. People like me who supported Obama from the beginning will have our faith severely tested. Franklin D. Roosevelt was perhaps the greatest President of the 20^th Century, but he was unable to fully fix the economy in the 1930’s, even though anyone else would have surely done worse. And like Roosevelt, Obama is bringing hope and vision when these are in short supply.

Governments around the world need to provide emergency relief – to their financial institutions, to major industries, and to their poorest citizens. But the well of government resources is not infinite. Essentially, government can only provide credit or subsidy, whether to home owners or to businesses and financial institutions. These require government borrowing, which will ultimately be offset by either increased taxes, or by resurgent inflation; neither is desirable.

There is no magic cure for a situation that was built up by many years of bad decisions by most of us. Consumers took on too much debt to finance homes and cars. Companies paid extravagant bonuses for very short term growth, which should have been retained as equity for future development. Governments opened the monetary and fiscal floodgates in foolish spending that did not address the most important needs like healthcare, energy conservation, and industrial restructuring.

So now, many people are on the ropes. Seniors about to retire have lost up to half of their retirement funds. More and more people are losing jobs, whether white collar or blue collar, so they will be unable to service their debt loads.

Digging ourselves out of this deep crater will require our combined efforts at every level: by individuals, families, companies, schools, and governments.

I wish I knew how much longer the stock market gyrations will last; perhaps another few weeks or for several more months? But I expect that in the aftermath of the financial storm, the needed economic restructuring and full recovery will take quite a long while.

What Lies Ahead: Recession or Depression?

There is an old aphorism that when your friend loses their job, it is a Recession but when you lose your job, it is a Depression.

In fact, the term “Depression” has almost gone out of use now, except for referring to a psychological state, or, in historical reference to the “Great Depression” of the 1930’s.

Prior to 1929, there were a number of “depressions”, but since the Great Depression, we don’t even use this “D” word anymore. In fact our governments and economists have mostly avoided the word “recession” as well. However, now everyone concedes that we are experiencing a full-blown global recession, at minimum.

But might we be plunging into something worse than a recession?

Since the 1930’s governments have used three methods to contain economic downturns:

· Fiscal stimulus based on the theory developed by John Maynard Keynes, a British aristocrat-economist who advocated major government intervention to manage recessions and depressions. He recommended tax cuts and/or more deficit spending to give consumers the ability to spend and thus to restore a general sense of confidence in the economy.

· Monetary stimulus which also was strongly advocated by Lord Keynes, but later considerably refined by University of Chicago economist Milton Friedman, who greatly influenced the development of Macroeconomics. Milton Friedman argued that monetary growth needs to carefully pace productivity growth and consumer demand, or else inflation becomes rampant, since excessive expansion of the money supply is inherently inflationary. His theories enabled developing world countries suffering from hyperinflation to stabilize their currency and to achieve balanced growth. Now Friedman’s officially enshrined concepts guide the European Central Bank in setting their monetary targets.

· Managing consumer and market psychology. This is the favourite technique of all modern governments. I would love to attribute this populace control method to Machiavelli, but there is considerable evidence that spin control was already well understood thousands of years ago by Chinese and Roman emperors.

If I were an academic, I would love to write a book on the thesis that American governments since the 1980’s have been trying to stamp out recessions permanently, but regrettably without success.

Instead, they have created an unhealthy economy where excessive monetary and fiscal stimulus produced unnaturally high growth of the housing and stock markets. This paved the way for the current global financial meltdown. (This ill advised policy was more fully described in my blogs last January and February.)

We are now likely plunging into a global depression. Time will tell if it will become a great depression on the scale of the 1930’s, rather than like the more ordinary-sized depressions of the 19^th Century.

From my experience as a banker and CFO, I doubt that the global capital markets and financial institutions can be fully repaired in less than three to five years. Meanwhile, companies will have little access to either credit or to new capital. Industrial production will soon suffer drastically, as is already evident with automobile sales declining for lack of credit.

This crisis has now become much, much more than a “subprime mortgage” problem, although that may have been the trigger. Banks are starting to fail worldwide and central banks are desperately offering billions in fresh credit (printing money) to stave off a complete financial shutdown. So fasten your seat belts. This may be the mother of all bumpy rides.

Far too little has being written about this impending depression in the mainstream press, but I suggest reading an article published October 5, 2008 by Tony Jackson, in the Financial Times of London “Parallels with 1929 highlight need for radical thinking” (http://www.ft.com/)

But don’t panic. Our ancestors lived through worse crises successfully many times. We currently enjoy a standard of living unparalleled in world history. If necessary, many of us could cut our expenditures by a quarter, which is probably what we will need to do for several years. Communities and families need to work together to alleviate suffering for those hit the hardest.

We must find ways to restructure our economy on a more reasonable basis. The recessions that were avoided during the past few decades by excessive government intervention would have made industrial and financial restructuring more gradual. However, now we need to do it aggressively, depending on massive government guarantees. Our challenge is to put our financial and business structures back together right.

On Money and Wealth

In this time of economic challenge it is worthwhile to reflect on the difference between money and wealth.

Many people have been shocked by the financial and housing crisis; some of us may have lost part of our net worth (or retirement savings) measured in money. But we may not necessarily be losing much of our true wealth.

In working with millions of dollars during my financial career, I have been astonished that people rarely think seriously about what money truly is, even though they work so hard to get it.

Money simply measures how much we owe to others and/or how much other people owe us in terms of future goods and services.

If you study money in ancient times, you will find that started out being any commodity with which you could barter – such as salt, or grain or gold.

Later, kings began to mint coins made of gold, silver and other metals, which they used to standardize the values in trade transactions.

In our modern era, we have abandoned the “Gold Standard”. Governments now print money as they believe it is needed for their economy. Money is created at central banks, like the US Federal Reserve Bank, or the Bank of England.

In essence, money has evolved to becoming a series of accounting entries between central banks, commercial banks, corporations and individuals, which are utilized for the expansion of credit.

Regrettably, with this new flexibility to create money, governments have created money too quickly, which is why gold has risen dramatically in price.

Monetary expansion originally brought us rapidly rising stock markets and much higher prices for houses, but now we are discovering that our savings are being devalued by increasing inflation.

Furthermore, the world monetary system has become destabilized, which is why global stock markets have dropped so much in 2008.

What does all this mean to you or me?

Money as a scorecard is neither stable nor entirely accurate. Despite having lots of money, we may not feel rich. We might even suffer from anxiety or depression.

Wealth, on the other hand, is defined as having abundance or plenty. (An example which illustrates the meaning: “She brings a wealth of experience to the project”).

Wealth includes having plenty of both material and non-material resources. To be wealthy, is to have plenty of what you truly need.

Many of the greatest things in life cost us little, such as music, books, walking in beautiful places, conversations with friends, etc.

Wealth includes having a healthy body and mind together with emotional stability.

Wealth consists especially in having strong relationships: in marriage, family, community, and at work. These relationships are vital. No matter how rich we may be in money, without these we are poor.

Once while traveling on a corporate jet, I was struck by the realization that if I should lose my high-paying job and all my net worth, it would not be so tragic, if I still had my wife and children. But if I should lose all my family and my friends, I would be heart-broken. That is my real bottom line.

When I made some money through taking a company public, I was glad about my good fortune. But it did not make me noticeably happier than I had been in previous years, which I found surprising.

I have watched people accumulate large sums of money, but I have rarely seen it bring happiness. Some of the richest people that I know are sad and lonely.

Does this mean that money doesn’t matter? Of course not! All of us need money every day, like food and water.

Beyond a reasonable amount to meet our basic needs, having lots of money doesn’t usually bring great happiness. However, if we use it to benefit those around us, it can help to improve everyone’s wealth. Philanthropy is the only way of gaining true satisfaction from a big bank account.

We can enjoy wealth in both good and in bad economic times. Our monetary net worth will always fluctuate, sometimes wildly. But our true wealth will remain stable if we are working towards the right objectives.

Money is just a means to an end, not an ultimate goal in itself. Having this perspective is immensely comforting when times get tough.

More Economic and Investment Woes Ahead

The last 6 months have been appalling for global stock markets and, furthermore, tragic for ordinary people who work and shop for their basic supplies.

I see no room for optimism about the economy, particularly in the United States. The worst economic news is likely still to come.

What commenced as a stock market and housing market correction in the USA now is intensifying into an enormous financial storm, which will likely spread globally.

Most of the fundamental factors remain as I have described them in my blog posts during the past 2 years. This severe financial crisis is the result of a decade of expansive fiscal and monetary policy, which tried to forestall necessary economic adjustments; now we face a gigantic day of reckoning.

Inflation is finally getting some attention, but it is now too late for a quick cure for this pernicious cancer. American monetary policy has been lax for several decades, so a little tightening now will yield very little result. We will get used to “stagflation”, which is economic stagnation combined with inflation.

Global demand for energy and basic materials will outstrip the supply for a while longer, so the litany of high gas prices, rising inflation and disappearing jobs will continue for a long time

I have no favourite investments to recommend in this kind of economic environment. Keeping your money in cash is discouraging, because the value of money is falling due to significant inflation, far more inflation than governments admit.

Governments report statistics for “inflation adjusted for energy, food and other abnormalities”, which means they exclude the things that are costing us more, in order to report a smaller inflation number. Any shopper knows that inflation is worse than reported.

Bonds are not a good investment now since interest rates will soon have to rise, so the prices of bonds will likely fall. Stocks are still dangerous in my view despite having fallen considerably in the past 6 months. So fasten your seatbelts.

The only real and lasting solution to our economic woes will be an ultimate return to economic prudence: by workers, by consumers, by banks, and by governments. We need to stop living on credit cards, bank loans, and government printing of money. We need to save before we spend.

Individuals and companies must return to solid work on good products and services which people can afford. The American economy in particular must face up to living in the real world.

Voters and politicians look for quick solutions and for scapegoats, but there are none available. High energy prices are not due to nasty speculators but rather due to our profligate consumption of disappearing resources.

(“Profligate” means utterly and shamelessly immoral or dissipated; thoroughly dissolute; recklessly prodigal or extravagant.)

No amount of new drilling for oil or new energy technology will enable us to maintain the consumption level we want. We must get used to high gas prices and airlines reducing their routes and charging us far more to fly.

We can, we must, and we will adjust to this harsh new economic reality. We could live on much lower consumption, as our families did successfully in previous generations.

Our choice is whether to reduce our spending quickly and voluntarily now, or to complain loudly, hoping vainly that the government can rescue us. The government does not have the resources to do this, regardless of the promises made during election campaigns.

Outside of the United States, conditions are not quite as dire yet. Canada is still doing OK. That is because the Canadian Government has maintained balanced budgets for a decade and now is enjoying the surplus from increased energy revenues. But most countries are doing worse.

Economies in Asia are still growing somewhat, but watching their biggest markets contract. The Chinese equity market has experienced a dramatic and much needed correction. There is considerable debate whether the rapidly developing countries will be able to escape the worst of the economic storm. Who knows?

Life can still be good in these reduced circumstances. This is a time to return to fiscal prudence and to enjoy the things which don’t cost much money – like friendship, family, nature, music, books and much more.

What is Good Communication?

I have always been fascinated by communication, whether in writing, public speaking, or conversation.

I was asked recently to teach a group of intelligent young bankers from Shanghai about communication in an English language business environment.

English is not their first language and so they make obvious mistakes in our language. I fully sympathize, since I understand perhaps a hundred words in Chinese. My daughter Jenny got her University major in Chinese and has gone to China for further language training, but still considers her skills quite inadequate, compared to native Chinese speakers.

So my teaching challenge was not to improve the English skills of my Chinese friends, which would have taken far too long. This was also unnecessary, since their command of English is already quite good for someone working in Asia. So I focused instead on what makes good communication, apart from expert language skills.

I thought of good and bad communicators I have known: for instance, there was Charlie, a Harvard graduate with a PhD. in economics who had an astounding vocabulary, but unfortunately was still a poor communicator. Then I remembered various immigrants and poorly educated business people who nonetheless became highly effective communicators despite their inadequate English.

After reflection, it became obvious that communication depends on something more fundamental than just language skills. Good communication requires a certain attitude, a willingness to share our inner thoughts and emotions, and to reveal who we truly are beneath our external appearance.

I wrote a previous blog on June 28, 2007 on Social Skills and Relationship Skills, which touched on some of these issues. I said building good relationships – whether in business or in our personal lives – does not depend primarily on charm and dazzling conversation, but rather on integrity, sincerity, empathic listening, and consciously nurturing important relationships.

Communication needs risk-taking, vulnerability, and passion. It requires reaching out to a person, or a whole group, to develop a closer relationship of trust.

Communication should normally be enjoyable to both the speaker and to the listeners. Humour and stories help this.

Good communication requires careful choice of the words we use and also attention to the response that we are receiving. It must be interactive, not a one-sided monologue. We should be brief and concise.

Communication becomes alive when we act out our thoughts and feelings in a spontaneous natural fashion. A formal speaking style inhibits this.

Communicating to a larger audience requires reflection and preparation so that we can get our points across without wasting time. A speech or essay needs a central thesis which is clearly stated with supporting facts, arguments and illustration. These should lead the audience to a reasonable, yet important conclusion. Making things plain, simple and understandable enables success.

Speech and conversation involve our whole person, especially face and eyes. Looking at our audience and trying to interpret their response is essential.

Body posture is also influential. Erect, confident posture inspires a positive reaction. Defensive posture and not looking at our audience detract immeasurably from our message.

I am still struggling with how to communicate better, especially in writing, where live interaction with readers is difficult. Some of you send brief notes with encouragement, criticism or questions, but mostly I write in sort of a vacuum. Meeting with people in person is more satisfying.

However, writing is the best way to communicate important ideas across both space and time. Despite the constant struggle, it is my most creative endeavour.

Business Success should be measured by friendships made and community established

As a young man of 30, I was selected over several older candidates to start up a commercial banking office in Vancouver for ABN AMRO. Although I had enjoyed a good career up to that point, I was struck by this enormous opportunity to build something completely new. What would it look like? What should be the main goal for this new office?

I finally decided that my paramount goal was to build up a business where all employees had the potential to enjoy and fulfill themselves on the job – to build a real workplace community.

My office did become a great place to work and it was also highly successful by any financial measure. It became the largest and most influential foreign bank office of its kind in Western Canada. What I discovered was that happy employees gave their customers superior service, which enabled the office to grow and become profitable.

I was thrilled that many of the employees told me this office was their best workplace ever during their entire career. Many of these employees still meet together to remember the good years we enjoyed as a big happy family (with a few normal squabbles, of course).

I later worked with some of the people from that ABN AMRO office in my other executive assignments. There are several colleagues with whom I have worked with repeatedly over 2 or 3 decades, due to lasting we friendships formed. And after 3 years of retirement, I still correspond frequently with friends that I worked with.

I wish I could say that my business career was an unbroken success story from start to finish – but I would be lying. Few careers really go that way. We all face tumultuous waves of challenge. Economic downturns, organizational chaos within big companies, unhealthy politics, and wrong-headed bosses make survival in any career hazardous, even when your own performance is superior. It is like being a great sailor on a small boat on a stormy ocean. Sometimes just getting home alive is a big accomplishment.

Fortunes of companies depend on countless factors, many of which are beyond management control. However in my experience, the best guarantee for organizational success comes when management is totally dedicated to the interest of all their staff; when it becomes a real community in the work place, a big happy family.

Two of the best run businesses in Western Canada – an airline and a bank – use this formula. All employees are shareholders and receive significant rewards when their organization succeeds. The Canadian Western Bank has had the highest stock price growth for the past 5 years of any bank in North America. The airline – WestJet is a pleasure to fly with as well as decidedly successful financially in a time when making any profit whatsoever seems difficult for the airline industry.

So is working for growth and profit wrong? Absolutely not! Both goals are essential for any company to survive and succeed. But if they are the only objectives, I believe the business will have a lower chance of success and it won’t become a friendly workplace.

Both human values and financial values are immeasurably significant in business. But when these values conflict, I always value people more than money. Business choices which put finances ahead of people rarely succeed in the longer run. But seemingly few companies have embraced this vision yet.

Gambling, Speculation and High Risk Investments

Here are two quick stories of people I knew well.

“Jim” (not his real name) was a close friend of our family. He was a very bright young man from a well-off family. Jim was sharp, persuasive and passionate. Unfortunately, his life didn’t work out for him at all.

Jim missed out on opportunities that should have worked for him. Then he found what seemed to be an easier way. His college instructor introduced Jim to a sure-fire mathematical system to win big money at gambling.

Before long, Jim had lent his new friend all of his money for their mutual gambling experiments. Soon, he had also used up all of his credit cards. He borrowed heavily from his friends, giving every reason but the true one. As he lost the trust of his friends, Jim sank deeper into debt and depression. Getting lucky at the gambling table seemed the only solution to him. Finally, after borrowing money from loan sharks, who beat him up, Jim chose to kill himself with a drug overdose, at the age of 22.

Second story: another young man I know well (“Sam”) inherited lots of money. Sam had an Ivy League college degree. He had several fine cars and spent his money freely. One day, Sam discovered the excitement of day trading. Although he told wonderful stories about his success, he lost everything when the NASDAQ high-tech market collapsed in early 2000. To his surprise, when Sam was broke, he couldn’t even find work at minimum wages because he lacked any recent job history.

What these two tragic young men shared was a mistaken belief that there is a quick, easy way to get rich. Jim and Sam sincerely believed that because they were quite intelligent, they would have the skill (and luck) to make it big outside the mundane world of hard work and patience.

They are not alone. When I watch people gamble away their hard-earned money in risky investments, I cringe. I feel sick in my stomach. It is like watching an approaching collision from a distance, with no way to stop the inevitable wreck.

This kind of irrational behaviour is not confined to the young and inexperienced. I have known many senior citizens, successful business people, and intelligent professionals behaving in a similar fashion and losing their money ever so quickly. Many have done it by simply following the advice of their stock broker or investment adviser.

Let me suggest a few rules to avoid tragic investment losses:

• Any investment that sounds quick and easy is likely to fail quickly.
  
  
• If someone parades impressive credentials or uses complex arguments in trying to sell you an investment, avoid it like the plague. I once invested a in a high tech company because its very distinguished chairman persuaded me that the company had enormous potential, even though I didn’t really understand his business. Within a month, the company was bankrupt.
  
  
• Don’t ever put all or most of your eggs in one basket. Spread out your investments into many parts, so that if one of them fails, you won’t suffer a catastrophe. Stock market indexes and mutual funds provide more diversification of risk than any individual stocks.
  
  
• Don’t expect to make large returns. Warren Buffett, perhaps the greatest American investor, warns against looking for returns greater than 6% to 8%. You may sometimes get lucky with a sound investment when the market is strong and make 15 – 20% on your whole portfolio for a year or two. But those instances will be offset in the longer run by investments that lose money in a bad economy, like the one unfolding at this moment. Long term investment returns rarely average above 10% for even the best people in the investment business.
  
  
• Avoid start-up companies, companies that are claiming a quick turn around, and/or innovative technical concepts which you don’t fully understand. At most, I would put a fraction of 1% of my money in that kind of situation, even if it sounded absolutely wonderful. Statistics don’t favor these kinds of investments.
  
  
• Avoid any investment which claims there are no risks involved. Even US Government bonds and bank deposits have some risk. Most investments have far greater risks; if you can’t see what these risks might be, you don’t understand them yet.
  
  
• Avoid any investments proposals made through the internet, from ads coming in the mail, or by telephone solicitation. They are hard to check out thoroughly.
  
  
• Also, avoid investments recommended to you by your friends. It is too tough to remain objective.
  
  
• All investments, whether in stocks, commodities and bonds can sometimes go down sharply. I have never met anyone yet, even a billionaire, who doesn’t lose money on some of their investment picks. They are lying if they tell you otherwise.
  
  
• Keep most of your money in the bank or in government bonds unless you can afford to take big losses. In the current economy, some of the world’s largest companies are seeing declines of their stocks of 10%, 20% or even 30% within a few months time period. If you believe that you can always tell the good stocks from the bad ones, I would like to recommend psychiatric help for you!
  
  

Gambling is a vice to be avoided, especially gambling with your precious savings on stock market or other investments. Investment is a humbling and risky business. To have long term success you will need to spread out your investments among very well proven assets. Trying to get rich quick is a path to financial disaster. Sound investing is mostly dull.

Postscript

My gloomy outlook on the world economy and financial markets (as expressed in my blogs during the past 18 months) is proving out to be correct. For what it is worth, I believe we are at least one or two years away from the bottom of this massive downturn. Beware!

Fed to the Rescue?

Before today, I had never heard of Professor Nouriel Roubini of New York University’s Stern School of Business, who is reported in the story below from the Financial Times. But readers of my blogs over the past few years will have noticed my similar views about the degenerating American economy. And I have previously mentioned the Financial Times of London, available online at http://www.ft.com/world. This paper, together with The Economist and others, have provided more objective reporting than is available in the mainstream American financial press.

One of my readers has pointed out the sharply declining non-borrowed reserves at the Federal Reserve system. I should warn you that I am a generalist in in economic matters, not a specialist on the banking system. But I have long been aware of the developing credit crunch, which is the result of countless bad loans, as mentioned in my blog of January 21 about the Big Time Debt Crisis.

Very briefly, I want to clarify that I agree that the Fed and the American Government must do whatever is needed to prevent widespread bank failures. However, going beyond that in vainly trying to stave off the necessary contraction of the stock market and housing prices would ultimately lead to a worse outcome (as I pointed out on February 4, 2008).

The banking system and the overall economy need a return to disciplined management, not perpetual bail-outs. The time for adolescent behaviour is past. The government and financial system must grow up and take the necessary medicine. This will not be pleasant, but the alternative is unthinkable. We need a return to sanity and sober economic principles. No government should stand in the way of necessary economic corrections. They provide cleansing for the whole system.

America’s economy risks mother of all meltdowns

By Martin Wolf

Published: February 19 2008 18:21 | Last updated: February 19 2008 18:21

“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.

That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”

Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

*A Coming Recession in the US Economy? July 17 2006, www.rgemonitor.com; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008

martin.wolf@ft.com

Copyright The Financial Times Limited 2008

Stop the Press: More Fiscal and Monetary Stimulus won’t fix the ailing American Economy

The traditional response to financial problems by Latin American, African and other third world countries has often been to print more and more money on their printing presses, which then unleashed enormous inflation and devalued their currencies. University of Chicago economist Milton Friedman gained worldwide acclaim by proclaiming that central banks must carefully control the growth of money in every country, or else the economy will suffer and stagnate. The Government of Chile imported his theories and gradually transformed their ailing economy into the most successful economy in South America; other countries later followed this proven model.

Surprisingly now however, the Government of the United States is behaving like a 3rd world country in choosing high monetary growth plus record fiscal deficits, desperately hoping to avoid a looming inflation. I believe these policies are a recipe for disaster.

Imagine a patient who goes to his doctor and says: “I want you to keep me healthy and to make me feel good all of the time. The way I know that I am healthy is by always feeling good. So never let me feel bad.”

The doctor obliges this unreasonable patient and at every visit prescribes more and more pills, but ultimately the patient becomes chronically ill. The patient has also stopped feeling good, a long time ago.

The doctor is the American government (Dr. Bush and Dr. Bernanke) and the patient is the American population who elects their government. The pills are fiscal and monetary stimulus.

This is not a perfect metaphor, but it comes close to the actual situation. The doctor has erroneously come to believe that with increasing doses of pharmaceuticals, no patient should ever get unhealthy or need to feel bad. So the doctor has prescribed these magic pills in ever increasing doses; regrettably, the patient is now looking and feeling just awful.

These expansive economic policies are not entirely new. They started gradually under Doctors Clinton and Greenspan at the beginning of the 1990’s. Since then, America’s trade (or current account) deficit went from a balanced position to an annual deficit of $850 Billion. The American federal deficit widened to over $400 Billion, partly to pay for the Iraq war.

A lot has been written on this distressing topic, particularly in one of my favourite economic newspapers, The Financial Times (http://www.ft.com/home/us). Regrettably, the American press is strangely silent about this potential economic nightmare.

Presidential candidates left and right are rushing to join the Stimulus Parade. The exception is Ron Paul, a little noticed Republican candidate, who seems to better understand this evolving economic crisis.

The real issue is no longer how to avoid a major recession in America – that recession regrettably is already inevitable, and it will be a worse one due to these ignorant doctors. The American population had been lulled into a comatose complacency by the previously escalating stock market and huge increases in house prices, which had made Americans feel rich; that false contentment has now given way to fear as housing prices and stock markets are falling.

Meanwhile, inflation has gained momentum and this unchecked rise of inflation will bedevil the US Government and US Federal Reserve years to come. We should pity the winner of the 2008 election, because he or she may get the worst economy since the one President Roosevelt inherited after the 1932 election.

But how does this all relate to the Big Debt Crisis? Very simply, when so much new money was created during the past 5 years at very low interest rates, lenders felt pressured to find a home, any home, for this ocean of excess liquidity. Credit standards were thrown out the window (e.g. subprime loans), since loans against houses were thought to be always collectible, even if the borrower was unable to pay. Now these bad loans are defaulting in catastrophic amounts and the entire financial system is in deepening danger.

Unfortunately, official government statistics are so distorted (please see my blog of June 9, 2007) that it will take a long while to unravel what has actually happened to the American economy. But at a minimum, the mighty American Dollar has been permanently devalued and de-throned as the world’s leading currency. America is now the world’s largest debtor nation, when a few decades back it was the world’s foremost lender.

Lowering interest rates and decreasing taxes will not stop this economic freefall for more than a brief time. The “doctors” are just printing more money and devaluing their currency still further. A far better course would be to take the painful medicine of an economic correction bravely and then to return to more disciplined economic practices.

Sound economic management would involve strictly controlling monetary growth, as has been done in Europe and elsewhere. It would mean encouraging higher personal saving for Americans, who have long had the lowest savings rate among industrial nations. It would also mean reigning in federal deficits. Balanced budgets these days are only political slogans; government projections always show the deficit disappearing in 5 – 10 years, but every year in fact the deficit continues to worsen.

Finally, the international trade balance really matters a lot. It is not good enough to blame this problem on lower wage counties like China and Mexico. Advanced nations have always needed to compete with poorer nations. America should stop whining and start producing goods and services that the world wants to buy.

There is much more to be said about sound management of an economy, but these are some of the core points. These structural changes could take up to a decade to accomplish. But unlike excessive monetary and fiscal stimulus, they would eventually produce a healthy economy.

(Note to readers outside of the USA: while the American recession will affect the whole world, it will not be nearly as intense in Canada, Europe and other soundly managed economies. But we should wish America well, since we will share some of its pain.)

Big Time Debt Crisis

The financial crisis that swept across America in 2007, and has now worsened in January 2008, seems very confusing. How could these subprime mortgage loans result in such a complete rout of the global stock markets and now also a looming American recession?

I have a special perspective on this financial situation, since my career included 25 years in banking. This emerging crisis began long ago and is the culmination of decades of bad choices by the financial community, particularly in America. The obsessive desire for short term gains to justify inordinate bonuses for CEO’s (and their supporting management) has finally brought us to a Day of Reckoning.

My post-graduate degree was from the “School of Hard Knocks” – on Wall Street in New York. I remember clearly my arrival to this new world. I had just graduated from Harvard University, where there were student demonstrations against the Vietnam War, idealistic concerns about poverty in America, and growing worries about the morality of the American government. Arriving at Wall Street in 1970, my angle of observation abruptly changed.

A crusty old banker gave us new management recruits a hypothetical challenge: we needed to bring in some new loans to increase the revenues at our bank in order to justify our salary. We needed to choose between lending to an unsuccessful businessman of good character, or else lending to a successful businessman who was totally unscrupulous.

It didn’t take long for our banking class to discern the “right answer”. Obviously, we could not get repayment on our loan by lending to an unsuccessful businessman, so damn the moral scruples and make the loan to the immoral client. (In my later banking career, I found out that both choices were equally bad.)

This vignette illustrates how little morality has ever counted on Wall Street. The only commandment they seemed to follow was Thou shalt not get caught! Virtually everyone worked exclusively for advantage to themselves, at the expense of everyone else. If there was a profit to made, that was sufficient justification for almost any conduct.

Despite this moral blind spot, Wall Street was an outstanding place to learn all about finance. People came from every continent to participate in this exciting marketplace. The New York technical expertise was unrivaled. In those days, it was truly the world’s financial Mecca.

However, there was one cloud in this brilliant sky in the 1970’s. It came from making large loans to poor nations (seemingly at a good profit.) I asked my bosses the innocent question of how these poor borrowing countries would ever be able to repay such giant loans. The executives retorted: “these loans will be refinanced, since a sovereign state can not possibly declare bankruptcy”. As it later turned out, my naive skepticism was prescient. When these loans eventually came due, there was indeed no refinancing available. This was the start of the Third World Debt Crisis, which lasted for decades, but which was small compared to the current financial problems.

In such a short space, I must oversimplify the current subprime situation to its central points. The engineers of these subprime loans correctly observed that mortgage loans have been remarkably solid historically in both good times and bad. Furthermore, the houses used as collateral have steadily risen in value, decade after decade. So why not offer these loans to a larger population including those without any credit history, since they would pay a premium rate to offset slightly higher anticipated loan losses?

What was left out of the equation was that the advent of vast sums of new mortgage credit would drive housing prices up sharply, until the housing bubble finally burst. That is what has now transpired. Many borrowers in America find they have mortgages which are bigger than the reduced value of their houses. Many of these people were already financially stretched when they applied for the subprime mortgages. So now the borrowers either walk away from their debt, or else their bankers call the mortgage loans, because the loans have gone into default.

There were other elements to this subprime situation, such as artificially low initial mortgage payments, which then rose sharply after a few years. But the central point is that these loans violated all reasonable credit standards. With the collapse of the housing market, the collateral is now inadequate as well.

Beyond subprime mortgages, creative financial engineering has created many other shaky financial debt structures, which are also collapsing like dominoes now. In aggregate, these additional classes of debt are bigger than the subprime loans. The largest financial institutions in America, and elsewhere, are facing the most severe crisis in confidence since the 1930’s. They are trying to raise new equity from foreign investors to stave off disaster. Who knows where this will all end.

(For those who read my blogs regularly, you may remember that I have been suggesting that a major correction is imminent in a number of my blogs last year, particularly the one entitled “A Hard Rain is A-Gonna Fall” on March 8, 2007)

But this is just half of the story of the Debt Crisis. The American Government had a major role in creating the conditions which brought this crisis about, so they deserve equal blame. I will explain that macro situation in a subsequent blog.